Telegram Group Inc. and its wholly owned subsidiary, TON Issuer Inc., denied that its proposed issuance of “Gram” digital tokens last month would have been part of an illegal securities offering that began in early 2018, as alleged by the Securities and Exchange Commission in a complaint filed on October 11. This is because, said the defendants, when issued, Grams would have constituted a virtual currency and/or a commodity and not a security under federal law.

In its complaint, the SEC charged that, in the first quarter of 2018, the defendants raised US $1.7 billion, including $424.5 million from US persons to fund the development of a proprietary blockchain – the Telegram Open Network – as well as their mobile messaging application, Telegram Messenger. The SEC claimed that the defendants’ offer and sale of Grams to US persons constituted an unregistered securities offering, and that Grams are securities because initial purchasers and subsequent investors expected to profit through Telegram’s efforts to develop TON, including to attract sellers and developers to use the blockchain, and to promote Grams. Among other things, said the SEC, Telegram proposed to facilitate resales on digital-asset trading platforms.

In their answer, defendants said that their fundraise from US persons was conducted pursuant to a valid exemption from securities registration laws – Regulation D. (Click here for background on Reg D.) They argued that what investors purchased in 2018 were investment contracts for a cryptocurrency. However, because the blockchain on which the cryptocurrency would operate was to have been completed and operational by the time the cryptocurrency was scheduled to have been issued by October 31, 2019, the virtual asset would not be a security when issued. Thus, any resale restrictions that would ordinarily apply to a Regulation D-issued security would not apply to Grams.

Defendants claimed that their position was supported by public statements by SEC Chairman Jay Clayton as well as William Hinman, SEC Director of Corporation Finance, that the initial issuance of a virtual asset – such as ether – might constitute a security offering, but the virtual asset over time could become a cryptocurrency.

The SEC brought its enforcement action despite defendants’ multiple voluntary productions of documents, meetings, and letters to the Commission from February 6, 2018 through October 11, 2019, to address issues raised by the agency’s staff. Notwithstanding, the SEC never provided “clear guidance and fair notice” that Gram tokens might be considered a security, and the SEC’s prosecution constitutes improper “regulation by enforcement,” claimed defendants.

(Click here for background on the SEC’s enforcement action in the article “Defendants Formally Stipulate to a Delay in Digital Asset Distribution That SEC Alleged Constituted an Unregistered Offering” in the October 20, 2019 edition of Bridging the Week.)

In other legal and regulatory developments involving Fintech:

  • Hong Kong Financial Regulator Offers Licensing for Security Token Trading Platforms: The Hong Kong financial regulator – the Securities and Futures Commission – adopted a voluntary licensing regime for virtual asset trading platforms that offer at least one security product (in addition to other types of cryptoassets). It also adopted an express framework for all asset managers who oversee investments in virtual assets.

Under the licensing regime for trading platforms, an eligible operator may apply for a license and, if granted, would operate in SFC’s regulatory sandbox “for a period of close and intensive supervision.” To qualify for a license, the operator would have to agree to limit its facilities to professional investors and provide access solely to persons with “sufficient knowledge” of cryptoassets; to maintain strict criteria for the inclusion of virtual assets for trading; and to utilize a “reputable” external market surveillance system. Additionally, the platform would have to apply prevailing know-your-customer, anti-money laundering and counter-financing of terrorism standards and have adequate policies and practices dealing with accounting and auditing, risk management and conflicts of interest. The platform would also have to maintain insurance to cover 100 percent of the risks of custody of virtual assets in hot storage and “substantial” coverage (e.g., 95 percent) of the risks of custody of virtual assets in cold storage. SFC’s requirements for licensed entities would apply to trading involving virtual tokens constituting both securities and non-securities.

Separately, SFC announced that, going forward, it will require all HK funds that invest in virtual assets that are not securities or futures to be licensed and, along with currently licensed funds that trade similar virtual assets, generally be subject to terms and conditions applicable to funds that currently trade securities or futures exclusively (e.g., disclosure of risks; safeguarding of assets; reasonable portfolio valuation methodology; risk management; use of auditors; and maintenance of sufficient liquid capital). These licensing conditions will apply to funds with a stated investment objective to invest solely in virtual assets or an intention to invest more than 10 percent of their gross asset value in cryptoassets. Distributors to HK persons of funds organized anywhere that invest in relevant virtual assets will also require licensing and be required to apply suitability standards.

  • SEC Highlights Legal Actions Involving ICOs and Digital Assets in Summary of FY 2019 Enforcement Highlights: The SEC’s Division of Enforcement issued its annual report noting that, for fiscal year 2019, it brought 862 enforcement actions, including 526 stand-alone cases. This compares with 821 actions including 290 stand-alone cases brought in FY 2018. Penalties and disgorgement ordered in fiscal year 2019 totaled US $4.349 billion compared to US $3.945 billion for the prior fiscal year. In its annual report, the SEC’s DOE noted that its enforcement activities involving the digital asset arena “matured and expanded” last year. DOE highlighted that, last fiscal year, it commenced enforcement proceedings for issuers of digital assets allegedly engaging in fraud or acting without required registration, and sometimes for purportedly engaging in both types of violations. The goal, said the DOE, was to send a 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 federal securities laws.”
  • IOSCO Encourages Stablecoin Issuers to Engage With Relevant Regulatory Bodies Prior to Issuance: The International Organization of Securities Commissions issued a statement that stablecoins are “rightly subject to significant international and public scrutiny” and urged all persons seeking to launch stablecoins – particularly those with potential global reach – to engage with all regulatory bodies in jurisdictions where they seek to operate. Although IOSCO acknowledged that stablecoins could potentially offer benefits to market participants, consumers and investors, the organization warned of the potential risks, including risks related to consumer protection, market integrity, transparency, conflicts of interest and financial crime, in addition to potential systemic risks as identified by the G20 in a recent press release (click here to access). IOSCO is an international policy forum for securities regulators; its members regulate 95 percent of the world’s securities markets in 115 jurisdictions.
  • AFME Recommends "Greater Supervisory Convergence" For Regulation of Cryptoassets in Europe: The Association for Financial Markets in Europe called for greater convergence of supervisory approaches in Europe to the regulation of crypto assets. Noting there is currently inconsistent regulation of cryptoassets across Europe and that existing regulations may not precisely fit cryptoassets, AFME recommended that industry representatives, national competent authorities and European Union representative bodies (e.g., European Banking Authority, European Securities and Markets Authority) collaborate to help develop a cross-European cryptoasset taxonomy; provide a clear road map regarding how to issue cryptoassets; ensure regulations are applied agnostically without regard to technology; apply existing regulations to regulated activities with amendments, as necessary; and ensure coordination of approaches with other global and regional initiatives. AFME acknowledged many potential benefits of the use of cryptoassets including potential faster and cheaper cross-border transactions; more efficient allocation of capital; faster settlement times; faster and less expensive time to market for securities issuance and greater auditability, transparency and regulatory compliance. However it also observed potential risks and operational concerns including impact on financial stability; asset and data security; consumer and investor protection; anti-money laundering; and resilience of distributed ledger systems. Although AFME noted that existed taxonomies of cryptoassets principally were based on their economic function (i.e., security/asset tokens; exchange/payment tokens and utility tokens), it indicated this should just be the starting point. Other relevant factors to consider include whether there is a clearly identifiable issuer; what activity is performed with the cryptoasset; to whom will the cryptoasset be made available; and what rights are associated with the cryptoasset. AFME regards itself as "the voice of all Europe's wholesale financial markets." Its board of directors consists of representatives of leading European and global banks

My View: Both Jay Clayton, Chairman of the SEC, and William Hinman, Director of the SEC’s Division of Corporation Finance, have acknowledged the characteristic of virtual assets might evolve over time, changing the nature of a cryptoasset from a security to a non-security. Both persons referenced the virtual asset ether as an example of such a cryptoasset. (Click here for background in the article “SEC Chairman Concurs With Division Head That a Cryptoasset’s Regulatory Classification May Morph Over Time” in the March 17, 2019 edition of Bridging the Week.) However, neither Mr. Clayton nor Mr. Hinman, nor the SEC and its staff, have issued precise guidance on when that transition occurs. SEC staff attempted to provide some guidance in a “Framework for ‘Investment Contract’ Analysis of Digital Assets” issued earlier this year, but the guidance was imprecise at best. (Click here for background in the article “SEC Staff Outlines Characteristics of Cryptoassets That Could Cause Them to Be Regarded as Securities” in the April 7, 2019 edition of Bridging the Week.) Indeed, Hester Peirce, another SEC commissioner, criticized the Framework claiming its "Jackson Pollock approach to splashing lots of factors on the canvas without any clear message leaves something to be desired." (Click here for background in the article "SEC Crypto Guidance Employing Jackson Pollock Techniques Too Cryptic Says Commissioner Hester Peirce" in the May 12, 2019 edition of Bridging the Week.)

This ambiguity – which is at the heart of the conflict between the Telegram Group and the SEC – contrasts with the precision of the definition of a narrow-based security index which is used to determine when a futures contract based on a security index is broad-based and under the jurisdiction of the Commodity Futures Trading Commission or narrow-based and under the joint jurisdiction of the CFTC and the SEC. (Click here to access 15 U.S.C. § 78c(a)(55)(B).) Generally, in the former case, the futures must be listed on a designated contract market unless exempt while in the latter case, the security futures must be registered and listed on a national securities exchange unless exempt.

This provision of law was key to a 2013 determination by the SEC that Eurex Deutschland – a non-US exchange and a non-registered DCM – violated Section 21(a) of the Securities Exchange Act (click here to access 15 U.S.C. § 78f(h)(1)) when it failed to qualify with the SEC a futures contract offered to US persons initially based on a broad-based index of non-US bank sector stocks. Eurex previously was authorized by the CFTC to directly offer and sell the futures contract to US persons without qualifying as a DCM because the derivative was based on a broad-based stock index that included no US companies. Over time, the weighting of stocks in the index changed, causing the index to become narrow-based and Eurex failed to spot this, qualify as a national securities exchange to offer the security futures to US persons (unless exempt); and qualify its security futures contracts with the SEC as required.

Notwithstanding, the SEC did not bring an enforcement action against Eurex, but solely issued a report of investigation advising the exchange of its violation and warning it (as well as other persons) to be mindful of the SEC’s requirements and not repeat its violation. (Click here for background in the section “My View” to the article “CFTC Issues Explanation of Its Oversight and Approach to Virtual Currency Markets; Texas Securities Board Enjoins Initial Coin Offering" in the January 7, 2018 edition of Bridging the Week.)

Contrast this with the approach of the SEC against Telegram.

The SEC might very well claim that it warned the industry of its views regarding virtual assets possibly being investment contracts in a report of investigation involving the DAO in 2017. (Click here for background in the article “SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issued in Accordance with US Securities Laws” in the July 26, 2017 edition of Between Bridges.) However, that situation involved a static virtual asset and not one that may (or may not) have had different attributes over time.

The SEC should more carefully tread in areas of Fintech innovation and not use its enforcement authority as a sledgehammer to create new regulations where the law is unclear at best. Not only is this technique fundamentally unfair, but it deprives parties of due process.