Why a new class action against Block One presents new peril to the defendants that the SEC settlement did not resolve

I am going to talk about the new Block One lawsuit that was filed on Monday. To my surprise, it’s a doozy with potential teeth.

If you were surprised by the SEC’s handling/treatment of this ICO and the $24 million settlement of a billion dollar sale, this lawsuit could actually deliver. Before I get into the details, a quick diversion into law student memory tricks and basic federal court civil procedure is necessary.

Mnemonic devices are a law student’s friend. I suppose everyone learns differently, but these suckers really work for me. Thus, when cramming for a labor law exam years ago I learned that you can violate the National Labor Relations Act if you “irk” employees – that’s short for interfere with, restrain or k[c]oerce employees in the exercise of their protected rights under the act. A mnemonic that has come in significantly handier for me as a commercial litigator is one that deals with the requirements for certifying a class action. I learned in my first year civil procedure class and will never forget that a class action CAN’T be certified without Commonality, Adequacy, Numerosity and Typicality.

Over-simplifying so that you stay with me, the gist is that if you want a class action to be certified in federal court in the U.S., you need to show common factual/legal issues for the class, that the class representative is “adequate” (claims are like those of the rest of the class, not a criminal, etc.), that there are enough class members (usually 40+) that it’s more efficient to litigate as a class action, and that the claims are typical of class members as a whole.

Once you satisfy these four requirements, you have to show one of a couple of different things. One of which is that “questions of law or fact common to class members predominate over any questions affecting only individual members, and that a class action is superior to other available methods for fairly and efficiently adjudicating the controversy.” Not surprisingly, this is sometimes known as the “predominance rule”.

If you can’t show all of those things, no class action.

This brings me to the new Block.one lawsuit, filed against the company and several of its founders in a New York federal court on Monday of this week. The lawsuit is filed on behalf of a Crypto Assets Opportunity Fund, LLC. The defendants are Block One, Brendan Blumer, Daniel Larimer, Brock Pierce and Ian Grigg.

It’s a 47-page lawsuit and, as these things go, well-crafted. Workman-like, as we say, and premised on the argument that tokens sold by Block One were unregistered securities and their sale was fraudulent – based on "materially false and misleading statements[.]"

As the Complaint summarizes at its outset:

"This case arises out of a fraudulent scheme, fueled by a global frenzy over cryptocurrencies and unchecked human greed, to raise billions of dollars through sales of a cryptocurrency called EOS – an unregistered security – to investors in violation of the United States federal securities laws. To drive the demand for and increase profit from the sales of EOS Securities, Defendants further violated the securities laws by making materially false and misleading statements about EOS, which artificially inflated the prices for the EOS Securities and damaged unsuspecting investors."

Now, remember my mnemonic from above? CAN’T + predominance? Here’s one of the interesting parts of this lawsuit. In order to prove a securities fraud claim, you have to show that the investor relied on false or misleading statements made by or on behalf of the defendants. This creates a challenge in a securities fraud class action, where you have to show that a large class of people – most of whom are unknown to start – relied upon the same or similar statements in making their individual purchases, all with the same state of mind.

In the past, Courts had held that 10b-5 fraud claims weren’t really suitable for class actions because individual reliance decisions would predominate. This changed in 1988 when the Supreme Court, in case called Basic, Inc. v. Levinson, 485 U.S. 224 (1988), adopted something called the “Fraud on the market theory.” As the Court explained:

"The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company and its business. . . . Misleading statements will thereforedefraud purchasers of stock even if the purchasers do not directly rely on the misstatements. . . . The causal connection between the defendants' fraud and the plaintiffs' purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations."

As the Court explained again in 2014:

"...investors [can] satisfy this reliance requirement by invoking a presumption that the price of stock traded in an efficient market reflects all public, material information—including material misstatements. In such a case, we concluded, anyone who buys or sells the stock at the market price may be considered to have relied on those misstatements."

See Halliburton Co. v. Erica P. John Fund, Inc., 573 US 258 (2014)

This is a helpful presumption in a token sale ICO case like this one, where it could be difficult to otherwise tease out reliance on an individual basis. And that is one of the strategies employed by the plaintiffs in the Block One lawsuit, who allege in the complaint that they will rely on this presumption to prove reliance and that there was at all relevant times an “efficient market” for EOS securities.

This will, of course, be a fight, subject to motion practice, and there is no guarantee that Plaintiffs will win. But it’s a credible argument and put forth by lawyers who know what they are doing, so it’s not something to dismiss out of hand.

There are a couple of serious landmines for the defendants here. The first is that there has already been a settlement with the SEC and a public Order stating that the token Block One ICO token sale violated the Securities Act of 1933. There’s a legal concept known as collateral estoppel which says that if an issue is decided against you in one case, you can’t relitigate it later. Under the doctrine of non-mutual offensive collateral estoppel, a non-party to the first case can use it against you.

Thus, we can expect the plaintiffs here to say that the initial SEC administrative adjudication (taking the form of a consent order) should preclude the defendants from relitigating the issue. It’s a slightly more nuanced area of law when you are dealing with agency adjudication. And there’s some weasel-word language in the introduction that says that Block One is consenting to the order "without admitting or denying the findings" in it.

While I suppose anything is possible, I give the chance of a court deciding that the tokens weren't securities a chance of slim to none, and slim just left town.

Plaintiffs also point out a bunch of problems with governance, deployment and technology and alleged misstatements regarding those things. Those seem like issues that may be hard-fought, but do not pose immediate peril.

Here’s the more dangerous and expensive issue: Plaintiffs suggest that price was manipulated to create artificial demand by essentially recycling investor funds:

"Instead, throughout the duration of the EOS ICO, Defendants continuously withdrew funds from the funding wallet, beginning as early as five days after the beginning of the ICO. In total, Defendants permitted the funds to be withdrawn nearly a hundred times, accounting for close to 90% of the total funds raised throughout the ICO period and averaging one withdrawal every 3-4 days. While withdrawal of funds during an ICO is not expressly prohibited, there are significant concerns about how the withdrawn funds might be used, e.g., to buy tokens on cryptocurrency exchanges, resulting in artificially inflated demand for EOS, increasing market price, and fueling speculation and interest in the sale."

Assuming that the case makes it through initial motion practice and discovery is permitted, Plaintiffs will surely seek financial information regarding these withdrawals, including evidence to support a theory that defendants were unlawfully "painting the tape" to create a false perception of market demand and artificially inflating the market price of the tokens. I’d be speculating, but it’s not difficult to see state and federal regulators and law enforcement interested in such evidence (not to mention those outside of the US).

There’s a subjective factor that is probably worth pointing out as well.

When I look at a lawsuit, one of the things that I do is check out who the lawyers are and their level of experience. The lead counsel here are partners in a well-respected (and presumably well-capitalized) firm with high-quality securities class action experience. They are high-quality plaintiffs lawyers who appear to know what they are doing, and with resources to fight a protracted battle over what they claim is the biggest crypto fraud to date.

Bottom line: it’s a dangerous case for the defendants, without a lot of cruft, and one worth watching.