Keyword: securities

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.

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

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

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

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

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

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

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

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

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

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

SEC Settles with BCOT on Alleged Violations of the Securities Act

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

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

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

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

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

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

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

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

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

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

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

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.

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.

The 2019 Token Taxonomy Act: A Path to Consumer Protection and Innovation Takes Shape

We’ve previously written that the Token Taxonomy Act first introduced to Congress by Representatives Warren Davidson (R-OH) and Darren Soto (D-FL) on December 20, 2018, was a welcome legislative initiative designed to provide a regulatory “light touch” to the burgeoning digital asset industry. The bill expired, however, with the termination of the 115th Congress, leaving open the question of what any future blockchain regulatory proposals, would look like. The industry’s questions were answered on April 9, 2019 when Representatives Davidson and Soto introduced the Digital Taxonomy Act of 2019 (DTA) and the Token Taxonomy Act of 2019 (TTA) to the 116th Congress. The DTA and TTA represent expanded efforts to clarify regulation and spur blockchain innovation in the United States.

According to Representatives Davidson and Soto, the DTA is meant to add jurisdictional certainty to efforts to combat fraudulent behavior in the digital asset industry. As such, the DTA grants the FTC $25,000,000 and orders it to prepare reports on its efforts to combat fraud and deceptive behavior. The DTA also specifically carves out from its purview the authority of the CFTC to regulate digital assets as commodities subject to the Commodities Exchange Act.

The 2019 TTA, with the backing of four bipartisan representatives in addition to Davidson and Soto, is similar to last year’s model. Besides defining digital assets and exempting them from certain securities law requirements, the 2019 TTA maintains proposals to amend the Investment Advisers Act of 1940 and the Investment Company Act of 1940 so that certain regulated entities can hold digital assets. Like the 2018 version of the TTA, the 2019 TTA would also allow the sale of digital assets to qualify for the benefits of Internal Revenue Code Section 1031 like-kind exchange provisions and for the first $600 dollars of profit from digital asset sales to be tax-free.

The TTA also has important updates. The most prominent change is the definition of a “digital asset.” As we’ve previously discussed, the 2018 version of the TTA required that a digital asset’s transaction history could not be “materially altered by a single person or group of persons under common control” to qualify for exemption from securities laws. Because of the unavoidable possibility of a 51% attack, which would alter a token’s transaction history, the language created the possibility that proof of work- and proof of stake-based tokens would not be eligible for regulatory relief, thus limiting the bill’s benefits.

In the re-proposed TTA, however, the newly proposed language of Section 2(a)(20)(B)(ii) requires that the transaction history, still recorded in a mathematically verifiable process, “resist modification or tampering by any single person or group of persons under common control.” Thus, any digital asset, even those subject to 51% attacks, may be exempt from certain securities law requirements, although the language appears to require that a governance or security system underline the token’s consensus system.

Another important update is the TTA’s proposed preemption of state regulation of the digital asset industry by federal authorities. While the TTA would still permit states to retain antifraud regulatory authority, it largely strips states’ rights to regulate digital assets as securities. Representative Davidson’s press release on the bill specifically cites the “onerous” requirements of the New York BitLicense regulatory regime as a reason for the inclusion of this provision.

Critics have been quick to point out that the bills, while well intentioned, leave many unanswered questions and therefore may not provide the regulatory certainty the bills’ authors hope to effect. And even a perfect bill would face an uphill battle in getting enacted these days. But the digital asset industry should nonetheless take comfort in the growing contingent of legislators who take seriously the imperative to balance consumer protection and blockchain innovation.

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

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

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

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

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

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

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

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

The Framework

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

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

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

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

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

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

No-Action Letter

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

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

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


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

The Beat Goes On: Division of Investment Management Seeks Input on the Impact of the Custody Rule on Digital Currency – and Vice Versa

As part of its ongoing examination of the Custody Rule, the SEC’s Division of Investment Management is seeking views from the securities industry members and the public on two issues regarding the Custody Rule: (1) the application of that rule to trading that is not handled on a delivery versus payment basis, and (2) the application of the rule to digital assets. In a March 12, 2019 letter to the President and CEO of the Investment Adviser Association published on the SEC’s website (“the Custody Release”), the Division seeks input to expand on its Guidance Update from early 2017. Both issues are important in view of the increasing complexity of types of securities that registered investment advisers are purchasing on behalf of their customers and, as discussed below, the issues overlap in a way that might predict an important use case for blockchain technology.

The Custody Rule

The Custody Rule under the Investment Advisers Act of 1940 provides that it is a fraudulent, deceptive or manipulative act, practice or course of business for a registered investment adviser to have “custody” of client funds or securities unless they are maintained in accordance with the requirements of the Custody Rule. The definition of custody includes arrangements where the adviser has authority over and access to client securities and funds.

By way of context, we note that although the Custody Rule applies only to registered investment advisers, its concepts are relevant for non-registered advisers and other intermediaries as well, since their clients or customers have a practical interest in assuring that: managed assets are appropriately safeguarded; and the absence of appropriate custody arrangements may preclude a client from investing with a particular adviser.

Also, as the Custody Release notes, the Division previously issued a letter inviting engagement on questions relating to the application of the Investment Company Act of 1940, including the custody provisions of that Act, to cryptocurrencies and related products.

The Custody Rule and DVP Arrangements

The Custody Release points out that when an investment adviser manages funds pursuant to delivery versus payment arrangements – that is, when transfers of funds or securities can only be conducted together with a corresponding transfer of securities or funds – then it provides certain protections to customers from misappropriation by the adviser. The Release seeks to assist the Division in gathering information on payment practices that do not involve delivery versus payment, seeking input on, among other things: the variety of instruments that trade on that basis; the risk of misappropriation or loss associated with such trading; and how such trades appear on client accounts statements.

The Custody Rule and Digital Assets

The Custody Release also asks about the extent to which evolving technologies, such as blockchain/distributed ledger technology, provide enhanced client protection in the context of non-delivery versus payment trading. That question presents a good lead-in to the second part of the Custody Release, which seeks to learn “whether and how characteristics particular to digital assets affect compliance with the Custody Rule.” These characteristics include:

– the use of distributed ledger technology to record ownership;

– the use of public and private cryptographic keys to transfer digital assets;

– the “immutability” of blockchains;

– the inability to restore or recover digital assets once lost;

– the generally anonymous nature of DLT transactions; and

– the challenges posed to auditors in examining DLT and digital assets.

With these characteristics in mind, the Division asks are fairly open-ended about the challenges faced by investment advisers in complying with the Custody Rule with respect to digital assets, including:

– to what extent are investment advisers construing digital assets as funds or securities?

– are investment advisers including digital assets in calculating regulatory assets under management in considering with they need to register with the SEC?

– how can concerns about misappropriation of digital assets be addressed?

– what is the process for settlement of digital asset transactions, either with or without an intermediary?

The most forward-looking question asked in the Release is whether digital ledger technology can be used for evidencing ownership of securities. The answer to this question – which could represent a direct application of the blockchain’s ability to record ownership and its immutability – could pave the way to resolving custody concerns with respect to any asset class transacted in by investment advisers on behalf of their clients. It certainly points the way to an important possible use of blockchain technology – to demonstrate custody in a way that is immutable, anonymous and auditable. Technologists, get to work!

The Custody Release’s questions are a significant next step in drawing digital assets into the embrace of investment adviser regulation, but a positive step nonetheless.