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Audet v. Fraser

United States District Court, D. Connecticut

October 11, 2017

DENIS MARC AUDET, et. al. Plaintiff,
v.
STUART A. FRASER, et. al. Defendants.

          RULING ON MOTION TO DISMISS

          Michael P. Shea, U.S.D.J.

         I. Introduction

         Plaintiffs Denis Marc Audet, Michael Pfeiffer, Dean Allen Shinners, and Jason Vargas (the “Plaintiffs”), individually and on behalf of a class of all others similarly situated, have filed suit against defendants Stuart A. Fraser (“Fraser”), GAW Miners, LLC (“GAW Miners”), and ZenMiner, LLC (“ZenMiner” together with GAW Miners, the “Companies”) alleging violations of both federal and state securities law. Fraser has moved to dismiss all counts against him. For the reasons set forth below, his motion to dismiss is DENIED.

         II. The Amended Complaint

          This case involves an alleged scheme to defraud customers and investors in a series of business ventures related to “virtual currency mining, ” which the amended complaint describes as the “appli[cation] of computer power in an attempt to solve complex equations that verify a group of transactions in [a] virtual currency [such as Bitcoin]. The first computer (or collection of computers) to solve an equation is awarded new units of that virtual currency.” (ECF No. 57 at ¶ 3.) The “people and computer equipment used in this process are known as miners.” (Id.) The following facts are taken from the amended complaint and are accepted as true for the purpose of deciding Fraser's motion to dismiss.

         A. Factual Allegations

         1. Garza and Fraser Meet and Form Several Business Ventures Fraser, the vice-chairman of Cantor Fitzgerald, an investment bank, and Homero Joshua Garza (“Garza”) first met in 2003 when Garza was in high school. (ECF No. 57 at ¶ 33.)[1]Fraser had hired Garza to install internet service at his vacation home in Vermont. (Id.) Following this meeting, “[t]he two quickly developed a close business and personal relationship” with Garza looking to Fraser for “business advice, direction, and mentorship.” (Id.) Over the next decade, Fraser “served as a mentor and business associate of Garza.” (Id. at ¶ 18.) They formed several businesses together, including Great Auk Wireless High Speed Internet (later known as GAW High Speed Internet or GAW-HSI). (Id. at ¶ 36.) Although they “rarely formalized their business relationships, ” they had an understanding that Garza “would serve as CEO of their respective companies, and Fraser would serve as the ‘Board.'” (Id. ¶ 34.) In their respective roles, the two frequently discussed, and made decisions concerning, the day-to-day operations of their businesses. (Id. ¶ 19-20.) Fraser also served as a financial investor in the companies. (Id. at ¶ 40.) “Unlike a traditional investor, ” Fraser “kept Garza on a tight least by doling out investments in piecemeal installments” and would withhold additional funding until Garza had reported back to him. (Id.)

         In July 2013, Garza emailed Fraser to discuss their business relationship, which “had not been revised for years.” (Id. at ¶ 37.) “Garza proposed that they split every system and company in half with the exception of GAW High Speed Internet, of which Fraser would own 80%.” (Id.) Garza also suggested that they create “an equal partnership (50/50) in [their] holding company[, ] Geniuses at Work Corporation, with Fraser holding the voting power.” (Id.) Under Garza's proposal, he “would contribute his stake or control over certain systems or companies, as well as patents to be created.” (Id.) For his part, Fraser would: (i) “provide a $10, 000 per month investment that would serve as Garza's salary, ” (ii) “forgive a $230, 000 personal debt, ” (iii) “allow Garza to live down the investment Fraser made in GAW in the past, ” (iv) “contribute a $150, 000 cash infusion, ” and (v) assist in obtaining the support of Howard Lutnick, the head of Cantor Fitzgerald. (Id.) Fraser agreed to Garza's proposal, and the two also agreed that their agreement “providing for 50-50 ownership would apply prospectively to new companies they created.” (Id. at ¶ 38.)

         2. GAW Miners and ZenMiner

         In March 2014, Garza incorporated GAW Miners to sell virtual currency mining equipment. (Id. at ¶¶ 46, 75.) Fraser and Garza each owned half of GAW Miners consistent with their 2013 agreement. (Id. at ¶ 48.) In this new venture, as with their prior ones, Garza served as GAW Miners' CEO while Fraser “served as a de facto Board” and financial investor. (Id. at ¶¶ 46-47.) Fraser invested $135, 000 in GAW Miners, which he supplemented a few months later in the summer of 2014 with three loans of $200, 000 each. (Id. at ¶ 47.) At its inception, GAW Miners' primary business was the sale of virtual currency mining equipment. (Id. at ¶ 75.) GAW Miners expanded its business to include: (i) hardware-hosted mining, whose customers were told that they had purchased specific pieces of physical mining equipment that were stored and maintained by GAW Miners for daily maintenance fees, but allegedly controlled by customers; (ii) cloud-hosted mining, which purportedly allowed customers “to control their mining hardware through a website;” (iii) investment contracts called Hashlets that paid returns on GAW Miners' virtual currency mining; (iv) GAW Miners' own virtual currency, Paycoin; and (v) investment contracts called HashStakers that held Paycoins and paid holders a fixed return. (Id. at ¶¶ 4-8.) According to the amended complaint, each of these services was fraudulent, largely because GAW Miners did not own all the computer hardware and associated computing power it marketed to its customers. (Id.) The allegations of the complaint describing each of these products are set forth in more detail below.

          i. Hardware-Hosted Mining

         Due to low profit margins on selling physical equipment, in June 2014, GAW Miners began offering its customers Hardware-Hosted Mining. (Id. at ¶ 77.) This service provided that, in exchange for a fee paid by customers to cover maintenance expenses, GAW Miners would host customers' mining equipment at its own datacenter. (Id.) GAW Miners told its customers they could access and control their mining equipment via remote management software offered by ZenMiner, a company co-owned by Fraser and Garza. (Id. at ¶¶ 38, 77-78, 85.) GAW Miners also represented to its customers that, at the customers' request, GAW Miners would terminate the hosted mining services and ship to them the physical mining equipment. (Id. at ¶ 81.) But GAW Miners “never had sufficient designated equipment to return to customers.” (Id.)

         ii. Cloud-Hosted Mining

         In July 2014, GAW Miners began offering Cloud-Hosted Mining. (Id. at ¶ 79.) Cloud-Hosted Mining gave customers “the option to engage in hosted mining without the ZenMiner software.” (Id.) The service allowed customers to purchase mining hardware from GAW Miners and then house that equipment at ZenMiner's datacenters for a fee. (Id.) Customers could then control their purchased mining equipment by “logging on to accounts they established on ZenMiner's website interface called ZenCloud.” (Id.) ZenCloud users could only mine in one of the pools offered on ZenCloud's website. (Id. at ¶ 80.) Further, under this service, GAW Miners represented that customers could terminate their “hosted services at any time and receive their physical equipment in the mail from GAW Miners.” (Id. at ¶ 81.) But “no mining actually occurred through ZenMiner's ZenCloud interface” and “very few pieces of mining equipment purchased by customers actually existed” at ZenMiner. (Id. at ¶ 89.)

          iii. Hashlets

          In August 2014, GAW Miners and ZenMiner decided to sell Hashlets, a concept that Fraser had initially proposed to Garza in May 2014. (Id. at ¶ 95-96.) A hashlet “entitled an investor to a share of the profits that GAW Miners and/or ZenMiner would purportedly earn by mining virtual currencies that were maintained in their data centers.” (Id. at ¶ 95.) Unlike customers of Hardware- and Cloud-Hosted Mining, Hashlet customers did not acquire rights in a specific piece of mining equipment. (Id. at ¶ 97.) “Hashlets were purported to earn a return based on the number of virtual currency units generated when the pools to which their computing power was directed succeeded in processing and confirming virtual currency transactions.” (Id. at ¶ 95.) GAW Miners told Hashlet customers that “they could log on to their ZenCloud accounts, activate their Hashlets using a code that was provided at the time of purchase, and then direct their Hashlets to engage in mining in one of the mining pools available through ZenCloud.” (Id. at ¶ 100.)

         “During their first week of availability alone, GAW Miners and ZenMiners oversold- between triple and quadruple-the number of hashlets for which they had the supporting computing power.” (Id. at ¶ 107.) “By October 2014, GAW Miners had oversold altcoin-mining Hashlets by at least 100 times its computing capacity, and bitcoin-mining Hashlets by at least about 5 times its computing capacity.” (Id. at ¶ 108.) “These sales took place before GAW Miners had even completed setting up the datacenter in Mississippi where the mining equipment was purportedly stored.” (Id.) Between “mid-August and December 2014, GAW Miners and ZenMiner sold at least $19 million of Hashlets to more than 10, 000 investors.” (Id. at ¶ 109.)

         iv. Paycoin

          In November 2014, GAW Miners announced its plans to launch a new form of virtual currency called “Paycoin.” (Id. at ¶ 136.) In advance of the launch of Paycoin, GAW Miners offered customers Hashpoints, which “were convertible promissory notes that could be purchased or mined and exchanged for Paycoin once Paycoin launched.” (Id. at ¶ 136.) GAW Miners and Garza represented to customers that “Paycoin would have an estimated value of $80-$100 per coin” and that Paycoin's price would not fall below a $20 price floor. (Id. at ¶¶ 139, 142.) They also represented that “banks and investment firms were standing in line to support Paycoin and were financially backing it” and that merchants were widely adopting it. (Id. at ¶¶ 140, 141.)

         v. HashStakers

         HashStakers were digital wallets designed to hold Paycoin. (Id. at ¶ 151.) Paycoins deposited in HashStakers “had an inherent lockup period of 30, 90, or 180 days.” (Id.) They functioned as “fixed-rate investment vehicles and they yielded a daily payout.” (Id. at ¶152) Their purchase price was based in part on the $20 Paycoin floor. (Id. at ¶ 153.) Paycoin, however, traded below that price floor because it was traded on other virtual currency exchanges, not just Paybase, the virtual currency exchange that GAW Miners and Garza had developed to “control trading and manipulate” the value of Paycoin. (Id.) The fact that it was traded on other exchanges and that Paybase did not become operational until much later than originally anticipated led the price of Paycoin to drop “precipitously.” (Id. at ¶ 156.) GAW Miners' customers “began to realize that not only were the purchased HashStakers too expensive, compared to the current price of Paycoin on the exchanges, but their locked Paycoins were losing value with a negative net-effective rate of return.” (Id.)

         According to the amended complaint, “[t]he design of HashStakers was intentional; Garza and Fraser wanted their customers' Paycoins to be locked up for the longest period of time possible… Once Paycoins were locked in interest-bearing investment wallets, the coins could not be dumped on the exchanges, depressing the market price of Paycoin.” (Id. at ¶ 157.) Further, “[b]ecause Garza ensured that GAW Miners' customers' Paycoins were locked in 30, 90, or 180-day HashStakers, the defendants were able to dump the more than 12 million Paycoins they secretly pre-mined-and falsely claimed to have destroyed-and reap the benefits of artificially inflated prices for Paycoin while GAW Miners' customers watched the value of their own Paycoins and HashStakers plummet.” (Id.)

         3. Alleged Misrepresentations

          The amended complaint provides the following examples of misrepresentations allegedly made by the “defendants”:

i. “that Hardware-Hosted Mining and Cloud-Hosted Mining customers could request shipment of the physical mining equipment they purportedly owned”;
ii. “that Hardware-Hosted Mining and Cloud-Hosted Mining customers could control the pools in which their mining equipment operated”;
iii. “that all of the Hashlets of computing power purchased by investors would be pooled together to engage in virtual currency mining, and that investors' returns, or ‘payouts, ' would be calculated based on the success of ...

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