Congratulations!
Your client just closed on the purchase of a cutting-edge, blockchainbased payment processing startup. Before this deal, you had heard of bitcoin and blockchain. But, you had never seen a company that actually accepted payment in bitcoin and other cryptocurrencies. You were a little confused by the whole idea. However, your client liked the prospect of purchasing a company that had dealt in digital assets, so you didn’t think much about it.
Arriving to the office the day after the closing, you open up your computer to learn news of a hack at one of the big bitcoin exchanges. The article explains that hackers had accessed the hot wallets on the exchange and made off with over $150 million in digital assets. News of the hack sent the price of bitcoin tumbling 15% in the four hours following the incident. Other digital assets had plunged even further. The headline jumped out at you because the company that your client just purchased used custodial wallets on the exchange to store a lot of its digital assets.
Five minutes after you finish reading the article, you get a call from your client. Sure enough, a good chunk of the digital assets that your client had just purchased were lost in the hack. To make matters worse, the new company had just lost 5 percent of its book value because of the crashing cryptocurrency market.
Volatility of Digital Assets Means Risk
The world of cryptocurrencies has matured somewhat. But, scenarios like the previous hypothetical above remain a real possibility. Indeed, 15 percent price swings in a matter of hours are still common for cryptocurrencies, also known as digital assets, especially for less established currencies. In addition to big price swings, the digital asset industry continues to face regulatory uncertainty, especially in the United States with the SEC, CFTC, FINRA and other regulators undecided about how exactly to regulate digital assets. Despite the volatility and regulatory ambiguity, for risk hungry participants, the potential for large gains has helped drive an increase in merger activity in the digital asset world during the past two years.
Acquiring or selling a company that deals heavily in digital assets presents a litigation risk. Many of the factors that increase the risk of litigation in mergers or acquisitions in the digital asset industry are outside the control of the parties to a transaction. Deal lawyers try to control for these externalities but, in the new and vibrant realm of companies who deal in cryptocurrencies, those controls can be elusive, which in turn enhances the risk of litigation.
There are, however, ways to minimize the chance of a dispute. The following are a few practical tips for transactional lawyers and litigators to help contain the risks inherent in digital asset M&As.
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- Valuation Methodology: Transaction and litigation counsel should pay close attention to valuation methods used in a digital asset transaction. Cryptocurrencies and digital tokens are new and the methods used to value them may be untested. Different digital assets have different applications, e.g., utility tokens versus value storage tokens, and valuation theories should be tailored to the transaction and assets involved. In light of these unique issues and the attendant risks, transactional lawyers should give particular scrutiny to the valuation formulas to avoid a dispute. Litigators, too, should take note of the valuation methods used since they may be fodder for a dispute. And, of course, litigators should also be aware of the possibility for a Daubert-type challenge of any expert valuation witness that may arise in a subsequent dispute.
- Earn-Outs/Purchase Price Adjustments: Transactional lawyers should pay special attention to earn-out or purchase price adjustment provisions in a digital asset M&A deal. Valuating digital assets is difficult; thus, inclusion of an earn-out or purchase price adjustment clause might help the parties reach a deal more easily. Given the volatility of digital assets, there is a higher than typical likelihood that the value of the earn-out or purchase price adjustment will also fluctuate substantially. Litigators, in turn, should also be especially cognizant of earn-out and purchase price adjustment provisions. Earn-out provisions can be especially ripe for dispute since the earn-out periods often extend for years after closing. While long earn-out periods might not present problems in more traditional fields, the fast pace of change and high levels of volatility in the digital asset industry mean that long earn-out periods are particularly susceptible to disagreement.
- Reverse Break Up Fees: Transactional lawyers should consider including a reverse breakup fee or a reverse termination fee. These are fees paid by the buyer if the buyer breaches the governing agreements or is unable to close the transaction. For example, imagine you represent the seller in a deal set to close in three days when news breaks about a lawsuit filed by a state attorney general against a new cryptocurrency company. The enforcement action sends the price of all digital assets plummeting by 20 percent in a matter of hours. Your client still meets all of the closing conditions, but the client’s value, which consists largely of digital assets, has just taken a huge hit and the buyer’s counsel is telling you that her client is going to walk away from the deal unless your client drops the price. A reverse breakup fee will help to lessen the buyer’s willingness to run from the transaction and may also help your client recoup costs incurred in the event the buyer does walk away. Litigators representing a buyer or seller should also pay particular attention to whether the conditions in a breakup fee or reverse breakup fee clause have been satisfied.
- Heightened Importance of Stock Terms: Transactional lawyers should give extra consideration to the applicable law and venue selection provisions in the deal documents. Some states, e.g., Wyoming, among others, have adopted more crypto-friendly regulatory regimes than other states. Consequently, transaction lawyers should consider the pros and cons of each viable state law. And, corporate attorneys should consider obtaining review of deal documents by experienced cryptocurrency litigators who can help position the transaction as best as possible in case of future litigation.
- Last, transaction lawyers should consider the appropriateness of a mandatory arbitration provision. Arbitration has its drawbacks, e.g., the cost of the arbitrator, absence of clear rules for discovery, restricted appeal rights, etc., but the benefits of arbitration may be particularly helpful when dealing with a digital asset M&A dispute. For example, the parties can make their proceedings confidential, which can avoid the disclosure of trade secrets or other proprietary information in public court proceedings. Further, in the highly technical field of cryptocurrencies, the parties have greater latitude to ensure that the proceeding is adjudicated by an arbitrator with pertinent knowledge of and/or experience in digital assets or blockchain technology.
Of course, the foregoing is not an exhaustive list of the ways to reduce risk in digital asset M&A deals. Other terms and conditions in the transaction contracts for a digital asset M&A deal should not escape scrutiny. Representations and warranties, contract exhibits and schedules should be tailored to the deal and the nature of digital assets in play. Due diligence is also an especially important component of risk mitigation since the nature of digital assets makes for a more difficult diligence process than a traditional transaction. Regardless of which contractual provisions are used, litigators and transactional lawyers should both be aware of and understand the heightened risk of a dispute in the volatile world of cryptocurrencies and digital assets.
© Polsinelli PC, Polsinelli LLP in California
