Keyword: SEC

Crypto Regulation Marches On With Potential Consequences for Trading Systems

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A flurry of recent activity has reinforced the SEC’s commitment to regulate crypto assets, including trading systems that trade crypto asset securities.

WHAT HAPPENED?

The SEC shared additional information in April 2023 on whether and how its proposal to expand the definition of “exchange” would affect trading systems for crypto asset securities. The SEC initially issued the proposal in January 2022. This revised proposal responds to comments the agency received requesting clarity on the application of existing rules and the proposal related to crypto asset security trading platforms that meet the proposed definition of an exchange or trading systems that use distributed ledger or blockchain technology, including DeFi systems.

WHAT DOES IT MEAN?

If the proposals take effect, they may require many crypto asset security trading platforms to register as national securities exchanges or as broker-dealers that must comply with Regulation ATS, which governs alternative trading systems. As currently drafted in the proposal, this would include decentralized exchanges operating on order book or automated-market-maker models.

WHAT DOES THE PROPOSAL SAY?

Current regulations say that a trading system must bring together “orders” to qualify as an exchange. The proposal would categorize a trading system as an exchange if it brings together “trading interest.”

Also, the rule now says an exchange must have “established, non-discretionary methods … under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.” The SEC’s proposal would require only that an exchange include “communication protocols” for the interaction of trading interest.

WHAT’S THE CONTEXT?

When the SEC shared additional information on how expanding the definition of “exchange” could affect trading systems, it was just the latest of several signs of the SEC’s stance on regulating crypto assets.

  • SEC Chair Gary Gensler said in a statement that “many crypto trading platforms already come under the current definition of an exchange and thus have an existing duty to comply with the securities laws.”
  • In a statement at a House Financial Services Committee hearing on SEC oversight, Chair Gensler also reiterated his view that, “given that most crypto tokens are securities, it follows that many crypto intermediaries are transacting in securities and have to register with the SEC.”
  • The hearing also touched on the SEC’s proposed $2.15 billion budget for fiscal year 2023, which represents an increase of almost $240 million to what it sought in fiscal year 2022. Notably, fintech accounted for half of the six key areas identified in its budget justification, including goals to:
    • prevent fraud concerning crypto assets.
    • ensure crypto assets register and comply with securities laws where appropriate.
    • craft the right regulatory and enforcement approach to fintech startups.

The SEC’s focus on enforcement of crypto matters does not appear to be slowing. Its Crypto Asset and Cyber Unit was initially envisioned as a 20-person operation but has doubled in size. Moreover, just a few weeks ago, the SEC also shared job postings for additional positions in the unit.

SEC Provides Expectations About Public Company Disclosures Regarding Crypto Ecosystem Impact

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What Happened

The Division of Corporation Finance of the Securities and Exchange Commission (“SEC”) issued a sample letter on December 8, 2022, highlighting considerations that public companies that are in, or connected to, the crypto industry should keep in mind as they prepare their public disclosures, spanning the description of business, management’s discussion and analysis (“MD&A”) and risk factor disclosures.

What Public Companies Need to Consider

While the letter highlights additional points for consideration in the business and MD&A sections, the majority of the comments focus on risk factor disclosure, flagging nine key risks, including:

  • any material gaps identified with respect to risk management processes and policies,
  • the “possibility of regulatory developments related to crypto assets and crypto asset markets,” and
  • material risk of reputational harm from recent disruptions.

Additionally, the sample letter also calls for increased disclosure regarding whether any of the crypto assets held or issued by the company serve as collateral for certain activities, as well as any downstream effects experienced by the company as a result of certain bankruptcies in the crypto industry. The sample letter gives insights into general themes of disclosures that the SEC is focused on, including the following: (i) the risk exposure a company has to other actors in the blockchain and cryptocurrency ecosystem (interdependencies within the industry), and (ii) changes to the value of assets held by the company resulting from fluctuations in the larger blockchain market.

In light of the heightened scrutiny faced by companies with exposure to the crypto industry, careful consideration should be given to any public disclosures regarding their operations in order to address the SEC’s concerns of providing adequate information to make a company’s public disclosures not misleading.

Contact Alice Hsu, Daniel Forester, Joseph Perkins or Soo Hwang for guidance on whether your company could be impacted or if you have any questions about navigating this evolving regulatory landscape.

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

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

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

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

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

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

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

The SEC Sends a Telegram to European Token Offerings: Avoid the U.S.

On March 24, the United States District Court for the Southern District of New York granted the U.S. Securities and Exchange Commission (SEC) a preliminary injunction preventing Telegram from distributing $1.7 billion of its “Gram” digital tokens to investors. By way of background: According to Court filings, during the first quarter of 2018, Telegram sold purchase contracts to 175 initial purchasers entitling them to receive Grams when Telegram launched its proprietary blockchain platform. Telegram claimed an exemption from SEC registration as a U.S. private placement (i.e., transactions not involving security sales to the public). Some initial purchasers were locked up from reselling the Grams for brief periods following receipt, but otherwise were unrestricted in their ability to resell Grams to anyone on Telegram’s blockchain platform.

It’s premature to cite the Court’s grant of a preliminary injunction as gospel, as the Court’s findings are, by their nature, preliminary and subject to appeal. In granting an injunction, the Court accepted the SEC’s argument that the SEC was likely to succeed in demonstrating a securities laws violation following a trial, and that, if the Gram distribution was not paused now, unwinding that distribution (i.e., curing the violation) years later would be impractical. Since a Gram distribution today would, effectively, moot the SEC’s case, the Court’s grant of an injunction is not surprising. The appellate courts, or the trial court, may still take a different view, and in another situation with different facts, a court may view the outcome differently, as well.

For now, though, the Court’s order provides some helpful clarifications and reminders for European companies considering token offerings (whether cryptocurrency, digital assets or digital tokens). First and foremost is that your safest best is to just avoid U.S. jurisdiction by carefully adhering to the restrictions provided in Regulation S under the U.S. Securities Act of 1933. Complying with Regulation S allows a security offering, and subsequent resales, to be excluded from SEC registration if the entire transaction – offers, sales and delivery – is conducted entirely outside the U.S., to non-U.S. persons, with restrictions in place to prevent flow-back of securities into the U.S. In practice, complying with Regulation S means you must have a closed pool of offerees, you must know the details of your initial purchasers, and you must have a closed resale/transfer system to effectively prevent resales to the U.S. or token distributions to U.S. persons (which the SEC refers to as “flow-back” to the U.S.). While there are exceptions and caveats to these general principles, the Court made clear its sympathy to the SEC’s view that the U.S. private placement and Regulation S rules broadly prohibit back-door public token distributions, regardless of whether the tokens themselves are “securities” under the SEC’s rules (which define “security” broadly, a discussion for another day), following a “securities” offering that is not registered with the SEC.

Another key lesson for European companies is that, if the SEC believes your token offering has violated the U.S. securities laws, the SEC may come after you, even if your U.S. contacts are minimal. Telegram argued (unsuccessfully) that its non-U.S. transactions should be exempted from SEC jurisdiction because the issuer was not a U.S. company, its control persons were not in the U.S., some of the contracts were not entered into in the U.S., some of the purchasers were not in the U.S., and some of the securities were not delivered in the U.S. Crucially, however, Telegram did not demonstrate in its court filings that it took the appropriate steps at the time of the offering, sale and intended distribution of the Grams to separate the U.S. private placement transactions from the Regulation S (non-U.S.) transactions. If you, and your proposed transaction, are wholly outside the U.S., but you determine to include some U.S. purchasers in your token offering, you risk bringing the entire transaction within the SEC’s jurisdiction if you do not carefully ensure that your U.S. private placement is separate and distinct from your Regulation S (non-U.S.) offering when you make an offer, confirm a sale, and deliver any tokens, and that the Regulation S transaction has sufficient safeguards in place to avoid flow-back of the tokens into the U.S. by subsequent resales. Structuring a token transaction to comply with Regulation S can be complicated and requires careful attention to current and future token offers, sales, distributions and transfers.

Orrick Hosts Fireside Chat with SEC Commissioner Hester Peirce

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

Providing Clarity to the Crypto Community

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

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

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

Insights into Commissioner Peirce’s Token Safe Harbor Proposal

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

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

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

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

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

Tokens Wrapped in Investment Contracts

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

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

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

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

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

Section (a)(4) and the Liquidity Requirement

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

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

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

Stablecoins

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

Educating Lawmakers and Regulators

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

Changing the Accredited Investor Regime

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

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

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

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

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

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

The Proposed Rule Would Provide Subjective and Prescriptive Requirements

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

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

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

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

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

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

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

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

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.

SEC Settles with BCOT on Alleged Violations of the Securities Act

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

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

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

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

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

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

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

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

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

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

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

Fraud is Fraud – Sales of Unregistered Digital Securities Resemble Classic Microcap Fraud

A Complaint filed by the SEC in the Southern District of New York last week reminds us that in the area of securities law violations there is not much new under the sun. Even though the action against Eran Eyal and UnitedData, Inc. d/b/a “Shopin” involves the sale of digital assets, and the business of the issuer of those digital assets purportedly involves a blockchain application, the alleged wrongful conduct bears the hallmarks of a traditional securities offering scheme; one can substitute “unregistered securities” for the tokens offered, “private placement” for the token pre-sale, and a speculative venture – such as the “self-cooling can” that was the subject of an SEC offering fraud case years ago – for the blockchain applications touted by the issuer, and the Complaint is one that could have been drafted thirty years ago. To the extent that certain recent cases involving offerings of cryptocurrencies have presented novel applications of the securities laws and the Howey test of whether a digital currency is a security, this case isn’t one of them.

A description of the alleged misconduct makes the parallels clear. The SEC alleges that the issuer, Shopin, and its CEO, Mr. Eyal, conducted a fraudulent and unregistered offering of digital securities. The company’s business plan involved the creation of personal online shopping profiles that would track customers’ purchase histories across numerous online retailers, and link those profiles to the blockchain. However, Shopin allegedly never had a functioning product. The company’s pivot to the blockchain and rebranding resulted from its struggles to stay in business as a non-blockchain business.

The company apparently commenced its digital securities offering with a “pre-sale” of tokens through an unregistered offering, not unlike the private placement of securities that is often alleged as the first step in an offering fraud. Shopin’s initial sales of investment interests were made pursuant to a SAFT – a simple agreement for future tokens – in which initial investors paid bitcoin or ether in exchange for an interest in tokens at a discount that would be delivered once Shopin created the tokens at the completion of the public ICO. The proceeds of this pre-sale purportedly would be used to develop, launch and market the Shopin network, similar to the types of promises made in microcap or blind pool offerings. Unsold tokens in the pre-sale would go to insiders at Shopin and its advisors. The SEC determined that the Shopin tokes were investment contracts under the Howey test, because the purchasers invested money in the form of digital currency, the investors’ funds would be pooled in a common enterprise, and the defendants led the token purchasers to expect profits from their purchases because of the defendants’ efforts.

In its complaint, the SEC treated the token sale – which, again, was not registered under the securities laws – as a private placement subject to Regulation D, and alleged that the defendants failed to ensure that the purchasers of the tokens were accredited investors. Indeed, the SEC alleged that certain investors tried to satisfy the minimum investment requirements by pooling their investments in syndicates. This is a variant of the artifices employed by microcap issuers to artificially achieve a minimum offering level by making nominee purchases. The defendants also, in another resemblance to a microcap scheme, allegedly told investors they intended to have the Shopin tokens listed on digital-asset trading platforms – analogous to a promise to list penny stocks on an exchange – which purportedly would enable investors to realize profits on their positions by selling the tokens at a premium.

Having established that the ICO had the elements of a securities offering, the SEC described the material misrepresentations that the defendants made to investors: that the company had participated in successful pilot programs with prominent retailers; that the defendants had partnerships with numerous retailers; and that it was advised by a prominent individual in the digital asset field, who in fact had asked the company to remove his name as an advisor. Finally, and most serious, the SEC alleged that the defendants had misused portions of the offering proceeds, including for personal expenses, such as an individual’s rent, shopping and entertainment and – the type of salacious detail the SEC likes to include – to pay for a dating service.

Securities schemes tend to fall into certain patterns that involve the use of unregistered securities and misrepresentations to separate investors from their money, and schemes involving digital currency that resembles a security often fall into the same patterns. Perhaps recognizing that those patterns are recognizable to triers of fact and the public, the SEC alleges violations involving digital currency in similar terms. SEC Chairman Jay Clayton has repeatedly emphasized that the regulator will use its traditional tools and standards in treating sales of digital assets that conform to the definition of a security: for example, as he stated last year, “A token, a digital asset, where I give you my money and you go off and make a venture, and in return for giving you my money I say ‘you can get a return’ that is a security and we regulate that. We [the SEC] regulate the offering of that security and regulate the trading of that security.” Legitimate sales and offerings of digital currency might use a different vocabulary and analysis but, as the allegations in the case discussed here show, fraud is fraud.

SEC Division of Enforcement 2019 Annual Report Shows Cryptocurrency Is Still Under the Microscope

The SEC Division of Enforcement’s 2019 Annual Report, released earlier this month, shows a continuing focus on activities involving blockchain and cryptocurrency, and its website shows an increase in cases since last fiscal year. The Annual Report provides an overview of the SEC’s enforcement activities during FY 2019, highlighting enforcement priorities and trends, noteworthy actions, and enforcement challenges. The SEC’s attention to enforcing the securities laws in the blockchain and cryptocurrency space features prominently in the Annual Report, securing special attention both in the introductory message from Division Co-Directors Stephanie Avakian and Steven Peikin, and as one of two “initiatives and areas of focus in Fiscal Year 2019” (alongside the SEC’s traditional focus on protecting retail investors).

But while Co-Directors Avakian and Peikin state that the Division’s “activities in the digital asset space matured and expanded” in 2019, the nature of its enforcement priorities as detailed in the 2019 Annual Report is not markedly different from the previous year. To be sure, the 2019 Annual Report highlights some of the more high-profile enforcement actions in the industry, such as the SEC’s ongoing case against Kik Interactive for allegedly conducted an illegal $100 million securities offering in 2017. And, as reported on the SEC website, the number of enforcement actions the SEC designates as relating to “Digital Assets/Initial Coin Offerings” has seen an uptick since last year (with 13 filed in FY 2018, and 21 in FY 2019).

One thing that the 2019 Annual Report more clearly highlights about the SEC’s activities this year is the Division of Enforcement’s attention to non-fraud violations related to cryptocurrencies. For example, the SEC charged the founder of a digital asset trading platform for operating as an unregistered national securities exchange, and charged an “ICO Incubator” and its founder for acting as an unregistered broker-dealer and selling unregistered digital asset securities. And for the first time, the SEC filed charges for the unlawful promotion of ICOs (against boxer Floyd Mayweather Jr. and music producer DJ Khaled).

With cryptocurrencies being one of the SEC’s “initiatives and areas of focus” and the fact that the Division’s Cyber Unit only became fully operational in Fiscal Year 2018, the volume of enforcement actions in this space may well continue to increase in FY 2020. Even if not, participants in the industry should be mindful that the SEC is still scrutinizing cryptocurrency activities and is able and willing to penalize non-fraud violations of the securities laws. As Co-Directors Avakian and Peikin noted in the Report: “Collectively, these actions send the clear message that, if a product is a security, regardless of the label attached to it, those who issue, promote, or provide a platform for buying and selling that security must comply with the investor protection requirements of the federal securities laws.”