Defrauded Cryptocurrency Investor Can Prosecute Securities Fraud Claims Against Hedge Fund & Principals, Despite Written Disclaimers.

As cryptocurrencies experience another major downturn this week, investors should know that the securities laws may provide remedies for crypto investors who have been misled or defrauded. The potential for sky-high returns has caused a boom in cryptocurrency investments, which now have a market capitalization of roughly $1.5 trillion dollars according to Coinmarketcap.com – even after a recent 40% drop in prices.[1] In the past three years, hedge funds and other traditional investment advisers have begun allocating substantial portions of their clients’ portfolios to this asset class. In fact, estimated assets under management for cryptocurrency funds increased from about $2 billion in 2019[2] to about $3.4 billion only a year later in 2020.[3] Those numbers are likely set to explode since cryptocurrency as an asset class is in the trillions of dollars – the market cap of Bitcoin alone is about $750 billion.[4]

Because cryptocurrency is a brand new asset class with extreme volatility, very little is known about managing and trading such assets. These factors combined with the large amounts of money chasing outsized returns create an increased likelihood of misleading and fraudulent representations. Consequently, it is important that crypto investors are aware of their rights under the securities laws.

The recent decision in KDH Consulting Grp. LLC v. Iterative Capital Mgmt. L.P. provides an example of how investors can use the securities laws to recover for cryptocurrency fraud. 2021 WL 1105603 (S.D.N.Y. Mar. 23, 2021). In KDH, an investor in a cryptocurrency hedge fund alleged that the principals of the hedge funds’ investment adviser lied to them about the fund’s purpose and the principals’ prior investment performance. 2021 WL 1105603, at *1-2. Within two years of the plaintiff investing, the defendants removed plaintiff from the fund, returning only a small fraction of plaintiff’s investment. Meanwhile, the defendants moved the funds’ assets into an entirely different business venture that focused on cryptocurrency “mining” which involved using specialized computer hardware to win newly-minted cryptocurrency. Id. at *3. The investor filed securities fraud claims under the federal securities laws, alleging that the defendants lied about the investment focus of the hedge fund, and about their prior investment track record. Id. at *1, *3.

The court denied the defendants’ motion to dismiss the complaint. First, the court held that the plaintiff adequately pled that the fund’s Private Placement Memorandum (“PPM”) fraudulently induced plaintiff’s initial investment in January 2018. The PPM allegedly misrepresented that the fund’s primary purpose was to trade cryptocurrency when, in reality, the principals knew that investor money would be used primarily to fund illiquid cryptocurrency mining, which would benefit the defendants’ separate business. Id. at *6-7.

The court also denied the motion to dismiss a claim to hold the principals personally liable under Section 20(a). The investor alleged that the principals lied about their track record of managing cryptocurrency funds and the feasibility of the fund’s investment strategy. Id. at *11. Critically, the investor alleged that the principals knew by mid-2017 that the cryptocurrency “mania” was “likely not going to continue” and, because of that, they previously shut down a similar cryptocurrency fund, but failed to disclose these facts to the investor in late 2017. Id. These specific allegations were enough to clear the motion-to-dismiss hurdle.

Second, the court ruled that disclaimers in the fund’s PPM and Subscription Agreement did not defeat, as a matter of law, the investor’s reasonable reliance on the principals’ oral lies in late 2017 and early 2018. The defendants pointed to the Subscription Agreement, which the investor signed, and the PPM which both disclaimed reliance on “any representations … except as set forth in the Private Placement Memorandum or the Partnership Agreement.” Id. at *8 (internal quotation marks omitted). The investor convinced the court that “‘[s]tanding alone … a general disclaimer … is not sufficient as a matter of law to preclude reasonable reliance on material factual misrepresentations, even by a sophisticated investor.’” Id. at *8 (quoting FIH, LLC v. Found. Capital Partners LLC, 920 F.3d 134, 141 (2d Cir. 2019)). Coincidently, a Sadis & Goldberg Litigation team won the FIH appellate decision that the KDH court relied on.

Third, the KDH case is just one of many ways that cryptocurrency investors can use the securities laws to recover for cryptocurrency fraud. The Securities and Exchange Commission (“S.E.C.”) recently sued Ripple Labs, Inc. for using its digital currency – the XRP – as a security to raise money to fund Ripple’s business operations, without registering their offering of the XRP cryptocurrency under the securities laws. S.E.C. v. Ripple Labs, et al., 20-Civ-10832 (S.D.N.Y., filed Dec. 22, 2020). The S.E.C.’s case against Ripple shows that the securities laws may in some cases apply to direct cryptocurrency transactions.

The KDH court’s rulings provide useful guidance for investors seeking to recover for cryptocurrency fraud. The decision shows that the federal securities laws and the robust case law that has interpreted those laws are effective tools to seek a recovery even in the new frontier of cryptocurrency hedge fund investing. In addition, common law fraud claims under New York or other State Law may provide another way to recover an investor’s cryptocurrency losses.

Our goal is to provide readers and potential clients with focused updates about key legal developments and insights in this increasingly active area of the law. The Sadis Summons is intended as a general discussion, and is not intended as legal advice. For legal advice tailored to your specific legal situation, please reach out to your Sadis & Goldberg Litigation contact at https://www.sadis.com/capabilities/litigation. We welcome the opportunity to speak to you.
 

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[1] CoinMarketCap, available at https://coinmarketcap.com.

[2] PwC, 2020 Crypto Hedge Fund Report at 8, available at https://www.pwc.com/gx/en/financial-services/pdf/pwc-elwood-annual-crypto-hedge-fund-report-may-2020.pdf.

[3] Markets Insider, Crypto hedge funds gained 35% in February as bitcoin soared – following a 200% increase in 2020 for the growing industry, available at https://markets.businessinsider.com/currencies/news/crypto-hedge-funds-february-bitcoin-price-btc-cryptocurrencies-2021-3-1030240486.

[4] CoinMarketCap, available at https://coinmarketcap.com.