February 13, 2023

2022 Year in Review: Digital Currency and Blockchain Litigation and Enforcement Developments

Throughout a tumultuous 2022, the digital currency and blockchain space saw a number of significant investigation, litigation, and enforcement matters as regulators continue their laser focus on the industry. This Year in Review, authored by members of Goodwin’s leading Digital Currency and Blockchain team, recaps the most significant litigation and enforcement developments from the past year.

Significant Developments in 2022

BlockFi Lending LLC (“BlockFi:) consistently made headlines in 2022.  It began in February 2022, when the U.S. Securities and Exchange Commission (“SEC”) charged BlockFi with failing to register the offers and sales of its crypto lending product. In this first-of-its-kind action, the SEC also charged BlockFi with violating the registration provisions of the Investment Company Act of 1940.

To settle the SEC’s charges, BlockFi agreed to pay a $50 million penalty; cease its unregistered offers and sales of the lending product BlockFi Interest Accounts; and attempt to bring its business within the provisions of the Investment Company Act within 60 days. To resolve parallel state actions announced the same day, BlockFi agreed to pay an additional $50 million in fines to 32 states to settle similar charges. BlockFi’s parent company also announced its intention to register the offer and sale of a new lending product under the Securities Act of 1933. To date, BlockFi has not been able to successfully register.

Then, in June 2022, BlockFi was confronted with a liquidity crisis caused by the collapse of crypto hedge fund Three Arrows Capital (“3AC”). In response, Sam Bankman-Fried, then-CEO of FTX Trading Ltd. (“FTX”),  offered BlockFi a liquidity life raft in the form of a $400 million credit line, which allowed BlockFi to continue its operations. But once FTX’s own liquidity issues were revealed, the BlockFi credit line disappeared. As a result, BlockFi voluntarily filed for Chapter 11 bankruptcy protection on November 28, 2022. Documents from the bankruptcy proceeding reveal that BlockFi had $415.9 million of its assets tied up with FTX and an additional $831.3 million in loans to Alameda Research LLC (“Alameda”).

As described further herein, BlockFi’s challenges over the past year demonstrate both the regulatory attention being paid to crypto products and how the interconnectedness of the crypto ecosystem can cause reverberations throughout the industry.

In May 2022, the algorithmic stablecoin of Terraform Labs, terraUSD (“UST”), lost its $1 peg. As UST token holders lost confidence, the value of UST’s companion token LUNA, which was meant to stabilize UST’s price, also fell precipitously. LUNA went from a high of almost $120 a token in March 2022 to being essentially worthless by May 16, after LUNA holders engaged in the crypto equivalent of a bank run.

Developed in 2018 by Stanford grad and former Apple and Google engineer Do Kwon, UST is a stablecoin that derives its value from algorithms linked to value of LUNA, as opposed to being backed by cash reserves or other tangible assets. The algorithm was designed to mint more LUNA to stabilize price if the value of UST were to go above $1, and vice versa. Under the model, holders could always redeem 1 UST to 1 LUNA. A series of events led to the depegging of UST, including large dumps of UST on Terra’s lending protocol, Anchor, and a stablecoin exchange protocol, Curve, which resulted in large amounts of LUNA being minted; failed attempts to defend the peg with BTC loans and buybacks; and, finally, the loss of investor confidence, resulting in a huge sell-off and swift drop in the price of LUNA. The crash wiped out tens of billions of dollars in value from the crypto markets and set off a panic cross the industry. In particular, the crash of LUNA contributed to the downfall of 3AC, once a high-profile crypto hedge fund. The demise of the fund, in turn, severely affected a number of crypto lenders, including BlockFi, from whom it had borrowed billions of dollars.

In September 2022, the Seoul Southern District Prosecutor’s Office issued arrest warrants for Kwon and other close affiliates, including the former head of research at Terra, Nicholas Platias, and staff member Han Mo. The individuals face charges of fraud and market manipulation in violation of South Korea’s Capital Markets Act, which regulates investment products. Interpol issued a Red Notice of Do Kwon’s arrest, but he has yet to be apprehended. He is currently believed to be hiding in Serbia.

On June 12, 2022, Celsius Network (“Celsius”), a cryptocurrency platform that offered, among other things, interest-bearing cryptocurrency accounts through its Earn program, announced it was pausing all customer withdrawals, swaps, and transfers, citing “extreme market conditions.” The following month, in July 2022, Celsius commenced voluntary Chapter 11 bankruptcy proceedings in the US Bankruptcy Court. In its initial bankruptcy filings, Celsius stated that it had anywhere between $1 billion and $10 billion in assets and liabilities and more than 100,000 creditors.

In September 2022, to fund its obligations to its secured creditors, Celsius sought to sell approximately $18 million worth of stablecoins from customers’ high-interest Earn accounts. After a series of disputes between the company and its customers over the ownership of customers’ deposited funds, the federal bankruptcy judge presiding over the Chapter 11 proceedings ruled that cryptocurrencies deposited into Celsius’ interest-bearing accounts belong to the network, not to customers. The court cited Celsius’ “unambiguous” terms of conditions, whereby any cryptocurrency assets deposited into Earn accounts became Celsius’ property. In particular, Celsius’ “clickwrap” terms of use—which the court found to constitute an enforceable contract between Celsius and its customers—specifically provided that customers “grant Celsius ... all right and title to such Eligible Digital Assets, including ownership rights” and the “right ... to pledge, re-pledge, hypothecate, rehypothecate, sell, lend, or otherwise transfer or use any amount of such Digital Assets ... with all attendant rights of ownership . . . and to use or invest such Digital Assets in Celsius’ full discretion.” For additional discussion of the implications of this opinion, see “Who Owns Digital Assets When a Cryptocurrency Platform Files Bankruptcy? The Terms of Use Answer the Question.”

According to the decision, Celsius can not only sell those stablecoins, but it also legally owns all cryptocurrencies currently sitting in customers’ Earn accounts. The court’s ruling affects approximately 600,000 accounts that held assets valued at $4.2 billion. These Earn customers will be treated as unsecured creditors in Celsius’ bankruptcy and consequently will stand in line for repayment behind Celsius’ higher-priority debts.

The decision highlights the importance—for both companies and the investing public—of understanding the ownership rights that may attach to platform deposits. While the decision related to digital assets in a bankrupt debtor may be one of first impression and is instructive in how custodial assets may be treated in other bankruptcy proceedings unfolding in the industry, including FTX, Voyager, and BlockFi, the underlying legal principles of contract law are not novel.

On June 1, 2022, the Department of Justice (“DOJ”) brought charges against Nathaniel Chastain, a former product manager at the OpenSea trading platform, for allegedly using OpenSea’s confidential business information to inform his trading in non-fungible tokens (“NFTs”). According to the indictment, Chastain would purchase NFTs that, by virtue of his position at that company, he knew would soon be featured on OpenSea’s homepage. Chastain allegedly knew that the value of the NFTs would increase significantly after they were featured. He took steps to conceal these purchases by using digital currency and anonymous OpenSea accounts to acquire the NFTs. Chastain would then allegedly sell the NFTs after they were featured, earning substantial profits. Based upon this alleged conduct, the indictment charged Chastain with one count of wire fraud and one count of money laundering, both of which carry a maximum sentence of 20 years.

In August 2022, Chastain filed a motion to dismiss the indictment. First, Chastain attacked the sufficiency of the evidence against him on both counts. With respect to wire fraud, he argued that the allegations were insufficient because confidential business information regarding which NFTs were to be featured was not technically “property” within the meaning of the statute. With respect to money laundering, he argued that because the Ethereum blockchain on which he executed the transactions is public, the DOJ cannot show the transactions were, in compliance with 18 U.S.C. § 1956(a)(1)(B)(i), “designed in whole or in part ... to conceal or disguise the nature, the location, the source, the ownership, or the control of the proceeds.” Second, Chastain attacked the sufficiency of the indictment, arguing that he could not be charged with “insider trading” because the DOJ did not allege that the NFTs were either securities or commodities.

In an order issued on October 21, 2022, Judge Jesse Furman of the Southern District of New York denied Chastain’s motion. First, Judge Furman found that while prosecutors may not be able ultimately to prove that the business information regarding NFTs is “property” or that Chastain engaged in money laundering conduct, those arguments are not appropriate to resolve on a motion to dismiss and must instead be presented to a jury. Second, Judge Furman stated that the wire fraud section under which Chastain was charged did not require the government prove that any security or commodity was at issue because the statute (18 U.S.C. § 1343) never refers to securities or commodities. Accordingly, the indictment’s allegations were sufficient.

The importance of the court’s order is twofold. Primarily, it demonstrates the DOJ’s willingness to pursue illicit trading activities or market manipulation in digital assets without taking the step of alleging that the assets are securities or commodities. However, the order also reveals some potential weaknesses in the government’s theories. As Judge Furman concedes, Chastain’s first two arguments—one of which hinges on the concept of property and the other of which hinges on the public nature of the blockchain—“have some force.”

Regardless of the outcome, this action should cause crypto companies throughout the industry to reexamine what might be considered material nonpublic information in the possession of its employees and adjust their conflict of interest and trading policies to mitigate the risks inherent in the misuse of such information.

On July 1, 2022, 3AC, a Singapore-based hedge fund focused on digital asset investment strategies, filed for bankruptcy, representing a stunning fall from grace. At its peak, 3AC was one of the most prominent hedge funds in the industry. It managed approximately $18 billion in cryptocurrency assets, which it amassed due, in part, to early investments in successful projects such as Ethereum and Avalanche. But in May 2022, the collapse of UST and LUNA had ripple effects across the industry, including contributing to 3AC’s ultimate collapse.

3AC had borrowed from institutional lenders and used funds for large investments, including in investments in UST/LUNA, hoping to make money on arbitrage positions. In a comment to The Wall Street Journal in June 2022, 3AC stated that it had invested $200 million in LUNA, but other industry reports estimated the fund’s exposure at closer to $560 million. Regardless of the actual amount, when LUNA failed, 3AC’s investment was rendered worthless. And when 3AC’s lenders made a flurry of margin calls, 3AC was unable to meet the demands; the money was not there. The exposure to 3AC had a catastrophic impact on other crypto lenders, many of whom suffered losses and eventually had to file for bankruptcy.

On June 27, 2022, a court in the British Virgin Islands ordered 3AC to liquidate its assets. A few days later, in July 2022, 3AC filed for bankruptcy under Chapter 15 of the U.S. Bankruptcy Code. Shortly thereafter, lawyers representing 3AC’s co-founders Su Zhu and Kyle Davies reported to the US Bankruptcy Court that the co-founders’ physical whereabouts were unknown. To add to 3AC’s woes, according to an October 2022 report by Bloomberg, both the Commodity Futures Trading Commission (CFTC) and SEC are investigating whether the fund misled investors about its balance sheet and failed to register with the two agencies. Most recently, multiple news outlets reported on January 16, 2023, that Zhu and Davies are seeking to raise approximately $25 million for a new crypto exchange, called GTX, that would allow creditors to buy and sell claims on bankrupt cryptocurrency companies, including 3AC.

On July 21, 2022, the DOJ announced the indictment of the three individuals on charges of wire fraud and conspiracy to commit wire fraud arising out of an alleged scheme to trade ahead of announcements regarding crypto assets being listed on Coinbase, a major digital asset exchange for which one of the defendants served as a product manager. That same day, the SEC charged the individuals with insider trading of digital assets, based upon the same underlying conduct.

In its initial complaint, the SEC identifies nine particular digital assets that the SEC alleged were “crypto asset securities” and sets forth allegations as to why each of the nine assets constitutes an unregistered security under the test articulated in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). It is unclear from the record whether the SEC had engaged with any of the issuers of the identified assets prior to filings its enforcement action. For additional discussion of the SEC’s complaint, please see “SEC Alleges ‘Crypto Asset Securities’ Insider Trading; Case Has Significant Implications For The Digital Asset Industry.”

In December 2022, the SEC amended its complaint, updating its charges to allege conduct regarding “more than 60” digital assets and described the use of surreptitious means of transferring funds, including through anonymous pass-through wallets and the use of WhatsApp chat exchanges on a foreign phone. The SEC also added additional detail based upon tracing analysis of wallet and IP addresses. In September 2022, one of the co-defendants, Nikhil Wahi, pled guilty to conspiracy to commit wire fraud in the criminal action. On January 10, 2023, he was sentenced to 10 months in prison with two years’ supervised release. On February 7, 2023, one of the other co-defendants, Ishan Wahi, pled guilty to two counts of conspiracy to commit wire fraud in the criminal action.

This case provides yet another example from this past year of the DOJ’s strategy of pursuing insider trading charges in digital assets based upon the wire fraud statutes, rather than alleging that the underlying assets are securities or commodities. The SEC action, on the other hand, presents another example of the agency’s strategy of providing guidance through enforcement, rather than engaging directly with the underlying token projects about what constitutes a security.

In September 2022, the CFTC brought a first-of-its-kind enforcement action, seeking to hold participating members of the OoKi Protocol (“Ooki DAO” or the “Protocol”), a decentralized autonomous organization (“DAO”), liable for alleged violations of the Commodity Exchange Act (“CEA”) and CFTC regulations. The alleged violations include failing to register OoKi’s platform and failing to conduct required customer due diligence. On the same date that it filed the complaint, the CFTC announced a settlement and consent order with the predecessor to Ooki, bZeroX, LLC, and its two founders, Tom Bean and Kyle Kistner. The CFTC’s consent order held the two founders of bZeroX, LLC responsible for the actions of the Protocol. With regard to the individual participating members in the DAO, the CFTC’s complaint attacks and tests the DAO structure, which the CFTC alleges is an unincorporated association comprising token holders that used their tokens to govern the Protocol by voting for Protocol decision making. In particular, the CFTC alleged that the DAO is an unincorporated association; that on the basis of state law principles, individual members of an unincorporated association can be found liable for the debts of the association; that participating members of the DAO (i.e., token holders that actually voted their tokens) have directed the operations of the DAO; and that therefore those members can be held liable for the DAO’s alleged violations of the CEA and CFTC regulations. For additional discussion of the complaint, please see “CFTC Attempts to Extend Liability to DAO Participants.”

In December 2022, Judge William Orrick in the Northern District of California permitted the CFTC to avoid traditional “personal” service of the complaint on the OoKi DAO. Instead, the CFTC requested that it be permitted to serve the complaint “‘via the online mechanisms the Ooki DAO has created to allow itself to be contacted by the public,’ namely a ‘Help Chat Box’ and ‘an online discussion forum’ on its public website.” In making this request, the CFTC asserted that the Ooki DAO was structured as a DAO with the intent to thwart enforcement actions by having no person or traditional entity that could be subject to regulatory oversight or enforcement.

Judge Orrick issued an order granting the CFTC’s motion for alternative service on Ooki DAO and allowing the CFTC to sue it as an unincorporated association. Judge Orrick’s ruling had several key takeaways:

  • Judge Orrick found Ooki DAO was not just software, but rather an unincorporated association because the DAO held the keys to control and govern the Protocol. Under California law, an unincorporated association can be sued. Judge Orrick rejected arguments by amici that Ooki is a technology and not an unincorporated association. The court found that the Protocol was developed by individuals who controlled it, and then turned over control of the Protocol to its token holders. Following the reasoning of this ruling, we should expect DAOs to continue to be sued as unincorporated associations, particularly in California. 
  • Judge Orrick found that the service through OoKi DAO’s Help Chat Box and an online discussion forum on its public website constituted both actual notice and the best notice practicable under the circumstances. This finding was based in part on a post appearing on OoKi DAO’s discussion forum that referenced the litigation and discussed next steps. Judge Orrick found this to be evidence that the DAO had received the complaint. 
  • A prior hearing, wherein Judge Orrick ordered service on the founders of bZeroX, LLC, also found that service on the two founders, as individuals that who hold a token, constituted service of the DAO.

These findings have clear implications for those interested in becoming part of a DAO or those already part of one. It is clear that at least one court will seek to create means to effectuate enforcement mechanisms where none previously existed, on a DAO not previously considered a legal entity capable of suing or being sued, exposing individuals to liability in a manner that is unprecedented in the space.

On November 7, 2022, Judge Paul Barbadoro of the United States District Court for the District of New Hampshire granted the SEC’s motion for summary judgment against LBRY, Inc., a New Hampshire-based software company that issued a digital asset called “LBRY Credits” or “LBC” to support its blockchain-based video sharing application.

The SEC’s complaint charges LBRY with conducting an unregistered offering and sale of crypto asset securities, alleging that, from at least July 2016 to February 2021, LBRY sold a “crypto asset security” LBC to numerous investors, including investors based in the United States, resulting in more than $12.2 million in profits. The SEC’s motion focused primarily on two aspects of LBRY’s alleged conduct. First, it pointed to multiple statements made by LBRY representatives, dating back to 2016, that discussed LBC’s “skyrocketing value” and “long-term value proposition,” and encouraged token holders to “hold on” to their LBC, reasoning that the credits will “appreciate accordingly” once LBRY further develops the project. Second, the SEC pointed to LBRY’s retention of hundreds of millions of LBC in its own coffers as motivating its efforts to promote and improve the value of the blockchain for itself and LBC holders.

On summary judgment, LBRY argued that LBC is not a security but rather an “essential component” of the LBRY blockchain; that LBRY had expressly warned in its marketing materials that LBC was not being offered as an investment; and that purchasers of LBC acquired it at least in part with the intention of using the assets for its utility on the platform. LBRY separately argued that the SEC’s attempt to treat LBC as a security violates its right to due process because the agency did not give LBRY “fair notice” that its offering would be subject to the securities laws.

The court found that the LBRY statements identified by the SEC were representative of LBRY’s “overall messaging about the growth potential of LBC” and reasoned that potential investors would understand that LBRY “was pitching a speculative value proposition for its digital token.” Furthermore, the court found that by retaining a significant number of LBC tokens, “LBRY made it obvious to investors that it would work diligently to develop the network.” The court rejected LBRY’s reliance on the disclaimers in its marketing materials, reasoning that a disclaimer cannot undo the objective realities of the transaction. The court similarly rejected LBRY’s arguments about the consumptive purpose of its token, reasoning that the fact that some token holder may have purchased for LBC’s utility “does not change the fact that the objective realities of LBRY’s offerings of LBC establish that it was an offering of a security.” Finally, the court rejected LBRY’s fair notice argument, finding that the SEC “based its claim on a straightforward application of a venerable Supreme Court precedent [stated in Howey] that has been applied by hundreds of federal courts across the country for more than 70 years.”

The court found that LBRY violated the charged provisions and reserved the determination of relief for a later date. The SEC seeks permanent injunctive relief, disgorgement plus prejudgment interest, and civil penalties. The court held a remedies hearing on January 30, 2023. During the hearing, the judge indicated that he was inclined to grant a “tier 1” fine, emphasizing that LBRY had conducted all of its business transparently and that there were no allegations of any fraudulent conduct. The judge also acknowledged that, while he rejected LBRY’s notice defense, it was not lost on the court that this was among the first actions brought in a non-ICO case. Finally, the court said on the record that he was not inclined to give an injunction that can be applied to secondary market sales. The judge otherwise reserved decision to allow the parties to engage in further discovery to support the appropriate disgorgement amount. The court’s order will be forthcoming.

While the LBRY decision provides additional insights for market participants in determining which digital assets may constitute a security, the court’s ruling is not likely to be outcome-determinative because the assessment of each digital asset still necessarily depends on the facts and circumstances particular to that case. And particularly where token issuances are seldom conducted in the model used by LBRY, this ruling is unlikely to have direct implications of token issuers structuring their offerings in 2023. That said, the court’s ruling in the SEC’s favor on summary judgment will inevitably have the practical implication of further emboldening the SEC in pursuing Section 5 violations against other issuers, and particularly in seeking to challenge the “fair notice” defense. On the other hand, assuming the court’s eventual remedies ruling confirms that the injunction will not extend to secondary market sales, this would be a significant win for the crypto industry. Such a ruling would lend further credence to the argument that marketplace-based secondary transfers of these assets do not create investment contract transactions. Notwithstanding what might be an industry win based on this potential outcome, the positive impact may be limited in light of the SEC’s attempts—demonstrated in Ripple and Wahi—to create a new class of security (without any basis in the law or rules) that they have dubbed a “crypto asset security,” which appears to ignore the Howey factors in favor of a newly enumerated security category applicable to the tokens themselves.

In November 2022, FTX and Alameda, the digital assets companies founded by Sam Bankman-Fried (“SBF”), suddenly collapsed. These failures have led to numerous US and international criminal and regulatory investigations and charges, including against SBF individually. What follows is a summary of a few of these actions.

Department of Justice. The US Attorney’s Office in the Southern District of New York charged SBF with conspiracy to commit wire fraud, wire fraud, conspiracy to commit commodities fraud, conspiracy to commit securities fraud, conspiracy to commit money laundering, and the unusual charge of conspiracy to defraud the Federal Election Commission (“FEC”) and commit campaign finance violations due to campaign donations he allegedly made in excess of the FEC’s contribution limits, in part from using other peoples’ identities for such donations. The government’s charges allege an intentional scheme by SBF to steal billions of dollars of customer funds deposited with FTX and mislead investors and lenders to FTX and Alameda. SBF is out pending bail, and a number of other FTX and Alameda executives are cooperating with the government.

U.S. Securities and Exchange Commission. The SEC charged SBF based upon his alleged scheme to defraud equity investors in FTX Trading Ltd. The nature of the alleged fraud is that in raising approximately $1.1 billion from approximately 90 US-based investors, SBF promoted FTX as a safe, responsible crypto asset trading platform, specifically touting FTX’s sophisticated, automated risk measures to protect customer assets. The complaint alleges that the representations were false and that SBF concealed from FTX’s investors “the undisclosed diversion of FTX customers’ funds to Alameda Research LLC, his privately held crypto hedge fund; the undisclosed special treatment afforded to Alameda on the FTX platform, including providing Alameda with a virtually unlimited ‘line of credit’ funded by the platform’s customers and exempting Alameda from certain key FTX risk mitigation measures; and the undisclosed risk stemming from FTX’s exposure to Alameda’s significant holdings of overvalued, illiquid assets such as FTX-affiliated tokens.” Additional allegations include that SBF used commingled FTX customers’ funds at Alameda to make undisclosed venture investments, lavish real estate purchases, and large political donations.

The SEC complaint filed in parallel with the announcement of the DOJ action was not a surprise, and with the filing of the complaint, SEC Chair Gary Gensler sent another warning to crypto platforms: “To those platforms that don’t comply with our securities laws, the SEC’s Enforcement Division is ready to take action.”

Commodity Futures Trading Commission. The CFTC, not to be outdone, also filed fraud charges against SBF, FTX, Alameda, Caroline Ellison (Alameda’s CEO), and Gary Wang (Alameda and FTX co-founder). Of particular interest are the allegations against Ellison and Wang. The CFTC alleges that beginning in October 2021, Ellison was co-CEO of Alameda, later sole CEO, and—along with SBF and others—directed Alameda to use billions of dollars of FTX funds, including FTX customer funds, to trade on other digital asset exchanges and to fund a variety of high-risk digital asset industry investments. The CFTC also alleged that Ellison made deceptive public statements, including statements regarding the supposed separation between the operations of Alameda and those of FTX.

Interestingly, the CFTC further alleges that Wang created features in the code underlying the FTX trading platform that effectively created a “back door,” which allowed Alameda to maintain a nearly unlimited line of credit on FTX. Similarly, it is alleged that SBF directed FTX executives, including Wang, to create other exceptions to FTX’s standard processes that allowed Alameda to have an unfair advantage when transacting on the platform, thus permitting Alameda to secretly siphon FTX customer assets from the FTX platform.

Ellison and Wang are in the process of resolving the claims against them with the SEC and with the CFTC.

Reach Out With Questions

Goodwin’s global team includes highly regarded advisers with expertise in the key areas impacting players in the crypto and digital asset space. For any questions related to the updates mentioned above, or for more information about how these developments are affecting the market in 2023, please reach out to the authors of this Year in Review or another member of Goodwin’s Digital Currency and Blockchain team.