Traders in the United States now routinely trade hundreds of crypto assets in secondary crypto markets, and the pool of tradable assets is growing. Through these transactions, traders have seen financial gains and losses, which at times have been substantial. But in addition to market-generated gains and losses, these traders risk significant financial loss from fraud by crypto asset sponsors or others.

Additional regulation may diminish such fraud ex ante, but defrauded traders may seek ex post relief in the form of private litigation. Traders sustaining losses from secondary transactions of stock or other more conventional assets routinely seek class-wide relief under Rule 10b-5, and defrauded crypto asset traders may as well.

Should they be allowed to do so, as both a doctrinal and public policy matter? A host of considerations bear on this question. In a recent article, I focus on two, one doctrinal and one public policy related.

A primary doctrinal consideration is definitional: Under what conditions will an exchange-traded crypto asset qualify as a security because it is an investment contract under the Supreme Court’s multipronged Howey test? My article evaluates the investment contract issue as it relates to exchange-traded crypto assets with an emphasis on Howey’s common enterprise and efforts of others prongs.

The contours of Howey’s prongs have been shaped by courts in primary transaction cases, that is, cases in which investors directly or indirectly transacted with the enterprise’s promoter. In a secondary transaction case – such as one involving an exchange-traded crypto asset – investors will have transacted with their trading counterparties, perhaps with the involvement of one or more intermediaries, and those counterparties ordinarily will not have been the enterprise’s promoter. Unlike those involving crypto assets, investment contract cases arising in connection with primary transactions did not involve instruments that readily lent themselves to secondary trading, so courts have not had much occasion to consider the operation of Howey in the secondary transaction context.

In many instances, the investment contract rules that courts have developed in primary transaction cases have been articulated in a manner that allows them to be sensibly applied to secondary transaction cases. That is not true for the horizontal commonality test, one of the three tests that courts use to assess Howey’s common enterprise prong. Because of its pooling requirement, that test is ill-suited for use in secondary transaction cases and thus requires reorientation.

The article proposes a slight generalization of the horizontal commonality test to make it suitable for both secondary and primary transaction cases. The generalized test recognizes that pooling is but one method by which investors’ financial interests in the underlying enterprise can become intertwined in the manner that horizontal commonality requires. Under the generalized test, horizontal commonality will be present if there is some mechanism, pooling or otherwise, that ties investors’ fortunes to one another and makes them dependent on the enterprise in which they are invested.

This test reasonably broadens the scope of instruments for which horizontal commonality would be found. As relevant to the article’s question of interest, even if there were no pooling of a secondary crypto asset investors’ purchase amounts, the generalized horizontal commonality test may still be satisfied because the asset’s trading price can serve as a non-pooling mechanism that causes the pecuniary interests of the crypto asset’s traders to be linked and dependent on the success of the crypto asset and any of its associated applications. For the crypto asset’s price to actually have served that non-pooling role for purposes of the generalized horizontal commonality test, the crypto asset’s price must generally respond to material, public information in a directionally appropriate way. As part of its analysis, the article also explains why certain facts of the investment contract cases that courts have analyzed to date – such as the presence of a contract among the investment contract’s promoter and the investors – simply represent common factual features shared by the decided cases, rather than elements of the pertinent legal rule.

The article also addresses aspects of Howey’s “efforts of others” prong relevant to application of Howey to exchange-traded crypto assets. First, the article explains that Howey’s efforts of others prong should not be understood as requiring a centralized body that exerts the requisite entrepreneurial or managerial efforts. Howey’s efforts of others prong instead is better understood as requiring investors to have reasonably believed that their profits were significantly determined by the entrepreneurial or managerial efforts of those other than the investors themselves, whether or not those “others” constituted a centralized group.

Second, investors’ expectations concerning the use of their sales proceeds is doctrinally irrelevant to Howey’s efforts of others analysis, which instead focuses on investors’ expectations concerning whose entrepreneurial or managerial efforts significantly determined their expected profits. Thus, the fact that investors’ sales proceeds in a secondary crypto asset transaction case may not have flowed to the crypto asset’s sponsors would not itself prevent Howey’s efforts of others prong from being met.

The article’s public policy analysis is prompted by the observation that stock-based Rule 10b-5 class actions have been the subject of academic criticism, intense at times. Supported by two longstanding primary critiques known as the circularity critique and the diversification critique, prominent voices have argued that stock-based Rule 10b-5 class actions fail to properly advance their intended public policy objectives of deterrence and compensation. Other scholars have disputed the relevance of the circularity and diversification critiques and also have identified theories that provide alternate public policy justifications for stock-based Rule 10b-5 class actions, with the leading example being a corporate governance justification for stock-based Rule 10b-5 class actions.

A normative inquiry into whether defrauded crypto asset traders should be able to rely on Rule 10b-5 class actions implicates a range of subsidiary questions. One is whether the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than for stock-based Rule 10b-5 class actions. If so, then that would support legal change that limits the availability of crypto asset-based Rule 10b-5 class actions, relative to stock-based Rule 10b-5 class actions, such as the adoption of prophylactic steps in the form of legislation or doctrinal modification that would curb crypto asset-based Rule 10b-5 class actions before they became commonplace, as stock-based Rule 10b-5 class actions have become. The article evaluates that specific public policy question in terms of the circularity and diversification critiques and the corporate governance justification.

While its public policy determinations are mixed and in part preliminary, the article’s analysis does not lend support to the notion that the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than the public policy justification for stock-based Rule 10b-5 class actions. As the article explains, the circularity critique has significantly less relevance in the crypto asset context than in the stock context. While the diversification critique may be more or less relevant in the crypto asset context than the stock context, nothing in the analysis indicates that it is significantly more relevant in the crypto asset context than the stock context. An offsetting consideration is that the corporate governance justification loses its relevancy in the crypto asset context.

This post comes to us from Professor Menesh S. Patel at the University of California, Davis – School of Law. It is based on his recent article, “Secondary Trading Crypto Fraud and the Propriety of Securities Class Actions,” available here