Blockchain and the Law

Part I: When You Jump Chains, Do NFTs Stay the Same? Ordinals on the Bitcoin Blockchain

The NFT community has been humming in 2023 after the recent rise in Bitcoin NFT mints. Ordinals, a non-fungible token (“NFT”) protocol, sent the community buzzing in January 2023 when it launched on the Bitcoin blockchain (as updated by soft forks in the protocol in 2017 and 2021, which among other things, added new features to the blockchain and increased the block size from 1MB to 4MB and allowed for the inscription of data). Bitcoin evangelists – true believers in Bitcoin as hard money – appreciate that the Bitcoin blockchain’s development is optimized for non-censorable, decentralized money but not file storage and consider Ordinals as immutable JPEG garbage that will only create network congestion, thereby increasing fees, and should be viewed as beneath the original peer-to-peer mission. Conversely, NFT enthusiasts and the blockchain curious are celebrating Bitcoin’s NFT scene as an innovative use of the chain: unlike traditional Ethereum-based NFTs (where the original underlying asset generally resides on a centralized server or the IPFS), Ordinals reside on-chain.  Needless to say, the rise of NFTs on the original blockchain is not without questions.

This article is Part I of a two-part article on Ordinals. In this part, we will break down Ordinals, explaining Ordinal Theory, ins-and-outs and functions. In Part II, we will dive into the implications of having NFTs on two separate blockchains. Continue Reading

Law360 Expert Analysis: SEC Approach In Wahi Presents New Challenges For Crypto

A recent guilty plea in U.S. v. Wahi in the U.S. District Court for the Southern District of New York, a crypto insider trading case, sets up an interesting situation where the defendants — who have already pled guilty to wire fraud — are challenging the SEC’s parallel civil charges.  Among other things, they are arguing that crypto tokens traded on a secondary market are not securities, regardless of whether they may have been considered “investment contracts” at issuance.

For the massive secondary crypto market ecosystem, this case has the potential to broadly extend SEC jurisdiction or upend the space, depending on one’s point of view.

Read the full Law360 article here.

Regulation in the Post-FTX Environment: SEC’s Proposed Enhanced Custody Rule and Its Effects on Crypto

When it rains, it pours.  On January 23, 2023, the New York Department of Financial Services announced that it had issued certain Guidance on Custodial Structures for Customer Protection in the Event of Insolvency in which it emphasized the importance of sound custody and disclosure practices to protect customers in the event of an insolvency or similar proceeding.  This month, the Securities and Exchange Commission (“SEC”) followed suit.

On February 15, 2023, the SEC proposed amendments to the Custody Rule under the Investment Advisers Act of 1940, which, among other changes, expands the current custody rule’s application to a broader array of client assets under the rule managed by registered investment advisers and clarifies certain aspects of the existing rule (see more digestible SEC Fact Sheet here).

The SEC’s proposed amendments are aimed at reducing the risk of loss of client assets by expanding the types of assets covered by the rule beyond “funds and securities” that will be subject to custodial safeguards and helping ensure assets are properly segregated. The proposed amendment would also impose certain reporting and compliance requirements on investment advisers, including requiring them to provide information about their practices in safeguarding client assets. Notably, if the amended rule is adopted after the 60-day comment period, which is not certain, then crypto assets will undoubtedly be affected. In a statement discussing the proposed amendments, SEC Chair Gary Gensler noted that the rule “covers a significant amount of crypto assets” and that “most crypto assets are likely to be funds or crypto asset securities covered by the current rule.”

Custody is a safekeeping activity by a financial institution involving storing, protecting, and securing assets separately from those of other customers or the investment firm itself. TradFi investment advisers are typically required to maintain customer funds and securities with a qualified financial firm (i.e., a custodian).  Most assets are intangible assets held “on account” with a broker-dealer (i.e., stocks and bonds, which are rarely held in certificate form), though some assets may consist of physical certificates, cash, or other tangible assets.  On the other hand, crypto custody consists primarily of bookkeeping because there is no physical asset and no centralized ownership record for a digital asset: the blockchain records wallet activity and balances.  While there is the option for self-custody of crypto assets, a crypto investor may allow a custodian or crypto exchange to hold their private keys for them, enabling the custodian to use the wallet to transact. This arrangement potentially opens up a range of risks, including the risk of hacking, insolvency risk, or malfeasance involving the commingling of investors’ cryptoassets with those of other investors or institutional assets. Continue Reading

Fraud Claims Against Token Issuer Dismissed Based on Disclosures to Accredited Investor

The organizers of an initial coin offering (ICO) recently won dismissal of an investor’s fraud claims by establishing that their public risk disclosures negated the investor’s claims of reliance on alleged misstatements.  The project, a video service provider’s ICO, was governed by a purchase agreement called a “Simple Agreement for Future Tokens” (“SAFT”).   The plaintiff investor later lost his entire investment as the token collapsed, allegedly due to the provider’s decision to scrap its initial plans for a decentralized platform and move to a permissioned blockchain (and also the provider’s choice to seek additional capital via a “Regulation A” public offering).  The New York court found that even if certain representations made by the issuer regarding the prospect of a decentralized network were actionable, the Plaintiff had not plausibly alleged  “reasonable reliance” on such representations in signing the SAFT. (Rostami v. Open Props, Inc., No. 22-03326 (S.D.N.Y. Jan. 9, 2023)). Continue Reading

New York Department of Financial Services Issues Guidance on Cryptoasset Custody in Wake of Recent High-Profile Bankruptcies

Demand for virtual currency services, including custody services, has soared in the past several years.  Like their counterparts in traditional finance, these custodians are stewards of retail and institutional customer funds and serve an important and valuable function.  However, as evidenced by a number of headline-grabbing failures during the lingering crypto winter, inadequate disclosures and poor custodial practices can seriously harm retail and institutional customers alike.  For many virtual currency customers, this recognition – in an industry built on the pillars of trust and transparency – was realized too late.  Recent disclosures emerging from notable bankruptcies involving crypto companies have led to allegations of fraud and mismanagement in connection with custodial services.  These allegations strike at the very core of the custodial relationship, and have had repercussions throughout the crypto industry.

Seemingly in direct response to these developments, on January 23, 2023, the New York Department of Financial Services (“NYDFS”) issued industry guidance to Virtual Currency Entities (“VCEs”) who act as custodians (“VCE Custodians”).  Entitled “Guidance on Custodial Structures for Customer Protection in the Event of Insolvency” (the “Guidance”), the Department emphasized the “paramount importance of equitable and beneficial interests always remaining with the customer” and reminded covered institutions of their obligations in connection with “sound custody and disclosure practices in the event of an insolvency” or similar proceeding.

The Guidance comes on the heels of developments in two high-profile insolvency proceedings: (1) the FTX proceedings, where, among others, the SEC has alleged co-founder Samuel Bankman-Fried concealed the diversion of FTX customer funds to the co-founder’s private crypto hedge fund, and (2) the Celsius proceedings, where the chief judge for the United States Bankruptcy Court for the Southern District of New York issued a decision holding that Celsius’ Terms of Use made clear that customer deposits into Earn Accounts became Celsius’ property at the time of deposit, such that the digital assets now constitute property of the debtors’ bankruptcy estate.  In Celsius, customers argued that the deposits in the Earn Accounts were held by Celsius as a custodian, but the court found that the plain language of the Terms of Use made clear that ownership interest had passed to the debtors. Continue Reading

Crypto Exchange Obtains Favorable Ruling in Arbitration of Claims over Alleged Trading Losses

This past month, a California district court granted a motion to compel arbitration of various claims by customers of cryptocurrency exchange platform, Coinbase Global, Inc. (“Coinbase”), finding that Coinbase’s User Agreement, which contains a broad arbitration provision, including a delegation clause that delegates questions of arbitrability to the arbitrator.  (Donovan v. Coinbase Global, Inc., No. 22-02826 (N.D. Cal. Jan. 6, 2023)). Unlike some electronic contracting disputes, which turn on whether the user had adequate notice of the terms and manifested consent to such terms (a ruling which often involves an examination of a site or app’s screen display and whether the user is reasonably presented with notice that completing a transaction will bind the user to terms of service), the account holders in this case did not dispute that they had agreed to the User Agreement, rather they argued that the arbitration provision and delegation clauses were unconscionable and unenforceable. Continue Reading

Consumer Law Claims against French Crypto Asset Wallet Provider May Proceed in California Court

Customer lists held by providers and the personal information users enter to obtain digital wallets or set up crypto exchange accounts are enviable targets for hackers.  Such data can be used to launch targeted phishing schemes and related scams to trick holders into divulging their private keys or else unknowingly transferring anonymized crypto assets to hackers.  One recent case involves a suit brought by customers who purchased a hardware wallet to secure cryptocurrency assets and are seeking redress for harms they allegedly suffered following data breaches that exposed their personal information.

A recent Ninth Circuit decision analyzed whether a federal court had personal jurisdiction over a foreign crypto asset wallet provider, an issue that can be important when litigating in this area, given the boundary-less nature of the world of crypto assets and related services. (Baton v. Ledger SAS, No. 21-17036 (9th Cir. Dec. 1, 2022) (unpublished)).  Continue Reading

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