Delaware Supreme Court Defines Damages in Deals Involving Cryptocurrency
Blockchain tokens have come to the public's attention with the proliferation of Initial Coin Offerings (ICOs) and the volatility of cryptocurrencies. Companies and virtual organizations are using blockchain tokens not only to raise non-dilutive capital but also to compensate or incentivize employees, consultants, and other service providers. However, such novel structures inevitably raise the question, "If a contract providing for token-based consideration is breached, how does the court calculate the judgment to be awarded?" along with some others.
A recent Delaware Superior Court ruling in Diamond Fortress Techs., Inc. v. EverID, Inc. clarified the treatment of cryptocurrency assets in calculating damages and established a framework for analyzing cryptocurrency assets in future actions. This ruling provides valuable guidance on classifying digital assets, valuation of cryptocurrency, and calculation of damages arising from a breach of a contract paid with cryptocurrencies. It also underscores the need for a novel perspective when dealing with such digital assets.
Background
This breach-of-contract action arises out of EverID, Inc. (the "Defendant") 's failure to compensate Diamond Fortress Technologies, Inc., and its CEO Charles Hatcher, II (collectively as the "Plaintiffs") for their combined assistance in developing EverID's cryptocurrency trading platform and mobile application.”1
EverID created the cryptocurrency ID Tokens alongside a blockchain-based identity and financial platform but needed the means to verify and validate users' identities. At that time, Diamond Fortress, a biometric software company, developed a patented software called ONYX which enables contactless fingerprint identification by using the camera of mobile devices to recognize the users' fingerprints and verify their identity. Diamond Fortress marketed the software to third parties, who can integrate it into their platforms by purchasing a license and software development kit. In addition, buyers often engage Mr. Hatcher as a consultant to assist with deployment procedures and management.
Accordingly, in September 2018, the parties entered into a license agreement under which EverID was granted an exclusive license to ONYX for digital or blockchain wallets for ten years. In addition, the parties entered into a separate consulting agreement with Mr. Hatcher, under which he agreed to provide services as an independent contractor to advise and assist EverID.
The Plaintiffs agreed to be compensated through distributions of ID Tokens at the initial coin offering or later at regular token distribution events ("TDEs") in both agreements. Under the license agreement terms, Diamond Fortress was to receive 10 million ID tokens, whereas Mr. Hatcher was to receive 2.5 million. Additionally, the ID Token grants were subject to a distribution lock-up provision. The initial 25% of the tokens would be distributed as of the ICO or final TDE, and the remaining 75% would be distributed after ICO or final TDE.
Although EverID held its first ICO on February 8, 2021, and several TDEs later, Plaintiffs never received tokens. After informally and formally demanding the contractual token distributions without EverID responding, the plaintiffs eventually filed suit and obtained a default judgment on the legal question of breach of contract.
Analysis
EverID's failure to assure within a reasonable time and inability to make payment constituted repudiation and a complete breach of both agreements.2 Given the novel circumstances of this case, the issue was not EverID's liability but the calculation of damages for EverID's failure to distribute ID Tokens.
As Judge Wallace noted, the otherwise straightforward breach of contract case raised new questions: what is the remedy when the counterparty is a new cryptocurrency with "volatile and unregulated" value, and in calculating that value, should the Court classify that cryptocurrency as a security/investment contract, commodity, property, or currency?3
The classification of cryptocurrencies.
Due to the lack of consensus among certain authorities, the Court first addressed the classification of cryptocurrencies under the proposed Digital Asset Market Structure and Investor Protection Act ("Digital Asset Act"). Under the Digital Asset Act, it appears that the characteristics of a cryptocurrency at a given time best determine its classification.
In addition, the Court applied the Howey test to ID tokens. It examined the totality of the parties' understandings and expectations when they were made and found that the ID tokens constituted an investment contract and, therefore, security when the plaintiffs suffered damages.4
- Investment of Money
The first consideration under Howey is whether a monetary investment was part of the transaction. As the Court noted, an investment of money refers more generally to an arrangement in which an investor contributes assets to an enterprise in a manner that exposes them to financial loss.
In this case, the plaintiffs invested their expertise and resources (e.g., an exclusive license) into EverID's then-developing platform. In return, the Plaintiffs agreed to be compensated with token distributions, knowing that their volatile nature exposed them to the risk of financial loss. Therefore, the Court found that the Plaintiffs' obligation to provide software and consulting services in exchange for ID Tokens constituted an investment of money.
- Common Enterprise
Howey's second consideration is whether there is a common enterprise in which the investors' fortunes are intertwined with and dependent on the efforts of those seeking the investment.5 In the context of this criterion, courts consider both "horizontal commonality" (shared risks and rewards among the investors) and "vertical commonality" (shared risks and rewards between the investors and the promoter).
In this case, the Court found vertical commonality because "EverID relied on Plaintiffs' software license and professional services (i.e., Plaintiffs' investment) to develop and launch its blockchain platform successfully." In turn, "Plaintiffs' ability to recover ID tokens for their investment was intertwined with and wholly dependent on the successful launch of EverID's blockchain."6 The Court also found horizontal commonality, as EverID's venture represented a pooling of invested proceeds to drive the platform's success, as the value of the tokens depended on the success of the blockchain venture as a whole. Therefore, the Court concluded that the common enterprise criterion was met.
- Expectation of profits derived from the efforts of others
Given that Plaintiffs granted EverID an exclusive license in exchange for ID tokens to be distributed at the ICO, Plaintiffs reasonably believed that this compensation arrangement would provide a pro-rata return of profits in proportion to their initial contribution or investment. Indeed, given that the token allocation was not in addition to payment for Plaintiffs' services but was traditional compensation for their contributions to EverID, Plaintiffs were dependent on EverID to develop, launch, and support the blockchain. Because Plaintiffs could not be compensated until after the initial ICO, their expected returns were directly dependent on EverID's substantial efforts, success, or failure. Accordingly, the Court found all of this sufficient to meet this criterion.
As SEC emphasizes in its framework, the Court does not depend solely on the satisfaction of the Howey test but also considers the economic reality of the parties' entire transaction. In this case, the Court finds that the Plaintiffs' overall investment in the platform was based on their expectation of being paid in the form of eventual distributions of ID tokens, which are inherently volatile.
Now that the Court has determined that the ID tokens, in this case, constitute an investment contract and ID Tokens should therefore be treated as securities, the Court then moves on to the question of damages.
The calculation of damages.
Under Delaware law, it is generally accepted that damages for breach of contract serve to place the injured party as he would have stood had the contract been performed.7 The volatile and unregulated nature of ID tokens presented a challenge in determining a reliable valuation source. Concerning this challenge, the Court found that CoinMarketCap is "a reliable valuation tool for cryptocurrencies," given other courts' reliance on the Digital Asset Act's endorsement of it and the widespread use of pricing data published by CoinMarketCap.8
In determining the price of a constantly fluctuating cryptocurrency, the Court relied on the fact that damages in a securities delivery default case "are determined by the highest market price of the security within two or three months of the plaintiff's discovery of the breach."9Therefore, the Court has calculated damages by multiplying the total number of ID tokens promised under each agreement by the highest value of the ID tokens within three months of discovering the breach.
Conclusion – Key Takeaways
In this case, the Court emphasized that multiple agencies may have regulatory authority in a given area at the same time. Thus, the fact that a cryptocurrency may be regulated as an investment contract under the Securities Act of 1933 does not necessarily mean that a cryptocurrency is not a commodity for purposes of the Commodity Exchange Act.
This case presents an important consideration for parties agreeing to receive cryptocurrency consideration in exchange for services. Because the Court's ruling indicates that this method of valuation was chosen based on the classification of ID tokens as securities at the time of the parties' commitments, parties should take note of this ruling and be aware that other courts may not categorically classify cryptocurrencies as securities, but instead consider the economic reality of their transactions. Parties should pay close attention to the breach of contract and damages provisions.
The parties should also consider possible infringement scenarios and negotiate how damages will be calculated. According to the Court's decision, damages for breach of contract are calculated similarly to retained securities if the parties have not agreed on specific methods for calculating damages. Thus, the breaching party is obliged to pay damages in the amount of the highest value within a reasonable period of time after the breach.
As the Court also recognizes that cryptocurrencies are novel, evolving, and defy categorical classification, it is still a big question whether courts and regulators will continue to apply traditional securities concepts to cryptocurrencies. It remains to be seen whether the same or similar analysis will be applied in calculating damages with respect to other blockchain tokens in cases where their status as "securities" is less clear or when they are purported "utility tokens."
Diamond Fortress Techs. Inc. v. EverID Inc., CA N21C-05-048-PRW-CCLD (April 14, 2022).
Diamond Fortress Techs. Inc. v. EverID Inc., CA N21C-05-048-PRW-CCLD (April 14, 2022).
Diamond Fortress Techs. Inc. v. EverID Inc., CA N21C-05-048-PRW-CCLD (April 14, 2022).
Diamond Fortress Techs. Inc. v. EverID Inc., CA N21C-05-048-PRW-CCLD (April 14, 2022).
Diamond Fortress Techs. Inc. v. EverID Inc., CA N21C-05-048-PRW-CCLD (April 14, 2022).
Diamond Fortress Techs. Inc. v. EverID Inc., CA N21C-05-048-PRW-CCLD (April 14, 2022).
Diamond Fortress Techs. Inc. v. EverID Inc., CA N21C-05-048-PRW-CCLD (April 14, 2022).
Diamond Fortress Techs. Inc. v. EverID Inc., CA N21C-05-048-PRW-CCLD (April 14, 2022).
Diamond Fortress Techs. Inc. v. EverID Inc., CA N21C-05-048-PRW-CCLD (April 14, 2022).