Decide Paul Wallace of the Delaware Superior Courtroom issued a current opinion in Diamond Fortress Technologies, Inc. v. EverID, Inc., clarifying the therapy of cryptocurrency belongings when calculating damages. [1] The opinion additionally lays a framework for analyzing the therapy of cryptocurrency belongings in future actions and offers helpful steering in deciphering current laws.
Plaintiffs Diamond Fortress Applied sciences, Inc., and its CEO Charles Hatcher II (plaintiffs), contracted with defendant EverID, Inc. (EverID) to supply EverID digital ID verification providers. EverID created cryptocurrency “ID Tokens” and developed a associated blockchain-based monetary platform. As part of this, EverID sought to make use of Diamond Fortress’s ONYX software program for id verification. The ONYX software program permits for touchless verification of a person’s id by scanning the person’s fingerprint with a telephone’s digicam. EverID additionally retained Hatcher as a advisor, and the agreements prohibited Diamond Fortress or Hatcher from working with different blockchain suppliers.
Quite than pay them in conventional foreign money, EverID agreed to compensate the plaintiffs via distributions of ID Tokens on the preliminary coin providing (ICO) and later at common token distribution occasions (TDEs). EverID held an ICO for the ID Tokens on February 8, 2021 however didn’t distribute them to Diamond Fortress or Hatcher. The plaintiffs thereafter made casual and formal calls for for the contractually agreed upon token distributions with out response from EverID earlier than sending a remaining communication on March 4, 2021, declaring the plaintiffs’ intent to deal with the contracts as breached. Shortly after delivering that remaining communication, the plaintiffs filed go well with. EverID didn’t reply the grievance. The plaintiffs moved for default judgment.
As a result of EverID’s legal responsibility was not at situation, the one query earlier than the court docket was the correct measure of damages. Because the plaintiffs had been to be paid in cryptocurrency with a fluctuating worth pursuant to the contract, the court docket needed to decide the best way to compensate the plaintiffs for his or her loss, which required two steps: “First, the Courtroom should discover a dependable cryptocurrency valuation supply to make sure the correct enter of values. Then the Courtroom should confirm the correct technique for calculating damages.” [2] The court docket utilized CoinMarketCap, an internet site posting day by day cryptocurrency pricing knowledge, as its valuation supply, noting different courts had performed so, and Congress had expressed approval of the web site in laws. [3]
Extra considerably, the court docket additionally decided that the ID Tokens supplied by EverID had been securities as a result of they had been “funding contracts” topic to regulation beneath the Securities Act of 1933 and the Alternate Act of 1934. Damages subsequently must be calculated beneath Delaware’s current precedent coping with failure to ship pursuant to contracts for the sale of securities. The court docket first examined whether or not cryptocurrency constitutes a safety or a commodity, noting that each the CFTC and the SEC have claimed jurisdiction over regulation of cryptocurrency. The court docket regarded to laws launched in July 2021 within the Home of Representatives by Donald S. Beyer, Jr. (D-VA) — the Digital Asset Market Construction and Funding Safety Act [4] — to create a check that analyzes whether or not a cryptocurrency constitutes an asset or safety based mostly on “a cryptocurrency’s traits at a given time.” [5]
To make this willpower, the court docket utilized the Howey check [6] to ID Tokens and decided that, on the time that the plaintiffs incurred damages, the ID tokens constituted a safety. First, the court docket discovered the plaintiffs’ dedication to supply software program and consulting providers in trade for cryptocurrency constituted an funding of cash. Second, the court docket discovered the Token ID cryptocurrency amounted to a typical enterprise as a result of, each pre- and post-ICO, the worth of the ID tokens was inextricably linked to the efficiency of EverID’s blockchain and platform as an entire. Third, the court docket discovered that the plaintiffs anticipated their income to be derived from the efforts of others as a result of the plaintiffs couldn’t be reimbursed till after the ICO was full. Because the court docket famous, “[t]he Plaintiffs’ general funding into the platform was based mostly on their expectation to be paid in eventual distributions of ID Tokens after the ICO. This expectation isn’t any totally different than that of a conventional funding contract entered into earlier than an IPO, and thus, ID Tokens is on this circumstance like a safety.” [7]
After figuring out the ID Tokens constituted securities owed to the plaintiffs beneath the related agreements, the court docket utilized current Delaware legislation governing damages calculations for failure to ship securities. Making use of the New York rule, which Delaware courts have adopted, the court docket discovered the very best worth for ID Tokens within the three months after EverID’s failure to ship and calculated damages based mostly on that, in the end awarding Diamond Fortress greater than $20,000,000 and Hatcher greater than $5,000,000. [8]
The court docket’s opinion lays out a helpful analytical framework for figuring out how cryptocurrency belongings could also be categorized, whereas acknowledging that some cryptocurrencies — as they acquire widespread adoption — could shift from being categorized as securities to commodities. However early-stage cryptocurrencies whose use is tied to a particular platform could represent securities, not less than beneath the analytical framework laid out by this court docket. In essence, the court docket’s check asks whether or not the acquisition of a cryptocurrency is predicated on a perception within the worth of the token itself or the blockchain platform underlying the token in query. Right here, the court docket discovered Diamond Fortress and Hatcher agreed to obtain cost in ID Tokens not due to a perception within the intrinsic worth of the ID Token, however due to a perception that the ID Token’s worth would rise as EverID’s blockchain platform was adopted on a wider scale.
Crucial to the court docket’s evaluation on this case was the truth that the plaintiffs reached their settlement with EverID earlier than the ID Token ICO, that means that the plaintiffs’ “funding” was essentially speculative based mostly on future efficiency, akin to the acquisition of a safety, and never the acquisition of an current commodity. Beneath the court docket’s framework, pre-ICO agreements to buy cryptocurrency could extra probably than not be correctly categorized as securities. Even post-ICO purchases, nonetheless, could represent securities beneath this court docket’s framework the place the worth of the cryptocurrency itself is closely tied to the efficiency of a bigger product utilizing the cryptocurrency’s blockchain. If the worth of cryptocurrency rises and falls with the efficiency of a product using a proprietary blockchain, the acquisition of cryptocurrency represents an funding within the bigger product, and thus probably constitutes a purchase order of securities.
Beneath this court docket’s evaluation, as a cryptocurrency grows and reaches widespread adoption, nonetheless, it could actually transition from a safety to an asset. Whereas the court docket on this case didn’t delineate precisely when such a transition happens, the unbiased use of the foreign money as a unit of trade is probably going a great indicator. Beneath the court docket’s framework, there’s a clear distinction between bitcoin or ethereum — currencies which might be accepted by some distributors and function a unit of trade with widely-adopted blockchain platforms — as in comparison with currencies tied to the efficiency of a particular utility or enterprise with its personal blockchain, such because the ID Tokens on this case. Whereas the biggest and most utilized cryptocurrencies could classify as belongings, smaller tokens created by startups usually tend to be securities, particularly when bought on the pre-ICO stage.
Cryptocurrency issuers and corporations contemplating ICO occasions ought to be aware of this court docket’s ruling and be aware that different courts and regulators could not categorically classify cryptocurrencies as belongings or securities however could as an alternative take a look at the person circumstances of every case together with the opportunity of a fluid evolution. Firms wishing to realize a sure classification ought to take efforts to show their cryptocurrency is or is just not a safety beneath the court docket’s framework. On the identical time, buyers ought to make the most of the court docket’s framework to judge potential cryptocurrency investments and the protections obtainable to them. The court docket’s opinion offers important clarification within the in any other case murky realm of cryptocurrencies, whereas nonetheless acknowledging that cryptocurrencies are novel, evolving, and proof against categorical classification.
[1] — A.3d –, C.A. No. N21C-05-048, 2022 WL 1127217 (Del. Tremendous. Ct. Apr. 14, 2022).
[2] Id. at *13.
[3] Id.
[4] H.R. 4741, 117th Cong. (2021).
[5] 2022 WL 1127217, at *6-7 (emphasis in authentic).
[6] Id. at *7 (“an funding contract is ‘a contract, transaction or scheme whereby an individual invests his cash in a typical enterprise and is led to anticipate income solely from the efforts of the promoter or a 3rd social gathering.'”) (quoting SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946)).
[7] Id. at *11.
[8] Id. at *15.