Crypto contagion – handling risk on several fronts | Proskauer – The capital commitment

by Arthur · April 4, 2023

Crypto firm bankruptcies and resulting disruptions to the crypto ecosystem will continue to exacerbate liquidity and regulatory concerns in this area. Signs of contagion are evident as the prices of almost every type of cryptocurrency have halved in recent months. Since all participants supporting the crypto ecosystem are at risk, managing this risk is critical.

Fund managers should be prepared on several fronts, as the following examples illustrate:

Regulators Expand Scope: The SEC is not only targeting fraudulent offerings, but is scrutinizing all participants, including investors, in crypto transactions. At last count, the SEC and CFTC have brought five times as many crypto enforcement actions as the rest of the regulators in the world combined.
Exchanges Under Scrutiny: Following well-publicized crackdowns on decentralized finance (DeFi) platforms, the enforcement spotlight is shifting to crypto exchanges. With recent collapses, regulators are under pressure to act.
DOJ: While the DOJ will undoubtedly continue to focus on the low-hanging fruit of outright fraud in the crypto space, you can expect to see more complicated money laundering prosecutions against exchanges and others who, whether knowingly or with willful blindness, facilitate crypto transactions that conceal or promote illegal activity.
Trading Issues: The CFTC and SEC will use templates traditionally used in the securities/commodity space for most crypto and crypto-related assets. For example, anti-manipulation, anti-touting, insider trading, statutory warranty, etc.
DAOs and NFTs: These projects have a number of regulatory requests – the SEC sees them as potentially under its jurisdiction, regardless of what they are called.
Private Claims by LPs: When an investment goes south, questions of hindsight will be raised, including about due diligence and whether the investment was appropriate for the fund.
Private securities lawsuits: When crypto companies falter, venture capital firms that backed the company are likely to be targeted by plaintiff firms looking for deep pockets.

TerraForm Labs illustrates the challenges that crypto businesses face on several fronts. When linked cryptocurrencies TerraUSD and Luna collapsed, their developer TerraForm Labs was already facing multiple regulatory investigations and had filed suit to contest the enforcement of an SEC subpoena. After the collapse, TerraForm Labs, along with its venture capital fund backers (known as the “Luna Foundation Guard”), were hit with several class action lawsuits in the United States. Each case included a variety of allegations, including RICO and/or securities violations and alleged that Luna Foundation Guard’s investments caused artificial inflation of the Terra tokens, which ultimately contributed to their collapse. Class action lawsuits by crypto investors against deep-pocketed venture capital funds are likely the next step. The explosion zone for such claims will potentially include limited partners who exercise control, through board representation, or involvement in operations.

The conclusion: the end is not yet in sight, rather this is only the end of the beginning. Regulators and plaintiffs’ lawyers show no signs of backing down anytime soon. In the words of SEC Chairman Gary Gensler: “Until crypto platforms comply with time-tested securities laws, the risk to investors will persist. It remains a priority for the SEC to use all of our available tools to bring the industry into compliance.”

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