Posts by: Sunny Hwang

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

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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.

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

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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.

EtherDelta Founder’s Settlement with the SEC Has Grim Implications for Smart Contract Developers

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The SEC recently brought its first enforcement action against the creator of a “decentralized” digital token trading platform for operating as an unregistered national securities exchange, and in doing so joined the CFTC in putting a scare into smart contract developers.

On November 8, 2018, the SEC issued a cease-and-desist order settling charges against Zachary Coburn, the creator of EtherDelta, an online “decentralized” digital token trading platform running on the Ethereum blockchain. The SEC charged only Coburn, the individual who founded EtherDelta, but no longer owns or operates it. Note that the SEC press release states that the investigation is continuing.

The SEC announced its action against Coburn a month after a CFTC Commissioner stated in a speech that smart contract developers could be found liable for aiding and abetting violations of commodity futures laws. Both agencies appear to be putting smart contract developers on notice that by releasing code into the ether, they are inviting potential liability for any rule violations, even if they sever their connections with the code.

The SEC found that EtherDelta provides a marketplace to bring together buyers and sellers of digital tokens. The platform facilitates these transactions through the use of a smart contract, which carries out the responsibilities generally assumed by an intermediary: the smart contract validates the order messages, confirms the terms and conditions of orders, executes paired orders, and directs the distributed ledger to be updated to reflect a trade. The SEC employed a “functional test” to determine whether EtherDelta constitutes an exchange and to hold Coburn, who “wrote and deployed the EtherDelta smart contract . . . and exercised complete and sole control over EtherDelta’s operations,” responsible. As the Chief of the SEC’s cyber unit stated in the press release, “[w]hether it’s decentralized or not, whether it’s on smart contract or not, what matters is it’s an exchange.”

EtherDelta is one example of the innovation that smart contracts can facilitate. Innovation, however, is not a substitute for compliance. Indeed, in the SEC’s press release announcing the settlement, Co-Director of Enforcement Steven Peiken acknowledged that blockchain technology is ushering in significant innovation to the securities markets, but cautioned that “to protect investors, this innovation necessitates the SEC’s thoughtful oversight of digital markets and enforcement of existing laws.”

Significantly, the SEC found that certain transactions on the platform involved digital tokens that constitute securities, but declined to identify those tokens. Senior SEC officials have previously stated that ether is not a security, but this case shows that the SEC has not reached the same determination for all tokens issued on the Ethereum blockchain.

Just Another Week on the Blockchain: September 10-16, 2018

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The week of September 10th was particularly eventful and saw a rather large number of recent enforcement and regulatory developments, even by blockchain industry standards. Notable actions seen during the week included the first time the SEC has issued an order against a cryptocurrency company for operating an unregistered broker-dealer; the first time the SEC has brought and settled charges against a hedge fund manager that invested in cryptocurrencies while operating as an unregistered investment company; the first FINRA disciplinary action involving cryptocurrencies; a decision by EDNY Judge Raymond Dearie in U.S. v. Zaslavskiy; the authorization of two stablecoin cryptocurrencies pegged to the U.S. dollar by the New York Department of Financial Services; and the release of Chairman Clayton’s “Statement Regarding SEC Staff Views.”

For summaries of these developments, read our recent Blockchain and Cryptocurrency Alert.