Tuesday, April 19, 2022

Delaware issues ‘novel’ ruling on crypto damages

By Anne Sherry, J.D.

The Delaware Superior Court determined that parties to a contract denominated in cryptocurrency were entitled to over $25 million in damages. While the classification and valuation of cryptocurrency, as well as the calculation of damages resulting from the breach of a cryptocurrency-paid contract, were novel matters to Delaware, the court reasoned that the lawsuit was otherwise a standard case of failure to deliver securities (Diamond Fortress Technologies, Inc. v. EverID, Inc., April 14, 2022, Wallace, P.).

The defendant, EverID, developed a cryptocurrency, ID Tokens, alongside a blockchain-based identity and financial platform. To verify and confirm users’ identities, EverID contracted with biometric software firm Diamond Fortress and its CEO (plaintiffs) to integrate Diamond’s ONYX software into its cryptocurrency platform. The plaintiffs agreed to be compensated in ID Tokens when EverID held its ICO and upon subsequent Token Distribution Events. The ICO and several TDEs arrived, but the plaintiffs received no tokens. They sued and obtained a default judgment on the legal question of breach, and the court held a hearing on damages.

State of crypto categorization. As an initial matter, the court wrote that it needed to characterize the ID Tokens as a security/investment contract, a commodity, property, or currency. The CFTC claims cryptocurrency as a commodity, the SEC’s DAO report calls it a security, and the concurrent regulation is confounding analysis in the courts. Under the proposed Digital Asset Market Structure and Investor Protection Act, the cryptocurrency’s characteristics at a given time determine whether it is subject to SEC or CFTC regulation. The bill would direct the SEC and CFTC to publish a joint proposed rule classifying each of the “major digital assets” (as reported by CoinMarketCap) as either a digital asset or a digital asset security.

The court next observed that courts applying the Howey test have determined that cryptocurrency is a security. The first prong of Howey—that a monetary investment was part of the transaction—is clearly met. Similarly, a common enterprise exists that either pools investor assets (horizontal commonality) or ties investors’ fortunes to the fortunes of the promoter (vertical commonality). Finally, cryptocurrency transactions satisfy the third Howey factor when investors expect to profit.

ID Tokens are securities. Applying these principles, the court concluded that a Howey analysis leads “inexorably” to the classification of the ID Tokens as a security. Plaintiffs committed assets (a software license and related services) and agreed to accept cryptocurrency down the road in lieu of dollars. EverID’s efforts to develop a successful token created a common enterprise. And the plaintiffs’ expected profits were directly tied to the fate of EverID’s blockchain platform. The court also put some weight on the fact that the parties agreed in their agreements that token distributions would be subject to Securities Act Rule 144.

Failure to deliver securities. Mindful of the fact that damages for a breach should not act as a windfall but should place the non-breaching party in the position they would be if the contract had been performed, the court had to account for the volatile nature of cryptocurrency and the express terms of the agreements. But putting aside the fact that the contracts were denominated in cryptocurrency, the dispute was otherwise a fairly standard case of failure to deliver securities. In these cases, damages are based on the highest market price of the security within a reasonable time of a plaintiff’s discovery of the breach.

The court found a three-month time period after discovery of the breach was reasonable. Referring to CoinMarketCap as a reliable source for the tokens’ value during this time period, the court determined that the highest price for the tokens was $2.01. As the plaintiffs together had been promised 12.5 million tokens, the court awarded $25,125,000 in damages, plus pre- and post-judgment interest.

The case is No. N21C-05-48.