What’s Happening in Technology, Arts, Small Business & Contracts – October 2017

Technology News

SEC files a complaint against initial coin offerings (ICOs) by companies REcoin and Diamond Reserve Club as well as individual Maksim Zaslavskiy.

Key terms: ICOs, material misrepresentation, deceptive acts, Securities and Exchange Commission

On September 29, 2017, the Securities and Exchange Commission (“SEC”) filed a complaint in the U.S. District Court of the Eastern District of New York against REcoin Group Foundation, LLC, DRC World, Inc. (aka Diamond Reserve Club or “DRC”) and Maksim Zaslavskiy. In this emergency action, the SEC claimed that Zaslavskiy should be stopped from:

[E]ngaging in illegal unregistered securities offerings and ongoing fraudulent conduct and misstatements designed to deceive investors in connection with the sale of securities in so-called “Initial Coin Offerings” (“ICOs”).

The complaint alleged that Zaslavskiy used the ICO process to raise at least $300,000 using material misrepresentations and deceptive acts related to token purchases.

REcoin is a Nevada limited liability company. According to the complaint, REcoin is engaged in the business of investing in real estate and developing real estate-related smart contracts.

Diamond is a company with its principal place of business being San Juan, Puerto Rico. According to the complaint, Diamond invests in diamonds and obtains discounts from product retailers for people who purchase a Diamond membership.

Zaslavskiy lives in Brooklyn, NY and is the sole owner, CEO and President of both companies. In addition, he holds an LLM from Cardozo.

For RECoin specifically, the SEC alleged that the following statements were materially false with regard to its ICO which appeared on its website until at least August 15, 2015:

(1)REcoin is “backed by real estate;” (2) REcoin will be “managed, tracked and authenticated through blockchain technology;” (3) “[A]n international team of attorneys and programmers have been working tirelessly on creating solutions for REcoin holders;” and (4) the above efforts would “inevitably lead to the exponential increase of the REcoin’s investment potential.

For Diamond, the SEC complaint alleged that it began promoting its initial membership offering (“IMO”) in July 2017. Like REcoin, Diamond purported that its IMO was hedged by physical assets, in this case, diamonds. In an attempt to distinguish its IMO from an ICO or IPO, Diamond explained on its Facebook page that:

“IMO is a brand new instrument of facilitating tokenized membership in a digital community or a club. Although, it appears to be similar to ICO or IPO, the similarities are scarce, if not nonexistent.”

Both REcoin and Diamond offered discount schemes where purchasers would receive a 15% discount for the ICOs.

Based on these and a number of other facts, the SEC brought this complaint under Section 2(a)(1) of the Securities Act [15 U.S.C. § 77b(a)(1)] and Section 3(a)(10) of the Exchange Act [15 U.S.C. § 78c(a)(10)] and asserted that the REcoin and Diamond offerings qualified as unregulated securities.

Under what is called the Howey test, derived from the case SEC v. W.J. Howey Co., a security may exist when 1) there was an investment of money; 2) there was a reasonable expectation of earning a profit from that investment; and 3) the profit expectation was due to the efforts of others.

In order to encourage the court to move quickly, the SEC stated that Zaslavskiy created over 18 websites designed to promote the Diamond coins which may result in additional fraudulent coin sales to the public.

The SEC requested that the court issue an order temporarily and preliminarily enjoining the defendants from “any future direct or indirect participation in any offering of unregistered securities” as well as any future violations of the Securities Act and the Exchange Act, as well as grant an order freezing all Defendants’ assets, enjoining defendants from destroying and altering evidence, repatriation of assets transferred abroad, a request to have Zaslavskiy surrender his passport, and a host of other requests made by the SEC as a result of these alleged violations.

SEC v. REcoin Group Foundation, LLC, et al., 17 Civ. 5725 (E.D.N.Y., Sep. 29, 2017

This is the first SEC complaint filed after it issued a warning related to its investigative report on July 25, 2017 finding that The DAO was offering unregistered securities in the form of tokens in exchange for “ether” a cryptocurrency developed by Ethereum. It is instructive that the SEC reviewed not only the published white paper, but paid particular attention to social media promotion. In addition, it is worth noting that when Zaslavskiy was questioned about his activities, he changed the white paper on his website in an attempt to destroy/alter evidence. This is called “spoliation of evidence” and a finding that a party to litigation altered, destroyed, withheld or fabricated evidence may result in sanctions against that party. The rules related to document destruction do not prohibit destroying documents which are not related to anticipated litigation or are otherwise required not to be kept by law. A document retention policy may assist companies who want to manage unnecessary and voluminous document files. Consider contacting Gayton Law to help your company with a document retention policy to manage your data as well as ensure retention of important information.

Intellectual Property

Motion to Dismiss based on Sovereign Immunity filed by Saint Regis Mohawk Tribe in Allergan case before the Patent Trial and Appeal Board.

Key terms: Patents, Sovereign American Tribes, Pharmaceuticals, Inter Partes Review.

This case tests the sovereignty limitations of American Tribes as it relates to intellectual property and patents in particular.

On September 22, 2017, the attorneys representing the Saint Regis Mohawk Tribe filed a Corrected Patent Owner’s Motion to Dismiss for Lack of Jurisdiction based on Tribal Sovereign Immunity with the United States Patent Trial and Appeal Board. In the Motion’s summary, the Tribe stated:

The Saint Regis Mohawk Tribe (“Tribe”), a federally recognized, sovereign American Indian Tribe, is the owner of U.S. Patent Nos. 8,685,930, 8,629,111, 8,642,556, 8,633,162, 8,648,048, and 9,248,191 (hereinafter “Patents-at-Issue”) that are at issue in these proceedings. The Tribe is a sovereign government that cannot be sued unless Congress unequivocally abrogates its immunity or the Tribe expressly waives it.

Background

In this case before the Board, several parties sought to challenge the validity of several patents using the inter partes review process against a previous patent owner, Allergan, Inc.

Allergan had brought an infringement action against Mylan, Teva and Akorn in the Eastern District of Texas in August 2015. Starting in June 2016, the defendants in the infringement action filed petitions for inter partes review. On September 8, 2017, Allergan, Inc. assigned its patents to the Saint Regis Mohawk Tribe which granted back an exclusive license to Allergan. The Tribe then filed an Updated Mandatory Notice indicating that Mohawk was the patent owner.

According to the Motion to Dismiss, since

Congress has not expressly and unequivocally abrogated the Tribe’s immunity for purposes of inter partes review

the inter partes review should not move forward due to the Tribe’s sovereign immunity.

The patents that Allergan held included Restasis, an eye drug which helps treat chronic dry eye. The patents related to this drug expire in 2024. The alleged infringers are considered “patent trolls” by Allergan and claimed that transferring the patent to the Tribe was a way to protect itself against generic drug makers who willfully infringe on the patents. The Hatch-Waxman Act is alleged to incentivize generic drug makers because it permits significant advantages for FDA approval which are not granted to the original inventor.

Inter Partes Review

An inter partes review (“IPR”) is a trial proceeding conducted by the United States Patent and Trademark Office’s Patent Trial and Appeal Board. This review process was introduced by the American Invents Act of 2011. According to the USPTO website, the proceeding is used to “review the patentability of one or more claims in a patent under Section 102 or 103 and only on the basis of prior art consisting of patents or printed publications. Section 102 addresses the conditions for patentability where the claimed invention is novel or has characteristics of novelty, e.g., it was not patented, described in a printed publication, or in public use, on sale, or otherwise available to the public before the effective filing date of the claimed invention, subject to exceptions. Section 103 addresses non-obvious subject matter where the claimed invention would be obvious to someone having ordinary skill in the art to which the claimed invention pertains.

Patents are considered to be personal property and entitled to protection by U.S. intellectual property law. Patent rights can be sold, licensed, or given. Absent a prohibition against the sale, licensing or gifting of patent rights, an owner is free to enter into agreements regarding those rights with whomever the owner chooses. Patent rights are unique because they do not grant the patent owner the right to use the patent (because there may be policies or laws which would prohibit a patent’s use, such as an invention related to pharmaceuticals) – rather, patent rights allow the owner to prohibit others from using the invention without permission.

Eleventh Amendment

This unusual motion to dismiss reveals some often overlooked facts about the relationship between the United States and sovereign American Indian Tribes. Under the Eleventh Amendment to the Constitution, the federal government, individual states and tribal governments cannot be sued unless such immunity has been waived. Specifically, the Eleventh Amendment says:

The Judicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by the Citizens of another State, or by Citizens or Subjects of any Foreign State.

The Indian Nations’ legal standing was set forth in at least three cases: 1) Johnson v. M’Intosh (1823); 2) Cherokee Nation v. Georgia (1831); and 3) Worcester v. Georgia (1832). The Bureau of Indian Affairs, created in 1824, serves as the intermediary between the tribes and the U.S. federal government.

Article 1, Section 8 of the Constitution says that Congress shall have the power:

To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes …

Coincidentally, this is the same article and section which states that Congress shall have the power:

To promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries …

Recognition of the Indian Nations’ sovereignty is well-established in the Constitution, case law, and legislation.

Congressional Action and Recent Court Orders

Senators Dianne Feinstein and Chuck Grassley of the Senate Judiciary Committee were asked by Senators Maggie Hassan, Bob Casey, Sherrod Brown and Richard Blumenthal to investigate whether Allergan was attempting to “shield its patents from review” in order to keep drug prices high. A bill was introduced by Senator McCaskill (D – Missouri) on October 5 called “Abrogation of Tribal Immunity” which states on the first page of the two page bill:

“To abrogate the soverign immunity of Indian tribes as a defense in inter partes review of patents.”

According to an article by Gene Quinn of IPWatchdog.com, “The hastily thrown together bill would only discriminate against Native American Indian Tribes and would allow state universities to continue to assert sovereign immunity pursuant to the PTAB’s January decision relating to a patent owned by the University of Florida Research Foundation.”

On October 10, 2017, Judge Bryson ordered Allergan and the Mohawk Tribe to submit a brief on October 13, 2017 showing that the patent transfer was not a “sham.”

See Allergan’s Motion to Join here.

Mylan Phamaceuticals Inc et al. v. Allergan, Inc.

This is a case to watch. Not only does it involve the right of a patent owner to freely alienate property rights, it outlines the inherent conflict of interest between the interests of Native American tribes as it relates to IP ownership and U.S. laws which curtail the exercise patent owner rights. It could also lead to more economic interference by the federal government into commerce as it relates prices. The IPR process has been under attack, in part because it has been alleged that the IPR is unconstitutional which is the subject of the Oil States Energy Service v. Greene’s Energy Group case before the Supreme Court this session. It is important to note that the IPR process was introduced as a result of the change from the “first to invent” patent system to the “first to file” system. Historically, only the first to invent was entitled to a patent grant in the United States. The AIA changed the law to grant a patent to the first to file a patent. Consequently, there are potentially many inventors who may have created the subject matter invention before the patent applicant. It is reasonable to deny a patent award under circumstances where the invention may have been known to the public (which goes to novelty) as well as well known to people who practice the art (which goes to non-obviousness). This is one case among many which challenge patent examiner analysis as well as the reliability of a patent grant causing confusion and potential diminishment of a patent’s value when subjected to the IPR process. 

Contracts

CFTC files complaint against Gelfman Blueprint for Bitcoin Ponzi scheme.

Key terms: algorithmic trading strategy, fraudulent and misleading solicitations, misappropriation of funds, Fifth Amendment.

Not to be overlooked in the cryptocurrency space, the Commodity Futures Trading Commission (“CFTC”) filed a complaint on September 21, 2017 against Gelfman Blueprint and its owner, Nicholas Gelfman (the “Defendants”), for operating a

Bitcoin Ponzi scheme in which they fraudulently solicited participation in a pooled fund that purportedly employed a high-frequency, algorithmic trading strategy, executed by Defendants’ computer program called “Jigsaw,” to trade the virtual currency Bitcoin, a commodity in interstate commerce.

Under 7 U.S.C. § 1a(9) (2012), Bitcoin and other virtual currencies are encompassed in the definition of commodity, over which the CFTC has jurisdiction.

According to the complaint, the Defendants made misleading claims and omissions to consumers in the form of solicitations regarding the reliability of the Jigsaw algorithm. Among the misleading statements were that 1) GBI customers averaged a 7-9% increase in their Bitcoin balances, 2) customers owned a specific Bitcoin amount and 3) GBI’s assets and performance were audited by a CPA. To conceal the fraud, GBI staged a fake hack causing the apparent loss of all GBI’s funds when in fact the Defendants misappropriated for themselves about $600k.

The CFTC started investigating GBI and issued an investigatory subpoena for Nicholas Gelfman which demanded his appearance on April 22, 2016. When Gelfman appeared at the hearing, he invoked his Fifth Amendment privilege against self-incrimination.

The CFTC then filed a case against GBI and Gelfman under the Commodity Exchange Act and related Commission Regulations.

Under the Act, it is unlawful to

“[U]se or employ, or attempt to use or employ, in connection with any swap, or a contract of sale of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity, any manipulative or deceptive device or contrivance, in contravention of such rules and regulations as the Commission shall promulgate …”

Under the relevant Regulation it is:

“[U]nlawful for any person, directly or indirectly, in connection with any swap, or contract of sale of any commodity in interstate commerce, or contract for future delivery on or subject to the rules of any registered entity, to intentionally or recklessly”

use any manipulative device, make any untrue or misleading statement of a material fact, engage in any act which would operate as a fraud or deliver or cause to be delivered a false or misleading report of market information.

The CFTC is seeking injunctive relief and requested a jury trial.

Commodity Futures Trading Commission v. Gelfman Blueprint and Nicholas Gelfman.

This is another case to watch. Many in the blockchain and cryptocurrency space have been paying significant attention to SEC’s actions related to ICOs, but this Commission deals specifically with fraudulent transactions related to commodities which include Bitcoin and other cryptocurrencies. These transactions were conducted under the auspices of a Bitcoin trading fund which had the earmarks of a private trading organization where potential and existing customers were solicited directly. Ponzi schemes are not new, so it is likely that the legal analysis for this Bitcoin case will undergo similar scrutiny.

Programs and Publications

Art on the Blockchain (AOTB). Cynthia Gayton is a co-host and co-founder with Jeff Clarkin of Art on the Blockchain podcast and MeetUp. This podcast and MeetUp intend to spread some light on the issues facing artists in this new technology and distribution space. Learn more here.

Legal Aspects of Engineering, Design and Innovation 10th edition by Cynthia Gayton

This edition was released in January 2017 and is available through the publisher, Kendall-Hunt publishers and on Amazon.com in paper and e-book form. This book is used in several engineering courses and is a useful reference for anyone interested in contracting, intellectual property, engineering practice, and other general legal issues. This new edition includes separate chapters for each intellectual property type, introduces and explanation of blockchain smart contracts, discusses trends in product liability, and has recent case law to highlight chapter topics. It also expands from a primarily engineering perspective to include design professionals and innovation-specific coverage.

Thank you for reading!

The information contained in this post is for general guidance on matters of general interest only. The application and impact of laws can vary widely based on specific facts. The information contained in this newsletter should not be construed as a substitute for consultation with professional advisors. Certain links in this newsletter connect to other websites maintained by third parties over whom Gayton Law has no control. Gayton Law makes no representations as to the accuracy or any other aspect of information contained in other websites.

© 2017 Gayton Law

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  1. […] case was discussed in Gayton Law News for October. Briefly, this the first SEC complaint filed after it issued a warning related to its investigative […]

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