A Connecticut jury recently held that four cryptocurrency related products were not “investment contracts,” providing crypto product issuers support that their cryptocurrency products may not be subject to state and federal securities laws. In Audet v. Fraser, No. 3:16-cv-940 (D. Conn. 2021), a class action was filed alleging that GAW Miners, LLC, ZenMiner, LLC, Homero Joshua Garza, and Stuart Fraser made false and misleading statements to investors about their cryptocurrency mining operations, bringing claims for violations of the Securities Exchange Act of 1934 and the Connecticut Uniform Securities Act. This case is significant as it is the first time a jury has reached a verdict on whether a cryptocurrency product is a “security” under the test set forth by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Thus, this verdict has wide-reaching implications in developing this area of the law.
In Audet, the defendants sold physical crypto mining hardware to investors who would use its computing power to mine for cryptocurrency. However, the defendants never had sufficient equipment to support the mining services. When unable to fulfill orders, the defendants then introduced “Hashlets,” which entitled the investors to a share of the profits from the defendants’ mining profits. The defendants sold far more Hashlets worth of computing power than they actually had in their computing centers. Once the Hashlets scheme unraveled, defendants pivoted and began selling “Hashpoints,” convertible promissory notes that could be converted into a new virtual currency called Paycoin. Paycoins could then be held in a digital wallet called “HashStakers.”
Whether the defendants violated securities laws depended on if the plaintiffs could prove that either of the four products offered were securities. Under federal law, the term “security” is broadly defined to include stocks, bonds, “investment contracts,” and numerous other types of securities. See 15 U.S.C. §§ 77b, 78c. Congress has not updated this definition to address the influx of digital products being issued today. As a result, courts rely on the Supreme Court’s Howey test to determine whether a digital product is an “investment contract” and, therefore, a “security” subject to securities laws requiring registration.
The key takeaways from this verdict include the following:
1) Injunction Defense Support: One of the Securities and Exchange Commission’s (“SEC”) weapons in its arsenal to prevent the issuance of a product is to obtain an injunction in federal court. In order to obtain an injunction, the SEC must show a substantial likelihood of success on the merits. Following the Audet verdict, a substantial likelihood of success may be difficult to prove.
2) Change in the Balance of Power: The verdict involved four different types of products. Given the victory on each product, cypto product issuers may be more inclined to litigate and resist enforcement.
Federal and state regulators continuously grapple with the question of whether a cryptocurrency product constitutes a security. The Audet verdict is instructive and may provide support for issuers in the near future.