Keyword: ICOs

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.

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.

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.

Recent Reports Show UK and EU (Slowly) Progressing Towards Virtual Currency Regulation

Currently there is no EU-harmonized approach for the specific regulation of virtual currency. In September 2018, the UK’s Treasury Committee released a report on crypto-assets as a part of its ongoing Digital Currencies Inquiry, in which the Committee strongly and unanimously recommended that the UK regulate virtual currencies and initial coin offerings (“ICOs”) as a matter of priority. It will be important for the UK not to be too restrictive as this could drive innovative business away from the UK. The EU Parliament’s All-party Innovation Group has drafted a proposal examining potential new rules that would bring ICOs within the scope of the EU-wide harmonizing crowdfunding regulation that is currently being drafted. While it is certain that any regulation needs to be carefully considered, the lack of a harmonized approach to regulation of ICOs will lead, as is happening currently, to a piecemeal approach across member states that will hamper blockchain developments.

Learn more from this recent Orrick-authored alert.