The dismissal by a federal court of claims against a decentralized cryptocurrency platform and its investors over the actions of fraudulent token issuers is a case of first impressions of major importance.
On August 29, 2023, the U.S. District Court for the Southern District of New York dismissed a proposed class action lawsuit against Uniswap Labs and its CEO, foundation and three venture capitalists[1] (the Defendants) were filed by plaintiffs seeking damages for alleged exposure to fraud tokens originating from anonymous third-party token issuers on the Company’s decentralized cryptocurrency trading protocol.
background
In April 2022, plaintiffs filed a proposed class-action lawsuit alleging that they lost money after investing in various scam tokens on the Uniswap protocol, one of the world’s most prominent decentralized cryptocurrency trading protocols. Due to the decentralized nature of Uniswap, the plaintiffs were unable to identify the issuers of the fraud tokens and therefore directed their lawsuit against the defendants.
The plaintiffs claimed that the defendants knew about the scams on Uniswap but ignored them in order to benefit from the liquidity fees associated with minting and exchanging tokens under the protocol. By providing a marketplace for buyers and sellers, assisting in the creation of smart contracts, and owning governance tokens, plaintiffs claimed that defendants “facilitated” these fraudulent transactions. Plaintiffs have asserted numerous causes of action, including violations of Sections 5, 15(a)(1), 20 and 29(b) of the Securities Exchange Act of 1934 (Exchange Act); the Securities Act of 1933 (Securities Act), Sections 5 and 12(a)(1); and various state legal claims – essentially, the defendants allege that they operated an unregistered exchange and promoted, offered and sold unregistered securities in the form of crypto tokens.
District Judge Katherine Polk Failla conditionally granted the defendants’ motions to dismiss, finding that the plaintiffs had failed to assert a claim under the federal securities laws and declined to exercise supplementary jurisdiction over the remaining claims under state law . Acknowledging that the case raises first impression issues, the court dismissed the plaintiffs’ attempt to impose liability under the federal securities laws on developers and investors in a decentralized cryptocurrency trading protocol, even if, for purposes of the motion, they assumed that the tokens in question qualify as securities.
Key themes and stocks
The court dealt with two key questions:
- whether the 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 fraud tokens within the meaning of the Securities Act.
Registration
Plaintiffs first alleged that transactions involving the scam tokens could be reversed under Section 29(b) of the Exchange Act, based on the defendants’ alleged operation of an unregistered exchange in violation of Section 5 of the Exchange Act and/or Defendants’ allegation of alleged conduct as an unregistered broker-dealer in violation of Section 15(a)(1) of the Exchange Act. Specifically, Plaintiffs alleged that Defendants entered into contracts with Plaintiffs to the extent that (i) the Uniswap protocol requires its users to buy and sell tokens using its Smart Contracts (namely, the Core Contracts and Router Contracts) in order to complete the transactions; (ii) Plaintiffs traded fraud tokens through the Uniswap protocol, thereby agreeing to these contracts; and (iii) the plaintiffs paid fees for each transaction they performed under the terms of the smart contracts.
In dismissing the unregistered exchange and broker-dealer lawsuits, the court ruled that it “is contrary to logic for an author of computer code underlying a particular software platform to be liable under Section 29(b) for misusing that platform by Third parties could be held liable.”[2] The court emphasized the difference between the base contracts underlying Uniswap and the token contracts, which are unique to each token and are made directly between the buyer and seller.[3] The court ultimately concluded that the basic contracts of the Uniswap protocol provided security for the fraud tokens; The founding treaties themselves could lawfully be executed and were therefore irreversible under Section 29(b).[4] The court likened the plaintiffs’ allegations to an attempt to hold peer-to-peer payment requests “liable for a drug deal in which the platform was used to facilitate a money transfer.” [5] In both cases, the actions of independent third parties caused the damage and not the platform they used.
sales
Next, the court dismissed plaintiffs’ argument that developers or investors could be held liable under Section 12 of the Securities Act for “selling” tokens to plaintiffs. There are two ways to establish “Seller” liability under Section 12:
- if a defendant transfers title or other interest in a security against value to the buyer; or
- when a defendant successfully solicits the purchase of a security, motivated at least in part by its own financial interests or those of the security owner.[6]
The court rejected both theories, noting that the scope of Section 12 is not broad enough to include participants who are collateral for the offer or sale of securities, such as those that merely facilitate the contested transaction. “Just as Section 12(a)(1) does not apply to those who draft basic arrangements for dealer access to the stock market, it also does not apply to software developers creating an exchange to facilitate trading efficiently.”[7]
With respect to the ownership transfer, Plaintiffs alleged that Defendants wrote, controlled, and maintained the smart contracts for the liquidity pools, that the tokens were held in those liquidity pools, which facilitated the token sales, and that the Defendants thus necessarily Tokens would have passed ownership to plaintiffs. Rejecting this argument, the court analyzed the role of liquidity pools and finally concluded that even if ownership of the Uniswap protocol were to pass from the pool to a plaintiff, “this autonomous function in a split second transfers the protocol to would make a security for the transaction.” .”[8]
As for the advertising, the plaintiffs allege that the defendants sold, promoted and/or recruited the tokens directly to the plaintiffs in order 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 is “safe” and “for many people.” The court found this argument too weakened to make a claim.[9] Comparing the DeFi protocol to centralized exchanges: “No plaintiff would sue the New York Stock Exchange or NASDAQ for tweeting that their exchange was a safe place to trade after this plaintiff lost money due to an issuer’s fraudulent activities .”[10]
Finally, the court denied the plaintiffs’ control claims based on their failure to disclose primary violations of the federal securities laws.[11] In dismissing the Controller’s claims on this basis, the court left unclear the extent to which ownership of governance tokens or participation in code or platform development, as alleged by plaintiffs to engage the three venture capital defendants, constitutes potential liability the control person could lead .
Impact on the digital asset industry
The dismissal of the plaintiffs’ claims is good news for developers of decentralized protocols, as it clarifies – at least on the basis of the allegations at issue – that they are not liable for transactions by others that take place on protocols they develop.
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, but instead assumed for analysis purposes and concluded that even then the plaintiffs’ claims failed , if that were the case. The applicability of these registration categories to centralized exchanges is the subject of several active cases involving other industry participants. Whether they apply to a DeFi protocol like the one in question can also be checked.
An interesting dictum in this case is the judicial classification of Ether (ETH) as a commodity.[12] Former SEC Director of Corporate Finance William Hinman expressed his view in 2018 that ETH is a commodity and therefore sales are not subject to securities laws, and the CFTC itself has labeled ETH a commodity.[13] However, subsequent statements by current SEC Chairman Gary Gensler have challenged that conclusion. This added support for characterizing ETH as a commodity is being welcomed by the digital asset community, particularly those working on decentralizing their own tokens.
While the court’s judgments in this district court proceeding are not binding on other courts, the judgment is significant as part of a growing body of cases showing that courts may be reluctant to impose liability where liability under applicable law is not is clearly stated.
Diploma
While the court was sympathetic to the plaintiffs’ losses, it concluded that they were “looking for a scapegoat for their claims because the defendants they are really seeking are unidentifiable.” The court specifically noted that loopholes in the law may have contributed to the current confusion over oversight and liability in the digital asset industry: “The current state of cryptocurrency regulation is waning [plaintiffs] “The plaintiffs’ concerns,” concluded Justice Failla, “are better addressed to Congress than to this court.” On that front is the last A number of far-reaching legislative proposals have sprung up over the years to fill regulatory gaps in digital asset markets, although none have yet garnered the cross-party support needed for passage.
endnotes
[1] Latham represented Andreessen Horowitz (a16z), one of the venture capital defendants, in the lawsuit.
[2] underpants. At. on the 31st
[3] underpants. At. at 32-33.
[4] underpants. At. at 35
[5] underpants. At. at 37
[6] underpants. Op. at 39 (quotations omitted).
[7] underpants. At. ate 41
[8] underpants. At. ate 44
[9] underpants. At. at 46
[10] underpants. At. at 46
[11] underpants. At. at 49
[12] underpants. At. at 35
[13] The CFTC regularly claims that certain digital assets, including ETH, are “commodities” in interstate commerce. See eg here and here.
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