Crypto Goes Corporate: Litigation Sure To Follow

Until recently, cryptocurrencies appeared to be far from the kind of institutionally sound investments that would be attractive to CFOs looking to diversify a corporate portfolio. Once seen as gimmicks for unsophisticated retail investors, many of whom purchased cryptocurrencies based on obscure internet nomenclature, nonsensical children’s songs, or even notable hip-hop artists, few would expect the notoriously volatile electronic currencies to find their way into corporate treasuries. The joke appears to be over, or perhaps is just beginning to turn stale. As executives have sought to stash excess corporate cash into electronic currencies, the novelty assets are now an increasingly popular option to add to corporate ledgers. With this expansion into uncharted territory, however, comes additional risks, from both private litigation and regulatory scrutiny. Likewise, as with any novel asset, CFOs must balance their desire to invest creatively with the concerns of wary shareholders. On these fronts, cryptocurrencies present potential pitfalls for those charged with charting companies through modern-day legal and regulatory shoals.  

Bitcoin Benefits

Corporate investment thus far generally has been in what passed for established cryptocurrencies—principally Bitcoin—that have been part of the finance world for several years. Tasked primarily with cash and liquidity management, corporate treasurers traditionally invested in low-yield, low-risk assets like money-market funds, government debt, or commercial paper. So what could prompt an established company to move its valuable assets into a currency that can fluctuate based on internet message boards? The main answer is simple: inflation. For many, Bitcoin and other established cryptocurrencies are a kind of digital gold, an asset that should theoretically hold its purchasing power when other assets—e.g., currencies subject to fiscal and monetary policy—might not.  As financial analysts have explained in relation to Bitcoin, because there is no central bank involved in regulating its price and the supply is fixed, the cryptocurrency could serve as a hedge against inflation caused by central bank monetary policy. Now, with fiscal stimulus flooding markets following the Covid-19 pandemic, inflationary concerns have made cryptocurrencies with fixed supply more attractive to certain corporations. 

Leading the way are companies and executives known for forward-thinking and sometimes brash business practices. At the forefront of this trend is MicroStrategy Inc., a software company that boasts that it has been putting billions of corporate assets into Bitcoin and now claims that the majority of its corporate treasury is in the cryptocurrency. Square, a financial technology firm led by Twitter CEO Jack Dorsey, likewise has a more than $200 million corporate stake in Bitcoin. 

In the area of disruptive financial technology, though, Elon Musk is the undisputed center of gravity. (Indeed, some speculate that his public statements about the cryptocurrency markets have moved the price of the asset on their own.) Musk has been at the vanguard of the corporate shift to cryptocurrency investments and has been a public cheerleader of the asset. In a February 2021 SEC filing, Musk’s electric vehicle company, Tesla, disclosed that it had purchased $1.5 billion in Bitcoin. Since then, Musk has been coy about the company’s digital holdings, but overall has been the most prominent corporate executive to suggest that digital currencies are the wave of the future for sophisticated multinationals.  Musk has also suggested that Bitcoin may be a viable option for retail purchases. In March 2021, Musk indicated that Tesla customers would be able to purchase its electric vehicles using Bitcoin. Almost immediately, critics pointed out the environmental costs of Bitcoin extraction—called “mining”—and argued that the climate implications of expanded cryptocurrency use were inconsistent with Tesla’s “green” image. Musk was forced to reverse course on the acceptance of Bitcoin for consumer purchases, though the company affirmed that it would keep its own investment in the digital asset. Musk’s advocacy has not been limited to Bitcoin, however; he has recently said that he would not sell another cryptocurrency—Dogecoin—and even went as far as to say that SpaceX, Musk’s commercial rocket company, would make a Doge-funded trip to the moon. It remains to be seen, however, how much of Musk’s involvement in cryptocurrencies is serious or in jest, and his comments on the subject have preceded wild fluctuations in price.

Crypto Risks

As one might expect from a novel asset class with a checkered past, cryptocurrencies carry unique legal and regulatory risks. Corporate managers must first and foremost consider whether investing corporate funds in cryptocurrencies affects their fiduciary duties to shareholders. Cryptocurrencies are not without detractors, some of whom surely hold stock in companies that have been or are considering using assets to purchase cryptocurrencies. Although shareholder suits based on cryptocurrency acquisition have yet to make their way to the courts in meaningful numbers, as more companies stuff corporate coffers with Bitcoin and other digital currencies, more litigation could follow from dissatisfied holders of stock. The most straightforward litigation risk is that despite the theoretical promise of cryptocurrencies as fixed and intervention-resistant assets, cryptocurrencies are volatile.  As demonstrated by the recent and seemingly arbitrary swings in cryptocurrency markets—with prices fluctuating wildly in recent weeks—cryptocurrencies can be highly unpredictable. This uncertainty is not limited to novel or exotic digital assets; Bitcoin recently plunged nearly 30% in a single day, prompted in part by China’s crackdown on cryptocurrency transactions. Recent market volatility in Bitcoin’s price has led some to question whether the cryptocurrency can serve as a hedge against rising inflation. Furthermore, as governments move to more closely regulate the purchase and sale of digital assets, the potential for a disastrous loss for those with large stakes in digital assets will only increase. Should such losses hit corporate treasuries, CFOs and other managers may face claims that they mismanaged corporate assets.

Volatility aside, cryptocurrencies raise an even more basic issue: storage. Typically, a cryptocurrency is stored in a digital “wallet” to which the owner is given a private access code. If the owner loses this code, there is often no practical way to access the digital assets, a fact which has led some cryptocurrency owners to be permanently locked out of their digital wallets. Human error is not the only storage issue. Cryptocurrency wallets can also fall prey to hacking. Corporations that take large public stakes in cryptocurrency may therefore become prime targets for digital theft. Either loss could lead to shareholder litigation for mismanagement of corporate assets if the company failed to take adequate security measures to protect its cryptocurrency investment.

Furthermore, as Musk’s about-face on Tesla’s acceptance of Bitcoin payments shows, cryptocurrencies’ environmental impact could affect their viability as a corporate asset. According to one analysis, worldwide Bitcoin mining alone accounts for the same energy consumption as the country of Sweden. With investors increasingly sensitive to companies’ environmental impact and willing to bring shareholder initiatives to force corporations to be faithful stewards of the environment, corporations that invest heavily in cryptocurrencies will face mounting pressure to account for that investment in their disclosures of climate impact. Entities that are not transparent could face shareholder lawsuits alleging that they were withholding about the environmental risks of their investments and that such omissions caused the value of the company to drop.  Companies also must ensure that any investment in cryptocurrencies is consistent with previous corporate statements, lest shareholders bring claims that the prior statements were fraudulent or misleading. Investors have used companies’ generic statements about a company’s environmental, social, and governance (“ESG”) policies in other issue areas as the basis of a securities class action where the company’s conduct was inconsistent with its aspirational statements.  Thus, a company’s generic statements about its “commitment to sustainability” may be deemed misleading if it nonetheless invests in resource-consuming digital assets. CFOs must therefore be careful that corporate investments in cryptocurrencies do not contradict their prior public statements in a way that could be deemed misleading, lest they expose the company to litigation.

Other features of cryptocurrencies also could generate litigation. For starters, digital tokens still exist on the relative fringes of the financial world. The largely anonymous nature of most crypto transactions has made them the currency of choice for criminals of all stripes. Even companies engaged in legitimate transactions are trusting their corporate funds in an assets class whose track record and reputation is unproven. Indeed, the decentralized and unregulated nature of cryptocurrencies—principal selling points for some investors—also means that corporate managers are left without meaningful guidance on the legal implications of their investments. For instance, no cryptocurrency-specific guidance exists for companies about how they should account for cryptocurrency holdings on their corporate ledgers. The Financial Accounting Standards Board, which sets accounting standards for U.S. corporations, has yet to set forth rules for cryptocurrency in particular. U.S. Generally Accepted Accounting Principles (GAAP) also are silent on the treatment of digital assets. So far, this has led companies to apply the accounting principles established for “intangible assets,” akin to corporate goodwill or brand recognition. Importantly, this means that the companies cannot book gains in value if the price of the asset rises, but must write down their investment if the value falls.  Thus, for accounting purposes companies may find difficulty booking a return on investment for cryptocurrency. A company may be able to explain what it considers the value of its digital assets to investors through additional disclosures, but the constant and decentralized trading of digital currencies like Bitcoin on multiple exchanges means that investors will only receive an approximation of an asset’s value that could be outdated nearly as soon as it is issued.  A similar problem is that public companies subject to auditing requirements may have difficulty proving that they have “custody” over decentralized digital assets.  Insofar as shareholders are dissatisfied with digital investments, corporations currently have little ability to show that their decisions to invest corporate funds in cryptocurrencies are profitable.

The lack of pertinent accounting standards also complicates companies’ public disclosure requirements to the U.S. Securities and Exchange Commission. Without uniform standards, companies will have to make do and cobble together a compliant financial disclosure from whatever provisions they deem relevant to cryptocurrencies from the traditional methods set forth in GAAP. In disclosures to investors and to regulatory bodies, companies with cryptocurrency positions will need to be highly transparent and explain why they give digital assets the accounting treatment that they do and how the investment figures into the overall investment strategy. 

No doubt the SEC will scrutinize these disclosures closely. The Agency has made regulation of cryptocurrency markets a top priority. This is evident from both public statements and recent enforcement actions. SEC Chair Gary Gensler recently commented that he would like to see more regulation of cryptocurrencies and that the volatile nature of the investment warrants increased investor protection. Indeed, the Agency’s enforcement arms seem to be training their sights on the various ways that cryptocurrencies can harm investors. During the 2021 Financial Industry Regulatory Authority Conference, Gensler identified cryptocurrency markets as bastions of “deceptive conduct by private funds, offering or accounting frauds, insider trading, market manipulation, failures to act in retail customers’ best interests, reporting violations, best execution and fiduciary violations, [and] other form[s] of misconduct.”

Further complicating corporate investment in cryptocurrencies, the SEC has taken different positions on the legal status of various digital assets, leading some to criticize this regulatory uncertainty. In a lawsuit against Ripple Labs, the SEC has taken the position that the Company’s digital token, XRP, qualifies as a security that must be registered and otherwise comply with federal securities laws. Yet, the Agency has classified Bitcoin and another established digital asset, Ether, as currencies rather than as securities. For CFOs purchasing cryptocurrencies, the Agency’s increased attention to the assets means that companies should expect the legal landscape to change rapidly. This unpredictable regulatory landscape also poses potential for significant impact on the value of corporate holdings of digital assets.

Cryptocurrencies represent an intriguing opportunity for CFOs who want to store corporate funds in an asset class that offers unique benefits, not to mention the publicity that comes from making a bold investment. Notwithstanding these potential upsides, the cryptocurrency market is rife with uncertainty. Numerous pitfalls in the form of litigation and regulatory scrutiny mean that companies should be well-versed in the specifics of a digital investment and ready to react quickly to the legal consequences.

Anthony Sampson, an associate at the firm, assisted in the preparation of this blog.

To read more from Robert J. Anello please visit www.maglaw.com