A Breach of Contract Involving Cryptocurrency as Compensation Results in $25 Million Awarded in Damages – Lexology

Abstract

An exclusive license between the parties specified that the defendant would compensate the plaintiffs through distributions of its cryptocurrency, in lieu of traditional currency. After plaintiffs demand for the contractually agreed upon distribution of the cryptocurrency went unanswered, plaintiffs filed suit. After entry of a default judgment, the only question for the court was the proper measure of damages for breach of the contract. The court determined that the cryptocurrency constituted securities owed to plaintiffs and awarded plaintiffs $25 million in damages.

Background

Diamond Fortress and its CEO Charles Hatcher sued EverID for breach of contract for failure to compensate them per the terms of an exclusive license agreement and an advisor agreement, respectively. Under the exclusive license agreement, Diamond Fortress granted EverID an exclusive license to its ONYX software for identifying verification in EverIDs blockchain financial services platform. Under the advisor agreement, Mr. Hatcher agreed to advise EverID with its mobile application using the ONYX software. Both Diamond Fortress and Mr. Hatcher agreed to be compensated through distributions of EverIDs cryptocurrency, known as ID Tokens at both the initial coin offering and then through token distribution events. Yet, when EverID held an initial coin offering for the ID Tokens, it did not distribute the tokens to Diamond Fortress or Mr. Hatcher.

Diamond Fortress and Mr. Hatcher made several demands for compensation, which went unanswered. Thereafter, they sent a communication to EverID stating they would treat the contract as breached, and then filed suit. Upon EverIDs failure to respond to the complaint, Diamond Fortress and Mr. Hatcher filed a motion for default judgment. The court granted their motion and was left to determine the remedy for the breach.

The Diamond Fortress Technologies Decision

When determining damages for breach of contract, courts typically determine expected damages and consequential damages based on traditional currency. However, in this novel case before the Delaware Superior Court, the court had to determine how to calculate damages based on cryptocurrency values.

Before determining the damages award, the court sought to classify cryptocurrency into one of a security/investment contract, a commodity, property, or currency. Several agencies have regulatory authority over how to treat cryptocurrency, albeit with different understandings and regulations. Under the Commodity Exchange Act, cryptocurrency may be treated as a commodity, while under the Securities Act of 1933 it may be regulated as an investment contract. The Securities Act of 1933 defines a security as an investment contract, which the Supreme Court in Howey further defined as a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or as a third party.

The court applied the Howey test to determine if cryptocurrency was an investment contract, and therefore a security under the Securities Act of 1933. The first prong of Howey requires a determination of whether an investment of money was part of the relevant transaction. The first prong was easily met.

Moving to the second prong, the court looked to see if a common enterprise exists where the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment of third parties. Because the investors would be affected in an unsuccessful launch at an initial coin offering, the second prong was also met.

The court then moved to the final prong, which required determining whether an investor entered a transaction expecting to make a profit. This final prong was also met because the investors did expect a yield return on the investment.

Thus, the court found ID Tokens to be securities subject to regulation under the Securities Act of 1933. The court then applied existing Delaware law for failure to deliver securities, using a two-step method to calculate damages. First, the court found a reliable cryptocurrency valuation source. Second, the court determined the proper method to calculate damages to put plaintiffs in the position they would have been in had the contract been fully performed.

The court used CoinMarketCap to determine the USD value of the ID Tokens, noting that a few courts had used the tool previously. Applying the New York Rule, which Delaware courts have adopted, the Court determined the highest value within a reasonable time to calculate damages. Based on the rule and the CoinMarketCap valuations, the Court awarded Diamond Fortress Technologies $20,100,000 and CEO Charles Hatcher $5,025,000.

Strategy and Conclusion

When dealing with cryptocurrency in agreements, parties should consider incorporating language on how cryptocurrency should be valued if a breach were to occur. Parties should also be aware that this is a developing area of law, and this decision is an example of one way a court may determine the value of a breach based on cryptocurrency.

Further Information

The Diamond Fortress Technologies decision can be found here.

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A Breach of Contract Involving Cryptocurrency as Compensation Results in $25 Million Awarded in Damages - Lexology