Jorge Pesok

Managing Associate

New York


Read full biography at www.orrick.com

Jorge Pesok is a managing associate in the White Collar, Investigations, Securities Litigation & Compliance Group in the New York office. His practice focuses on SEC and CFTC investigations and enforcement actions, internal investigations and securities class actions with an emphasis on distributed ledger technology related matters.

Jorge represents financial institutions, technology companies, digital asset trading platforms and individuals in a variety of regulatory, compliance and litigation matters. His work includes representing clients in enforcement and litigation matters before the Securities and Exchange Commission, Department of Justice, Commodity Futures Trading Commission and Chicago Mercantile Exchange. He also counsels blockchain and cryptocurrency clients on the application of federal and state securities, commodities and money transmission laws.

A decorated veteran, Jorge served on active duty in support of Operation Iraqi Freedom, where he was awarded the Army Commendation Medal. Jorge retired from the United States Army National Guard in 2014 after serving eight years in the Judge Advocate General Corps and obtaining the rank of sergeant.

While in law school, Jorge was a member of the Maynard Pirsig Moot Court. Jorge also served as a judicial extern for the Honorable Richard H. Kyle of the United States District Court in St. Paul, Minnesota.

Posts by: Jorge Pesok

They Did It for the Gram: SEC and Telegram File Dueling Expert Reports

The battle in federal court between the SEC and Telegram continues to progress at breakneck speed. The SEC commenced its action less than four months ago, on October 11, 2019, by seeking a temporary restraining order against Telegram Group Inc. and TON Issuer Inc. (collectively, “Telegram”). That same day, Judge Castel in the Southern District of New York granted the SEC’s TRO request and ordered expedited discovery. Months of intensive discovery ensued that culminated with both parties filing cross motions for summary judgment on January 15, 2020.

At the center of the dispute is whether issuers of digital tokens can avoid registering their sale with the SEC by issuing them pursuant to “SAFTs,” or Simple Agreements for Future Delivery. SAFTs are commercial instruments used to convey rights to digital tokens to sophisticated investors prior to the development of the functionality of the platform on which the tokens are designed to operate. Issuers usually treat SAFTs as securities and offer and sell them pursuant to the exemption from registration in Rule 506(c) of Regulation D under the Securities Act of 1933. The digital tokens are later issued pursuant to the SAFTs once the platform for which the tokens were designed to use is “fully functional.” The theory is that once use-cases exist for the tokens, they no longer constitute securities, but rather utility tokens that can be distributed as commodities or currency without being subject to regulation as securities by the SEC. The SEC action against Telegram based upon its SAFTs and intended issuance of Grams is the first litigated case to contest that theory.

According to the SEC, from January 2018 to March 2018 Telegram entered into SAFTs with sophisticated investors for the future delivery of Grams. Grams have not yet been delivered. In its TRO motion, the SEC argued that the Grams were securities at the time the SAFTs were executed and the temporal separation between the signing of the SAFTs and delivery of the Grams upon the launch of the fully functional Telegram platform (the “TON Blockchain”) is immaterial and does not change the nature of the Grams themselves. The SEC further argued that upon delivery of the Grams to the SAFT investors, those investors will be able to resell the Grams without restrictions. “Once these resales occur, Telegram will have completed its unregistered offering” for which no exemption from registration exists.

In opposition, Telegram argued that the Grams must be separately analyzed from the SAFTs under the federal securities laws. Telegram contended that the Grams are not securities because they “do not exist and may never exist.” Rather, under the SAFTs, Telegram represented that it will create and distribute Grams only upon the launch of a “fully functional TON Blockchain,” which will provide Gram’s use-cases; that is, once the TON Blockchain is launched, Grams will be able to be used for, among other things, payment for physical and digital products and services, commission paid to TON validators for processing transactions and smart contracts, voting on parameters of the protocol, and payment for services provided by third-party applications on the TON Blockchain.

The SEC is expending significant resources in this case. It recently submitted to the Court expert opinions to support its position that token sales are offerings of securities subject to its regulation. Together, these opinions are intended to buttress the SEC’s argument that Telegram’s offering satisfied the Howey test and qualified for no exemption from registration:

  • A financial economist at the SEC’s Division of Economic and Risk Analysis, Carmen A. Taveras, Ph.D., provided an opinion that the price at which Grams are sold increases exponentially over time and is a function of the total number of Grams in circulation. As a result, the price at which purchasers who bought Grams pursuant to the SAFTs is significantly discounted to the price at which Grams will be available for purchase by subsequent buyers. The opinion also disputed Telegram’s representation in promotional materials that it will maintain price stability following the launch of the TON Blockchain by setting up a “TON Reserve” to strategically buy and sell Grams. Taveras concluded that the TON Reserve’s ability to buy and sell Grams would likely have a limited effect on curbing sudden spikes and dips in the price of Grams.
  • A blockchain data scientist in private practice, Patrick B. Doody, opined that while it is reasonable for private placement purchasers to buy Grams expecting to profit by selling them in the secondary market, Grams are unlikely to attract investors seeking a “realistic currency option to buy goods and services.” Telegram’s promotional materials appealed to potential investors seeking to profit through resales, while providing short shrift to factors that would enhance Grams’ viability as a currency, including fraud prevention, theft, integration with existing banking relationships, compliance with financial regulations, and price stability such as that which can be achieved by pegging the price of Grams to a fiat currency.
  • An expert in the field of computer science at Brown University, Maurice P. Herlihy, Ph.D., opined that the publicly released version of the TON Blockchain code lacks critical components that would be required in a fully developed and running system, and users cannot evaluate the security and effectiveness of the TON Blockchain in its current state. Moreover, the TON Blockchain is not yet mature enough to support the suite of services described in TON public documents.

Taken together, the SEC’s experts took the position that (1) Telegram SAFT investors reasonably expected to profit from Telegram’s efforts to develop the TON Network, and (2) that the current state of the TON Network reveals it is not yet mature enough to support the suite of services promised by TON’s public documents.

Telegram also retained its own expert, Stephen McKeon, who holds a Ph.D. in management with a finance focus and a master’s degree in economics. McKeon’s expert report rebuts the SEC’s experts by opining that (1) the profit expectations of SAFT investors is independent from, and not relevant to, the expectations of purchasers following the TON Blockchain launch, and (2) that most TON Network “components are complete or nearing their completion and will be fully available to the TON blockchain users at the launch of the mainnet.”

As further evidenced by the filing of amicus briefs by the Chamber of Digital Commerce and the Blockchain Association, the stakes for the industry in this case are high.

SEC Settles with BCOT on Alleged Violations of the Securities Act

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

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

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.

Playing Catch-Up: Commissioner Peirce Proposes a Safe Harbor for Certain Token Offerings

SEC Commissioner Hester Peirce has once again earned her title as “Crypto Mom” by expressing support for building a “non-exclusive safe harbor” for the offer and sale of certain cryptocurrency tokens. Peirce explained that the concept of a safe harbor is still in its infancy and did not propose a timeline for the project. Nevertheless, her support is welcome news for the industry, which can hope that her well-stated views will influence the rest of the Commission to move to adopting a separate securities regulatory framework for cryptocurrency.

We expect that the SEC will take its time in moving forward with the development and implementation of a safe harbor for token offerings. Peirce previously defended the SEC’s slow approach to crypto regulation, indicating that delays in establishing crypto regulations “may actually allow more freedom for the technology to come into its own.” Peirce is cognizant of the repercussions of moving too slowly and seems to be trying to balance the need for regulatory certainty with the need to get the regulatory framework right.

Peirce explained that in developing its crypto regulatory regime, the SEC can learn from other countries that have taken the lead in developing a regulatory framework for token offerings. For example, Peirce explained that the “nebulous” definition of a security in the U.S., coupled with the difficulty of determining the precise nature of a digital asset – is it a currency, commodity, security or derivative? – has slowed our regulatory progress. Peirce suggests looking at the approach taken by Singapore for the classification of offerings as non-securities, since Singapore does not treat every token offering as a securities offering. Similarly, earlier this month the SEC and FINRA issued a joint statement explaining that there are still unanswered questions regarding custody of digital assets that have led to delays in approving ATS applications. Peirce recommends reviewing Bermuda’s guidance on the subject because “Bermuda is one of the only jurisdictions to address the custody question in detail.”

With so many countries so far ahead of the U.S. in developing regulatory regimes for token offerings, the SEC has an abundance of approaches to review. Ideally this will speed up the development and implementation of the safe harbor. If, however, the SEC continues to drag its feet, token projects that would otherwise prefer to launch in the U.S. might be expected to continue to choose jurisdictions with clearer regulatory regimes.

The SEC’s Second No-Action Relief for Digital Tokens: Meaningful Relief or a Wolf in Sheep’s Clothing?

Pocketful of Quarters, Inc. (PoQ) is the second-ever recipient of no-action relief from the Division of Corporation Finance of the Securities and Exchange Commission for the issuance of “Quarters.” Quarters are a digital arcade token that is usable, like its conventional physical counterparts, across participating games and platforms. This no-action relief evidences a more thoughtful and sophisticated approach to the regulation of digital tokens and, in that respect, is welcome news to an industry that has been adrift since SEC Chairman Clayton’s statement in December 2017 that “[b]y and large, the structures of initial coin offerings that [he has] seen promoted involve the offer and sale of securities.” This no-action relief, though arguably unnecessary because Quarters are clearly not securities, confirms that certain classes of tokens are not subject to the requirements of the federal securities laws. Moreover, the conditions and restrictions imposed by the no-action letter on the issuance and use of Quarters are so onerous that the relief granted, while reaffirming, is not groundbreaking.

In the no-action relief, the Chief Legal Advisor to FinHub indicated that, subject to conditions, the Division would not recommend enforcement action to the Commission if PoQ offers and sells Quarters without registering the tokens as securities under Section 5 of the Securities Act and Section 12(g) of the Exchange Act. Some of the more significant conditions are:

  • The Quarters will be immediately usable for their intended purposes (gaming) at the time they are sold;
  • PoQ will restrict the transfer of Quarters through technological and contractual provisions governing the Quarters and the Quarters Platform that restrict the transfer of Quarters to PoQ or to wallets on the Quarters Platform;
  • Gamers will only be able to transfer Quarters to addresses of Developers with Approved Accounts or to PoQ in connection with participation in e-sports tournaments;
  • Only Developers and Influencers with Approved Accounts will be capable of exchanging Quarters for ETH at pre-determined exchange rates by transferring their Quarters to the Quarters Smart Contract;
  • Quarters will be made continuously available to gamers in unlimited quantities at a fixed price;
  • PoQ will market and sell Quarters to gamers solely for consumptive use as a means of accessing and interacting with Participating Games.

Considered as a whole, these conditions are so restrictive and duplicative that they raise doubt as to the necessity of the relief. For example, since Quarters will be made continuously available in unlimited quantities at a fixed price, no reasonable purchaser can expect the price of Quarters to increase and therefore cannot expect to profit from the purchase of Quarters. Accordingly, the transfer and secondary market trading restrictions are superfluous, and by highlighting them as a condition of the relief, CorpFin is effectively imposing conditions on a non-security.

Commissioner Hester Pierce raised a similar concern regarding the staff’s issuance of the first token no-action letter to TurnKey Jet, a charter jet company that sought to tokenize gift cards that could be used to charter its jet services. She stated that the offering of Turnkey tokens is so “clearly not an offer of securities that I worry the staff’s issuance of a digital token no-action letter . . . may in fact have the effect of broadening the perceived reach of our securities laws.” She continued by stating that the Turnkey no-action letter “effectively imposed conditions on a non-security.” Nevertheless, the Quarter’s no-action relief should be touted because it reestablishes the possibility of issuing a digital token that is not a security.

There are three additional aspects of PoQ’s letter requesting no-action relief that merit special attention: (i) the two-tiered token approach used by PoQ; (ii) the built-in token economics managed by a smart contract; and (iii) the condition that KYC/AML compliance reviews must be made at account initiation and on an ongoing basis.

First, Quarters are the second class of tokens that PoQ will issue, but the only one for which it sought no-action relief. PoQ conceded that the first class of tokens PoQ issued, “Q2 Tokens,” are securities, which were sold to investors through an exempt offering to raise funds to build the Quarters platform. The holders of the Q2 Tokens will benefit from the sale of Quarters by receiving, ratably, 15% of the funds collected from the sale of Quarters. This, or a similar, structure could prove beneficial to other investors that purchased tokens through an exempt offering and are now waiting for a return on their investment.

Next, the no-action relief implicitly approves the token economics of the PoQ network. According to PoQ’s letter requesting no-action relief, a portion of the funds received from the sale of Quarters will be used to compensate developers, influencers and Q2 Token holders in ETH. The funds distribution process will be managed by a smart contract. If Quarters are purchased with fiat currency, PoQ will transfer an equivalent amount of ETH to the Quarters Smart Contract upon such purchases for the purposes of such compensation.

Last, the no-action request raises, but leaves unanswered, a question pertinent to all token issuers: whether PoQ or any participant on the Quarters Platform must register with FinCEN as a money services business. Although this question is left unanswered, it appears that PoQ has built in some processes that would be required if it were a registered MSB. For example, a condition of the no-action relief states that: “to create an Approved Account, Developers and Influencers will be subject to KYC/AML checks at account initiation as well as on an ongoing basis.” In addition, the no-action request explains that purchases of Quarters through the PoQ Website “will occur via a licensed payment processor.” Similarly, purchases made through the Apple App store and Google Play store will occur via the standard payment processing solutions generally applicable to purchases made through those platforms; it is possible that this system was put in place to take advantage of one of the money transmitter exemptions such as the payment processor exemption. For the time being, however, it appears that PoQ has not registered with FinCEN; PoQ does not appear as a registered entity on FinCEN’s MSB Registrant database.

Though restrictive in its terms, the Quarters no-action relief demonstrates the SEC’s willingness to engage with token issuers and permit use of cryptocurrency outside of the SEC’s regulation, although the agency does not appear ready to give the concept free reign.

The SEC Can’t Keep Kik-ing the Crypto Can

The SEC’s Action

On June 4, 2019, the SEC sued Kik Interactive Inc. (“Kik”), a privately held Canadian company, in the Southern District of New York, alleging that Kik’s offer and sale of $100 million worth of Kin tokens in 2017 constituted the unregistered sale of securities in violation of section 5 of the Securities Act. In a nutshell, the SEC asserts that, although Kik filed a Form D exemption from registration for the offering, the Kin sale did not qualify for the exemption because the tokens were offered and sold to the general public, not exclusively to accredited investors.

Importance

This case could yield guidance from a court on whether and when tokens constitute securities, to substitute precedential law for the SEC’s pronouncements in settled enforcement actions and guidance issued by its Divisions. The SEC charges that Kin tokens are securities under the Howey test. As a result of Kik’s failure to register the tokens, the SEC alleges, investors did not receive the information from the company relevant for evaluating Kik’s claims about the potential of the investment, including current financial information, proposed use of investor proceeds, and the company’s budget. The Complaint emphasizes the reasonable expectations of “investors” in Kin that the value of their tokens would increase based upon Kik’s efforts, in terms that suggest that Kik’s statements about its projects lacked support and might even have been misleading. And although scienter is not a component of Section 5 charges, and the SEC did not charge fraud, the Complaint alleges that Kik knew or should have known that it was offering securities because, among other things: (1) the SEC had issued the DAO report that applies the Howey test before Kik began offering and selling the tokens; (2) a consultant warned Kik that Kin could be considered a security; and (3) the Ontario Securities Commission told the company that a sale to the public of Kin would constitute a securities offering. Kik’s primary defense is that Kin is not a security but a transaction currency or utility token akin to Bitcoin or Ether, which are not regulated as securities.

This appears to be the SEC’s first litigated federal action against an issuer solely for failure to register. Most registration cases have settled, and the ones that proceeded to litigation involved fraud claims in addition to failure to register. Since 2017 there have been over 300 ICO-related Form D offerings, so many companies may be directly impacted by the outcome of this case. Kik has stated that it intends to litigate through trial, and Kik and the Kin Foundation reportedly have raised a war chest of nearly $10 million (and are still seeking contributions to its defense fund).

Defenses

Although Kik has not yet answered the complaint or moved for its dismissal, the company’s position is well laid out in both a public statement from its General Counsel reacting to the filing, and an extensive Wells submission that Kik took the highly unusual step of making public. The General Counsel commented that the SEC’s complaint stretches the Howey test beyond its definition by, among other things, incorrectly assuming that any discussion of a potential increase in the value of an asset is the same as promising profits solely from the efforts of others. The Wells submission states that Kin was designed, marketed and offered as a currency to be used as a medium of exchange, taking it outside the definition of security, and that it was not offered or promoted as a passive investment opportunity. Besides extensively elaborating on its view that the Howey test is not met, Kik takes issue with “regulation by enforcement,” given the industry’s “desperate” need for guidance regarding the applicability of the federal securities laws.

Conclusion

SEC Chairman Jay Clayton stated last year that all ICOs he has seen are securities. And yet the SEC has pursued enforcement actions against only a small portion of ICOs – less than ten percent – most of which involved fraud or other intentional misconduct. It’s too soon to tell for sure, but this action might suggest that the SEC is now entering a new phase in its enforcement approach to ICOs.

NYDFS to Virtual Currency Exchange: Don’t Let the Door Hit You on Your Way Out

The New York Department of Financial Services virtual currency license is back in the spotlight after NYDFS announced that it had rejected the application of Bittrex Inc., a virtual currency exchange, to conduct virtual currency business in the Empire State. The NYDFS virtual currency license, or BitLicense, is notoriously difficult to obtain, having been granted to only 19 companies since it was implemented in July 2014. Although all BitLicense application denials are technically publicly available (but not published), the announcement of Bittrex’s application denial in such a public way is a first for the regulator. The rejection letter states that “Bittrex has failed to demonstrate responsibility, financial and business experience, or the character and fitness to warrant the belief that its business will be conducted honestly, fairly, equitably and carefully. . . .” The denial, coupled with the requirement that Bittrex immediately close up shop in New York, marks a very public rebuke of the exchange, which Bittrex met with a prompt and strongly worded response of its own.

Bittrex submitted its BitLicense application on August 10, 2015. On April 10, 2019, NYDFS publicly announced the rejection of Bittrex’s application. New York allowed Bittrex to operate in the state during the three and a half year application process under the terms of a safe harbor. According to NYDFS’s public rejection letter, the prolonged application process culminated in a four-week on-site review of Bittrex’s operations by NYDFS in February 2019. As a result of the on-site review, NYDFS rejected Bittrex’s BitLicense application based primarily on “deficiencies in Bittrex’s Bank Secrecy Act (BSA), Anti-Money Laundering (AML) and Office of Foreign Assets Control (OFAC) compliance program; a deficiency in meeting the Department’s capital requirement; and deficient due diligence and control over Bittrex’s token and product launches.” This long list of deficiencies, after such a long and laborious application process, appears at odds with the Department’s statement that “throughout Bittrex’s application process, the Department worked steadily with Bittrex” to address deficiencies in some of the very same areas found to be deficient during the February 2019 review.

According to the rejection letter, Bittrex has approximately 35,000 New York-based users who must now find a new exchange on which to trade. This is not going to be an easy task because Bittrex is a market leader listing 212 digital assets on its exchange. By way of comparison, Coinbase, which received its BitLicense in January 2017, lists six digital assets on its exchange (not including the digital assets listed on Coinbase Pro).

Within hours Bittrex responded to the public rejection with its own statement asserting that the rejection “harms rather than protects New York customers,” and stating that “Bittrex fully disputes the findings of the NYDFS” in its rejection letter. According to Bittrex, the NYDFS rejection letter contains “several factual inaccuracies” which Bittrex addresses in its response letter.

Given the public nature of this confrontation and the status of New York as a major financial hub, it is unlikely that we have heard the last of this from the parties involved. In the interim, industry participants should review the NYDFS rejection letter and Bittrex’s response, both of which provide helpful insight into the BitLicense application process and the requirements that digital asset companies have to meet if they seek to offer services in New York.

Three Yards and a Cloud of Dust: SEC Staff Provides Its “Plain English” Framework to Guide Future Discussions

The SEC chose a week that saw the price of Bitcoin spike by over $700 in an hour, kicking off a rally reminiscent of the go-go days of 2017, to issue its long-awaited “plain English” guidance for determining whether a digital asset constitutes a “security” under the federal securities laws.

The SEC also unexpectedly released its first no-action letter to a company planning to issue a digital asset without registering the transaction under Section 5 of the Securities Act of 1933 and Section 12(g) of the Securities and Exchange Act of 1934.

Now that the dust has settled, we can start to analyze what all this means for the digital asset industry. Upon review, the Bitcoin rally might have been the more impactful event.

On April 3, a statement entitled “Framework for ‘Investment Contract’ Analysis of Digital Assets” (the “Framework”) was issued by Bill Hinman, Director of Division of Corporation Finance, and Valerie Szczepanik, Senior Advisor for Digital Assets and Innovation; and the Commission’s Division of Corporation Finance issued its first no-action letter regarding digital assets to TurnKey Jet, Inc., a U.S.-based air carrier and air taxi service.

The Framework goes out of its way to caution that it represents the views of the Strategic HUB for Innovation and Financial Technology of the Commission and is not a rule, regulation or statement of the Commission: that the Commission has neither approved nor disapproved its content; and that it is not binding on the Divisions of the Commission. The Framework further emphasizes its limited scope: “Even if no registration is required, activities involving digital assets that are securities may still be subject to the Commission’s regulation and oversight,” for example buying, selling, or trading; facilitating exchanges; and holding or storing digital assets. Thus, the Framework has limited utility from a factual, legal or precedential standpoint. Nevertheless, we expect it to be a significant source document that will be cited by the Commission, practitioners, and courts alike.

On the same day, the Commission’s Division of Corporation Finance issued its first no-action letter regarding digital assets to TurnKey Jet, Inc., a U.S.-based air carrier and air taxi service (the “No-Action Letter”). The No-Action Letter is not binding on the Commission and only applies to the very specific, and restrictive, set of conditions presented in the No-Action Letter request and, therefore, it does not have broad implications for the industry in general. Like the Framework, the No-Action Letter provides little guidance to the industry, but it should be touted as a step in the right direction, albeit a small step.

Though the Framework and No-Action Letter are not as helpful as some might have hoped, both are key developments that shed light on the Staff’s current views regarding the regulation of digital assets and the activities of industry participants under the federal securities laws.

The Framework

The Framework, which the Staff emphasized does not “replace or supersede existing case law, legal requirements or statements or guidance” from the SEC, largely relies on the 73-year-old Howey test for determining whether a digital asset is a security in the form of an “investment contract.” The Howey test is composed of four prongs: (i) an investment of money; (ii) in a common enterprise; (iii) with a reasonable expectation of profit; (iv) derived from the efforts of others.

The Framework succinctly analyzes the applicability of the first two prongs to an offer and sale of a digital asset in three sentences and reserves the other nine pages for the latter two prongs. It is reasonable to ask whether the existence of a common enterprise in an offer and sale of a digital asset is as foregone a conclusion as the SEC evidently believes.

The Framework introduces a term to identify the principal actor or actors in the development or maintenance of a digital asset network, an “Active Participant” or “AP,” broadly defined to include a “promoter, sponsor, or other third party (or affiliated group of third parties).” The activities of the Active Participants are emphasized as critical factors for determining whether a purchaser has a reasonable expectation of profits (or other financial return) to be derived from the efforts of others. This is an expansive reading of the Howey test. For example, under the Framework the following are indicative of reliance by the purchaser of a digital asset on the “efforts of others”: (i) when an AP promises “further developmental efforts in order for the digital asset to attain or grow in value”; (ii) when the purchaser expects that the AP will be “performing or overseeing tasks that are necessary for the network or digital asset to achieve or retain its intended purpose or functionality”; (iii) an AP creates or supports a market for the digital asset; (iv) an AP maintains a managerial role in the project; and (v) when a purchaser would reasonably expect the AP to “undertake efforts to promote its own interests and enhance the value of the network or digital asset.” As an aside, introducing the concept of “Active Participant” suggests that the SEC might be in the early stages of promulgating a refined regulatory scheme for digital currency that focuses on the role of actors whose efforts help maintain or enhance the value of existing currency.

In the section entitled “Other Relevant Considerations,” the Framework spells out how a digital asset can be structured to avoid being considered a security. As a general matter, the stronger the presence of certain identified characteristics, the less likely a digital asset would constitute a security under the Howey test. These characteristics include (i) the network is fully developed and operational; (ii) holders of the digital asset are immediately able to use it for its intended functionality; (iii) the good or service underlying the digital asset can only be acquired, or more efficiently acquired, through the use of the digital asset on the network; and (iv) the digital asset is marketed in a manner that emphasizes the functionality of the digital asset. However, some of the other characteristics cited would pose challenges for “traditional” digital asset issuances, including: (i) prospects for appreciation in the value of the digital asset are limited, e.g. the design of the digital asset provides that its value will remain constant or even degrade over time; and (ii) if the AP facilitates the creation of a secondary market, transfer of the digital asset may be made only by and among users of the platform.

The Framework briefly discusses when a digital asset “previously sold as a security” should be reevaluated at the time of later offer or sale. Relevant considerations in that reevaluation include whether purchasers “no longer reasonably expect that continued development efforts of an AP will be a key factor for determining the value of the digital asset.” The broad definition of AP is especially troubling when coupled with the Framework’s broad list of examples of continued involvement by the AP in the development or management of the network or digital asset because it arguably could apply to almost any project in the industry.

This discussion is largely a restatement of Director Hinman’s oft-cited speech “When Howey Met Gary (Plastic),” and is generally not helpful in addressing the great leap required to transition from a product developed by a group of identifiable individuals to a “de-centralized” organization. Note that the Framework does not address, among other things, the status of SAFTs and the issuance of tokens thereunder. It also says nothing about projects where sale of tokens are restricted to non-U.S. buyers, and U.S. residents later wish to use the tokens.

No-Action Letter

In the No-Action Letter, the Division of Corporation Finance indicated that, subject to specified conditions, it would not recommend enforcement action to the Commission if TurnKey Jet offers and sells its tokens without registration under the Securities Act and the Exchange Act. The No-Action Letter is instructive because it provides an example of the narrow range of activities that, under the Framework, would exclude a digital currency from treatment as a security. Some of the key features of the digital asset represented in the No-Action Letter request include:

  • TurnKey will not use any funds from the token sale to develop its platform, network, or application, and “[e]ach of these will be fully developed and operational at the time any tokens are sold.”
  • TurnKey’s tokens will be immediately usable for their intended functionality when they are sold.
  • The seller must restrict transfers of the tokens to its proprietary wallet.
  • The token’s marketing focuses on the functionality of the token and not its investment value.
  • The tokens will be priced at US$1 per token “through the life of the program” with each token essentially functioning as a prepaid coupon for TurnKey’s air charter services.

While TurnKey can celebrate being the recipient of the first no-action letter regarding the registration requirements of the Securities Act and the Exchange Act applicable to digital assets, the highly restrictive covenants it must abide by to avoid registration are in conflict with the characteristics of most ICOs and, therefore, the No-Action Letter provides little relief to the typical industry participant.


Although the Framework and the No-Action Letter largely reiterated what digital asset market participants already knew, taken together they have opened the door to further constructive discussions with the Staff that, hopefully, will produce more clear-cut guidance based upon the analysis of specific cases.

SEC’s Light Touch: An ICO Settlement Without a Penalty

In another first for the digital token industry, on February 20 the SEC announced a settlement involving a self-reported unregistered initial coin offering (ICO) without imposing a penalty. Like its earlier settlements with AirFox and Paragon, the SEC required Gladius Network LLC to repay investors and register its GLA tokens as securities. This time, however, in a sign that the SEC is willing to work with companies trying to come into compliance, the SEC did not impose a monetary penalty due to the company’s “decision to self-report and its extensive cooperation with the staff’s subsequent investigation.”

Having just completed their freshman year at the University of Maryland College Park in 2017, Max Niebylski, Alex Godwin, and Marcelo McAndrew during their summer break founded Gladius as a cyber security company dedicated to ending Distributed Denial of Service attacks. On September 27, 2017 Gladius released a White Paper, and between October 13, 2017 and December 13, 2017 it raised a total of $12.7 million dollars through the sale of GLA tokens.

In an apparent attempt to maneuver around the securities laws and avail itself of the as-yet-untested utility token defense – which attempts to show that the tokens did not represent an investment contract but rather, like it sounds, something with utility for the purchaser – Gladius required participants in the ICO to warrant that they were purchasing GLA tokens “solely for the purpose of accessing Services . . . [and not for] any investment, speculative or other financial purposes.” Nevertheless, in the summer of 2018 Gladius self-reported the unregistered sale of GLA tokens to the SEC’s Division of Enforcement.

The SEC, in the settlement order, included a one-sentence Howey analysis, finding that the sale of GLA tokens met the factors of Howey because “[a] purchaser in the offering of GLA Tokens would have had a reasonable expectation of obtaining a future profit based upon Gladius’s efforts to create a ‘marketplace’ using the proceeds from the sale of GLA Tokens and to provide investors with liquidity by making GLA Tokens tradeable on secondary markets.”

Although the Company will have to comply with notice and reporting requirements under the federal securities laws, the only ordered monetary relief is the requirement that the Company refund GLA token purchases made between September 2017 and December 2017 pursuant to a claims process similar to what the SEC devised for the AirFox and Paragon settlements. Given the infrequency with which investors actually file claims, it is unlikely that the Company will end up refunding the full $12.7 million-dollar obligation it faces.

In another notable deviation from the AirFox and Paragon settlements, the SEC directed Gladius to provide the Commission advance notice if it planned to file a Form 15 to terminate its registration pursuant to Rule 12g-4 under the Securities Exchange Act of 1934 on the grounds that the GLA Tokens no longer constitute a “class of securities.” This seemingly superfluous requirement could be the SEC’s way of signaling to the industry that token issuances that remain below the monetary and holder threshold requirements of Rule 12g-4 will not run afoul of securities laws.

All told, the Gladius settlement is proof that the SEC continues to show leniency to token issuers who violated the securities laws if they act in good faith and come into compliance.