Crypto Caselaw Minute #53–9/13/19
By: Nelson M. Rosario
Tags: Blockchain, Cryptocurrency, Law, Ethereum, Bitcoin

This week’s Crypto Caselaw Minute looks at a case of saying too much, how to apply foreign law in a token generation event, and a non-class action token lawsuit. When will stop writing about tokens? Haha, never. This is the Hotel California!

Disclaimer: Crypto Caselaw Minute is provided for educational purposes only by Nelson Rosario and Stephen Palley. These summaries are not legal advice. They are our opinions only, aren’t authorized by any past, present or future client or employer. Also we might change our minds. We contain multitudes.

(As always, Rosario summaries are “NMR” and Palley summaries are “SDP”. Our Image credit: https://pixabay.com/photos/apple-red-delicious-fruit-256261/ (Pixabay license).

SEC v. Mahabub, and GenAudio Inc., Civil Action №15-cv-2118-WJM-SKC (D. Col. ordered September 5, 2019)[NMR]

Link to order

You may not realize it, but most of what we cover at the ole CCM is at a high level about really basic stuff that your parents should have taught you. Stuff like keep your word, don’t lie, don’t cheat, don’t steal, do your best, be honest, eat your vegetables*, and things that are basically common sense. Anyways, if you do those things you likely won’t get in trouble that often in life. Anyways, you really shouldn’t lie about Steve Jobs being interested in your software if, you now, he probably isn’t. That tidbit and more are what is at the heart of this recent order out of Colorado in an SEC enforcement action.

This filing is an order from the district court judge granting an SEC motion in part for particular remedies against the defendants in this case: Mahabub and GenAudio. Who are the defendants? Well, Taj Mahabub founded a company called, yep, GenAudio. The idea behind the company was to turn any set of speakers into 3D surround sound sounding speakers. Pretty cool idea. Unfortunately, over a period of three years Mahabub made six public statements that were not true. The statements claimed that Apple, yes that Apple, was very interested in Mahabub’s technology. Now, Mahabub did speak with some mid-level executives at Apple, but he told people he was speaking with a global VP and that Steve Jobs was personally interested in the project. Why would he do that? Well, he was also engaged in the sale of unregistered securities for GenAudio during the relevant time period. As loyal CCM readers know the SEC doesn’t like that kind of activity, which is what prompted the enforcement action.

Mahabub did not contest the underlying facts of the case, so what is this particular filing about? Well, the SEC moved for a particular remedy in the suit. Namely, the SEC moved for disgorgement of Mahabub’s ill-gotten gains connected to his illegal securities offerings. Mahabub’s lawyers countered that this remedy wasn’t proper in this case, and even if that remedy was proper it should only be limited to $15,000 of loss that the SEC proved. The Court in this order was having none of that.

So, what about crypto? Well, the SEC provided a declaration from an accountant named McDevitt who spoke with Mahabub starting in July 2017, and who over the course of a year and more Mahabub confided the following:

• he owns a recording studio in California worth over $10 million; • he owns a yacht in Panama and land in Costa Rica; • he has made significant profits trading in Bitcoin; • he has started a new company to create software for automated cryptocurrency trading, and has contracts for work in that field; and • he is deliberately hiding assets from the SEC.

That doesn’t look good for Mahabub, but then the Court points out the following, which is somehow worse:

“Interestingly, he nowhere denies making the claims that McDevitt reports — indeed, he does not mention McDevitt at all. He instead directly denies owning a recording studio, a yacht, or real property; denies having profited from foreign currency trading (although he does not mention Bitcoin trading); and denies having real business prospects with his cryptocurrency software.”

Yeah, that’s not good. The Court goes on to say that it has no reason to believe Mahabub that he doesn’t have any money. So, what penalty is he looking at? Well, Mahabub owes $1,280,900, and his company GenAudio owes $4,503,000. Don’t do the frauds. If you do, own up to it and don’t try and hide your assets from the SEC. Mahabub is gonna have to pay. He’ll likely appeal, but it doesn’t look good.

*Vegetables are good for you bitcoin carnivores. Sorry not sorry.

In Re Xunlei Limited Securities Litigation, 2019 U.S. Dist. LEXIS 154010 (S.D.N.Y. decided September 10, 2019) [NMR]

This is a consolidated class action lawsuit where the defendants have just had their motion to dismiss granted for failure to state a claim. You don’t often see the defendants having success here at the CCM, but it happens. What’s the case about? Come on, it’s about a token offering that went wrong. Obviously.

The defendant is Xunlei Limited “an internet company operating primarily in China providing services such as content delivery network (“CDN”), download acceleration, video and gaming acceleration, and distributed cloud storage.” As was all too common in 2017 the company got the blockchain bug and in September released a blockchain based cloud storage service, thingamajig called OneThing Cloud. A month later Xunlei announced OneCoin as a rewards program crypto for users of the aforementioned service. They also rolled out a wallet, which allowed users to transfer OneCoin out to the exchanges and engage in speculation. Xunlei never had a relationship with those third party exchanges, which will be important.

Around the time of the launch of OneCoin the Chinese government announced a ban on ICOs. Shortly thereafter, in October 2017, an employee at a subsidiary of Xunlei told a trade publication that OneCoin couldn’t be an ICO, because you could only use it to buy Xunlei goods and services. A month later there was a disagreement between Xunlei and one of it’s business partners, who was also a VP at Xunlei, and this VP said publicly that OneCoin was a disguised ICO, an illegal fundraising scam, and that the Chinese authorities were already investigating the company. Yikes. That ultimately triggered a series of events that led to a crash of the Xunlei stock price, and the Chinese authorities issuing a risk warning to investors that the blockchain offerings of the company might be an illegal ICO.

So, what the heck is this doing in a US court? The plaintiffs here accused Xunlei of securities fraud due to the company’s statements surrounding the launch of OneThing Cloud, OneCoin, and the rewards program. In essence, the plaintiffs tried to use US security laws, because they had lost money according to them due to Xunlei’s alleged illegal conduct and misrepresentations. The plaintiff’s had one big problem that the Court points out. None of that is true.

The Court in its analysis looked at the official ICO notice from the Chinese government and the statement from the Chinese financial regulator and concluded that Xunlei had done nothing illegal. With respect to the supposed misstatements, the Court said:

“The statements in this article are not misleading because they are true. As already discussed, the Rewards Program was not a disguised ICO and Plaintiffs do not allege that Xunlei ever offered OneCoin in exchange for anything other than Xunlei affiliated products and services. Nor do Plaintiffs allege that the trading of OneCoin on third-party platforms had even begun on the date the Yicai Global article was published — six days after the

Rewards Program [*29] launched.”

Since the plaintiffs failed to show that Xunlei had done anything illegal, or that the defendants made any misrepresentations the Court granted the motion to dismiss. Rekt. The defendants were successful here in this forum, but it sounds like they still have issues back home to deal with.

Clemens v. Uledger, Inc. et al., 2:19-cv-07834, C.D. Cal., 9/10/2019 [SDP]

This is a new token sale lawsuit. It’s not a class action. Instead, it’s filed on an individual basis by Craig Clemens against Uledger and people involved in the sale and marketing of ULD tokens.

The Complaint says this sale raised $30 million between “late 2017” and “late 2018.” The lawsuit has 9 counts — 1 is for allegedly violating the Securities Act of 1933 by failing to register with the SEC and the others are state law claims, breach of contract and a variety of common law tort claims, along with a corporate veil peircing theory (styled as “alter ego liability”) in count 8.

Per the Complaint, “ULEDGER is a start-up technology company that purports to have succeeded in ‘leveraging blockchain’s capability to create an immutable history of data’ to give its customers ‘a secure, private, tamper-proof, mathematically verifiable record of the content of their data at a point in time.’’ By doing so, ULEDGER claims to provide its clients’ data ‘greater integrity and makes it easily verifiable in the event of audit, legal challenge, or regulatory inquiry.’” (So basically, Uledger is a blockchain company that uses blockchain to create secure data?)

Anyway, they raised $30 million, allegedly, and Plaintiff says he bought $300,000 of tokens, but that the sale was based on “many misrepresentations, factual omissions, and unlawful action”, that he will never see a return on his investment and that the Defendants enriched themselves at the expense of investors.

Oh, about the defendants — it’s not just Uledger, which plaintiff says was just a device to enrich individuals. So the complaint names the management team, including Taulant Ramabaja, Pete Anewalt and Josh McGiver. Also, it names Lorien Newman, who is described as a “Security Token Advisor” (remember those?) based in Israel.

One of the useful things about a corporation is that provides protection from individual liability — if it is set up correctly. In cases like this one, involving an alleged investment gone bad, it’s pretty typical for a plaintiff to sue individuals involved in the scheme and to try to show that the corporation was just a sham. That is part of what is going on here and why there is an entire count of the complaint devoted to “alter ego liability.”

What does this mean and why does it matter? If the Complaint only succeeds on a claim against the corporation alone, if and to the extent the veil pierced the individual defendants will be held jointly and severally liable. It also means that (assuming the claim stands) plaintiff will be able to do discovery related to corporate structure or lack thereof, as the case may be, and (potentially) some aggressive asset tracing discovery from the individual defendants before actually getting a judgment.

We’ve covered lots of token sale litigation in CCM and this one looks like many others that we’ve seen, with the interesting twist that the “security token advisor” was also added as a party. It also (again) shows how everything you say electronically can end up as an exhibit in a Complaint, including this excerpt where one of the defendants promises the sun, moon and stars: