Section 12 and Fundraising Via Digital Assets
By Genc Arifi
Whenever law and a new technology collide, courts either analyze the statute and case law and arrive at an updated interpretation that fits the new invention, or they invite Congress to enact new rules to provide guidance. With the advent of blockchain technology and its financial side-kick cryptocurrency, courts have adopted the former approach, taking it upon themselves to provide guidance on how statute and case law apply to the particular nuances of the new technology. Section 12 of the Securities Act has provided relief to purchasers of traditional securities from unscrupulous sellers since its inception almost 100 years ago. Now, in the absence of new statutes, courts are increasingly relying on Section 12 to interpret the meaning of the term “seller” within the new and ever-evolving cryptocurrency ecosystem and within the larger universe of social media, impacting who may be held liable for providing misleading information about a security or other investment vehicle.
Blockchain and Cryptocurrency – a primer
Blockchain is a decentralized, distributed ledger technology that records transactions across many computers so that registered transactions cannot be altered retroactively. Cryptocurrency is a digital currency operating on the blockchain. While all cryptocurrencies are built on blockchain technology, not all blockchain applications involve cryptocurrencies. One of the main features of blockchain technology is the decentralization of networks, meaning that no single entity has control over the network.
For this article, it will be assumed that all cryptocurrencies mentioned fall under the securities umbrella. However, the decentralization analysis will eventually become pivotal in determining whether a cryptocurrency is classified as a security, whether via a new interpretation of the Howey Test, which lays out the four criteria an asset must meet to qualify as an investment contract, or through legislative rulemaking.
Section 12 of the Securities Act – who is a seller?
Section 12(a)(1) of the Securities Act creates a private right of action for a purchaser against the seller in any transaction that violates Sections 5(a) or (c) and includes the right to sue for damages or rescission. Section 12(a)(2) creates liability for misleading statements in “a prospectus or oral communication.”
The Supreme Court in Pinter v. Dahl defined a “statutory seller” as someone who (1) “successfully solicits the purchase [of a security], motivated at least in part by a desire to serve [its] own financial interests or those of the securities’ owner” or (2) passes title, or other interest in the security, to the buyer for value.
Solicitation – the rise of social media
Cryptocurrency and other investment projects promoted on social media are challenging the definition of “seller” under Section 12 of the Securities Act. Lower courts have begun to issue rulings determining whether online videos promoting crypto tokens constitute “solicitations that make someone a seller.” However, varying interpretations by lower courts have created uncertainty for investment firms regarding what they can promote online without risking legal action.
For example, the first SEC enforcement actions focused on celebrities who took to social media to advertise Initial Coin Offerings (“ICOs”) without disclosing that they had been paid for their promotion of the tokens. World-renowned boxer Floyd Mayweather, Jr. and music personality DJ Khaled were found to have violated the Securities Act for touting ICOs and failing to disclose that they had been paid do so.
More recently, in October 2023, the Supreme Court declined to grant certiorari for a case involving Cardone Capital LLC, a real estate management company, after a California district court ruled that the CEO of Cardone Capital was not a “seller.” The plaintiff alleged a violation of § 12(a)(2) and claimed that the CEO made “untrue statements of material fact or concealed or failed to disclose material facts in Instagram posts and a YouTube video in 2019” where the CEO stated that, “it doesn’t matter whether the investor is accredited or non-accredited … you’re gonna walk away with a 15% annualized return….” The district court noted that the CEO was not a seller under the first prong of the Pinter test, as title was not passed, and further, Cardone was not found to be a “seller” under the second prong because the “plaintiff never alleged that [the CEO] or Cardone Capital was directly and actively involved in soliciting Plaintiff’s investment, nor that Plaintiff relied on such a solicitation when investing.” However, the Ninth Circuit overturned this decision, holding that “§ 12 of the Securities Act contains no requirement that a solicitation be directed or targeted to a particular plaintiff... [and] that a person can solicit a purchase, within the meaning of the Securities Act, by promoting the sale of a security in a mass communication.” The Ninth Circuit further held that the plaintiff “need not have alleged that he specifically relied on any of the alleged misstatements.”
The Ninth Circuit opinion followed the Eleventh Circuit case, Wildes v. BitConnect International PLC. The Wildes court noted that, “when a person solicits the purchase of securities to serve their financial interests, they are liable to a buyer who purchases those securities – whether that solicitation was made to one known person or to a million unknown ones.” The Wildes court emphasized the relevance of the Securities Act, noting that “technology has opened new avenues for both investment and solicitation, sellers can now reach global audiences through podcasts, social media posts, online videos, and web links.”
Passing Title – centralized vs decentralized exchanges
A centralized cryptocurrency exchange is a digital platform where buyers and sellers can trade various cryptocurrencies, such as Bitcoin or Ethereum, using traditional order book systems. These exchanges operate as intermediaries, facilitating transactions between users by matching buy and sell orders and executing trades on behalf of participants. Centralized exchanges typically maintain control over users’ funds by holding them in centralized wallets, and users must create accounts and undergo verification processes to trade on the platform. Examples of centralized exchanges include Binance, Coinbase, and Kraken.
On April 5, 2024, the Second Circuit reversed the district court in Oberlander v. Coinbase Global Inc., holding that plaintiffs had sufficiently alleged that Coinbase was a seller under Section 12(a)(1) because some newly discovered agreements between buyers and Coinbase stated that buyers were purchasing digital assets from Coinbase, thus satisfying the passing title prong of Pinter. Without the language of the agreements expressly stating that Coinbase was a seller, the Second Circuit would likely have upheld the ruling of the district court since Coinbase was an intermediary, meaning that it provided the infrastructure to execute trades between buyer and sellers but itself did not maintain title to or sell any digital assets. It is important to note that the Second Circuit did not disturb the district court’s holding that Coinbase did not solicit the sale of securities and that its involvement was merely collateral participation, which is not sufficient to satisfy the first Pinter prong.
In contrast, a decentralized cryptocurrency exchange (“DEX”) operates on a blockchain network without the need for a central authority or intermediary. Instead of relying on a centralized entity to facilitate trades, DEXs use smart contracts to automate the trading process, allowing users to trade directly with each other in a peer-to-peer manner. Users retain control of their funds at all times. Examples of decentralized exchanges include Uniswap, PancakeSwap, and SushiSwap.
In Risley v. Universal Navigation Inc., the court ruled against the plaintiffs, stating that developers of smart contracts do not transfer title of tokens. The court likened their role to lawyers or underwriters in traditional exchanges who facilitate but are not party to transactions. The court also determined that the exchange and other defendants did not have title over each token and that any momentary transfer would be insufficient to establish liability under Section 12.
Conclusion
To date, courts have been able to apply long-standing case law to grapple with the technological intricacies of blockchain technologies and the risks of cryptocurrency. However, blockchain technology is poised to evolve at a far greater pace than court precedents could hope to keep up with. What is evident is that the interests of investors and the various blockchain projects can best be served via rule-making and robust regulatory framework, both lacking at this time.