District Court For The Southern District of New York Declines To Extend Securities Liability To Defendants Involved In The Uniswap Lab Crypto Exchange Because They Are Not Issuers Or Sellers Under The Statutes

On August 29, 2023, the court in in Risley v. Universal Navigation Inc. et al, Case No. 1:22-cv-02780 (S.D.N.Y. Apr. 4, 2022), dismissed claims under Section 12(a)(1) of the Securities Act of 1933[1] and Section 29(b) of the Securities Exchange Act of 1934,[2] against Defendants running a decentralized cryptocurrency trading platform called the Uniswap Protocol (the “Protocol”). Plaintiffs alleged that they suffered losses from fraudulent “scam tokens” that were traded on the Protocol. At the outset of the opinion, the Court identified Plaintiffs’ fundamental and incurable problem that required dismissal with prejudice: even though they had suffered identifiable losses from the alleged scams, they did not – and could not – identify the actual issuers or sellers of the scam tokens. Although Plaintiffs had cast a wide net naming numerous entities and individuals as Defendants based on their involvement with promoting and encouraging transactions on the Protocol, none of the named Defendants were “issuers” or “sellers” as required by Sections 12 of the Securities Act and 29(a) of the Exchange Act to impose liability.[3]  The Court noted that Plaintiffs’ theory for liability for the named Defendants would require legislation to extend the scope of liability under Section 12(a) of the Securities Act and Section 29(a) of the Exchange Act.    

The structure and operation of the Protocol was critical to the Court’s decision to dismiss the complaint. As discussed by the Court, “in a traditional stock or centralized exchange, buyers and sellers are matched on a one-to-one basis orders — when a buyer’s bid matches the seller’s ask, a trade occurs.” (Opinion and Order on Motion to Dismiss at 5 (citing First Amended Complaint, (“FAC”) at ¶ 38)). “By contrast, in a decentralized exchange (also known as a “DeFi” exchange), buyers and sellers are empowered to use nontraditional methods to trade and create tokens, including…liquidity pools.” (Opinion and Order on Motion to Dismiss at 5 (citing FAC at ¶ 39)). With liquidity pools, instead of users interacting with one another and matching trades, they instead interact with the pool. The Protocol is an “onchain [(meaning it operates directly on the blockchain)] system of ‘smart contracts’ that functions through an “Automated Market Maker” or “AMM,” which Uniswap claims replaces the buy and sell orders in an order book market with liquidity pools. (Opinion and Order on Motion to Dismiss at 6 (citing FAC at ¶ 78; v2 Whitepaper 1).” AMMs are basically algorithmic protocols that determine digital asset prices and automate asset trades on the liquidity pool. Liquidity pools gather assets through users called liquidity providers who contribute to a percentage of the crypto asset in a liquidity pool smart contract. Liquidity pools use AMMs that connect users aiming to trade pairs with the appropriate smart contracts for them. “Smart contracts” are self-executing, self-enforcing programs that write the terms of the agreement between buyers and sellers of tokens directly into the program’s code.

The Protocol operates on the Etherium Blockchain, which allows for the use of smart contracts.  The Etherium Blockchain uses an application standard called ERC-20 (Ethereum Requests for Comments) that allows for smart contract tokens to be created on Ethereum, which creates ERC-20 tokens. Starting in 2021, companies and issuers began raising funds through initial coin offerings most of which were launched as ERC-20 tokens and were not registered with the SEC and which were promoted with little information underlying the offering through social media and other informal processes. FAC at ¶¶ 47-59. As the Plaintiffs acknowledged, many of these issuers flocked to the Protocol, which allowed them to issue new ERC-20 tokens anonymously, without any sort of conduct verification or background check. Id. ¶ 59. 

The Court, acknowledging that the Protocol is subject to fraud (while also writing that it is “innovative and more efficient than centralized systems,” id. at 13), noted two major scams alleged by Plaintiffs that are common to the Protocol: “rug pulls,” where “a new issuer puts their tokens into a liquidity pool and receives Liquidity Tokens in exchange” only for “[t]he issuer [to] then prematurely withdraw[] their pool tokens, thereby removing all liquidity from the pool and leaving other investors with nothing but now worthless tokens[,]” FAC at ¶179; and “pump and dumps.” Id. at ¶180.[4]  Plaintiffs allege that Defendants were aware of these schemes and that they did “nothing to stop them because Defendants stand to profit from the liquidity fees” and that, “[b]y providing a marketplace for buyers and sellers, by assisting with the drafting of smart contracts, and by and through their ownership of governance tokens…Uniswap Defendants and the VC Defendants ‘facilitate[]’ these scam trades – and facilitated Plaintiffs’ trades of the Tokens.” Opinion and Order on Motion to Dismiss at 14.

Plaintiffs’ Section 29(b) claims – which sought recission of certain “contracts” – were grounded on the allegation that Defendants contracted with Plaintiffs through the Protocol’s use of smart contracts. To establish a violation of Section 29(b), a plaintiff must show that “[i] the contract involved a prohibited transaction, [ii] he is in contractual privity with the defendant[s], and [iii] he is in the class of persons the [Exchange] Act was designed to protect.” Thus, Section 29(a) can only render void those contracts which by their terms violate the Act. Recission is not permitted when the “violation complained of is collateral or tangential to the contract between the parties. In other words, “‘only unlawful contracts may be rescinded, not unlawful transactions made pursuant to lawful contracts.’” The Court held that Plaintiffs failed to allege the very first element of Section 29(a).  Here, the smart contracts in question were not unlawful and could be carried out lawfully. 

The Court reasoned that the smart contracts that were in operation for each liquidity pool were “similar to an overarching user agreement” and were “foundational” in nature, distinct from token contracts unique to a particular pool and drafted by specific issuers. Opinion and Order on Motion to Dismiss at 32.[5]  Aware that Plaintiffs, unable to hold the drafters of the token contracts accountable, sought to hold accountable those who drafted the code for the Protocol, the Court stated that holding the drafter of the computer code underlying the Protocol liable under Section 29(b) for a third-party’s misuse of the Protocol “defies logic.” Id. at 31. Citing again the fact this was a case of first impression, the Court reasoned that:

While no court has yet decided this issue in the context of a decentralized protocol’s smart contracts, the Court finds that the smart contracts here were themselves able to be carried out lawfully, as with the exchange of crypto commodities ETH and Bitcoin….Accordingly, the Court finds that Defendants’ underlying core and router contracts were collateral to the Scam Token activity – which occurred subject to the Token issuers’ activity and, for at least some, the issuer-drafted smart contracts – and constituted the sort of tangential activity that falls outside of Section 29(b).

Id. at 35-36 (emphasis added). See also id. at 37 (“Regulators may someday address this gray area in the securities laws….[T]he law is currently developing around these [decentralized] exchanges, such that Defendants cannot currently be held liable under a traditional Section 29(b) theory.”).

The Court also dismissed Plaintiffs’ Section 12(a) claims. “The list of potential defendants in a section 12(a)(1) case is governed by a judicial interpretation of section 12 known as the “statutory seller” requirements.” Opinion and Order on Motion to Dismiss at 39. Liability can attach if the defendant passed title or other interest in the security to the buyer for value. The Court did not accept Plaintiffs’ transfer of title theory – that because Defendants wrote the contracts allowing the Protocol to function, they were statutory sellers for each transaction occurring on the Protocol – because Section 12(a)(1) is not applicable to those who created the software code for a decentralized exchange to efficiently facilitate trades, and because no “Defendant[] can be found to directly control the Protocol to the degree that they hold title to assets on the Protocol simply because they hold certain tokens that can impact how the Protocol may function in the future.” Id. at 44.[6  The Court was also not convinced by Plaintiffs’ solicitation theory – that Defendants sold, promoted, and/or solicited Tokens to Plaintiffs directly in order to increase the value of their UNI governance tokens – because the social media posts from defendant CEO Hayden Z. Adams about the security of the Protocol and that it was “for many people” was too attenuated, analogizing it to a hypothetical scenario where NASDAQ or the NYSE published a social media post about the security of their exchanges for trading. Id. at 46 (quotation marks omitted). As can be clearly gleaned from the decision, the Court was unwilling to help Plaintiffs find a scapegoat for their claims just because the real defendants were unidentifiable.

The Court, in making it clear that Plaintiffs’ claims could not be pursued under the statutes, signaled that the issues presented in this case were best addressed by Congress:

In a perfect (or at least, a more transparent) world, Plaintiffs would be able to seek redress from the actual issuers who defrauded them. In the absence of such information, Plaintiffs are left to argue that Labs facilitated the trades at issue by ‘providing a marketplace and facilities for bringing together buyers and sellers of securities, in exchange for [it] having the ability to charge a fee on every transaction it made possible on the Protocol’ (FAC ¶ 199), and that Labs, Adams, and the VC Defendants, through drafting smart contracts that allow the Protocol to operate and owning UNI governance tokens, somehow ‘sold’ the Tokens as unregistered broker-dealers (id).  In a similar vein, unable to sue the issuers for their potentially unlawful solicitation efforts, Plaintiffs are left to sue Defendants for issuing statements on social media that the Protocol was “for many people” and “safe” to trade on, and for “transferring title” of the tokens in each liquidity pool to Plaintiffs in violation of the Securities Act.  (FAC ¶¶ 9, 52-53, 133, 198, 735; Pl. Opp. 28-30).  As explained below, the Court declines to stretch the federal securities laws to cover the conduct alleged, and concludes that Plaintiffs’ concerns are better addressed to Congress than to this Court.

Opinion and Order on Motion to Dismiss, ECF No. 90, at 28 (emphasis added). See also id. at 6 (regarding ERC-20 tokens, the Court noted that “each of them [issuers, or “developers”] theoretically could register their tokens with the Securities and Exchange Commission (the ‘SEC’), but such registrations are few, as Congress and the courts have yet to make a definitive determination as to whether such tokens constitute securities, commodities, or something else.” (emphasis added)) and 47 (“Whether this anonymity is troublesome enough to merit regulation is not for the Court to decide, but for Congress.”) (emphasis added).

The Court also appeared to suggest that the SEC should continue to try and regulate the crypto space. For example, the Court pointed to the benefits of having to register with the SEC, stating that whitepapers describing new coin offering do not provide nearly the amount of information that would be required in an SEC registration statement. Id. at 7. Additionally, the Court noted that, in the context of Plaintiffs’ Section 29(b) theory of liability, “[r]egulators may someday address this gray area in the securities laws,” pointing by way of example to a warning issued by SEC Chairman Gensler in September 2021 that “[t]here’s still a core group of folks that are not only writing the software, like the open-source software, but they often have governance and fees. There’s some incentive structure for those promoters and sponsors in the middle of this.”

On the face of it, this decision is likely to be viewed by those operating in the decentralized crypto exchange industry as a win, since the Court dismissed the Complaint with prejudice, leaving Plaintiffs to appeal to the Second Circuit, which they have done. However, if the Court’s reasoning is upheld and if other courts rule similarly for such claims, then there may be increased pressure on Congress to act to mitigate the scams purportedly occurring on this (and perhaps other similar) cryptocurrency exchanges. 

The docket for Risley v. Universal Navigation Inc. et al, Docket No. 1:22-cv-02780 (S.D.N.Y. Apr. 4, 2022), is accessible on Bloomberg Law here.


[1] Section 12(a) of the Securities Act of 1933 provides that:

(a) In general

Any person who--

(1) offers or sells a security in violation of section 77e of this title, or

(2) offers or sells a security (whether or not exempted by the provisions of section 77c of this title, other than paragraphs (2) and (14) of subsection (a) of said section), by the use of any means or instruments of transportation or communication in interstate commerce or of the mails, by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission, shall be liable, subject to subsection (b), to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security.

[2] Section 29(b) of the Securities Exchange Act of 1934 provides in pertinent part that “[e]very contract made in violation of any provision of this chapter or of any rule or regulation thereunder, and every contract…the performance of which involves the violation of, or the continuance of any relationship or practice in violation of, any provision of this chapter or any rule, or regulation thereunder, shall be void…as regards the rights of any person who, in violation of any such provision, rule, or regulation, shall have made or engaged in the performance of any such contract.”

[3]  Contrary to other recent decisions addressing violations of federal securities laws from cryptocurrency transactions, the Court here accepted Plaintiffs’ assertion that the Tokens in question were “bona fide securities” without making any factual findings on this issue. Opinion and Order on Motion to Dismiss, ECF No. 90, at 25.

[4] The Court noted that “Plaintiffs lay out several other scams that can take place on the Protocol[,]” including “what Plaintiffs refer to (somewhat imprecisely) as a Ponzi scheme[.]” Opinion and Order on Motion to Dismiss at 1.

[5] The Court explained the transaction approval process of the Protocol as follows: “Plaintiffs note that the first time a user attempts to swap a token or add liquidity using the Protocol, they must ‘approve’ the transaction, thus ‘giv[ing] the Uniswap Protocol permission to swap that token from [their] wallet.’…After doing so once, the user is seemingly not prompted again when trading in a second pool. This is further evidence that the contracts drafted by Defendants – namely, the core and router contracts underlying the Protocol – serve as a single, foundational base, where any token-specific terms are subject to the issuer who drafts them.” Id. at 34-35.

[6] Plaintiff argued in their Opposition to the Motion to Dismiss that Defendants had control over the Protocol by virtue of issuing themselves preferred Uniswap shares, in the form of a token called “UNI.” Memorandum of Law in Opposition to Defendants’ Motion to Dismiss, ECF No. 82, at 2.

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