Cryptocurrency Risks Underscored in New $1B U.S. Lawsuit

March 7, 2018 by Hugo Miller

One of the highest profile digital-currency projects in Switzerland, a country that’s been among the most enthusiastic advocates for cryptocurrencies, is under fire from both outsiders and insiders over allegations of false marketing and mismanagement, prompting its president to resign.

Now the Tezos Foundation, which raised $232 million in an initial coin offering, is engaged in the most American of pursuits: a round of lawsuits.

The non-profit’s fundraising touted an all-new model for the blockchain technology that underpins cryptocurrencies. A group of investors are claiming in a California court that the entrepreneurs behind the offering misleadingly marketed the purchase of “Tezzie” tokens as part of a charitable contribution, which would leave investors with nothing if the project collapses.

Switzerland ranks second just behind the U.S. in capital raised in ICOs, with most of the transactions done by foreigners flocking to Switzerland, according to a 2017 report by venture capital firm Atomico. This case has broad implications for Switzerland’s future as a launching pad for ICOs.

“Will the judge accept the narrative that this was just like contributing to public radio and all you get is a tote bag, or was it an investment where everyone expected a return,” says Stephen Palley, a lawyer who runs the cryptocurrency practice at the firm of Anderson Kill in Washington. “The structure was misused and the age of token entrepreneurs going to Switzerland to set up Swiss foundations is probably over.”

Securities and Exchange Commission Chairman Jay Clayton last month said that ICOs will face fresh scrutiny as the market is probably full of fraud. The SEC has issued a clutch of subpoenas to ICO operators as part of a broad crackdown.

The Tezos lawsuit “should give Swiss or other foreign entrepreneurs and enthusiasts pause if they are thinking about trying to raise funds for a U.S. operation or from U.S. investors using an ICO structure that doesn’t comply with the registration requirements of the Securities Act,” says Joel Fleming, a Boston lawyer who represents some of the plaintiffs.

At a hearing on March 15 in San Francisco, the investors are expected to consolidate their putative class-action lawsuits. The legal action comes on top of a separate dispute between Tezos’s co-founders, a Franco-American couple named Kathleen and Arthur Breitman, and South African Johann Gevers, one of the pioneers behind Zug’s push to make itself a cryptocurrency hub. The Breitmans have accused Gevers of mismanagement and conflicts of interest.

$1 Billion?

The stakes for the Tezos project have risen to more than $1 billion, the plaintiffs allege, as the value of the ether and Bitcoin tokens which were used to invest in the ICO in July has surged. Bitcoin fell 1.4 percent to $10,636 at 7 a.m. in New York, according to a composite of prices compiled by Bloomberg. The leading cryptocurrency has fallen 25 percent this year after climbing more than 15-fold in 2017.

Late last year, the Swiss regulator that oversees foundations examined Tezos and demanded it add a board member to reinforce the foundation’s independence. On Feb. 22, Gevers stepped down as president of the Tezos Foundation and five days later, an entirely new board was appointed.

Oliver Bussmann, who worked with Gevers to establish Crypto Valley, acknowledged that the Tezos dispute has had a negative impact. But he said he’s glad that with a new board and Gevers’s resignation, Tezos appears to have “solved their deadlocked situation and can move forward.”

Gevers acknowledged a LinkedIn request but didn’t respond to a request for comment. On Jan. 19, he sent a flurry of tweets on the topics.

Interference, Obstruction

“After months of incapacitating interference, obstruction, and attacks, the Tezos Foundation has regained the ability to act,” he wrote. “In a high-trust environment, the impossible becomes possible. In a low-trust environment, even the possible becomes impossible.”

U.S. District Judge Richard Seeborg on Feb. 1 stayed any action in the planned class-action until the Supreme Court decides on whether state courts can handle such a case. Lawyer Brian Klein, who represents the Breitmans’ investment firm Dynamic Ledger Solutions, declined to comment to Bloomberg Law last month on the case against his client but said “we are pleased the judge issued the stay and recognized that this case belongs in federal court.”

The looming lawsuit comes as Swiss financial regulator Finma tries to temper some of the government’s enthusiasm for cryptocurrencies. While Swiss Economy Minister Johann Schneider-Ammann has visited Zug to support Crypto Valley, Finma issued guidelines in February to remind investors money-laundering rules will be applied to Swiss ICOs. The regulator has organized roundtable discussions with investors on how these guidelines will affect ICOs in Zug and Geneva on March 14 and 21 that are already fully booked.

Last September, Finma shut down cryptocurrency provider E-Coin for accepting deposits without a banking license, and then began investigations into several ICOs over possible fraud.

Bussmann, who now runs a cryptocurrency advisory firm in Zug, says the guidelines will dissuade rogue entrepreneurs and also provide more certainty for legitimate investors.

“They have to protect investors but they cannot shut out venture capital,” Bussmann said. “Switzerland has not always had great access to venture capital, and ICOs give them access to that.”

‘Notorious Haven’

The plaintiffs in California have a blunter assessment of Zug. In their lawsuit, they tar the city as a shady place to start a business.

“Zug is a notorious haven for white-collar miscreants,” reads the complaint, citing the past example of Marc Rich, a commodities trader eventually pardoned by Bill Clinton. “The defendants admitted that they chose to use a foundation in Zug to conduct the ICO and collect investor funds because they perceived Switzerland’s regulatory oversight to be weaker than that of the U.S.”

The case is Baker vs. Dynamic Ledger Sols., Inc. Northern District of California — 17-cv-06850-RS, 2/1/18