The organizers of an initial coin offering (ICO) recently won dismissal of an investor’s fraud claims by establishing that their public risk disclosures negated the investor’s claims of reliance on alleged misstatements.  The project, a video service provider’s ICO, was governed by a purchase agreement called a “Simple Agreement for Future Tokens” (“SAFT”).   The plaintiff investor later lost his entire investment as the token collapsed, allegedly due to the provider’s decision to scrap its initial plans for a decentralized platform and move to a permissioned blockchain (and also the provider’s choice to seek additional capital via a “Regulation A” public offering).  The New York court found that even if certain representations made by the issuer regarding the prospect of a decentralized network were actionable, the Plaintiff had not plausibly alleged  “reasonable reliance” on such representations in signing the SAFT. (Rostami v. Open Props, Inc., No. 22-03326 (S.D.N.Y. Jan. 9, 2023)).

Demand for virtual currency services, including custody services, has soared in the past several years.  Like their counterparts in traditional finance, these custodians are stewards of retail and institutional customer funds and serve an important and valuable function.  However, as evidenced by a number of headline-grabbing failures during the lingering crypto winter, inadequate disclosures and poor custodial practices can seriously harm retail and institutional customers alike.  For many virtual currency customers, this recognition – in an industry built on the pillars of trust and transparency – was realized too late.  Recent disclosures emerging from notable bankruptcies involving crypto companies have led to allegations of fraud and mismanagement in connection with custodial services.  These allegations strike at the very core of the custodial relationship, and have had repercussions throughout the crypto industry.

Seemingly in direct response to these developments, on January 23, 2023, the New York Department of Financial Services (“NYDFS”) issued industry guidance to Virtual Currency Entities (“VCEs”) who act as custodians (“VCE Custodians”).  Entitled “Guidance on Custodial Structures for Customer Protection in the Event of Insolvency” (the “Guidance”), the Department emphasized the “paramount importance of equitable and beneficial interests always remaining with the customer” and reminded covered institutions of their obligations in connection with “sound custody and disclosure practices in the event of an insolvency” or similar proceeding.

The Guidance comes on the heels of developments in two high-profile insolvency proceedings: (1) the FTX proceedings, where, among others, the SEC has alleged co-founder Samuel Bankman-Fried concealed the diversion of FTX customer funds to the co-founder’s private crypto hedge fund, and (2) the Celsius proceedings, where the chief judge for the United States Bankruptcy Court for the Southern District of New York issued a decision holding that Celsius’ Terms of Use made clear that customer deposits into Earn Accounts became Celsius’ property at the time of deposit, such that the digital assets now constitute property of the debtors’ bankruptcy estate.  In Celsius, customers argued that the deposits in the Earn Accounts were held by Celsius as a custodian, but the court found that the plain language of the Terms of Use made clear that ownership interest had passed to the debtors.

This past month, a California district court granted a motion to compel arbitration of various claims by customers of cryptocurrency exchange platform, Coinbase Global, Inc. (“Coinbase”), finding that Coinbase’s User Agreement, which contains a broad arbitration provision, including a delegation clause that delegates questions of arbitrability to the arbitrator.  (Donovan v. Coinbase Global, Inc., No. 22-02826 (N.D. Cal. Jan. 6, 2023)). Unlike some electronic contracting disputes, which turn on whether the user had adequate notice of the terms and manifested consent to such terms (a ruling which often involves an examination of a site or app’s screen display and whether the user is reasonably presented with notice that completing a transaction will bind the user to terms of service), the account holders in this case did not dispute that they had agreed to the User Agreement, rather they argued that the arbitration provision and delegation clauses were unconscionable and unenforceable.