Indemnity, insurance and (Riot) blockchain

All business involves risk. This is true of blockchain and non-blockchain-related ventures. 

I’m going to get to a lawsuit involving one of the former in a second, but before doing that, I'd like to offer a few words on indemnity and hold-harmless clauses that will provide some useful context.

A variety of contractual mechanisms have developed over the millennia to manage this risk. One way to manage risk is to transfer it to your contractual counter-party in an indemnity or hold-harmless agreement. Allocating responsibility to third parties is an ancient concept, of which we can find evidence thousands of years ago – at least as early as this passage from the Book of Exodus:

"If a man causes a field or vineyard to be grazed, and lets loose his animal, and it feeds in another man’s field, he shall make restitution from the best of his own field and the best of his own vineyard." (Exodus 22:5, King James Version)

These fault-shifting mechanisms can both be implied or imposed by law, but have also over the ages been formalized in contracts.

Thus, for example, if a merchant agrees to buy a large number of floor tiles from a manufacturer, the contract might say that the manufacturer agrees to indemnify and hold harmless the seller from claims by third-party consumer purchasers arising out of defects in the tiles. On the other hand, the seller might agree to indemnify the manufacturer for claims by third-party consumer purchasers arising from defects in the tiles not present when delivered but arising out of acts, errors of omissions of the seller in the storage and delivery of the product. 

A huge body of law – both judge-made and statutory, and far too vast to cover in detail in this modest essay – has developed around indemnity agreements. Insurance is also frequently used to provide protection for all parties involved in a transaction and to cover the risk, cost and expense of indemnified claims.  Insurance and indemnity can serve a belt-and-suspenders function. You shift risk to a counter-party and then (hopefully) an insurance policy can be available to cover the cost and expense of covering indemnified claims.

This all leads me to a new lawsuit that was filed against Riot Blockchain by one Barry Honig and a company called GRQ Consultants, for whose Roth 501(k) plan he served as trustee. According to the lawsuit, the Defendant entered in a Securities Purchase Agreement (“SPA”) and Registration Rights Agreement (“RRA”) by which the plaintiffs made a $1.725 million investment into Riot Blockchain.  Per the Complaint, “[a]ll of the agreements contain robust indemnification provisions which require Defendant to defend and indemnify Mr. Honig and GRQ against any subsequent lawsuits or claims ‘with respect to any of the’ securities purchases that they made, and/or ‘any violation or alleged violation by [Defendant] of the Securities Act, [or] the Exchange Act.’”

Riot Blockchain was sued in 2018 in a number of lawsuits alleging that the securities transactions described in the RRA and SPA “were part of a scheme that violated securities laws.” Mr. Honig and GRQ were named in these lawsuits too, as well as in an SEC investigation.  The Complaint describes this as follows:

Every one of the complaints in the Shareholder Derivative Actions allege that Riot Blockchain, Mr. Honig, and various Riot Blockchain directors and officers committed violations of securities laws. Every one of the complaints in the Shareholder Derivative Actions alleges that Mr. Honig utilized acquisitions of Riot Blockchain stock to purportedly gain “control” over the company in order to engage in violations of securities laws. Certain of the complaints expressly allege that the purchase of the specific securities sold via the SPAs and RRAs played a part in this alleged fraudulent scheme.

In or around April 2018, the Securities and Exchange Commission (“SEC”) opened a formal order of investigation concerning Riot Blockchain, and issued subpoenas to various parties (the “SEC Investigation”).

In connection with the investigation, Mr. Honig provided extensive responses to document requests and voluntarily submitted to several days of interviews, among other things. 

According to the Complaint: “The SPAs and RRAs contain advancement and indemnification provisions pursuant to which Defendant agrees to indemnify and hold harmless Mr. Honig and GRQ from any expenses, including legal fees, incurred under certain conditions.” 

On this basis, Plaintiffs say they asked Riot Blockchain for indemnity and for advancement of unpaid expenses, including legal fees that they have already incurred, which already exceed $728,000. Nonetheless, Riot Blockchain refused the request, and this lawsuit followed.

Of course, we don’t have all of the inside baseball on negotiation between the parties here or on the merits of the indemnity demand. That said, the lawsuit does go to show that indemnity agreements are sometimes worth about as much as the paper that they are written on and in some cases you have to go to court to enforce them, whether or not the word blockchain is in your counter-party’s name.

Another way that an indemnity like this can be handled is by requiring that your counter-party secure directors and officers (sometimes referred as management liability) insurance coverage to provide coverage for things like shareholder derivative lawsuits and SEC Investigations. A good insurance policy from a financially sound insurer can provide significant protection in a case like this. Whether any of the parties have such insurance in place is not clear from the Complaint.

Another advantage to insurance is that it provides protection against a penurious indemnitor – that is, a counter-party who doesn’t actually have the money to live up to the indemnity they promised you.

How this all gets worked out, of course, remains to be seen. I read lawsuits like this and am reminded of the importance of belt-and-suspenders protection against risk like this – get the indemnity clause, for sure, but (where possible) get insurance to cover the risk too, and insist that your counter-party have it. 

It may be true that business is risk. Smart businesses, however, lay that risk off when they can, and insurance is one way to do so, whether you are buying and selling blockchain-related services or floor tiles.