On August 29, 2023, Judge Katherine Polk Failla of the United States District Court for the Southern District of New York dismissed with prejudice a putative class action against a decentralized cryptocurrency trading platform and certain of its investors under Section 12(a)(1) of the Securities Act and Section 29(b) of the Securities Exchange Act. Risley v. Universal Navigation Inc., 2023 WL 5609200 (S.D.N.Y. Aug. 29, 2023). Plaintiffs alleged that they purchased fraudulent cryptocurrency tokens on the exchange. The Court held, assuming but not deciding that the tokens were securities, that plaintiffs failed to state a claim for rescission.
The Court explained that the cryptocurrency platform’s structure, which facilitates trades with the use of various self-executing “smart” contracts and pairs traders in a liquidity pool, prevented plaintiffs from identifying who issued the tokens that they purchased. Id. at *3–9. As the Court observed, “therein lies plaintiffs’ dilemma,” since plaintiffs were unable to seek redress from the issuers of the tokens themselves and instead were relegated to arguing that defendants should be liable for having facilitated the trades at issue, and that defendants “sold” plaintiffs the tokens by virtue of having established the smart contract structure through which plaintiffs obtained their tokens. Id. at *11. Plaintiffs also sought to hold defendants liable for making statements that the platform was “for many people,” “safe” to trade on, and for “transferring title” of the tokens in each liquidity pool to plaintiffs in violation of the Securities Act. Id.
The Court first explained that plaintiffs’ Section 29(b) claims failed because defendants merely created computer code to support the execution of smart contracts that governed transactions on the platform. Id. at *12. The Court distinguished those contracts from the contracts governing the tokens themselves—the smart contracts defendants created wrote code that allow the platform to operate, while the token contracts were drafted by the token issuers themselves and provided the terms of the sale of the token and the rights that transaction afforded. Id. at *13–14. The Court observed that defendants were not responsible for the token contracts but were merely responsible for designing protocols pursuant to which those contracts could be executed. Id. at *13. And the Court held that, even if defendants’ smart contracts were the applicable contracts governing the transactions and even if they could be rescinded, rescission would still not be warranted because the contracts were not unlawful on their face. Instead, the Court agreed with a decision issued by Judge Engelmayer (the subject of our prior post) and analogized that the smart contracts operated as a type of user agreement that was not a transaction-specific contract, but rather a series of protocols designed to provide for uniform transactions. Id. Because these smart contracts were able to be carried out lawfully to facilitate the exchange of cryptocurrencies, they were thus collateral to the fraudulent issuance of the tokens that plaintiffs purchased. Id. at *14.
The Court rejected plaintiffs’ analogy that failing to hold defendants liable would be like failing to hold liable a technology company that created self-driving cars that caused injuries regardless of whether the company was responsible for the flaws in the car. Id. The Court explained that this analogy failed because it presumed that defendants had caused plaintiffs harm by having created a system that could allow for fraud to occur, and thus was more like trying to hold a payment transfer platform liable for a drug deal where payment was facilitated by those means. Id. “There, as here, collateral, third-party human intervention causes the harm, not the underlying platform.” Id. The Court cautioned that the operation of such platforms could soon become the province of securities regulations, which counseled in favor of caution here. Id. at *15.
The Court next assessed plaintiffs’ Section 12(a)(1) claims. The Court rejected plaintiffs’ arguments that defendants were statutory sellers. Id. The Court specifically rejected the contention that simply because defendants designed protocols allowing the platform to operate meant that they passed title to the tokens to plaintiffs. Id. at *16. The Court noted adopting this rule would mean that any exchange that facilitated transactions could be held liable under Section 12(a)(1). Id. As the Court explained, just as those who “draft base-level agreements for traders to access the stock market” are not statutory sellers under the securities laws, neither are “software coders who create an exchange to efficiently facilitate trades. In both circumstances, the party sued facilitated—but was not party to—the contested transaction.” Id. To the extent that plaintiffs contended that there were moments where title was held by the software for an instant in the course of transitioning title automatically from one party to the other, that was not sufficient to create liability because the buyers did not in any meaningful sense purchase the security from defendants. Id. at *17–18. The Court also rejected plaintiffs’ suggestion that defendants sold, promoted, and/or solicited tokens to plaintiffs in order to increase the value of tokens defendants created, noting that plaintiffs only offered conclusory allegations that defendants actually sold, promoted, and/or sold the tokens, and didn’t even allege that such solicitation efforts were successful. Id. at *18. The Court reasoned by way of analogy that a stock exchange would not be liable for making statements that it is a safe place to trade. Id. at *19. The Court also emphasized that any allegations that defendants obtained some sort of profit from plaintiffs’ transaction fees that were paid in connection with the fraudulent transactions were also conclusory. Id.
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Risley v. Universal Navigation Inc.