Fraud on the Crypto Market

The secondary trading of crypto assets, once a niche activity, is now mainstream. A diverse array of investors now readily rely on the secondary trading of crypto assets for portfolio appreciation and diversification, but significant investor protection concerns loom. Previously, instances of crypto asset fraud primarily occurred in the context of crypto asset initial offerings. Between 2017 and 2019, thousands of crypto assets were offered to the public and others through initial coin offerings. Many of those offerings were legitimate, but many other crypto asset initial offerings were riddled with fraud, with crypto asset sponsors and others misrepresenting to investors key aspects of the offering.

But as crypto asset investing has grown to encompass the widescale secondary trading of crypto assets on crypto exchanges, the focal point of fraud has concomitantly evolved to also encompass fraud occurring in connection with secondary crypto asset transactions. False or misleading statements by crypto asset promoters or third parties risk significant injury to the millions of investors who are or will be engaged in the secondary trading of crypto assets. Those affected investors include many retail investors who are ill-equipped to weather the financial losses that accompany fraud, as well as institutional investors that are increasingly engaging with the crypto asset ecosphere. Such unchecked fraud risks injuring investors who trade the affected crypto assets and also the reputation of legitimate crypto assets whose trading markets can be tainted by the prospect of fraud.

Both the Securities and Exchange Commission and the Commodity Futures Trading Commission actively exercise their civil enforcement powers to deter and redress fraud occurring in the context of crypto asset transactions. Defrauded investors themselves also have brought private suits, including class actions, to recover their fraud-based losses. As defrauded crypto asset traders seek redress, courts will be asked to make doctrinal determinations that will be pivotal to injured traders’ ability to recover. A primary issue that courts will need to confront is whether crypto asset traders can avail themselves of fraud on the market in connection with claims asserted under SEC Rule 10b-5 or CFTC Rule 180.

In this paper, I show that fraud on the market is available in Rule 10b-5 and Rule 180.1 cases involving secondary transactions of a crypto asset occurring on a crypto exchange, because those assets’ prices, as a general matter, are informationally responsive in manner doctrinally required. That does not mean, however, that crypto asset traders in every case will be able to avail themselves of the doctrine’s rebuttable presumption of reliance. Instead, traders’ ability to do so in a given case depends on whether they can establish the doctrine’s elements, which in turn will depend on the specific circumstances of the crypto asset at issue and the market or markets in which it trades.

As the paper explains, while fraud on the market originated and was shaped in Rule 10b-5 cases involving the secondary trading of stock, nothing doctrinally limits fraud on the market to stock transactions. Instead, the doctrine is predicated on how the asset transacts—in particular, whether the asset trades in a market where the asset’s price sufficiently incorporates material, public information—and traders’ assumed reliance on the integrity of that price. Before the Supreme Court’s 2014 decision in Halliburton II, many lower courts understood fraud on the market as grounded on the semi-strong efficiency of asset prices, a financial economic notion of price responsiveness that demands that material, public information be fully and rapidly reflected in an asset’s price. Halliburton II made clear that fraud on the market is not predicated doctrinally on such an exacting standard of price responsiveness and instead is based on the weaker notion that an asset’s price generally reflects material, public information.

For purposes of ascertaining the availability of fraud on the market in cases involving an exchange-traded crypto asset, Halliburton II’s general efficiency standard thus renders inapposite an inquiry into whether crypto asset prices are semi-strong efficient. The relevant efficiency standard is met with respect to exchange-traded crypto assets because, as empirical studies show, crypto asset prices generally respond to material, public information. Furthermore, while crypto assets ordinarily generate no cash flow for their holders, and therefore those assets’ positive price will exceed the assets’ fundamental value in terms of the net present value of their discounted cash flow (which will be zero), that too does not preclude, as a doctrinal matter, availability of fraud on the market in crypto asset fraud cases.

While fraud on the market is available to defrauded traders in Rule 10b-5 or Rule 180.1 cases involving an exchange-traded crypto asset, to be able to avail themselves of the doctrine in a given case, traders must establish its elements, including the general efficiency of the at-issue crypto asset’s price. The paper also articulates a framework for how fraud on the market should be applied to the crypto asset context and discusses methodological issues relevant to the framework’s application in a given crypto asset case, including considerations relating to the use of event studies for assessing price efficiency of the at-issue crypto asset.

Menesh Patel is a Professor of Law at UC Davis School of Law.