Second Circ. Court: Paycoin & Mining-Related Assets Are Not Securities – The National Law Review

Thursday, November 4, 2021

A Connecticut federal jury just answered one of the biggest questions on the minds of cryptocurrency investors, developers, and regulators are cryptocurrencies securities? The jury concluded that Paycoin and several cryptocurrency mining-related assets are not securities.

This is an important verdict because it is the first time a federal jury has considered whether a cryptocurrency is a security, as the SEC has posited. Significantly, the verdict follows parallel SEC and DOJ actions that reached the opposite conclusion with respect to the same digital assets. The DOJ had successfully prosecuted Homero Joshua Garza (Garza), the founder of Paycoin and the crypto currency mining operation at issue, under the theory that the products offeredweresecurities. Garza plead guilty in 2017 and was sentenced to 21 months in prison and ordered to pay $9,182,000 in restitution.

It is not surprising that a jury arrived at the opposite conclusion given years of confusion among laypersons, investors and regulators concerning how to classify and regulate cryptocurrencies. For example, as recent as August 2021,SEC Chair Gary Gensler remarkedthat cryptocurrency was the Wild West and that many tokens are offered and sold assecurities. But at the same time, the Commodities Futures Trading Commission (CFTC) (Genslers former employer)issued guidanceindicating that cryptocurrencies like Bitcoin and Ether arecommoditiessubject to the jurisdiction of the CFTC. Adding to the mix, last month DOJannouncedthe creation of a National Cryptocurrency Enforcement Team (NCET) to tackle complex investigations and prosecutions of criminal misuses of cryptocurrency. While Mondays jury verdict is significant, it is far from a conclusive referendum on the issue, and potentially more of a product of the specific facts and cryptocurrency at issue.

The Connecticut case involved a civil securities class action against Stuart Fraser, who was a business partner and mentor of Garzas, and two cryptocurrency mining entities founded by Garza (GAW Miners, LLC and ZenMiner, LLC). The Complaint alleged that the defendants employed an evolving scheme to defraud investors, originating with the sale of interests in defendants cryptocurrency mining companies and culminating with the issuance of Paycoin.

Defendants first sold investors Hashlets, which represented an interest in the computing power of defendants cryptocurrency mining operation. This promised investors a return based on defendants cryptocurrency mining powers and without having to operate sophisticated cryptocurrency mining computers. Investors were supposedly able to control how their Hashlets (or computing power) were deployed to mine cryptocurrency. However, the Complaint alleged that the investment operated much like a classic Ponzi scheme because the amount of Hashlets sold to investors far exceeded the companies actual mining power and investor crypto returns were paid with newer investors funds. The scheme evolved with the issuance of a cryptocurrency token, Paycoin, which was held in specific cryptocurrency wallets, Hashstakers, all of which defendants allegedly misrepresented as a stable and viable cryptocurrency token project.

After an eight-day jury trial, the question of whether the products at issue were investment contracts, and therefore securities, was submitted to the jury. To answer this question, the judges instructions to the jury incorporated the well-known Howeytest, which was derived from the U.S. Supreme Courts decision inSEC v. W.J. Howey Co., 328 U.S. 293 (1946). The judge directed the jurors to determine whether plaintiffs had proven that the products at issue constituted an: (1) investment of money, (2) in a common enterprise, and (3) with profits to be derived solely from the efforts of others. The jury instructions further elaborated that [i]f there was a reasonable expectation of significant investor control, then profits would not be considered derived solely from the efforts of others, and the jury would have to find for defendants. After deliberation, the jury concluded that none of the products at issue Hashlets, Hashpoints, Hashstakers, or Paycoin constituted an investment contract or a security. The jurys conclusion also handed Fraser a complete defense verdict.

While the jurys verdict might provide an interesting glimpse into public sentiment and understanding of cryptocurrency, it is far from the last word on how cryptocurrencies will be defined as an asset class, if at all. The verdict also stands in stark contrast to the intensifying wave of state and federal regulatory activity concerning cryptocurrencies.

1994-2021 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. All Rights Reserved.National Law Review, Volume XI, Number 308

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Second Circ. Court: Paycoin & Mining-Related Assets Are Not Securities - The National Law Review