On August 29, 2023, the court in in Risley v. Universal
Navigation Inc. et al, Case No. 1:22-cv-02780 (S.D.N.Y. Apr.
4, 2022), dismissed claims under Section 12(a)(1) of the Securities
Act of 19331 and Section 29(b) of the Securities
Exchange Act of 1934,2 against Defendants running a
decentralized cryptocurrency trading platform called the Uniswap
Protocol (the “Protocol”). Plaintiffs alleged that they
suffered losses from fraudulent “scam tokens” that were
traded on the Protocol. At the outset of the opinion, the Court
identified Plaintiffs’ fundamental and incurable problem that
required dismissal with prejudice: even though they had suffered
identifiable losses from the alleged scams, they did not –
and could not – identify the actual issuers or sellers of the
scam tokens. Although Plaintiffs had cast a wide net naming
numerous entities and individuals as Defendants based on their
involvement with promoting and encouraging transactions on the
Protocol, none of the named Defendants were “issuers” or
“sellers” as required by Sections 12 of the Securities
Act and 29(a) of the Exchange Act to impose liability.3 The Court noted that Plaintiffs’
theory for liability for the named Defendants would require
legislation to extend the scope of liability under Section 12(a) of
the Securities Act and Section 29(a) of the Exchange Act.
The structure and operation of the Protocol was critical to
the Court’s decision to dismiss the complaint. As discussed by
the Court, “in a traditional stock or centralized exchange,
buyers and sellers are matched on a one-to-one basis orders —
when a buyer’s bid matches the seller’s ask, a trade
occurs.” (Opinion and Order on Motion to Dismiss at 5 (citing
First Amended Complaint, (“FAC”) at ¶ 38)). “By
contrast, in a decentralized exchange (also known as a
“DeFi” exchange), buyers and sellers are empowered to use
nontraditional methods to trade and create tokens,
including…liquidity pools.” (Opinion and Order on Motion to
Dismiss at 5 (citing FAC at ¶ 39)). With liquidity pools,
instead of users interacting with one another and matching trades,
they instead interact with the pool. The Protocol is an
“onchain [(meaning it operates directly on the blockchain)]
system of ‘smart contracts’ that functions through an
“Automated Market Maker” or “AMM,” which
Uniswap claims replaces the buy and sell orders in an order book
market with liquidity pools. (Opinion and Order on Motion to
Dismiss at 6 (citing FAC at ¶ 78; v2 Whitepaper 1).” AMMs
are basically algorithmic protocols that determine digital asset
prices and automate asset trades on the liquidity pool. Liquidity
pools gather assets through users called liquidity providers who
contribute to a percentage of the crypto asset in a liquidity pool
smart contract. Liquidity pools use AMMs that connect users aiming
to trade pairs with the appropriate smart contracts for them.
“Smart contracts” are self-executing, self-enforcing
programs that write the terms of the agreement between buyers and
sellers of tokens directly into the program’s code.
The Protocol operates on the Etherium Blockchain, which allows
for the use of smart contracts. The Etherium Blockchain uses an
application standard called ERC-20 (Ethereum Requests for Comments)
that allows for smart contract tokens to be created on Ethereum,
which creates ERC-20 tokens. Starting in 2021, companies and
issuers began raising funds through initial coin offerings most of
which were launched as ERC-20 tokens and were not registered with
the SEC and which were promoted with little information underlying
the offering through social media and other informal processes. FAC
at ¶¶ 47-59. As the Plaintiffs acknowledged, many of
these issuers flocked to the Protocol, which allowed them to issue
new ERC-20 tokens anonymously, without any sort of conduct
verification or background check. Id. ¶ 59.
The Court, acknowledging that the Protocol is subject to fraud
(while also writing that it is “innovative and more efficient
than centralized systems,” id. at 13), noted two
major scams alleged by Plaintiffs that are common to the Protocol:
“rug pulls,” where “a new issuer puts their tokens
into a liquidity pool and receives Liquidity Tokens in
exchange” only for “[t]he issuer [to] then prematurely
withdraw[] their pool tokens, thereby removing all liquidity from
the pool and leaving other investors with nothing but now worthless
tokens[,]” FAC at ¶179; and “pump and dumps.”
Id. at ¶180.4 Plaintiffs allege that
Defendants were aware of these schemes and that they did
“nothing to stop them because Defendants stand to profit from
the liquidity fees” and that, “[b]y providing a
marketplace for buyers and sellers, by assisting with the drafting
of smart contracts, and by and through their ownership of
governance tokens…Uniswap Defendants and the VC Defendants
‘facilitate[]’ these scam trades – and facilitated
Plaintiffs’ trades of the Tokens.” Opinion and Order on
Motion to Dismiss at 14.
Plaintiffs’ Section 29(b) claims – which sought
recission of certain “contracts” – were grounded on
the allegation that Defendants contracted with Plaintiffs through
the Protocol’s use of smart contracts. To establish a violation
of Section 29(b), a plaintiff must show that “[i] the contract
involved a prohibited transaction, [ii] he is in contractual
privity with the defendant[s], and [iii] he is in the class of
persons the [Exchange] Act was designed to protect.” Thus,
Section 29(a) can only render void those contracts which by their
terms violate the Act. Recission is not permitted when the
“violation complained of is collateral or tangential to the
contract between the parties. In other words, “‘only
unlawful contracts may be rescinded, not unlawful transactions made
pursuant to lawful contracts.'” The Court held that
Plaintiffs failed to allege the very first element of Section
29(a). Here, the smart contracts in question were not unlawful and
could be carried out lawfully.
The Court reasoned that the smart contracts that were in
operation for each liquidity pool were “similar to an
overarching user agreement” and were “foundational”
in nature, distinct from token contracts unique to a particular
pool and drafted by specific issuers. Opinion and Order on Motion
to Dismiss at 32.5 Aware that Plaintiffs, unable to hold the
drafters of the token contracts accountable, sought to hold
accountable those who drafted the code for the Protocol, the Court
stated that holding the drafter of the computer code underlying the
Protocol liable under Section 29(b) for a third-party’s misuse
of the Protocol “defies logic.” Id. at 31.
Citing again the fact this was a case of first impression, the
Court reasoned that:
While no court has yet decided this issue in the context of a
decentralized protocol’s smart contracts, the Court finds that
the smart contracts here were themselves able to be carried out
lawfully, as with the exchange of crypto commodities ETH and
Bitcoin….Accordingly, the Court finds that Defendants’
underlying core and router contracts were collateral to the Scam
Token activity – which occurred subject to the Token
issuers’ activity and, for at least some, the issuer-drafted
smart contracts – and constituted the sort of
tangential activity that falls outside of Section
29(b).
Id. at 35-36 (emphasis added). See also id. at
37 (“Regulators may someday address this gray area in the
securities laws….[T]he law is currently developing around these
[decentralized] exchanges, such that Defendants cannot currently be
held liable under a traditional Section 29(b) theory.”).
The Court also dismissed Plaintiffs’ Section 12(a) claims.
“The list of potential defendants in a section 12(a)(1) case
is governed by a judicial interpretation of section 12 known as the
“statutory seller” requirements.” Opinion and Order
on Motion to Dismiss at 39. Liability can attach if the defendant
passed title or other interest in the security to the buyer for
value. The Court did not accept Plaintiffs’ transfer of title
theory – that because Defendants wrote the contracts allowing
the Protocol to function, they were statutory sellers for each
transaction occurring on the Protocol – because Section
12(a)(1) is not applicable to those who created the software code
for a decentralized exchange to efficiently facilitate trades, and
because no “Defendant[] can be found to directly control the
Protocol to the degree that they hold title to assets on the
Protocol simply because they hold certain tokens that can impact
how the Protocol may function in the future.” Id. at
44.[6
The Court was also not convinced by Plaintiffs’ solicitation
theory – that Defendants sold, promoted, and/or solicited
Tokens to Plaintiffs directly in order to increase the value of
their UNI governance tokens – because the social media posts
from defendant CEO Hayden Z. Adams about the security of the
Protocol and that it was “for many people” was too
attenuated, analogizing it to a hypothetical scenario where NASDAQ
or the NYSE published a social media post about the security of
their exchanges for trading. Id. at 46 (quotation marks
omitted). As can be clearly gleaned from the decision, the Court
was unwilling to help Plaintiffs find a scapegoat for their claims
just because the real defendants were unidentifiable.
The Court, in making it clear that Plaintiffs’ claims could
not be pursued under the statutes, signaled that the issues
presented in this case were best addressed by Congress:
In a perfect (or at least, a more transparent) world, Plaintiffs
would be able to seek redress from the actual issuers who defrauded
them. In the absence of such information, Plaintiffs are left to
argue that Labs facilitated the trades at issue by ‘providing a
marketplace and facilities for bringing together buyers and sellers
of securities, in exchange for [it] having the ability to charge a
fee on every transaction it made possible on the Protocol’ (FAC
¶ 199), and that Labs, Adams, and the VC Defendants, through
drafting smart contracts that allow the Protocol to operate and
owning UNI governance tokens, somehow ‘sold’ the Tokens as
unregistered broker-dealers (id). In a similar vein,
unable to sue the issuers for their potentially unlawful
solicitation efforts, Plaintiffs are left to sue Defendants for
issuing statements on social media that the Protocol was “for
many people” and “safe” to trade on, and for
“transferring title” of the tokens in each liquidity pool
to Plaintiffs in violation of the Securities Act. (FAC ¶¶
9, 52-53, 133, 198, 735; Pl. Opp. 28-30). As explained below, the
Court declines to stretch the federal securities laws to cover the
conduct alleged, and concludes that Plaintiffs’ concerns
are better addressed to Congress than to this Court.
Opinion and Order on Motion to Dismiss, ECF No. 90, at 28
(emphasis added). See also id. at 6 (regarding ERC-20
tokens, the Court noted that “each of them [issuers, or
“developers”] theoretically could register their tokens
with the Securities and Exchange Commission (the ‘SEC’),
but such registrations are few, as Congress and the courts have
yet to make a definitive determination as to whether such tokens
constitute securities, commodities, or something else.”
(emphasis added)) and 47 (“Whether this anonymity is
troublesome enough to merit regulation is not for the Court to
decide, but for Congress.”) (emphasis added).
The Court also appeared to suggest that the SEC should continue
to try and regulate the crypto space. For example, the Court
pointed to the benefits of having to register with the SEC, stating
that whitepapers describing new coin offering do not provide nearly
the amount of information that would be required in an SEC
registration statement. Id. at 7. Additionally, the Court
noted that, in the context of Plaintiffs’ Section 29(b) theory
of liability, “[r]egulators may someday address this gray area
in the securities laws,” pointing by way of example to a
warning issued by SEC Chairman Gensler in September 2021 that
“[t]here’s still a core group of folks that are not only
writing the software, like the open-source software, but they often
have governance and fees. There’s some incentive structure for
those promoters and sponsors in the middle of this.”
On the face of it, this decision is likely to be viewed by those
operating in the decentralized crypto exchange industry as a win,
since the Court dismissed the Complaint with prejudice, leaving
Plaintiffs to appeal to the Second Circuit, which they have done.
However, if the Court’s reasoning is upheld and if other courts
rule similarly for such claims, then there may be increased
pressure on Congress to act to mitigate the scams purportedly
occurring on this (and perhaps other similar) cryptocurrency
exchanges.
The docket for Risley v. Universal Navigation Inc. et
al, Docket No. 1:22-cv-02780 (S.D.N.Y. Apr. 4, 2022), is
accessible on Bloomberg Law here.
Footnotes
1. Section 12(a) of the Securities Act of 1933
provides that:
(a) In general
Any person who–
(1) offers or sells a security in violation of
section 77e of this title, or
(2) offers or sells a security (whether or not
exempted by the provisions of section 77c of this title, other than
paragraphs (2) and (14) of subsection (a) of said section), by the
use of any means or instruments of transportation or communication
in interstate commerce or of the mails, by means of a prospectus or
oral communication, which includes an untrue statement of a
material fact or omits to state a material fact necessary in order
to make the statements, in the light of the circumstances under
which they were made, not misleading (the purchaser not knowing of
such untruth or omission), and who shall not sustain the burden of
proof that he did not know, and in the exercise of reasonable care
could not have known, of such untruth or omission, shall be liable,
subject to subsection (b), to the person purchasing such security
from him, who may sue either at law or in equity in any court of
competent jurisdiction, to recover the consideration paid for such
security with interest thereon, less the amount of any income
received thereon, upon the tender of such security, or for damages
if he no longer owns the security.
2. Section 29(b) of the Securities Exchange Act of
1934 provides in pertinent part that “[e]very contract made in
violation of any provision of this chapter or of any rule or
regulation thereunder, and every contract…the performance of
which involves the violation of, or the continuance of any
relationship or practice in violation of, any provision of this
chapter or any rule, or regulation thereunder, shall be void…as
regards the rights of any person who, in violation of any such
provision, rule, or regulation, shall have made or engaged in the
performance of any such contract.”
3. Contrary to other recent decisions addressing
violations of federal securities laws from cryptocurrency
transactions, the Court here accepted Plaintiffs’ assertion
that the Tokens in question were “bona fide
securities” without making any factual findings on this issue.
Opinion and Order on Motion to Dismiss, ECF No. 90, at
25.
4. The Court noted that “Plaintiffs lay out
several other scams that can take place on the Protocol[,]”
including “what Plaintiffs refer to (somewhat imprecisely) as
a Ponzi scheme[.]” Opinion and Order on Motion to Dismiss at
1.
5. The Court explained the transaction approval
process of the Protocol as follows: “Plaintiffs note that the
first time a user attempts to swap a token or add liquidity using
the Protocol, they must ‘approve’ the transaction, thus
‘giv[ing] the Uniswap Protocol permission to swap that token
from [their] wallet.’…After doing so once, the user is
seemingly not prompted again when trading in a second pool. This is
further evidence that the contracts drafted by Defendants –
namely, the core and router contracts underlying the Protocol
– serve as a single, foundational base, where any
token-specific terms are subject to the issuer who drafts
them.” Id. at 34-35.
6. Plaintiff argued in their Opposition to the Motion
to Dismiss that Defendants had control over the Protocol by virtue
of issuing themselves preferred Uniswap shares, in the form of a
token called “UNI.” Memorandum of Law in Opposition to
Defendants’ Motion to Dismiss, ECF No. 82, at 2.
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