A new crop of legal challenges await issuers of the Bitcoin exchange-traded funds now available to broad swaths of investors, lawyers say.
The investment vehicle’s broad appeal means that issuers need to go above and beyond standard compliance with disclosure requirements, focusing on investor education to acquaint those less familiar with volatile digital assets, crypto-focused lawyers say. Security and custody issues that traditional asset classes don’t face are also seen as potential sources of litigation for the Bitcoin ETF sponsors.
“This is where litigation always comes into play; if it’s in the prospectus, that’s not always a ‘get out of jail free card,’ depending on what the asset is,” said Fred Rispoli, senior managing partner at Hodl Law PLLC. Hodl is one of a crop of firms now advising companies on crypto-related disclosures and representing retail investors in class action litigation over digital assets. “How much are you really putting it in their face instead of on page 24 in size 12 font?”
The term “hodl” caught on with the crypto community after one Bitcoin investor’s rant on a popular online forum featured that misspelling of “hold.” It’s since taken on the double meaning for some traders of “hold on for dear life,” Rispoli said. He adopted it for his firm’s name to emphasize its crypto focus.
Behind closed doors, the transition of the crypto asset manager’s Grayscale Bitcoin Trust into an ETF more than a decade after its inception was a matter of carefully tailoring disclosures for a wider audience of investors, said Joe Hall, partner at Davis Polk & Wardwell LLP who advised Grayscale in its listing of the product on an exchange. GBTC has more than $20 billion in assets, according to Bloomberg terminal data.
“The issues surrounding the fact that this asset is Bitcoin, and the particular disclosure issues that raises are ones that we and Grayscale have been working on for almost a decade at this point and they are significant,” he said. “We had to start from scratch in describing the asset, how the asset is traded, risks associated with the trading of the asset, and the market structure for the spot market well before the SEC ever agreed to allow the spot product to trade as an ETF.”
Grayscale, Fidelity Investments, VanEck, and BlackRock Inc.’s iShares are championing more widespread adoption of Bitcoin through retail accounts, retirement plans, and institutional investments. As first movers in issuing the products, they also may be among the first to shoulder legal risks associated with bringing a volatile asset class to the masses.
Clarity Helpful
Complex exchange-traded products are nothing new, with examples like inverse and leveraged ETFs sold to retail investors posing significant hurdles to an uninitiated investor’s comprehension, which issuers have accounted for in risk disclosures, said Cliff Cone, partner at Clifford Chance who advised on the VanEck and iShares spot Bitcoin ETFs.
Additional regulatory clarity on the status of cryptocurrency would also aid in issuers’ efforts to make the tokens truly accessible and ubiquitous on exchanges, he says. Regulators have long relied on a standard known as the Howey Test, derived from a 1946 Supreme Court ruling in SEC v. W.J. Howey & Co., which seeks to determine whether an investment was made in a common enterprise with the expectation of profits derived from the efforts of others.
“It would really be helpful to the cause if Congress created a framework to regulate crypto, rather than having litigators and practitioners in the space go back and try and shoehorn these products into a Howey analysis from 1946 that couldn’t possibly contemplate this kind of asset,” Cone said
Issuers hoping to avoid litigation should also be willing to invest in financial literacy education to the same extent they invest in the development of new products, said Amanda Wick, CEO of the Association for Women in Cryptocurrency, who is also a former prosecutor and senior investigative counsel for the US House of Representatives. The speed of adoption doesn’t always keep pace with an increase in consumer protections or awareness around the technology underlying the asset class, she said.
“If these ETFs don’t do an incredible job on consumer education, if they don’t explain this asset and what it is, I think they put themselves at risk of lawsuits,” Wick said. “Even the ones that legally might not be valid, they still could open themselves up to lawsuits if the facts are egregious enough. It won’t stop plaintiffs’ lawyers from filing a case that legally might not be valid, if optics-wise it shakes money loose from trees.”
Insurability Uncertain
Issues with the custody and security of underlying crypto assets is another area that could raise legal concerns for ETF issuers more accustomed to more traditional asset classes and the accompanying safeguards, according to Zack Shapiro, managing partner at Rains LLP.
“Insurance isn’t a settled question yet for digital assets, that’s not really a thing that exists yet,” he said. “If something goes wrong with custody—this has been known to happen in crypto, if there’s a hack or the keys are lost, or something like that—that would create a massive flurry of litigation and class action questions.”
Bitcoin’s tendency to follow historic peaks with up to 80% in drawdowns on a roughly cyclical basis is another factor that could also flood ETF issuers with lawsuits in the future, according to Hodl Law’s Rispoli.
He predicts that cycle could combine with the widespread accessibility of the digital asset to a new class of retirement savers, prompting a wave of class action litigation upon the next significant drawdown.
“There’s just a lot of people in these retirement plans that will be like ‘What 80% drawdown? I didn’t know anything about that!” Rispoli said. “The millennials and zoomers will be like, ‘Come on boomer, how did you not know about this?’”