District Of New Jersey Denies Motion To Dismiss Class Action Against Blockchain-Based Company, Finding That Plaintiff Adequately Pled Defendants’ Initial Coin Offering Constituted The Offer And Sale Of Unregistered Securities
On December 10, 2018, Judge Susan D. Wigenton of the United States District Court for the District of New Jersey denied defendants’ motion to dismiss a putative class action asserting violations of Sections 12(a)(1) and 15 of the Securities Act of 1933 (the “Securities Act”). Solis v. Latium Network, Inc., et al., No. 18-10255 (D. N.J. Dec. 10, 2018). Plaintiff alleged that the defendants, a blockchain-based tasking platform (the “Company”) and its co-founders and officers, sold over $17 million in cryptocurrency tokens in an initial coin offering (“ICO”) without registering the tokens. The Court held that plaintiff sufficiently alleged that the Company’s tokens were securities that should have been registered under the Securities Act prior to the ICO.
The Company allows users to create tasks, select desired applicants, verify that a task has been completed to specified standards, and pay with its cryptocurrency tokens, known as “LATX tokens.” Between July 2017 and March 2018, defendants conducted an ICO in multiple stages, marketing and selling LATX tokens in limited supply. Plaintiff participated in the ICO and electronically transmitted $25,000 to defendants in exchange for 208,333.33 LATX tokens on January 12, 2018. Six months later, plaintiff filed a class action against defendants, alleging that LATX tokens should have been registered as securities because they constituted investment contracts under the Securities Act. Defendants moved to dismiss.
Section 5 of the Securities Act prohibits the unregistered offer or sale of securities. Under the Securities Act, a “security” is defined as, inter alia, an “investment contract.” In S.E.C. v. W.J. Howey CO., 328 U.S. 293, 298-99 (1946), the Supreme Court established three requirements for establishing an investment contract: (i) an investment of money, (ii) in a common enterprise, (iii) with profits to come solely from the efforts of others. Defendants acknowledged that the first prong of the test was satisfied because participants in the ICO invested either U.S. dollars or the cryptocurrency Ether to purchase LATX tokens.
With respect to the second prong, the Court noted that a common enterprise can be established by showing “horizontal commonality” characterized by “a pooling of investors’ contributions and distribution of profits and losses on a pro-rata basis among investors.” Based on this test, the Court held that plaintiff sufficiently pled horizontal commonality by alleging that the funds raised were pooled to develop and maintain the tasking platform, and that an investor’s return on an investment in the ICO was directly proportional to the amount of the investor’s financial stake and number of LATX tokens owned.
The Court also held that plaintiff satisfied the third prong of the Howey test, which requires investors to be attracted to the investment by the prospect of a profit on an investment derived solely from others’ efforts. Notwithstanding the functionality of the LATX tokens (i.e., to pay for labor on the platform), the Court ruled that the Complaint detailed myriad ways in which defendants led investors to expect a profit from the LATX tokens. Specifically, the Court noted that defendants’ promotional materials and public statements emphasized the limited supply of tokens and referred to the ICO as a “unique investment opportunity” that would “generate better financial returns.” Accepting the facts in the Complaint as true, the Court ruled that plaintiff had sufficiently alleged that LATX tokens are investment contracts under the Howey test. Because the LATX tokens were never registered with the Securities and Exchange Commission, the Court held that plaintiff may pursue a cause of action under Section 12 of the Act.
Lastly, the Court held that plaintiff adequately pled control person liability under Section 15 because the Company’s co-founders and officers allegedly had authority to influence and control the Company’s conduct in offering the cryptocurrency tokens for sale.