Blockchain Meets Morrison: Court Rejects Blockchain Class Settlement Over Concerns About Sufficient Representation – Securities

The US District Court for the Southern District of New York recently rejected a proposed settlement of a securities class action involving buyers of digital tokens due to concerns about whether the lead plaintiff had adequately represented the class for settlement purposes. Judge Lewis A. Kaplan stayed Williams v. Block.one that the federal securities laws did not appear to apply equally to all class members’ token purchases, and that the lead plaintiff had not presented evidence showing that its own purchases were (or were not) subject to the securities laws in a manner similar to the other class members’ purchases.

The Williams the decision highlights the complexity of applying to blockchain transactions the Supreme Court’s transaction test to determine the applicability of the Securities Act. These factual complexities may increase the difficulty of litigating or settling securities class actions involving classes of digital coin purchasers.

Legal background

For several decades before the Supreme Court’s decision in 2010 i Morrison v National Australia Bank, courts had allowed securities plaintiffs to bring claims under the federal securities laws—regardless of where the securities transactions had occurred and regardless of the plaintiffs’ residence or nationality—based on some version of the “conduct or effects” test. That test examined whether substantially unfair
behavior related to non-US securities transactions had occurred in the US or if wrongful conduct outside the US had had a significant effect on American markets or investors.

In 2010, the Supreme Court threw out the “conduct or effects” test and announced a new “transactional” test to determine the reach of the federal securities laws.
Morrison held that the securities laws apply only to alleged misstatements or omissions made “in connection with the purchase or sale of [i] a security listed on a US stock exchange, and [ii] purchase or sale of other securities in the United States.” Most of the subsequent litigation has involved the second prong, for transactions in unlisted securities. In 2012, the Second Circuit – in a widely adopted ruling – held in Absolute Activist Value Master Fund Ltd. v. Ficeto that a transaction in unlisted securities is “domestic if irrevocable liability is incurred or title passes in the United States”.

Factual background

The Williams plaintiffs asserted federal securities law claims against defendants in connection with Block.one’s initial coin offering. The plaintiffs alleged that Block.one’s tokens were securities and that the defendants had violated securities laws by failing to register the securities with the SEC and by making false or misleading statements to the public. The defendants argued that the tokens were not securities, and they had sought to prevent direct purchases by American investors (although the court observed that “this prohibition was easily circumvented”).

The parties reached a proposed settlement while the defendant’s motion to dismiss was pending. The settlement covered all purchasers of Block.one’s tokens during the class period and provided for a cash payment that would be split pro rataamong all class members regardless of whether the federal securities laws applied to each class member’s token purchase.

The court preliminarily approved the proposed settlement, but after receiving additional briefing, it requested additional information regarding the percentage of the lead plaintiff’s and class members’ token purchases that were and were not subject to the federal securities laws pursuant to Morrison and
Definitely an activist. The court ultimately refused to approve the proposed settlement because it concluded that the lead plaintiff had not established that it could adequately represent the class “in light of questions regarding the proportion of the lead plaintiff’s purchases of tokens that were domestic—and therefore covered by the securities laws and entitled to a damages—compared to the share of domestic purchases by absent class members.”

The court’s decision

To determine whether the lead plaintiff could adequately represent the class, the court first had to consider which token purchases were and were not covered by the securities laws.

The easiest part of that analysis involved
Morrison‘s first tip, for listed securities. The court noted that the SEC had determined that at least one cryptocurrency exchange on which Block.one’s tokens traded (Poloniex) was a national securities exchange. Accordingly, class members who had purchased their tokens “on a domestic exchange such as Poloniex” maybe be able to recover damages under federal securities laws.

The more difficult question, as usual, involved Morrison‘s other tip: about tokens not purchased on a national securities exchange may be subject to the securities laws as domestic transactions. This question was whether “irrevocable liability” between the buyer and the seller had been incurred in the United States. The court expressed its view that “a transaction-by-transaction approach seems appropriate for determining whether blockchain transactions outside of a domestic exchange are domestic or foreign under the second part of
Morrison.” “Generally, ‘irrevocable liability’ accrues when the transaction has been verified by at least one individual node in the blockchain. Accordingly, the location of the node that confirmed the transaction in question should check in this circuit below Morrisonhis other striker who interpreted in Definitely an activist.”

However, the court did not have to definitively conclude whether this test should apply because the lead plaintiff had provided “little or no information … regarding the proportion of its transactions that were domestic compared to the absent class members.” The court could therefore not decide whether the main plaintiff could adequately represent the class.

The court was concerned that the lead plaintiff, “in light of the proportion of investments made in domestic versus foreign transactions, may have an incentive to accept a lower settlement offer than would have been insisted upon by absent class members who purchased only or more predominantly in domestic transactions.” The lead plaintiff may thus have “had an incentive to take a larger ‘haircut’ on the aggregate settlement price than would have existed for class members who had higher shares of domestic purchases.” This potential intraclass conflict prevented the lead plaintiff from adequately representing the class.

Implications

The Williams the decision raises at least two sets of questions that could play out in future litigation: questions regarding the applicability of the Securities Act to blockchain transactions and questions about structuring a putative class for litigation or settlement purposes.

On the substantive securities law issue, the court did not issue a final ruling, although it expressed its view on how
Morrison and Definitely an activist should apply to blockchain transactions. The court criticized other decisions that had focused on the location of the buyer at the time of the transaction because, under Second Circuit precedent, “the location of the buyer is not determinative of the location of a transaction in non-blockchain transactions.” The court also disagreed with an approach that held that a blockchain transaction becomes irrevocable “‘only after it has been validated by a network of global “nodes”‘” and examined whether that network of global nodes was “‘clustered more densely in the United States than in any other country.'” I Williams court’s view, “every blockchain transaction becomes irrevocable for buyer and seller when the transaction is cryptographically validated by a single node.” Thus, “the location of other nodes on the blockchain that may later accept the transaction does not have a proper bearing on when and where ‘irrevocable liability’ between buyer and seller has accrued.” This debate may continue in future blockchain matters.

On the procedural question Williams the decision highlights the importance of ensuring that the lead plaintiff’s interests are aligned with, and do not potentially conflict with, the interests of other class members. Perhaps the court’s concern could have been mitigated if the class had been represented by multiple lead plaintiffs with significantly different shares of US and non-US token transactions. The court observed that the settlement of Petrobras securities class action – which had also involved US and non-US transactions – had had three named plaintiffs, each represented by separate lawyers. Two of these plaintiffs had purchased only in domestic transactions, but they did not object to equal treatment of class members who had purchased in transactions outside the United States. This consent reduced concerns about class conflicts between domestic and non-domestic buyers. However
Williams the court noted that the non-US claimants’ transactions in Petrobras had only amounted to approx. 2% of the settlement class – a relative de minimisamount. Thus Petrobras the decision is distinguishable when the non-US transactions constitute a significant percentage of the class, even if the domestic and non-US purchasers have separate counsel. Moreover, the court noted that, unlike i Williams case, the whole class
Petrobras settlement “does not appear to have been reduced to account for the presence of foreign claims.” Therefore, issues of adequate representation in class actions covering transactions that are and are not subject to the federal securities laws will therefore continue to require careful attention and, depending on the facts, may require appropriate subclassification to protect the various interests of all class members.

Blockchain Meets Morrison: Court Rejects Blockchain Class Settlement Due to Adequate Representation Concerns

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