A federal court’s dismissal of claims against a decentralized cryptocurrency platform and its investors for the actions of fraudulent token issuers is a case of first impression of broader scope.
On August 29, 2023, the United States District Court for the Southern District of New York rejected a proposed class action against Uniswap Labs and its CEO, its foundation and three venture capital backers(1) (the Defendants) brought by plaintiffs seeking damages for alleged exposure to fraudulent tokens from anonymous third-party token issuers on the Company’s decentralized cryptocurrency trading protocol.
In April 2022, the plaintiffs filed a proposed class action lawsuit, claiming they lost money after investing in what turned out to be various fraudulent tokens on the Uniswap protocol, one of the world’s leading trading protocols. largest decentralized cryptocurrencies in the world. Given the decentralized nature of Uniswap, the plaintiffs were unable to identify the issuers of the fraudulent tokens and therefore targeted the defendants in their lawsuit.
The plaintiffs alleged that the defendants knew about the scams taking place on Uniswap, but ignored them to take advantage of the liquidity fees involved in minting and trading tokens on the protocol. By providing a marketplace for buyers and sellers, assisting in the drafting of smart contracts, and owning governance tokens, the plaintiffs alleged that the defendants “facilitated” these fraudulent transactions. Plaintiffs have asserted numerous causes of action, including violations of the Securities Exchange Act of 1934 (Exchange Act), Sections 5, 15(a)(1), 20, and 29(b); the Securities Act of 1933, Sections 5 and 12(a)(1); and various state law claims – basically alleging that Defendants operated an unregistered exchange and promoted, offered and sold unregistered securities in the form of cryptographic tokens.
District Judge Katherine Polk Failla granted the defendants’ motions to dismiss with prejudice, finding that the plaintiffs failed to assert a claim under the federal securities laws and declining to exercise additional jurisdiction over the others state legal claims. Recognizing that the case raised questions of first impression, the court rejected the plaintiffs’ attempt to impose liability under the federal securities laws on developers and investors in a decentralized cryptocurrency trading protocol, even assuming, for the purposes of the motion, that the tokens at issue were qualified. as titles.
Key questions and titles
The court addressed two key questions:
- whether Defendants operated an unregistered securities exchange and/or acted as unregistered broker-dealers in violation of the Exchange Act; And
- whether the defendants “sold” the fraudulent tokens within the meaning of the Securities Act.
The plaintiffs initially asserted that the transactions with the fraudulent tokens were subject to reversal under Section 29(b) of the Exchange Act, based on the defendants’ alleged operation of an exchange not registered in violation of Section 5 of the Foreign Exchange Act, and/or Defendants. alleged conduct as unregistered broker-dealers, in violation of Section 15(a)(1) of the Exchange Act. Specifically, the plaintiffs alleged that the defendants entered into contracts with the plaintiffs to the extent that (i) the Uniswap protocol requires its users to buy and sell tokens using its smart contracts (i.e. the base contracts and the router contracts) to finalize transactions; (ii) the plaintiffs traded fraudulent tokens on the Uniswap protocol, thereby agreeing to these contracts; and (iii) the plaintiffs paid fees for each transaction carried out in accordance with the terms of the smart contracts.
In dismissing the exchange and broker’s unregistered claims, the court found that it “defies logic that a writer of computer code underlying a particular software platform could be held liable under the section 29(b) of the misuse of this platform by a third party”.(2) The court highlighted the difference between the fundamental contracts that underpin Uniswap and token contracts that are unique to each token and entered into directly between the buyer and seller.(3) The court ultimately concluded that the fundamental contracts of the Uniswap protocol were collateral for the fraudulent tokens; the founding contracts could themselves be legally enforced and therefore could not be terminated under section 29(b).(4) The court likened the plaintiffs’ allegations to trying to hold peer-to-peer payment apps “liable for a drug trafficking operation that used the platform to facilitate a transfer of funds.” (5) In both cases, it was the actions of independent third parties that caused the harm rather than the platform they were using.
Next, the court rejected the plaintiffs’ argument that developers or investors can be held liable for “selling” tokens to plaintiffs under Section 12 of the Securities Act. There are two ways to establish liability as a “seller” under Article 12:
- if a defendant transfers title or other interest in a security to the buyer for value; Or
- if a defendant successfully solicits the purchase of a security, motivated at least in part by his or her own financial interests or those of the owner of the securities.(6)
The court rejected both theories, noting that the scope of Section 12 does not extend to include participants who are guarantors of the offer or sale of securities, such as those who merely facilitate the disputed transaction. “Just as Section 12(a)(1) does not apply to those who draft basic agreements allowing traders to access the stock market, it does not apply to software coders who create an exchange to efficiently facilitate transactions.”(7)
With respect to the transfer of title, the plaintiffs alleged that the defendants drafted, controlled and maintained the smart contracts for the liquidity pools, that the tokens were held in these liquidity pools, which facilitated the token sales, and that the defendants had therefore necessarily transferred title to the property. tokens to the plaintiffs. In rejecting this argument, the court analyzed the role of liquidity pools, ultimately determining that even if title passed from the pool to the Uniswap protocol to the plaintiff, “this split-second autonomous function would make the protocol a guarantee for the transaction “. .”(8)
With respect to solicitation, Plaintiffs allege that Defendants sold, promoted, and/or solicited the Tokens directly to Plaintiffs in an attempt to increase the value of their Governance Tokens (UNI). In support of this claim, the plaintiffs relied on comments on social media suggesting that the Uniswap protocol was “secure” and “for many people.” The court found this argument too attenuated to make a claim,(9) analogizing the DeFi protocol to centralized exchanges: “no plaintiff would sue the New York Stock Exchange or NASDAQ for tweeting that its exchange was a safe place to trade after that plaintiff lost money due to NASDAQ’s fraudulent schemes.” an emitter. »(ten)
Finally, the court dismissed plaintiffs’ controlling person claims based on their failure to disclose material violations of the federal securities laws.(11) In rejecting the controlling person’s claims on this basis, the court did not resolve the extent to which ownership of governance tokens or participation in the development of codes or platforms, as plaintiffs claim in their appeal to the three venture capital defendants, could lead to potential liability of the controlling person. .
Impacts on the digital assets sector
The dismissal of the plaintiffs’ claims is good news for developers of decentralized protocols as it clarifies – at least based on the allegations at issue – that they are not responsible for transactions made by others on the protocols that they developed.
The court did not address the underlying securities law issues of whether the defendants operated an unregistered securities exchange or acted as unregistered broker-dealers, instead assuming that they were for purposes of analysis and concluding that the plaintiffs’ claims had failed even if they were. The applicability of these recording categories to centralized exchanges is the subject of several active cases involving other industry players. Their application to a DeFi protocol like the one at issue in this case can also be tested.
An interesting saying in this case is the court’s characterization of ether (ETH) as a commodity.(12) William Hinman, former SEC director of corporate finance declared its view in 2018 that ETH was a commodity and therefore sales were not subject to securities laws, and the CFTC itself referred to ETH as a commodity.(13) Subsequent statements by current SEC Chairman Gary Gensler, however, have called this conclusion into question. This additional support for the characterization of ETH as a commodity will be welcomed by the digital asset community, especially those working to decentralize their own tokens.
Although the court’s rulings in this district court case will not be binding on other courts, the decision carries weight as part of a growing body of cases showing that courts may be reluctant to impose liability when responsibility is not clearly stated in the current statutes.
While understanding the plaintiffs’ losses, the court found that they were “looking for a scapegoat for their claims because the defendants they are actually seeking are not identifiable.” The court noted that legislative gaps may have contributed to the current state of confusion regarding oversight and accountability in the digital asset sector: “The current state of cryptocurrency regulation leaves (plaintiffs) without recourse, from less so with regard to the specific allegations alleged in this case. suit.” “Plaintiffs’ concerns,” Judge Failla concluded, “are better addressed to Congress than to this Court.” On this front, a series of far-reaching legislative proposals have emerged over the course of in recent years to close regulatory gaps in digital asset markets, although none has yet garnered the bipartisan support needed for enactment.
(1) Latham represented Andreessen Horowitz (a16z), one of the venture capital defendants, in the litigation.
(2) Slide. at 31.
(3) Slide. at 32-33.
(4) Slide. Op. at 35 years old.
(5) Slide. at 37.
(6) Slide. at 39 (citations omitted).
(7) Slide. Op. at 41 years old.
(8) Slide. Op. at 44 years old.
(9) Slide. Op. at 46 years old.
(ten) Slide. Op. at 46 years old.
(11) Slide. at 49.
(12) Slide. Op. at 35 years old.