Keyword: Federal securities laws

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.

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.

Blockvest II: Court Reverses Itself and Grants the SEC a Preliminary Injunction in the Face of Manifest Fraud

As we previously discussed, the SEC suffered a rare defeat in Securities and Exchange Commission v. Blockvest, LLC et al. on November 27, when Judge Curiel of the U.S. District Court for the Southern District of California issued a denial (the “November Order”) of its motion for a preliminary injunction against Defendants’ future violations of Section 17(a) of the Securities Act of 1933 (“Section 17(a)”), despite manifest evidence of fraudulent representations in the Defendants’ website postings. The November Order attracted intense scrutiny and on December 17, the SEC moved for partial reconsideration of the November Order. Last week, on February 14, the court granted, in part, the SEC’s motion for reconsideration (the “February Order” and, together with the November Order, the “Orders”), relying on purported new evidence and an argument that the court apparently had overlooked. It is fair to ask whether the new evidence motivated the reversal.

As Judge Curiel recited, under the Federal Rules of Civil Procedure, a motion for reconsideration is appropriate, among other reasons, if the district court is “presented with newly discovered evidence.” Judge Curiel stated that the standard for granting a preliminary injunction requires the SEC to show: “(1) a prima facie case of previous violations of federal securities laws, and (2) a reasonable likelihood that the wrong will be repeated.” Based upon these standards, the court concluded that reconsideration in this case was warranted “based upon a prima facie showing of Defendants’ past securities violation and newly developed evidence which support the conclusion that there is a reasonable likelihood of future violations.” However, it is not clear what “newly developed evidence” formed the basis for this conclusion.

In applying the Howey test to the tokens offered by Blockvest, the court agreed with the SEC that “the Howey test is unquestionably an objective one.” The court disputed the SEC’s assertion that in the November Order the court had applied a “subjective test” by relying solely on the beliefs of some individual investors. Rather, the court stated that it had “objectively inquire[d] into the ‘terms of promotional materials, information, economic inducements or oral representations at the seminars, or in other words, an inquiry into the ‘character of the instrument or transaction offered’ to the ‘purchasers.’”

The court emphasized that in the November Order it had denied the motion for a preliminary injunction “because there were disputed factual issues as to the nature of the investment offered to alleged investors.” Nonetheless, the court acknowledged that in denying the SEC’s motion for a preliminary injunction, it did not “directly address” an alternate theory originally presented by the SEC that the promotional materials presented on Defendants’ website, in the whitepaper posted online, and on social media accounts concerning the ICO of the token constituted an offer of unregistered securities that contained materially false statements and therefore violated Section 17(a). The court again applied the Howey test to find that the tokens being offered were securities. The court also rejected the defendants’ arguments that applied state law to interpret “offer” narrowly to require a manifestation of an intent to be bound, finding that “offer” is broadly defined under the securities laws.

The court also found that the SEC had satisfied the required showing that there is a reasonable likelihood of future violations, one of the elements of injunctive relief. In support of its ruling, the court cited the misrepresentations in Defendants’ website postings that had been detailed in the November Order and which were manifestly fraudulent. Based upon this information, addressed by the SEC in supplemental briefing, the court granted partial reconsideration of the November Order.

Also factored into the February Order were the findings that defense counsel had moved to withdraw as counsel because “the firm found it necessary to terminate representation due to, inter alia, Defendants instructing counsel to file certain documents that counsel could not certify under Rules of Civil Procedures 11… and Defendants have yet to find substitute counsel.” The court stated its concerns that Defendants would resume their prior alleged fraudulent conduct, in light of its order allowing defense counsel to withdraw.

Given the severity of the fraudulent representations as alleged in the SEC’s action, which included false claims of approval by federal regulators and a wholly fabricated federal agency, it was surprising that the court had originally denied the SEC’s request for a preliminary injunction; the need to shut down ongoing fraud and protect investors often drives a court’s rulings on requests for interim relief in these cases. It appears that in reversing itself, the court rethought its reasoning based on the information and arguments that the SEC had originally presented. In one telling ruling in the new decision, the court declined to accept new arguments raised by defendants in opposition to the motion for reconsideration because they had not previously raised them. It appears that the SEC can shrug off its original loss and continue to seek to shut down this alleged fraud with all the power of the federal securities laws.

SEC and FINRA Confirm Digital Assets a 2019 Examination Priority

Recently, the Staffs of the SEC and FINRA announced their annual examination and regulatory priorities: the SEC’s Office of Compliance, Inspections and Examinations (OCIE) issued its 2019 Examination Priorities just before its employees were sent home on furlough, and FINRA issued its 2019 Risk Monitoring and Examination Priorities Letter last week, several weeks later than its usual first-of-the-year release. The high points and overlap of the two releases are covered in an Orrick Client Alert, but for purposes of On the Chain, we will briefly discuss the two regulators’ not-surprising designation of digital currency as one of their priorities.

The priorities letters clearly telegraph both regulators’ intentions to examine firms’ participation in the digital assets marketplace. OCIE flags digital assets as a concern because of the market’s significant growth and risks. OCIE indicates that it will issue high-level inquiries designed first to identify market participants offering, selling, trading, and managing these assets, or considering or actively seeking to offer these products. Once it identifies those participants, OCIE will then assess the extent of their activities and examine firms focused on “portfolio management of digital assets, trading, safety of client funds and assets, pricing of client portfolios, compliance, and internal controls.”

For its part, FINRA treats digital assets under the heading of “Operational Risks,” and encourages firms to notify it if they plan to engage in activities related to digital assets, even, curiously, “where a membership application is not required.” In this context, FINRA references its Regulation Notice 18-20, July 6, 2018, which is headlined “FINRA Encourages Firms to Notify FIRNA If They Engage in Activities Related to Digital Assets.” These initiatives provide a partial explanation for the long-expected delays in FINRA granting member firms explicit authority to effect transactions in digital assets.

FINRA also states its intention to review these activities and assess firms’ compliance with applicable securities laws and regulations and related supervisory, compliance and operational controls to mitigate the risks associated with such activities. FINRA states that it will look at whether firms have implemented adequate controls and supervision over compliance with rules related to the marketing, sale, execution, control, clearance, recordkeeping and valuation of digital assets, as well as AML/Bank Secrecy Act rules and regulations. These issues are addressed in detail in FINRA’s January 2017 report on “Distributed Ledger Technology: Implications of Blockchain for the Securities Industry.”

The SEC and FINRA clearly will seek to align their concerns about firms participating in the digital asset markets and the compliance and supervision standards to which they will hold them. The regulators’ jurisdiction overlaps, but the SEC’s is broader – it extends to all issuers, while FINRA would be limited only to those issuers that are member broker-dealer firms. The SEC also has jurisdiction over investment advisers, while FINRA again is limited to those advisers who are members. And because the SEC effectively owns the definition of security, FINRA also states its intention to coordinate closely with the SEC in considering how firms determine whether a particular digital asset is a security. At the same time, FINRA has jurisdiction over any activities engaged in by broker-dealers with respect to its customers, even those that do not involve a security, meaning that a member firm’s transactions in or custody of, for example, bitcoin – declared by the SEC not to be a security – still will implicate FINRA’s oversight.

The regulators’ coordination on their digital currency reviews will likely not diminish regulatory attention, but at least it will provide industry participants some comfort that coordinated thought is being given to how best to regulate this emerging area.

Transactors in Digital Tokens – New Bill Offers Hope

On December 20, 2018, Representatives Warren Davidson (R-Ohio) and Darren Soto (D-Fla) offered some early holiday hope to digital token issuers by introducing the “Token Taxonomy Act” (the TTA). If passed, the TTA would exclude “digital tokens” from the federal securities laws and would undoubtedly have profound effects for the U.S. digital token economy. The TTA is an ambitious piece of legislation that faces an uncertain future. Nevertheless, Representatives Davidson and Soto should be commended for attempting to provide some regulatory relief and certainty to an industry that has been yearning for it.

In addition to exempting digital tokens from the securities laws, the TTA would amend the Internal Revenue Code and classify the exchange of digital tokens as like-kind exchanges under Section 1031, and allow digital tokens to be held by retirement accounts.

The TTA would also amend language in the Investment Advisers Act of 1940 and the Investment Company Act of 1940 so that state-regulated trust companies, which include broker dealers, investment advisors and investment companies, would be able to hold digital assets for customers.

According to the TTA’s authors, the intention behind the bill is to provide much-needed regulatory certainty to digital token issuers and to ensure the U.S. remains competitive against other countries like Switzerland, where blockchain startups are thriving.

However, the TTA’s benefits are hypothetical at this point, since it is likely to be opposed by the SEC. On November 30, 2018, SEC Chairman Jay Clayton opined at a New York Times-hosted event that SEC rules were made by “geniuses” and “have stood the test of time.” He stated that he did not foresee changing rules “just to fit a technology.” While he was not referring specifically to the TTA, these comments indicate an unwillingness by the SEC to change its longstanding rules to accommodate a nascent technology.

Even if the bill is passed, it would permit the SEC to determine whether a particular digital unit qualifies as a security and therefore is subject to the SEC’s regulation. The SEC thus would have the power to halt an offering and force compliance with the applicable securities laws. The TTA would spare issuers from any penalties if they have acted in good faith and take reasonable steps to cease sales. But with an unclear, and a potentially costly or lengthy, appeals process, the SEC could discourage issuers from taking the risk of attempting to qualify and sell digital tokens from the start. This provision would blunt the intended deregulatory impact of the TTA.

Although its future is uncertain, the TTA shows that there are government leaders that are listening to the concerns of the digital token issuers. If the TTA is introduced in the 116th Congress, it will be a piece of legislation worth tracking. Even if this particular bill is not enacted, it might point the way to other legislation whose passage might provide some regulatory relief to those who transact in digital tokens.

Despite Alleged Fraud, Judge Denies SEC’s Preliminary Injunction Request Based on Howey

Despite evidence of egregious fraud in the marketing of tokens, a judge in the U.S. District Court for the Southern District of California recently held the line against the SEC and denied its request for a preliminary injunction. In doing so, the court reaffirmed that in order for an injunction to be issued, the SEC must make a compelling showing that the tokens qualify as securities under the Howey test.

In Securities and Exchange Commission v. Blockvest, LLC et al., Judge Curiel of the U.S. District Court for the Southern District of California ruled on November 27, 2018, on a request by the SEC for a preliminary injunction against Blockvest, LLC and its principal Reginald Ringgold. The SEC’s request for a preliminary injunction came six weeks after the court granted a temporary restraining order in the SEC’s favor.

To obtain a preliminary injunction, the SEC bore the burden of showing that Blockvest and Ringgold committed a prima facie case of a securities law violation, and that such violation would likely repeat.  Specifically, the SEC alleged that Blockvest and Ringgold had engaged in an unregistered securities offering when selling proprietary BLV tokens to 32 individuals. The SEC argued that under the Howey test, these tokens qualified as securities because Blockvest and Ringgold engaged in a marketing campaign to induce purchasers to believe that, based on the efforts of Ringgold and Blockvest’s employees, the tokens would appreciate in value. Blockvest’s and Ringgold’s wrong would allegedly repeat because Ringgold demonstrated disregard for the SEC’s enforcement efforts in the days immediately after the initial delivery of its complaint.

Compounding the SEC’s case was the allegedly egregious fraud perpetrated by the Defendants. Ringgold represented that his offering was endorsed by the SEC, CFTC, and Deloitte Touche, as well as a fictional regulatory agency called the “Bitcoin Exchange Commission” that had the same address as the SEC and a seal modelled upon the seal of the SEC.

Despite the strong allegations of fraud, Judge Curiel denied the preliminary injunction because he gave credence to the Defendants’ rebuttals, and because the SEC had failed to make a compelling case. For instance, the court considered Ringgold’s assertion that the alleged 32 token purchasers were simply testers who had no expectation of profit; indeed, the pre-sale program through which the purchasers obtained the tokens had not yet even been cleared by the company’s compliance officer and the website where the purchases allegedly occurred was not operational.

All told, the court found that the SEC could not show that under the Howey test, any purchase based on an expectation of profit had actually occurred.  Likewise, the court concluded that the SEC could not show a reasonable likelihood of repetition of the wrong because no wrong had occurred in the first place, and Ringgold demonstrated intent to comply with securities laws going forward.

Could Digital Assets Be Considered Securities? A Perspective From Regulators

Earlier this year, two key SEC officials shared their views on digital assets under federal securities laws. While an ultimate determination will be dependent upon the specific facts and circumstances in a given situation, and these views do not constitute official policy, they are nonetheless helpful in understanding the SEC’s perspectives and considerations for potential future direction.

Learn more about key takeaways from this recent article published by one of our cross-practice teams.