Crypto Fraud Is Likely to Continue. Here’s How the Courts Might Handle It.

A rule established in the 1980s has the potential to help crypto traders recoup some of their losses.

Illustration by II

Illustration by II

Amid the fallout of cryptocurrency exchange FTX’s implosion and subsequent bankruptcy, investors — and their lawyers — are considering ways that they can be made whole when faced with similar crises.

A working paper set to be published in the Harvard Journal of Law & Technology in 2023 attempts to show how legal teams could potentially use an SEC rule to sue crypto asset promoters who make false or misleading statements about the securities they trade.

While bankruptcy rules mean that investors probably won’t be able to use this law — called “Fraud on the Market” — to sue FTX or its team anytime soon, it could be considered in other cases. As the paper’s author — Menesh Patel, acting professor of law at UC Davis — noted, the increased use of crypto trading platforms likely means that more fraud will enter the market.

“Many [of the harmed] are retail investors who are ill-equipped to weather the financial losses that accompany fraud,” Patel wrote in a Columbia Law School blog post on the paper. “Such unchecked fraud not only risks injuring investors who trade the affected crypto assets but also risks damaging the reputation of legitimate crypto assets whose trading markets can be tainted by the prospect of fraud.”

Here’s how he believes a judge could interpret a crypto fraud case. Fraud on the market is a legal concept that is applied through an SEC rule called 10b5, which provides mechanisms for trader recoveries when the person they’re suing has made “materially false or misleading statements in connection with the purchase or sale of a security,” according to the paper.

Fraud on the market specifically dates back to the 1980s, when a company called Basic Inc. publicly denied that it had received a takeover offer from a competitor — even though it had. Investors who eventually sued Basic said these denials led the company’s stock price to fall, and as such, they lost money. They eventually won the case, and the fraud-on-the-market theory was born.

The idea is now “a mainstay of federal securities law and is essential to investors in securities class actions” according to the paper. However, because cryptocurrencies are a nascent asset class, the rule has not yet been applied to them.

According to Patel, crypto traders seeking to use this rule as part of a legal action will first need to show that a cryptocurrency falls under the court’s definition of either a security or a commodity. He notes that this will likely be the case, given that the SEC has brought numerous enforcement actions against cryptocurrency fraudsters.

Crypto investors will also have to show that the asset’s price “generally reflects material, public information,” according to Patel’s blog post. This is also likely doable, he notes in his paper, because past research has shown that currencies including Bitcoin, Ether, and Ripple responded to “public, material information” in a directionally appropriate way. That is, if there was bad news reported about Bitcoin, the price would fall in kind.

The paper shows that U.S. courts have a big job ahead of them when it comes to establishing if — and how — crypto traders can be made whole after experiencing fraud. The latest crypto winter, and the spate of revelations that have followed, will likely provide ample opportunity for them to try.