Co-authored by Todd Friedman, a commercial litigation associate at Kenny Nachwalter.
Permissionless blockchains, like the one underlying the bitcoin payment network, were created to provide the public with transparency over transaction information and records. Attorneys draft arbitration clauses primarily to do the opposite. Public access prevailed in the Eleventh Circuit's recent Leidel v. Coinbase decision, involving a dispute between aggrieved cryptocurrency investors and a money services business that converts fiat to and from crypto.
Given the staggering amount of money that has entered the industry in the last several years, coupled with underdeveloped regulatory guidance, crypto companies face an elevated risk of exposure to litigation. As a result, these companies increasingly rely on arbitration clauses in their terms and services to mitigate that threat. The Leidel decision highlights a potential pathway for aggrieved investors (crypto or otherwise) to avoid mandatory arbitration provisions by asserting claims that arise solely from duties owed by defendants under other duties imposed by law owed not only to the contracting parties, but also to third parties and the public.
Background
There is a growing number of regulated money platforms operating around the world that help customers convert cryptocurrencies, like Bitcoin, to and from fiat. But back in 2014, those seeking to convert their fiat into crypto had limited options. Purporting to provide an option, Paul Vernon opened an "exchange" in Delray called Cryptsy that claimed to offer fiat-to-crypto exchange services. Underneath the surface, however, Cryptsy had not built the infrastructure or obtained the necessary licenses, to directly facilitate crypto to fiat conversions. Instead, Cryptsy opened accounts with Coinbase (a regulated virtual currency financial service provider that allows users to buy and sell certain cryptocurrencies with fiat) to convert Cryptsy's customer's fiat into crypto. Cryptsy entered into a contractual relationship with Coinbase, agreeing to arbitrate all claims "arising under" the contract.
In January 2015, Vernon reportedly stole more than $8 million from Cryptsy's users and fled to China. He allegedly laundered the stolen funds through Cryptsy's and Vernon's accounts on Coinbase.
After Vernon fled the country, Leidel and a court-appointed receiver brought a class action suit against Coinbase for failing to adequately monitor, detect, and report Vernon's theft. The class obtained a default judgment against the financially defunct Cryptsy for $8.2 million, and brought tort claims against Coinbase, the only deep pocket left, alleging that Coinbase violated duties owed to Cryptsy's customers under federal and common law, including the Bank Secrecy Act. In sum, the Crypsty class alleged that Coinbase negligently failed to ask any questions when Cryptsy executed anomalously large trades.
District Court
In federal proceedings brought in Florida's Southern District, Coinbase moved to enforce its arbitration agreement with Cryptsy against Cryptsy's customers. Coinbase argued that any duty it owed to Cryptsy's customers necessarily arose out of the agreement with Cryptsy and the accounts established pursuant to that agreement, and therefore, the arbitration agreement governed the class's claims. The District Court rejected Coinbase's motion to compel arbitration on the ground that the class was not asserting any rights or benefits under Cryptsy's agreement with Coinbase, but were instead asserting rights owed to the class independent of the contract containing the arbitration provision, namely, rights owed under federal law irrespective of the contractual relationship: "the contract entered into between Cryptsy [and Coinbase] had nothing to do with the alleged wrongful conduct. Any indirect benefits Plaintiff received did not arise from the contract, but from the regulatory scheme under which [Coinbase] operates."
Eleventh Circuit
On appeal, the Eleventh Circuit affirmed the district court's decision, indicating that Coinbase's arbitration clause was narrow in scope because it only compelled arbitration of claims "arising under" the agreement, rather than also subjecting claims "related to" the agreement to arbitration. Furthermore, the Eleventh Circuit repeated that a significant relationship between a claim and an agreement "does not necessarily exist merely because the parties in the dispute have a contractual relationship" even where "the dispute would not have arisen but for the existence of the contract and consequent relationship between the parties." Rather, the court wrote that a claim must "emanate from an inimitable duty created by the parties' unique contractual relationship, [and a] claim does not have a nexus to a contract if it pertains to the breach of a duty otherwise imposed by law or in recognition of public policy, such as a duty under the general common law owed not only to the contracting parties but also to third parties and the public." Accordingly, the Eleventh Circuit held, "Because Leidel's claims rely on obligations allegedly imposed by law and in recognition of public policy to persons who are strangers to the user agreements, his claims neither rely on, nor bear a significant relationship to, those agreements."
Implications
Companies that provide customers with the ability to settle crypto transactions in U.S. dollars face the challenge of complying with a gauntlet of federal and state regulations. For example, companies like Coinbase must navigate 50 different states' money transmitter rules that often lack consistency in application or approach. To further complicate matters, money servicers like Coinbase may also owe duties to accountholders or their beneficiaries that arise under federal and state regulations unrelated to company's contractual relationship with its accountholders.
The Liedel decision provides insight for how aggrieved investors may be able to draft pleadings against third-party money service providers like Coinbase to avoid mandatory arbitration provisions. Leidel suggests that plaintiffs could focus on alleging duties owed to third parties and the public, rather than contractual duties only owed between the parties in privity. For defendants like Coinbase, the decision suggests, but does not answer, that a more broadly-worded arbitration agreement may withstand scrutiny, but a possible—though less likely—reading of the case could involve a potential retreat from the longstanding federal policy of strongly favoring arbitration clauses, at least where noncontractual rights are involved.
It is only a matter of time until the courts color in these lines. By some reports, parties have filed more cryptocurrency-related cases in the first four months of 2018 than all prior years combined. And with reports surfacing that Coinbase—only one of several U.S. digital currency platforms—reportedly generating more than $1 billion in 2017, it is inevitable that more disputes will require judicial intervention. Until the courts clarify the applicability of arbitration agreements generally toward claims arising under federal or state laws, institutional money servicers like Coinbase should update the scope of its arbitration clause and consider requiring their institutional account holders adopt terms and services of their own that compel their clients to arbitrate claims against ultimate money transmitters as well.
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