Posts by: Brian Bloomer

“But if You Fall, You Fall Alone” – The SEC Goes After Ripple

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Seven years after Ripple Labs, Inc. first began to sell its digital asset XRP, the Securities and Exchange Commission on December 22, 2020, filed a Complaint in the Southern District of New York against Ripple and its current and former CEOs, alleging that since it began these sales, Ripple has been engaged in an unregistered securities offering through the sale of its XRP token within the United States and worldwide. In the action, which does not allege fraud, the SEC is seeking injunctive relief, disgorgement with prejudgment interest, and civil penalties.

The SEC applied a legal analysis similar to that in other enforcement actions against offerors of digital assets, such as Kik and Telegram. What separates the Ripple Complaint from others is the years-long history of activity the SEC draws upon to allege that the Defendants created substantial risk to investors through asymmetric information disclosures for their own personal gain—the very thing the securities laws are designed to protect against.

The Howey test is used to determine if a financial instrument is an “investment contract” and thus a security. An investment contract was defined by the Supreme Court in SEC v. W. J. Howey Co., 328 U.S. 293 (1946), as an investment in a common enterprise with a reasonable expectation of profits or returns derived from the entrepreneurial or managerial efforts of others. Applying that test, the SEC alleges that purchases of XRP constituted investments, and the XRP offering constituted a common enterprise because the fortunes of the participants were tied together. In typical cases brought by the SEC to date alleging that a form of cryptocurrency is a security, these two prongs of the Howey test have been easily met.

As to the third prong: the SEC alleges that purchasers of XRP reasonably expected their profits to be derived from the efforts of the Defendants, pointing to their efforts to create, control, and manage secondary markets for XRPs, to develop XRP use cases, and to work with banks and other financial intermediaries to implement said use cases. In contrast, note that SEC officials have declared that Bitcoin is not a security—and at least one former commissioner has stated that, in his view, Ether, in its current decentralized form isn’t either—because those tokens do not meet the “reasonable efforts of others” prong of the test, since there is no single third party the token holders are reliant upon for the their continued management and success. (The SEC has elaborated on this analysis in the Framework for “Investment Contract” Analysis of Digital Assets.) The SEC is arguing that this is not the case with Ripple, because, according to the Complaint, XRP investors are not in any position to undertake “various, complex, expensive and all-encompassing strategies about when or how to sell XRP into the markets to protect XRP’s price, volume, and liquidity. Nor are XRP investors in any position to increase significantly ‘demand’ or ‘value’ for XRP by developing a ‘use’ for the token through entrepreneurial efforts—at least not without Ripple’s support.”

The 71-page, 404-paragraph fact-intensive Complaint appears designed to leave little to doubt about the extensive history of the conduct alleged. (According to the Complaint, the statute of limitations as to possible claims against the company was tolled six times.) The SEC’s efforts to bolster its legal conclusions includes, oddly, a footnote citing to guidance from a sister regulator, FinCEN, for its views on the application of the federal securities laws to convertible virtual currencies. And the lengthy Complaint overpleads the SEC’s case, devoting substantial discussion to facts suggesting manipulative conduct designed to support the price of XRP through artificial means, although the SEC does not go so far as to include a cause of action for manipulation. 

In sum, it is unclear whether the attention given by the SEC’s Complaint to dated facts, and allegations that go well beyond the causes of action, constitutes a litigation strategy; a hint about the future direction of SEC cryptocurrency enforcement efforts; or compensation for the SEC’s inaction with respect to this company until now. But it does beg the question as to why the SEC allowed Ripple to operate for as long as it did before bringing this Complaint, during which the XRP attained widespread distribution and heavy concentration with some investors.

The SEC Gets its Kiks out of a Successful Application of the Howey Test

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In a closely-watched cryptocurrency case, on September 30, the Southern District of New York ruled in favor of the SEC in SEC v. Kik Interactive, Inc., holding that the Kin tokens Kik had offered and sold through a pre-sale and ICO were securities under the Howey test. The case illustrates the difficulties cryptocurrency companies face when they try to avoid having their tokens classified as securities; even though Kik intended to create a decentralized ecosystem for their Kin tokens on which third parties would supply products and services, the Court reasoned that Kik’s essential role in driving that ecosystem meant that token holders were reliant on Kik’s efforts to realize a profit on their Kin holdings.

Kin tokens were issued on the Ethereum blockchain, and Kik planned to develop an ecosystem of products and services that accepted Kin as currency. Kik stated in its white paper that Kin purchasers would profit through an appreciation of the value of Kin – as more products and services became available within the Kik ecosystem there would be a greater demand for Kin, but the supply of tokens would remain fixed. This increased demand against a fixed supply would drive up the price, which Kin holders could realize by selling their Kin on secondary markets. Kik would not be the sole developer of products and services in the ecosystem – third party participation was expected.

Courts use the Howey test to analyze whether a cryptocurrency is an “investment contract,” which is a type of security. The Howey test is comprised of three prongs: (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profit derived from the managerial or entrepreneurial efforts of others.

Kik’s critical role to the development of the Kin ecosystem was enough for the Court to find that Kin holders expected to derive their profit from Kik’s efforts, thereby making Kin a security (the other two prongs of the Howey test were more clearly met). The Court found that “the economic reality is that Kik, as it said it would, pooled proceeds from its sales of Kin in an effort to create an infrastructure for Kin, and thus boost the value of the investment,” and that, while Kik planned for Kins to have a “consumptive use,” those uses were not available at the time of the Kin distribution and would “materialize only if the enterprise advertised by Kik turned out to be successful.” Growth of the company “would rely heavily on Kik’s entrepreneurial and managerial efforts,” the Court found, because Kik would play an “essential role…in establishing the market” and “Kik had to be the primary driver of [the] ecosystem”; Kik planned to provide significant resources to develop the Kin ecosystem, to integrate Kin into their Kik messenger product, and to provide incentives for developers to create new uses for Kin. Furthermore, if Kik did not follow through with the aforementioned efforts and no ecosystem developed, “Kin would be worthless.”

This reasoning around the “efforts of others” prong is similar to what the Southern District of New York said in SEC v. Telegram, where the Court applied a “Bahamas Test,” reasoning that were the Telegram team to immediately decamp to a tropical island after launching their blockchain, the TON Blockchain project and Grams would “likely lack the mass adoption, vibrancy, and utility that would enable the Initial Purchasers to earn their expected huge profits.” Telegram, like Kik, also had plans to integrate their token into their proprietary messaging product.

A determination of whether a financial instrument is a security based upon the Howey test depends of course upon the facts and circumstances of the particular matter. The Court ruled against Kik Interactive principally because the company disclosed that the value of tokens purchased could increase based upon the company’s efforts, and because at the time of the token sales the tokens did not yet have an immediate utility. A different result might have been reached if the company already had established a working infrastructure in which the tokens had a use independent of investment value. It is not clear that would be enough in all cases to defeat application of the securities laws, but it is at least one helpful argument.

A “Key” OCC Interpretation – National Banks Can Provide Cryptocurrency Custody Services

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Banking regulators took a significant step toward the mainstreaming of cryptocurrency recently when the Office of the Comptroller of the Currency (OCC) provided guidance about how a bank can provide custody services for cryptocurrency. In Interpretive Letter #1170, published on July 22, the OCC concludes that “a national bank may provide these cryptocurrency custody services on behalf of customers, including by holding the unique cryptographic keys associated with cryptocurrency.”

The OCC’s Letter arrives at an opportune time, when, according to CipherTrace’s recently published findings, the majority of cryptocurrency transactions are cross-border and, on average, each of the top ten U.S. retail banks unknowingly processes an average of $2 billion in crypto-related transactions per year. Providing custody services might help bring more of these transactions in to the open.

The OCC Interpretive Letter

The Interpretive Letter—which was issued just a few short months after the former Coinbase chief legal officer Brian Brooks became the Acting Comptroller of the Currency—is a breakthrough in terms of bringing cryptocurrency within a regulated environment. The OCC outlined three sources of market demand for banks to provide cryptocurrency custody services: (1) cryptocurrency owners who hold private keys want to store them securely because private keys are irreplaceable if lost—misplacement can mean the loss of a significant amount of value; (2) banks may offer more secure storage services than existing options; and (3) investment advisors may wish to manage cryptocurrencies on behalf of customers and use national banks as custodians.

The OCC recognized that, as the financial markets become increasingly technological, there will likely be increasing need for banks and other service providers to leverage new technology and innovative ways to provide traditional services on behalf of customers. The OCC pointed out that cryptocurrency custody services fit neatly into the long-authorized safekeeping and custody services national banks provide for both physical and digital assets.

With respect to cryptocurrency, the Letter states that national banks may provide fiduciary and non-fiduciary custody services. Non-fiduciary custodial services typically entail providing safekeeping services for electronic keys, which, as discussed above, fit neatly into the types of activities national banks have historically performed. Specifically, the OCC explains that a bank that provides custody for cryptocurrency in a non-fiduciary capacity typically would not involve physical possession of the cryptocurrency but rather “essentially provide safekeeping for the cryptographic key that allows for control and transfer of the customer’s cryptocurrency.” Fiduciary cryptocurrency custody services (such as those where the service provider acts as trustee, administrator, transfer agent, or receiver, or receives a fee for providing investment advice) are permissible if conducted in compliance with the National Bank Act and other applicable laws and regulations (such as 12 CFR Part 9 and 12 U.S.C. Ch. 2). Banks are authorized to manage cryptocurrency assets in a fiduciary capacity just as they manage other types of assets in a fiduciary capacity.

Banks that provide cryptocurrency custody services have to comply with existing policies, laws, and regulations, and conduct its custody services in a safe and sound manner, including having adequate systems in place to identify, measure, monitor, and control the risks of its custody services. In particular, banks should ensure they assess the anti-money laundering (AML) risk of any cryptocurrency custodial services and update their AML programs to address that risk. It would be advisable for AML compliance personnel to be well-integrated in the development of cryptocurrency custodial services. Banks must also implement effective risk management programs and legal and regulatory reporting practices for these services. Cryptocurrency custody services may raise unique issues identified by the OCC, including the treatment of blockchain forks, and consideration of whether technical differences between cryptocurrencies (for example, those backed by commodities, those backed by fiat, or those designed to execute smart contracts) may require different risk management practices.

The OCC Letter points out that different cryptocurrencies may be subject to different regulations and guidance. For example, some cryptocurrencies are deemed securities and therefore are subject to federal securities laws and regulations. In addition, because crypto assets are thought of as offering a greater level of anonymity or as falling beyond the ken of centralized banking systems, they have been associated with illicit activity including money laundering. Consequently, banks must ensure that their AML programs are appropriately tailored to effectively assess customer risk and monitor crypto-related transactions. Just yesterday, the Financial Crimes Enforcement Network published an advisory warning that “[f]inancial institutions dealing in [cryptocurrency] should be especially alert to the potential use of their institutions to launder proceeds affiliated with cybercrime, illicit darknet marketplace activity, and other [cryptocurrency]-related schemes and take appropriate risk mitigating steps consistent with their BSA obligations.”

While there has been limited enforcement of federal law against banks for crypto-currency related activity, earlier this year, the OCC brought its first crypto-related enforcement action, against M.Y. Safra Bank for deficient AML processes for digital asset customers. The OCC concluded that the Bank’s deficiencies included its failure to: (1) appropriately assess and monitor customer activity flowing to or from high-risk jurisdictions; (2) conduct ongoing testing of its due diligence processes; (3) implement sufficient controls for its digital assets customers, including cryptocurrency money service businesses (MSBs); (4) address the risk created by the significant increase in wire and clearing transactions created by the cryptocurrency MSB customers; and (5) notify the OCC of its significant deviation from its previous business plan. In the Matter of M.Y. Safra Bank, SFB, AA-NE-2020-5, Consent Order (Jan. 30, 2020).

The OCC’s Letter should give comfort to many banks that have been bystanders to the growth of the cryptocurrency market. Now banks can offer more cryptocurrency-based financial services with more certainty, although many questions will likely be answered through greater participation. More marketplace involvement by traditional banks will in turn have a beneficial effect. Smaller businesses wishing to engage in cryptocurrency-based transactions now may do so by interacting with large, stable, and well-regulated banking institutions.

OCC’s Consideration of an MSB Regime

OCC’s Interpretive Letter may be part of a broader movement by the OCC to promote greater integration of cryptocurrencies into mainstream financial services. Acting Comptroller of the Currency Brooks announced on a podcast on June 25 that the OCC intends to unveil a new bank charter including a national payments charter that will pave the way for nationwide participation by cryptocurrency payments companies. As contemplated, that charter would be equivalent to FinCEN’s MSB registration process and stand in (under the doctrine of preemption) for individual state-level MSB licensing requirements. It also should answer questions like how the Community Reinvestment Act might apply to banks that do not take deposits and how the OCC will impose capital standards on companies that do not bear credit risk.

Orrick Hosts Fireside Chat with SEC Commissioner Hester Peirce

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On March 2, Orrick had the pleasure of hosting SEC Commissioner Hester Peirce for a fireside chat discussion at our San Francisco office on the state of blockchain and cryptocurrency, the emerging regulatory landscape and her safe harbor proposal. Commissioner Peirce was joined by Orrick partner Ken Herzinger and CipherTrace CEO David Jevans, and moderated by Mark Friedler.[1] To view a recording of the full discussion, please click here. Read on for key takeaways from the panel discussion.

Providing Clarity to the Crypto Community

Commissioner Peirce sees signs of progress at the SEC and believes that her colleagues have the best intentions. She’s hopeful and optimistic that the SEC can continue to make progress and both protect investors and allow innovation to move forward.

Commissioner Peirce believes that regulators have provided more clarity regarding blockchain and cryptocurrency regulation, but there’s a long way to go. Regulators struggle because there’s great variation across digital assets, so it’s hard to lump them together and produce a regulatory framework that works for everything. Furthermore, she acknowledged the fact that often the clarity that comes from the SEC is provided in the format of a facts-and-circumstances discussion, which can be frustrating for people who want to be given straightforward bright line rules. However, she says, U.S. securities laws just typically don’t work that way.

While she is hopeful that the SEC can provide more clarity, she does not know if we will ever get to a point where people feel there are no questions that they need to hire lawyers to help them figure out.

Insights into Commissioner Peirce’s Token Safe Harbor Proposal

Commissioner Peirce said her February 6, 2020 Token Safe Harbor Proposal is solely her own, and her colleagues at the SEC need to be convinced to put it forward as a formal proposed SEC rule pursuant to the SEC’s normal rulemaking process. The theory behind the safe harbor is that the regulatory framework, as currently applied, serves as an obstacle to launching token networks and giving them the time to mature into decentralized networks. Token project creators are afraid that if they launch their network it will be treated as a securities offering. The purpose of the safe harbor proposal is to find a way for people to feel comfortable releasing tokens under an exemption that works for tokens specifically.

Commissioner Peirce explained that one reason you would want securities laws to cover token offerings would be so that the people who are purchasing tokens are receiving the information they need to make good purchasing decisions, so the disclosure requirement was tailored to meet the needs of token purchasers.

Commissioner Peirce published the proposal because she wants to solicit feedback to refine it, and encourages people to contact her with thoughts and ideas to improve upon it.

Section (f) and the Application of the Safe Harbor to Tokens that Have Already Been Distributed

Section (f) of the Safe Harbor provides for how the safe harbor would apply to digital assets previously sold pursuant to an exemption. Commissioner Peirce said those who have already launched and distributed tokens have to think about whether the token sales were done pursuant to an exemption – i.e., tokens sold pursuant to an exemption could rely on the safe harbor to then do a future token distribution. Projects would have to consider on a case-by-case basis if they could take advantage of the safe harbor and if it would be meaningful. For example, if a promoter used the Reg A exemption (which applies to public offerings that do not exceed $50 million in any one-year period), the safe harbor may still be useful for having a wider distribution and allowing the tokens to trade more freely.

Tokens Wrapped in Investment Contracts

Commissioner Peirce highlighted the unique problem that arises with certain token launches, where tokens wrapped in investment contracts are sold, thus creating what looks like a traditional offering, but then when the tokens start being used in the network they no longer look like securities. At that point, it is a stretch to argue the securities laws should still apply.

Interestingly, in the SEC v. Telegraph case currently pending before Judge Kevin Castel in the U.S. District Court for the Southern District of New York, the SEC Enforcement Staff is arguing that the Judge should conflate the investment contract and proposed token launch and view the sale of an investment contract and subsequent token distribution as “one transaction.” Enforcement and Commissioner Peirce do not appear to be on the same page regarding this issue.

“Network Maturity” and the Meaning of “Decentralized” and “Functional”

Commissioner Peirce acknowledged that she needed to do more work defining what it means to be “decentralized.” She thinks it will be easier to tell if a network meets that definition after having been in existence for three years.

She also noted that the functionality test is there because the safe harbor is also trying to protect networks that are intended to remain centralized. There are companies that have created token-based economies that exist on centralized networks. She pointed to the “no action” letters issued to Pocketful of Quarters and TurnKey Jet. In her view, issuing no action letters about things that are clearly not securities is not helpful, because the letters contain conditions, thereby placing constraints on the ability of the companies to run their networks in certain ways.

Section (a)(4) and the Liquidity Requirement

Commissioner Peirce noted that some had suggested that it may be premature to assume that a secondary market would enable trading of a nascent token, and that, initially, the liquidity may need to be found elsewhere. She indicated that some liquidity could be found through non-U.S. decentralized exchanges which could also play a role in creating liquidity in the beginning stages of a token network. Only, later would the token be traded on an exchange with an intermediary that could then conduct the AML/KYC requirements. The issuer could also find ways to create liquidity in the beginning, which is something she has seen centralized projects do. That said, there are clearly unanswered mechanical questions about how a token promoter would generate liquidity.

Section (b)(6) Disclosures Regarding the Initial Development Team and Certain Token Holders

Commissioner Peirce indicated that the type of person covered in Section (b)(6) of the safe harbor is similar to those individuals who fall under Section 16 of the Securities Exchange Act of 1934. Project teams should ask themselves, when they talk about their project, who do they say is working on the project? The people that are being advertised are likely to be the ones who should be disclosed. She wants to be sure that project teams are not intentionally hiding a team member who has been previously arrested for securities fraud, for example.

Stablecoins

Commissioner Peirce said stablecoins are a unique category of tokens, but there is enough variation among them that they may not all fall into a single previously established category. Each one should be judged on its own facts, and there are potential implications for the securities laws depending on how they are set up. They could function like securities or they could function like money market funds. Commissioner Peirce encouraged people interested in launching a stablecoin to think through the implications and reach out to the SEC and other regulators.

Educating Lawmakers and Regulators

Commissioner Peirce said lawmakers and regulators are extremely busy and they have to deal with a wide variety of different issues. The crypto community should try to educate regulators and help them understand the basics of the technology; creating familiarity amongst regulators will generate better regulation. Technologists should not expect regulators to know as much as them, but they can help regulators get to a place of understanding, where the technology does not seem as scary as it might otherwise.

Changing the Accredited Investor Regime

Commissioner Peirce noted that the SEC has issued proposed amendments to expand the definition of “accredited investor” in Rule 501(a) of Regulation D and soliciting comments on whether the accredited investor regime should change. [The formal rule proposal amending Regulation D was published on March 4 which followed the publication of the Commission’s concept release in June]. While the amendments propose modest changes, they raise questions about broader changes that would open up accredited investor status to a wider range of individuals. Personally, she agrees that the correlation currently in use today – i.e., the use of wealth and income as a rough proxy for sophistication – is not perfect. There are also liberty concerns with the regime: people work very hard to earn their money and then the government places constraints on how they can spend it; however, she recognized that issue runs throughout our securities laws. Improving upon the accredited investor regime will help the problem, but Commissioner Peirce is doubtful we will see a radical shift in the accredited investor regulations.

[1] Commissioner Peirce prefaced her remarks by stating that the views she expressed were her own and do not necessarily represent those of the Securities and Exchange Commission or her fellow Commissioners.

Power of the Peirce: SEC Commissioner Spends Some of Her Influence on Trying to Help Crypto Network Developers

SEC Commissioner Hester Peirce continues to be one of the most vocal persons in leadership positions at federal regulators who are promoting innovation in digital currency and the blockchain. On February 6th, she unveiled Proposed Securities Act Rule 195 – Time-limited Exemption for Tokens, a rule proposal for a safe harbor that would provide regulatory relief under the federal securities laws for developers attempting to build functioning token networks. Her proposal is a step in the right direction to address one of the greatest challenges token network projects face.

As explained by the Commissioner, in the course of building a functioning network, developers must get tokens into the hands of other persons. These efforts run the risk of violating the U.S. securities laws regulating offers and sales, and the trading of, investment contract securities under the Howey test. Thus, she stated, the SEC has created a “regulatory Catch 22.” The Proposed Rule addresses this issue head-on by providing a three-year period during which an Initial Development Team can build their network and distribute tokens to persons who will use the network without concern that these efforts will be deemed by the SEC to violate the securities laws.

Of course, the Proposed Rule, as conceded by Commissioner Peirce and as discussed below, is a work in progress, and a great deal of work is necessary to address outstanding issues. One overarching issue is the degree to which the Proposed Rule should be prescriptive and thereby decrease the need for development teams to seek no-action relief. However, if overly prescriptive, the Proposed Rule would not be flexible enough to accommodate evolving technological developments and the complex facts that will arise in each case.

The Proposed Rule Would Provide Subjective and Prescriptive Requirements

The Proposed Rule provides Initial Development Teams with a three-year safe harbor from the application of the securities laws, with the exception of its anti-fraud provisions. In order to be covered by the safe harbor, five conditions would have to be met:

  1. The Initial Development Team must intend for the network to reach “Network Maturity,” defined as either decentralization or token functionality – within three years of the first offer and sale of tokens and undertake good faith and reasonable efforts to achieve that goal;
  2. Detailed disclosures pertaining to the token project and the Initial Development Team must be made to the public;
  3. The token must be offered or sold for the purpose of facilitating access to, participation on, or the development of the network;
  4. The Initial Development Team must intend to and undertake good faith and reasonable efforts to create liquidity for users; and
  5. The Initial Development Team must file a Notice of Reliance with the SEC.

The safe harbor conditions incorporate elements that are both subjective and prescriptive. The first and third conditions are principle-based and highly subjective, and without further regulatory guidance or authoritative precedent, it is unclear how the SEC would determine if they are being complied with. Additional guidance regarding the definition of “Network Maturity,” particularly in the form of hypotheticals and Q&A’s, would help provide clarity. Thus far, there are few concrete examples, beyond Bitcoin and Ethereum – which appear to have passed the SEC’s muster – to which developers can refer to understand the considerations relied upon by the SEC in determining whether a token is not deemed to be a security.

The second and fifth requirements are prescriptive. The disclosure requirements are intended to address information asymmetries between token issuers and purchasers. However, given that the anti-fraud provisions of the securities laws remain in place, it is not self-evident that an overlay of specific disclosure requirements is necessary.

As proposed, the notice requirement presents potential challenges to Initial Development Teams, particularly in the case of its applicability to tokens previously sold in compliance with the securities laws. It is uncertain as to the remedial actions that would be required, and what fines or penalties might be imposed, if the requirements of the Proposed Rule are not satisfied in whole or in part. Also, what would happen at the end of the three-year period if a network has not reached Network Maturity, e.g., the Proposed Rule does not provide a mechanism whereby the development team can request an extension of the safe harbor period and how such a request would be processed.

Until it is Enacted, the Rule Will Not Provide Industry Relief

Since the Proposed Rule is not binding on the Commission, SEC enforcement actions can and will continue to be prosecuted without regard to the Proposed Rule; attempted compliance with the Proposed Rule will not serve as a defense to an enforcement action. At the same time, the elements of the Proposed Rule can and should inform discussions between the Staff and development teams. In this regard, the specific disclosure requirements of the second condition may, in the short term, have the greatest impact, as they might serve as a ready checklist for statements by development teams and counterparties in connection with the development of their networks.

As positive a development as is the Proposed Rule Proposal, it is only the preliminary proposal of one Commissioner and the adoption of a proposal such as this one is subject to a rigorous vetting process by the SEC. Therefore, its future is uncertain.

SEC Settles with BCOT on Alleged Violations of the Securities Act

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On December 18, 2019, the Securities and Exchange Commission announced settled charges against blockchain technology company Blockchain of Things Inc. (BCOT) for conducting an unregistered initial coin offering (ICO) of digital tokens. BCOT raised nearly $13 million to develop and implement its business plans, including developing its blockchain-based technology and platform, referred to as the “Catenis Enterprise” or “Catenis Services” (collectively, “Catenis”).

BCOT conducted the ICO from December 2017 through July 2018 (the “Offering Period”), after the SEC had warned in its DAO Report of Investigation that ICOs can be securities offerings. The settlement alleged that the BCOT Tokens were securities and that they were offered and sold in violation of Section 5 of the Securities Act of 1933 because BCOT did not register its ICO thereunder, nor did it qualify for an exemption from its registration requirements.

With respect to the status of the BCOT Tokens as “securities” under the federal securities laws, the SEC brushed aside the fact that purchasers of the BCOT Tokens were required to represent that “they were not purchasing BCOT Tokens for ‘future appreciation’ or ‘investment or speculative purpose[s].’” Rather, the SEC focused on statements in the offering documents that it found nevertheless would lead purchasers to “reasonably have expected that BCOT and its agents would expend significant efforts to develop [its] platform . . . increasing the value of their BCOT Tokens.”

Factors the SEC found also weighed in favor of BCOT Tokens being securities include:

(i)   the BCOT platform was not fully functional during the Offering Period, i.e., during the Offering Period Catenis was functioning only in a beta mode;

(ii)   BCOT reserved the right to adjust the price of Catenis Services in its discretion, “based upon its operating costs and market forces”; and

(iii)  the BTOC Tokens “were designed to be freely transferrable upon issuance and delivery, with no restrictions on transfer.”

The remedies agreed to in the BCOT settlement include: (i) the payment of a monetary penalty of $250,000; (ii) the registration by BTOC of the BCOT Tokens as a class of securities under the Securities Exchange Act of 1934 and compliance with the reporting requirements thereunder; and (iii) implementation of a protocol under which (x) purchasers of the BTOC Tokens during the Offering Period are notified of their potential claims under the Securities Act “to recover the consideration paid for such securities with interest thereon, less the amount of any income received thereon,” and (y) all payments that BTOC deems to be due and adequately substantiated are made.

The BCOT settlement is similar to the enforcement actions settled by the SEC with Gladius Network LLC on February 20, 2019, and CarrierEQ, Inc. (d/b/a Airfox) and Paragon Coin, Inc., each on November 16, 2018. As in the case of the Gladius settlement, the BTOC settlement provides explicitly for the possibility that BTOC might in the future renew its argument that the BCOT Tokens are not securities under the Exchange Act and, therefore, BTOC should not be required to maintain the registration of its Tokens thereunder. None of these enforcement actions included allegations of fraud. However, the Gladius settlement is distinguishable in that the company self-reported its violations and was not required to pay a monetary penalty.

It is also noteworthy that, in conjunction with the BTOC settlement, the SEC issued an order to BTOC under Rule 506(d)(2)(ii) of the Securities Act granting a waiver of the Rule 506(d)(1)(v)(B) disqualification provision thereunder. We are not aware of similar relief having been requested or granted to Gladius, AirFox or Paragon, though it was granted in conjunction with the BlockOne/EOS settlement that was entered on September 30, 2019.

The BTOC settlement clearly shows that the SEC is still applying a strict view with regard to violations of Section 5 of the Securities Act while at the same time showing slightly more flexibility in its remedies to those Section 5 violations.

Wyoming, the “Equality State,” Seeks to Level the Playing Field for Digital Assets Businesses

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In its continued effort to establish itself as the go-to jurisdiction for digital asset businesses, Wyoming, through its Department of Audit, Division of Banking, recently published a digital asset custody regime for its newly created, special purpose depository institutions (SPDIs). SPDIs are banking institutions authorized to take custody of digital assets. If they function as intended, SPDIs may prove to be a solution to, among other things, digital asset companies’ money transmitter licensing woes.

One major impediment to entering the U.S. market for digital asset companies is the requirement to obtain money transmitter licenses from individual states. Applying for these licenses state by state can be expensive and burdensome, and some states have created additional hurdles for digital asset companies. New York, for example, requires digital asset companies to obtain a “BitLicense,” which is notoriously difficult to obtain, to operate in the state. California may soon follow suit, imposing substantial licensing requirements under Assembly Bill 1489, which has been introduced in the legislature.

Wyoming is trying a different approach. In establishing SPDIs, Wyoming is helping blockchain companies avoid the costs of these burdensome licensing regimes while still protecting customers by taking advantage of a regulatory benefit enjoyed by banking institutions like SPDIs. Per the Bank Secrecy Act, banks are exempt, as a general matter, from needing money transmitter licenses.

Further, advocates argue that the SPDIs will provide a solution for startups seeking to operate in New York without a BitLicense. Federal law, through the Riegle-Neal Amendments Act, protects the parity of national banks and the state-chartered banks of other states. Accordingly, if a state exempts a national bank from a regulation, then other state-chartered banks must be exempt from that regulation as well. Because New York exempts national banks from the requirement to obtain a BitLicense to operate, so the argument goes, Wyoming’s SPDIs – which are state-chartered banks – should be exempted from that requirement as well. This theory remains untested, and New York has not taken a position on whether it will exempt SPDIs from needing a BitLicense to operate there. Perhaps Wyoming’s status as “The Equality State” will prompt New York to provide its state-chartered banks with “equal” treatment.

While the first new SPDIs could become operational by early 2020, which might provide a work-around for the current money transmitter licensing barriers facing digital asset companies, there remain a few obstacles for a company desiring to take advantage of the law, albeit surmountable ones.

First, SPDIs are required to maintain a minimum capital requirement of $5 million – making it prohibitive for most startups to charter their own SPDI. However, multiple companies may partner with one unaffiliated SPDI to pool assets. Assuming cooperation among market players, startups should be able to find enough capital among other SPDIs to satisfy the capital requirement. Second, SPDIs are required to maintain the principal operating headquarters and the primary office of its CEO in Wyoming, but – as we know – the excellent skiing, beautiful vistas and abundant wildlife in Wyoming provide ample justification for setting up shop there.

Wyoming’s creation of SPDIs comes on the heels of other pro-blockchain moves by the state, including authorizing corporations to issue securities via “certificate tokens in lieu of stock certificates,” creating a FinTech sandbox that enables startups to receive waivers from laws or regulations that may unnecessarily burden their ability to test new products and services, and classifying digital assets as property.

Wyoming’s small population and limited infrastructure may make it difficult to attract personnel and capital to create a competitive SPDI market. But with sufficient incentives, and the opportunity to engage in a potentially lucrative and groundbreaking industry, Wyoming is making a bid to become the crypto capital of the U.S.

Reading the Blockchain Tea Leaves: Reconciling Telegram and Block.one

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The juxtaposition of two recent SEC enforcement actions against token issuers may shed some light on the regulator’s evolving regulatory framework.

On October 11, 2019, the SEC won a motion for a temporary restraining order from the U.S. District Court for the Southern District of New York against Telegram Group Inc., the creator of Messenger, an encrypted messaging application, to halt its planned $1.7 billion “Gram” token distribution and follow-on sale. The SEC’s action, which alleged that the planned offering of Grams would violate the registration requirements of Sections 5(a) and 5(c) of the Securities Act of 1933, put a halt to a long-running development project and more than 18 months of continued interaction with the SEC.

The SEC’s stance against Telegram stands in stark contrast to its settlement on September 30, 2019, with Block.one, the creator of the EOSIO blockchain protocol. Block.one conducted a year-long initial coin offering that raised a record $4 billion in 2017 and 2018. Block.one’s ICO utilized a dual-token structure: over the course of the ICO, Block.one sold 900 million digital assets (“ERC 20 tokens”) to purchasers. These tokens were freely transferable while the ICO was ongoing. At the end of the ICO, the ERC-20 tokens became nontransferable and, upon the subsequent launch of the EOSIO blockchain, holders of the ERC-20 tokens were entitled to receive the native EOS token. Block.one settled the SEC’s claims against it by agreeing to pay a monetary penalty of $24 million. Unlike what we have seen in similar settlements, the SEC did not require rescission of the sale of the ERC-20 tokens, which were designated securities, or the EOS tokens, which received no mention in the cease-and-desist order. The EOSIO blockchain protocol remains live, and EOS tokens remain in circulation. The SEC also explicitly granted a “bad actor” waiver under Regulation D permitting the Company to continue fundraising and capital formation in the United States.

The SEC’s seemingly distinct approaches to Block.one’s and Telegram’s offerings have left the industry scratching its collective head. What is most odd is the SEC’s decision in the case of Telegram to seek emergency relief, a remedy typically reserved for ongoing frauds, which is not alleged here. In lieu of a public explanation from the SEC, reviewing the differences between the two offerings may be the only way to extract guidance from these actions. There is, however, no way of knowing which differences actually had an impact on the results. Nevertheless, below we discuss some of the differences.

Token Use Case

The SEC’s disparate treatment of Telegram and Block.one may come down to the differences in the nature, purpose and design of their technologies. The SEC has given indications (although not official guidance) that a critical part of the Howey analysis as to whether a token is a security is if purchasers are dependent on a centralized group of people to drive its value; if the developer community of a blockchain technology is decentralized enough, the token may fall outside of Howey.

The Gram may have always been doomed to fail this test because of the planned integration with Messenger, which is a proprietary product. The integration with Messenger was supposed to be a significant driver of the Gram’s value, and the development of Messenger is entirely dependent on Telegram.

In contrast, the EOS tokens and the EOSIO blockchain protocol are designed and meant to power a smart contract platform on top of which other developers may build. Perhaps Block.one’s intention to build a decentralized platform resembling Ether helped it find favor with the SEC.

Manner of Token Sale

Telegram sold “Gram Purchase Agreements” to sophisticated purchasers that promised Grams upon the launch of Telegram’s TON blockchain. No Grams were to be distributed until the launch of the blockchain, presumably because Telegram held the view that if Grams were not distributed until the blockchain was live it might escape the “efforts of others” Howey prong. Clearly, this wasn’t enough to satisfy the SEC.

Block.one’s dual-token structure – issuing ERC-20 tokens first, which entitled holders to EOS tokens once the native EOSIO platform launched – gave the SEC the opportunity to take action against the ERC-20 tokens and remain silent on EOS. It is questionable whether this move is justified by strict legal analysis: the ERC-20 tokens were sold in conjunction with “Token Purchase Agreements” that made it clear to purchasers they were being sold the right to receive EOS tokens. Furthermore, until EOSIO launched, the future value of those EOS tokens was dependent on Block.one. Given the manner of sale, it is unclear why EOS received the apparent favorable treatment over Grams.

Participants in Sale and Availability of Tokens on Secondary Markets

In their official documents, the SEC presented two distinctly different attitudes towards the availability of a token on secondary markets accessible to U.S. persons. For Telegram, such availability justified the SEC in shutting down its entire operation, while for Block.one the availability only provoked a slight admonition, without enjoining the offering.

Block.one made some efforts to prevent U.S. customers from participating in the ICO: it blocked U.S.-based IP addresses and required purchasers to sign a contract that included a provision stating that any purchase by a U.S. person rendered the contract null and void. However, despite those measures, U.S. persons still succeeded in participating in the ICO; moreover, Block.one made efforts that could be viewed as conditioning the U.S. market, including participating in blockchain conferences and advertising EOSIO on a billboard in Times Square. Notably, too, the ERC-20 tokens were widely traded and available for purchase by U.S. persons on secondary markets. Block.one took no steps to prevent this.

In contrast, the fact that Telegram’s tokens would be available to U.S. purchasers on secondary markets drove the SEC’s argument that a TRO and preliminary injunction were necessary, regardless of the fact that Telegram limited the sale of Gram purchase agreements to sophisticated investors and that upon the distribution of Grams and the sale to the public the Telegram network would be fully functional.

Takeaways

The SEC’s distinctly different treatment of Telegram and Block.one provides insight into the SEC’s perspective on what sorts of tokens are securities, and which are not. It appears that the Gram’s integration into Telegram’s proprietary product – and therefore its dependence on Telegram – was critical to the SEC’s analysis. The analogous nature of EOS to Ether probably led to it not being designated a security. However, both ICOs were deemed in violation of securities laws, so neither should serve as a safe harbor for others. Furthermore, there is still no clear legal path to launching a token like EOS.