The Legal Risks with Investing in Cryptocurrency

Securities lawyer Jake Zamansky outlines potential issues and opportunities related to cryptocurrency, bitcoin and ethereum. For more information visit: https://www.zamansky.com/practices/bitcoin-and-cryptocurrency/

Transcript

Welcome to The Investment Lawyer Speaks, a podcast by the Zamansky Law Firm — founded by Jake Zamansky, one of the top security lawyers in the country. Listen along as we shed light on investment scams, negligence, and how you can recover your investment loss.

Nancy: Welcome to The Investment Lawyer Speaks, a podcast by the Zamansky Law Firm. I'm Nancy Rapp from PaperStreet, and I'm speaking with the founder of Zamansky Law Firm, Jake Zamansky. Jake is one of the preeminent lawyers in the country for securities fraud matters and FINRA arbitration. The law firm represents individual and institutional clients and cases against Wall Street firms for investment fraud losses. 

Today, we're discussing a topic that's no stranger to the news: cryptocurrency. The media is more negative than positive with this investment option. And Jake will help us understand some of the potential issues and legal options. Good morning, Jake.

Jake: Good morning to you.

Nancy: Thank you for joining us again.

Jake: Thank you,

Nancy: Jake, let's dive right into that many investors may not fully understand how cryptocurrency works and its connection to Bitcoin. Let's start with a brief overview. Could you provide us with some quick insights? 

Jake: Sure. Cryptocurrency is a digital currency designed to work as a medium of exchange through a computer network. It's not connected to any central authority like a government or bank. Many people also use this as an investment hoping it goes up in value like a stock. The two most popular coins are Bitcoin and Aetherium. 

I just want to mention a few of the key terms. First, the blockchain is a computer ledger that keeps track of all transactions held by a currency holder. Mining, like coal or gold mining, is the use of large computers with a lot of electric power to mine or generate coins. There’s also wallets. Just like you have a wallet in your pocket for your money, there's a software-based cloud service wallet used to hold cryptocurrency. And lastly, exchanges. When you buy a stock, it's on the NASDAQ or the New York Stock Exchange. Well, here we have crypto exchanges, where crypto is bought, sold, or held. Some of the most prominent ones we'll talk about are FTX, Genesis, and Coinbase.

Nancy: Now, what is cryptocurrency? What is its appeal to investors?

Jake: [Cryptocurrency interests investors who] don't want to go through a bank or the Federal Reserve. If I want to send my crypto to you, [we can send it back and forth] directly. So a lot of people want to use it to transact money without the fees and intermediaries. Now some of the problems are money laundering, and terrorists also use cryptocurrency. Also, a lot of people want to buy it. At one point, it went up tremendously in value, [but then] it went down, but a lot of people use it as an investment.

Nancy: Now, it seems like there seem to be more negatives than positives with this type of investment. What are some of the kinds of cryptocurrency claims that your firm has seen? 

Jake: Let me first say that crypto is not regulated by the Securities Exchange Commission or the Commodities Futures Trading Commission like a stock or a commodity would be. A lot of people have compared it to the Wild West — anything goes. 

There are some very serious risks that people need to understand. First of all, it's not insured. There's no FDIC like there is on bank deposits, and it's hard to convert tangible currency like US Dollars or Euros. And your crypto can be hacked, as we've seen many times. It's an intangible technical asset, which is hard to recover. So we've seen situations where people have had their accounts hacked — somebody comes in and just literally steals from your wallet. We've had people that have tried to sell Bitcoin on an exchange and their accounts were frozen. So you can't sell it, you can't take it out. Sometimes they bought coins that no longer trade. And we've also seen tremendous volatility. In the case of Bitcoin, it started trading a couple years ago at $10,000 or $20,000 a coin, then it went up to over $60,000, and now it's down to about $20,000 again. So we've seen a lot of volatility. But the biggest problems I've seen have been hacks and people not being able to access their accounts

Nancy: Understood. And I suppose a lack of regulation from the SEC is a big factor with that.

Jake: That's right. Nobody's watching the store. There are proposals in Congress and the SEC, but that takes time. So people have to get their arms around where they stand right now.

Nancy: Let's talk about one of the biggest cases that you've already alluded to that's everywhere in the media: Samuel Bankman Fried of FTX. Can you tell us about that case and what went wrong?

Jake: FTX was one of the largest crypto exchanges in the world. They had over a million customers. Sam Bankman Fried, they call them SBF, was a 30-year-old, bright young man. He was the founder and CEO of FTX and was in the Bahamas. In November of 2022, the FTX exchange was shut down — this $35 billion empire essentially collapsed and filed for bankruptcy. There are both criminal and civil investigations. SBF was arrested and charged with securities and wire fraud, as was his girlfriend, Karen Ellison, who has since pled guilty. She was the number two person in the company. SBF is charged with misappropriating billions of dollars of customer funds. 

This is one of the big problems that we see in the crypto space. He apparently was commingling customer funds with his own hedge fund, which was called Alameda Research, which also filed for bankruptcy. So we have customer funds from a million people that are supposed to be segregated into accounts. And he's essentially using their money or loaning their money to his own company, which violates an agreement that he had with customers. So SBF could face decades in prison. There are billions of liabilities to customers and a bunch of other lawsuits that have sprung up. 

Nancy: Explain the collapse a little bit more. We can see the fraudulent elements, or at least many of your listeners probably understand the fraud. But how does a company like that collapse? What happens, what goes wrong?

Jake: When anybody loses faith in the validity of an exchange, everybody tries to pull their money out. It's like a run on the bank. So if you had an accountant at JP Morgan Chase and there were problems, and millions of people tried to pull their money out, the bank could collapse. We saw that in the 1920s with banks. So there was news about FTX’s problems and SBF, and everybody tried to get their money out. It turned out the money wasn't there. The regulators started looking at it both in the Bahamas and in the States. And no one could do any business with FTX. They were trying to have themselves acquired by another firm. And it all just fell apart like a house of cards.

Nancy: Now there was something with brand ambassadors with FTX. And I think that people may have noticed that in the media, there are celebrities like Tom Brady, Steph Curry, and a bunch of others that were connected to the FTX and the collapse. How are those celebrities involved? 

Jake: Celebrities like Tom Brady, Gisele Bundchen, Steph Curry, the basketball player, Larry David, the comedian were on commercials endorsing FTX as a “safe and secure currency” to their millions of followers. When people see Tom Brady, a lot of people identify that he's used in other commercials for food and soft drink products. But the difference between those products and a financial instrument is if you're endorsing a financial instrument like FTX you have a responsibility, according to these lawsuits that have been brought, to do due diligence and to make sure you understand it. That’s because it's not just like a Subway sandwich — you're telling people that it's safe, that they can invest their life savings, their hard-earned money into this. So there are class actions against all of these individuals. And I believe that there could be substantial liability for the endorsers or influencers who were peddling this. There was one case where Kim Kardashian had to pay over a million dollars for something she said regarding a crypto investment. So this is a whole new area of law endorsers who could be held liable to FTX investors.

Nancy: Did they know about the scams going on? And then even if they didn't, could there perhaps have been negligence and not researching the companies further?

Jake: Yeah. I mean, that's part of the problem. It's unlikely that they knew about this. The question is, should they have had people looking at the company before they put their name behind it? That'll be a big issue. Even people like President Bill Clinton and the former prime minister of the UK, Tony Blair, were at a conference with SBF, lending tremendous credibility to him. So there are a whole bunch of questions. But I think one thing it's going to do is make these endorsers think twice before they endorse something like a financial product versus Gatorade or a Subway sandwich. There's probably a lower standard of responsibility, but not so here. So I think you're going to see some pretty interesting cases, and other people that are endorsing crypto also could be held responsible.

Nancy: Very interesting. It's a whole new branch of law connected to all of this, that's for sure. Now, we've talked about companies collapsing, but we've also seen some cryptocurrency companies going bankrupt — Genesis and Gemini were some of the most recent. What do investors need to know if the company they're investing in with cryptocurrency has gone bankrupt?

Jake: Bankruptcy is now one of the biggest risks that crypto customers are facing. You mentioned FTX, Gemini, and there's also a company called BlockFi that filed for bankruptcy. Once there's a bankruptcy, the court gets involved — a specific bankruptcy court marshals the assets and ensures an orderly distribution. 

It's very frustrating to customers in the crypto space when one of their exchanges files for bankruptcy. For example, customers will not have access to deposits while the bankruptcy court sorts out what's going on. 

Here's what customers should be doing: They should contact a claim agent and get involved in the claims process — this is usually on the website. There's a separate website set up by the bankruptcy court for FTX and Gemini. It's crucial that customers document what they had on deposit and what it was worth. So if you had FTX in November of 2022, you need to look at statements and records to show [how much you had in your account]. For instance, if you had half a million dollars in Bitcoin, establish what Bitcoin was trading at the time to establish your value. When you submit your claim, there's a form online that you should get and fill out just like in any other bankruptcy case. If you have a stock, like Enron, that goes bankrupt, you have to file a claim. So that's what you need to do here. 

Importantly, you need to follow the bankruptcy case for developments [on the website for the relevant bankruptcy court]. There are going to be a lot of different developments coming out. You should also stay involved in the claim process. You also might be looking for another exchange if you can get some of your money out. For example, there’s Coinbase, which is a leading exchange for buying and storing crypto, and Robinhood, which also trades stocks.

Nancy: When you were talking about monitoring bankruptcy and filing a claim and things like that, do lawyers get involved with this? Or is this really up to the investor?

Jake: Lawyers get involved. There are bankruptcy lawyers and class actions. It's expensive to hire your own lawyer for something like this. Most people who trade crypto are somewhat technologically savvy. So they should start by doing their own research. They also should see what class action lawsuits are filed, so that they can get involved in those — there may be recoveries there. But you’ve got to do your own homework in this particular situation.

Nancy: Jake, you mentioned that another major issue with cryptocurrency was hacked wallets. Could you discuss these situations, the legal ramifications, and what investors need to know about this situation?

Jake: Sure. Hacking has occurred throughout the crypto space. It's a real risk that the industry and customers are grappling with, and the industry is looking for a response. Again, it's important to keep accurate and meticulous records of what you hold. You could be hacked at any time. If your bank account is hacked at JP Morgan Chase, there's a very strong chance you're gonna get your money back, and that they'll be able to trace the funds because it's a bank. It’s not so with crypto, where most hacks go unresolved. It's hard to chase the involved criminals — many of them are overseas in countries that are not friendly to the US. 

So in a hack, when you look at your customer agreement that you have with FTX, or some of the other [exchange]s, they disclaim liability in many cases. In other words, they say, “We're not responsible if there's a hack.” Now, that's just the starting point. It's not the endpoint. 

I'll give you an example of a case that we looked at this past year. A company called IRA Financial was soliciting people to invest their IRAs in crypto. They had a relationship with Gemini that's now bankrupt, and that's where it was traded. IRA wasn't an exchange, they were just an introducing broker that gathered assets. Well, there was a hack of $36 million of customer funds. I got calls from numerous investors, and I looked at the agreements that investors sign. First, IRA financial had an arbitration clause. So you couldn't go to court, you had to go to arbitration and go to South Dakota, where the company was located. Somebody in New York or California probably doesn’t want to go to South Dakota, but that's where you had to arbitrate. 

Gemini had a different arbitration agreement. With them, the arbitration could be located at a different place on a different arbitration forum. But what's even worse is that both companies were pointing fingers at each other. IRA said, “We’re not responsible for the hack, talk to Gemini.” Gemini said the opposite. So investors really have a quandary here. If you bring a case like this, you need to prove that the exchange or the company did not have reasonable processes in place to protect against the hack. That's not easy to prove. So this is a tough challenge for the industry and customers.

Nancy: Now, is this a separate area that maybe new laws and regulations will stem from? You mentioned that crypto is not regulated by the SEC. Could the hacking come into a new area of law, like you have to have a certain amount of reasonable protection? Or is that even still undefined at this point? 

Jake: That’s something that also needs to be addressed. I mean, banks have responsibility. And even companies. There was a big hack of an oil pipeline a year or so ago during the winter. When you have a regulated industry like oil companies or banks, there are certain requirements to have certain firewalls against hacking, and you have to have insurance in many cases. That hasn’t happened yet in crypto. 

It’s a new area that's ripe for regulation. This was a trillion-dollar industry under fire from all circles. If [these companies] want to succeed and keep their customers, they're gonna have to have reasonable procedures and transparency. And they're going to have to give people confidence that if you put your life savings in a crypto account, you're not going to be hacked and lose everything.

Nancy: It’s a frightening thought. Now, we also mentioned crypto accounts being frozen. Does that follow the same elements as a hack and things like that? Is it the same conundrum? You just can't access your money, and you have to prove where you stood?

Jake: Absolutely. In the situation I described before, where there's a run on the bank, everybody's trying to get their money out. These crypto exchanges have frozen withdrawals. So at some point, you have to be able to show what you had and what it was worth. So yeah, absolutely. If there's a freeze, you have to stay on top of your crypto exchange, and you have to keep your records.

Nancy: Are freezes included in a lot of the cryptocurrency agreements, or is this something that's kind of just going rogue?

Jake: It's kind of a rogue situation. It's not something that's really contemplated. It's supposed to be a free-flowing exchange, but it's a real risk that people have to look at. So again, that'll be the subject of additional lawsuits.

Nancy: Now, we've talked about these cryptocurrency lawsuits, and it seems like each case has different elements and different situations that are involved, whether it's company security or what they're allowed to do when hacks happen. But what about just the damages and all of that? Investors expect the same amount of compensation and other things that they wouldn't in other investment fraud cases. Are there punitive damages? Do investors see anything from these cryptocurrency cases? Or is it just a question of getting their money back?

Jake: This is, as I say, a new area, and the cases are just being filed. Not a whole lot of laws have been developed yet. There are class actions against exchanges for disruption of services and hacks. I mentioned arbitration by individual customers against their exchange when there's a problem. There are all these bankruptcy proceedings and claims processes. So the courts will be deciding on a case-by-case basis, and it'll be an evolution of liability for crypto exchanges and other sellers. So it's a whole new space. We'll be putting out things on our website as new developments come up on Zamansky.com if investors want to keep in touch with us.

Nancy: As you just said, it does seem a little bit like the Wild West of the legal world.

Jake: It sure is. And like I said, it's developing. There are rules that pertain to banks, and when you give custody of assets to somebody, maybe the courts will look at some of those cases. But we're talking about a whole new technology of having your cryptocurrency in an online exchange created by a blockchain. So there's going to be a tremendous amount of litigation and people trying to keep their own records from the blockchain. So you’ve got to be careful — this is a very, very risky space.

Nancy: Even if somebody has not been persuaded by all the potential pitfalls that we've discussed so far, what can investors do to stay safe with crypto? Is there anything that they can do to try to make the most of the situation at this point?

Jake: I hope that we're showing investors that you have to be aware of these risks: hacks, shutdowns, bankruptcy, etc. You have to keep meticulous records of your holdings and what they're worth. But most importantly, you have to limit your investments to a small amount of your net worth. A lot of people, particularly younger people, are putting too much of their hard-earned money or savings into crypto hoping it'll zoom up in value as it once did. That may not happen again, and may not happen for a long time. So you have to have a very small percentage of your money in cryptocurrency. Otherwise, you could be in real trouble — for example, if you had 30 to 50% of your money or more in crypto. I've heard horror stories of people having all their money in crypto because they believe in the space. You should never do that. So it’s best to keep it very small until we get more confidence in the space.

Nancy: Do you anticipate that? Of course, these are just your own thoughts here. But do you anticipate that the SEC will ever step in and start to regulate crypto, or does it seem like the hands-off approach will be here for a long time to come?

Jake: I think the SEC will come in. There's the question of whether crypto is “security,” which is what the SEC regulates. Is it a security? Is it a commodity? Is it something else? There's a lot of political pressure and economic pressure. Again, this is over a trillion-dollar industry. But for there to be regulation, Congress has to get involved, and there are different factions there. I think it's coming, but it's going to take a long time and it's going to evolve. This is not something they're going to jump in and deal with right away. There are other economic problems that Congress in the SEC are dealing with, but it's certainly something that's on their radar, and I think it will eventually happen.

Nancy: All right, Jake. Well, you've certainly given investors a lot to think about. Thank you again for shedding some insight into this mysterious investment option of cryptocurrency, and thank you to our listeners for listening to the second episode of The Investment Lawyer Speaks. Jake will be here next time to give you more investment tips and security fraud warnings and discuss how to handle your legal situation. If you have any further questions, you can always visit Jake's website: Zamansky.com.  Thanks so much, everybody. Have a wonderful day.

Jake: Thanks for listening to The Investment Lawyer Speaks, a podcast by the Zamansky Law Firm. Please subscribe, rate, and share.