Background
The plaintiffs in this action were Diamond Fortress Technologies, Inc. (Diamond Fortress) and its CEO, Charles Hatcher II. Diamond Fortress is a biometric software company that developed a patented software called ONYX. ONYX is a touchless fingerprint identification software that uses the camera on the user’s device to detect the user’s fingerprint and verify their identity. Diamond Fortress markets the software to third parties, which can integrate the ONYX software into their own platforms by purchasing a license and software development kit. Buyers often hire Mr. Hatcher as an advisor to assist with integration and management. The defendant was EverID, Inc. (EverID), a Delaware corporation active in the emerging blockchain and cryptocurrency industry. EverID created the cryptocurrency “ID Tokens.” In connection with ID Tokens, EverID developed a blockchain-based identity and financial platform but needed a means to verify user identities.
In September 2018, the parties entered into a License Agreement under which the majority of Diamond Fortress’s compensation would be in ID Tokens. The License Agreement granted EverID an exclusive license to ONYX for digital or blockchain wallet applications for a 10-year term. In exchange, EverID would compensate Diamond Fortress with an initial payment of US$2,500 plus “Run-Time Transactions Fees” equal to 15 percent of gross revenues received from the sales of products using the ONYX technology. The Run-Time Transaction Fees were due quarterly. The License Agreement further provided that EverID would grant Diamond Fortress 10 million ID Tokens, which would be delivered when EverID held its initial coin offering (ICO) (the cryptocurrency equivalent of an initial public offering) or other token distribution event(s) defined in the License Agreement. The 10-million-token grant would be treated as an advance and credited to EverID as payment for Run-Time Transaction Fees. The token grant was also subject to a lock-up provision, whereby the first 25 percent of the tokens would be distributed as of the ICO or other distribution event, and the balance of 75 percent of the tokens would be distributed in 20 equal quarterly distributions after the event. EverID executed a separate Advisor Agreement with Mr. Hatcher with a similar compensation structure.
On February 8, 2021, EverID had its ICO. At that time, EverID should have tendered its first partial payments to the plaintiffs. EverID failed to make these payments. Despite numerous efforts by plaintiffs ‒ both directly and through counsel ‒ EverID refused to respond or distribute the tokens. The plaintiffs filed suit for breach of contract in Delaware Superior Court. Upon EverID’s failure to respond or otherwise defend itself, the Court entered a default judgment against EverID under Rule 55(b). That much was relatively straightforward.
The puzzle for the Court was to determine the remedy given the novel type of consideration involved in these contracts. The Court found that the plaintiffs could treat EverID’s failure to provide adequate assurance of performance within a reasonable time as repudiation of the contract. And, the Court further found that this “repudiation coupled with simultaneous non-performance gives rise to an action for total breach, allowing the non-breaching party to bring an action for the entire contract price.” The question was how the contract price should be calculated. After granting the default judgment, the Court ordered the plaintiffs to submit supplemental briefing on damages and then issued this subsequent opinion on the computation of damages.
Analysis
The Court began its analysis with the acknowledgment that this appears to be a novel area of law in Delaware: “When the consideration to be paid on a contract is in cryptocurrency and the contract is breached, how does the Court calculate the judgment to be entered?”
The Court explained that before fashioning a proper award, it must first determine how to classify cryptocurrency, asking, “is it a security/investment contract, a commodity, property, or currency?” The lack of consensus among authorities exacerbates the problem. For example, the Commodity Futures Trading Commission (CFTC) says that digital currencies are commodities subject to its regulatory authority. The Securities and Exchange Commission (SEC), on the other hand, maintains that digital currencies are subject to the Securities Act of 1933 and the Securities Exchange Act of 1934. In mid-2021, Congress introduced the Digital Asset Market Structure and Investor Protection Act (Digital Asset Act). The Court pointed out that, under this proposed legislation, “it appears that a cryptocurrency’s characteristics at a given time best determine whether it is subject to SEC or CFTC regulation.” The Digital Asset Act provides that, within 150 days of enactment, the SEC and CFTC will jointly publish a proposed classification of each of the major digital assets as “digital assets” or “digital asset securities.” In defining “major digital assets,” the mandate refers the SEC and CFTC to the CoinMarketCap website as “an appropriate publicly available website” that publishes data on digital assets. Even though the Digital Asset Act is yet to be enacted, the Court in this case seemed to take as persuasive both the Digital Asset Act’s focus on the cryptocurrency’s characteristics, as well as its endorsement of CoinMarketCap.
Another source of authority considered by the Court was the test articulated by the United States Supreme Court in SEC. v. W.J. Howey Co., 328 U.S. 293 (1946). The Securities Act of 1933 defines a “security” to mean “an investment contract.” Under the Howey test, an investment contract is a “contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” The Howey Court explained that this test “embodies a flexible rather than a static principle, one that is capable of adaption to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” The Delaware Superior Court observed that other courts have applied the Supreme Court’s standard in Howey to determine whether to treat cryptocurrencies as securities. Citing recent federal authority in New York, the Court determined that this will be a “highly fact-specific inquiry” requiring a court to “examine the series of understandings, transactions, and undertakings at the time they were made.” The Court explained that, generally, courts applying Howey have found cryptocurrency to be a security.
The Court then proceeded to explain each of the three prongs of the Howey test and apply them to the instant case. The first prong is “whether an investment of money was part of the relevant transaction.” The Court explained that an investment of money “need not be made in cash.” Instead, the investment prong “refers more generally to an arrangement whereby an investor commits assets to an enterprise or venture in such a manner as to subject himself to financial losses.” The Court observed that several federal district courts have recently found the first prong “rather easily met” in the case of cryptocurrencies. Turning to the instant case, the Court found the first prong satisfied because the plaintiffs “committed both an exclusive license to their ONYX software and related professional services to EverID’s then-developing, blockchain-based cryptocurrency platform.” The plaintiffs, in turn, “elected to be paid in eventual token distributions rather than by traditional means ‒ knowing full well that cryptocurrency value is ever-fluctuating.” Hence, the plaintiffs “bore the risk of those fluctuations by agreeing to accept the cryptocurrency as payment instead of dollars and subjected themselves to any attendant financial losses.”
The second prong is whether “a common enterprise exists where the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment of third parties.” In connection with this prong, courts consider both “horizontal commonality” (shared risks and rewards between the investors) and “vertical commonality” (shared risks and rewards between the investors and the promoter). In this case, the Court appeared to find both sorts of commonality. The Court found vertical commonality because “EverID relied on the Plaintiffs’ software license and professional services (i.e., Plaintiffs’ investments) to successfully develop and launch its blockchain platform,” while, in turn, “the Plaintiffs’ ability to recover any remuneration for their investment was interwoven with and wholly dependent upon the successful launch of EverID’s blockchain.” The Court also found horizontal commonality because the enterprise represented “pool[ing] [of] invested proceeds to increase the range of goods and services from which income and profits could be earned,” where the value of each subsequent token distribution is “dictated by the success of the blockchain enterprise as a whole.”
The third prong is whether the putative investor entered into the transaction with the expectation to make a profit from the efforts of others. This criterion is satisfied where an investor’s fortunes “are directly tied to the failure or success of the products the investee purports to develop, and no individual investor can exert control over the success or failure of his or her investment.” In other words, an investment entails some relinquishing of control by the investor. In this case, the Court found that the plaintiffs’ expected returns “were directly tied to the failure or success of EverID’s blockchain platform.” The Court found that the plaintiffs’ “dependence on EverID to develop, launch, and support the blockchain” was sufficient to hold that the plaintiffs’ expectation of profits relied on the “essential efforts” of EverID.
The Court further found that both the License Agreement and the Advisor Agreement included language that token distributions were subject to regulatory compliance under Rule 144 of the Securities Act of 1933. The Court found that the inclusion of this language indicated that the parties themselves “anticipated treating the ICO and forthcoming distributions like those of a security.”
Having determined that the ID Tokens in this case should be treated as a security, the Court turned to devising a remedy that would place the plaintiffs “in the same place as [they] would have been if the contract had been performed.” The Court acknowledged the challenge of fashioning a remedy to account for “(1) the volatile and unregulated nature of cryptocurrency; (2) the express terms of the Agreements requiring immediate distribution of 25% of the total token grant at the ICO (a concrete and discernible amount); and (3) the remaining periodic token distributions whose values are so unpredictable that a blanket damages calculation indeed could operate as a windfall.” The Court explained that it must proceed in a two-step process: First, it must find a reliable cryptocurrency valuation source “to ensure the proper input of values.” Second, it “must ascertain the proper method for calculating the damages such that it will place the Plaintiffs in the same position they would have been [in] had the Agreements been fully performed.”
With respect to the first step, the Court found CoinMarketCap to be “a reliable cryptocurrency valuation tool” based on the reliance on CoinMarketCap by other courts, the Digital Asset Act’s endorsement, and the frequent use of CoinMarketCap by news publications that report on virtual currency prices. The Court relied on historical pricing data published by CoinMarketCap to determine the proper U.S. dollar value of the ID Tokens.
With respect to the second step, the Court agreed with the plaintiffs that, but for the novelty of the security instrument, this lawsuit is analogous to any other “failure to deliver securities” case. The Court relied on well-established Delaware precedent that damages in a failure to deliver securities case “are determined by the highest market price of the security within a reasonable time of a plaintiff’s discovery of the breach.” The Court explained that “a reasonable time” should be a measure of how long it would have taken the plaintiff to replace the securities on the open market ‒ and that Delaware courts have accepted two to three months as a reasonable period. Against this backdrop, the Court calculated the damages by multiplying the number of total tokens awarded under each of the Agreements by ID Tokens’ highest intermediate value within three months of the discovery of EverID’s breach. The result was a judgment for Diamond Fortress in excess of $20 million and a judgment for Mr. Hatcher in excess of $5 million.
Key takeaways
- Cryptocurrency characterization and valuation is still a new and emerging field in Delaware and nationally.
- Looking at both the intentions of the parties and precedent from other jurisdictions on the treatment of cryptocurrencies, the Delaware Superior Court held that cryptocurrency tokens may be treated as securities.
- Where cryptocurrency tokens are treated like securities, the damages for breach of a contract to be paid in such tokens will be calculated under well-established precedent for “failure to deliver securities” cases.
- The Court found CoinMarketCap to be “a reliable cryptocurrency valuation tool” that can be used as an input for the value of cryptocurrencies when calculating damages under the “failure to deliver securities” framework.
Client Alert 2022-129
