SEC Tells Telegram to Hit Pause on Its Token Issuance

SEC Tells Telegram to Hit Pause on Its Token Issuance

This past Friday (October 11, 2019), the Securities and Exchange Commission filed an emergency action and temporary restraining order against Telegram, a messaging app similar to WhatsApp. The emergency action is an attempt by the SEC to stop Telegram’s unregistered offering of its digital asset, “Grams.” As the SEC outlines, Telegram failed to adhere to the requirements of an exempt offering using Regulation D, the investment agreements to purchase Grams and the Grams tokens themselves are securities, and the investors and Telegram would flood the U.S. markets with billions of Grams. Telegram will now work with the SEC and further assess whether it needs to further delay the launch of TON.

In the complaint, the SEC takes the position that both the Grams Purchase Agreement to purchase the tokens and the tokens themselves are securities. The SEC noted that “Telegram has taken the position that the Gram Purchase Agreements were investment contracts i.e., securities, and placed a restrictive legend on the Gram Purchase Agreements…Telegram, however, claimed that Grams, the heart of the Gram Purchase Agreements, without which the agreements have no value or purpose, were not securities but rather currency.” The SEC continues, “Grams are investment contracts. Based on Telegram’s own promotional materials and other acts, a reasonable purchaser of Grams would view their investments as sharing a common interest with other purchasers of Grams as well as sharing a common interest with Defendants in profiting from the success of Grams. The fortunes of each Gram purchaser were tied to one another and to the success of the overall venture, including the development of a TON ‘ecosystem’ integration with Messenger, and implementation of the new TON blockchain. Investors’ profits were also tied to Telegram’s profits based on Telegram’s significant holdings of Grams.”

The SEC’s complaint goes on to state that the Grams would have no utility or use upon the distribution of the Grams other than speculation. Much of the complaint focuses on the materials and discussions of Telegram insiders promoting the tokens as well as the undertaking that Telegram was promising to support the tokens and the continued development of the ecosystem after the launch. While the SEC’s complaint does not cycle through the factors of the Howey test, a key focus of the Howey analysis is what was offered or promised to potential purchasers to determine whether the promoter held out an investment opportunity. Such a determination requires “an objective inquiry into the character of the instrument or transaction offered based on what the purchasers were ‘led to expect,’” which includes the terms of the offer, the plan of distribution, economic inducements promised to the purchasers, and an analysis into the promotional materials used for the transaction.

Further, alluded to in the complaint by the SEC is that Grams’ investors are dependent on the managerial efforts of Telegram. One of Howey’s progeny cases, which is not mentioned in the complaint, but which shares similarities with Telegram’s role in the transaction, is the Second Circuit’s decision in Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc. In that case, the Second Circuit held that investors in certificates of deposit expected profits from Merrill Lynch’s managerial efforts because Merrill Lynch promised to create and operate a secondary market for the certificates. Investors thereby “bought an opportunity to participate in the CD Program and its secondary market. And, they are paying for the security of knowing that they may liquidate at a moment’s notice free from concern as to loss of income or capital.” As the SEC points out in the current complaint, Telegram issued a two-page teaser to investors to expect a listing of Grams on the major cryptocurrency exchanges. A Telegram executive and Vice President of Business Development also projected to list Grams on his trading platform allowing Gram holders to trade Grams with no restrictions. Additionally, 52% of the supply of Grams would be “retained by the TON Reserve to protect the nascent cryptocurrency from speculative trading.” Similar to Merrill Lynch in the Gary Plastic case, but not argued by the SEC, Telegram appears to have promised to create a secondary market for Grams to immediately be sold with no restrictions and guaranteed some price stability for investors that wish to liquidate their positions.

There is still much to speculate whether Telegram will settle with the SEC or pursue a similar path to that of Kik. The facts and issues behind the Kik case heavily overlap on the surface with those of Telegram. Nonetheless, this lawsuit will be one to watch as the SEC’s regulation by enforcement continues.

Article by Stanley Sater

Founders Legal

[email protected]

Equity Compensation in the Gig Economy

Last week, Uber sent a letter to the Securities and Exchange Commission (the “SEC”) seeking an amendment to Rule 701 promulgated under the Securities Act of 1933. Rule 701, which was recently modified in July 2018, allows non-reporting companies (i.e. startups and other privately held companies) to issue securities for compensatory purposes to eligible recipients (including employees, consultants, advisors, etc.) without registering such issuances with the SEC. In the letter, Uber stated its preference for the term “entrepreneurial economy” over the commonly used term “gig economy”. Presenting itself as a company that has “empowered millions of individuals around the world to take control of their lives through [their] technology platform”, Uber provides brief recommendations to expand the scope of Rule 701 to allow them to issue equity to its drivers.

Under the revised Rule 701(e), an issuing company must release financial statements, risk factors and other disclosures if the aggregate sales price or amount of securities sold by the company under Rule 701 during any consecutive, rolling 12-month period exceeds $10 million.

Aware that Rule 701 has not been updated since 1999 and the changing nature of business, SEC Chairman Jay Clayton stated in a press release, “The rule as amended, and the concept release, are responsive to the fact that the American economy is rapidly evolving, including through the development of both new compensatory instruments and novel worker relationships – often referred to as the ‘gig economy.’ We must do all we can to ensure our regulatory framework reflects changes in our marketplace, including our labor markets.”

It is well known that Uber has consistently and continually identified its drivers as independent contractors rather than employees not only in the press but also in court. Most recently, the United States District Court for the Eastern District of Pennsylvania held that Uber drivers were independent contractors. As Rule 701 is currently constituted and interpreted, it allows for issuances of restricted stock to ‘consultants’ as an eligible class of persons, but not to ‘independent contractors’. For obvious reasons, this interpretation doesn’t work within Uber’s framework, as it is cross-purposes with its essential argument that its workforce, is comprised of independent contractors. Thus, its recent letter to the SEC is an attempt to open the Rule 701 framework to be more inclusive as to eligible persons (among other matters).

Interestingly, Uber competitor Juno previously tried offering restricted stock units to its independent contractor drivers that would be redeemable when Juno went public or was sold, which it was sold to Gett in 2017. However, Juno ended the program due to implementation difficulties, a clear example of the complexity and expense which can be involved in internal company securities issuances.

Fellow “gig economy” company, Airbnb also sent a request to the SEC on September 21, 2018 to allow it to issue company stock to its hosts. Additionally, it offered suggestions to expand Rule 701(c) to include “persons with substantial, but non-traditional relationships with the issuer”.

Given the growth of the sharing economy, such changes to Rule 701 would seem to be a positive step toward the democratization of equity ownership; allowing more people to participate in the wealth generated from these companies when (and if!) they do go public.

It is unclear if the Uber and Airbnb requests are a peace offering to drivers and hosts or signaling that the dominant “gig economy” companies are truly maturing as they look into the IPO route. Regardless, other platforms based on the “gig economy” relying on alternative contractual relationships between companies and individuals who work with them could follow similar incentive packages, which could include other options like unit appreciation rights plans or restricted stock units, to attract necessary platform employees.

How the SEC will react to these entreaties is not yet certain. Clearly, the SEC is warm to the idea of updating and modernizing key Securities Act transaction exemptions to take current market realities into account, and the seemingly logical (but limited) expansion of eligible persons under Rule 701 is an appealing step in that direction. However, it would also represent another channel of securities distributions that essentially fly below the radar of regulatory and public scrutiny; and, in a world where the long-term trend away from IPOs seems to be unidirectional, the SEC may not wish to allow for more shade to darken the picture frame.


Commentary by Stan Sater
 & Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected] 

jeff

 

Regulation Enforcement of CryptoCurrency Sept-2018

The Financial Industry Regulatory Authority (“FINRA”) announced on Tuesday, September 11, 2018, its first disciplinary action for securities violations against a cryptocurrency. The disciplinary action involves Rocky Mountain Ayre, Inc. (RMTN) in connection with its issuing and selling of HempCoin, which was marketed as “the first minable coin backed by marketable securities”. Ayre bought the rights to HempCoin in 2015 and effectively securitized HempCoin by backing it with RMTN’s publicly traded common stock. HempCoin was touted as the “the world’s first currency to represent equity ownership” in a publicly traded company and promised investors that each coin was equal to 0.10 shares of RMTN common stock. Through late 2017, investors were able to mine more than 81 million HempCoin securities and subsequently buy and sell the coin on two cryptocurrency exchanges.  FINRA alleges in its complaint that Ayre defrauded investors in RMTN by making materially false statements and omissions regarding the nature of RMTN’s business. Such false statements include failing to disclose its creation and unlawful distribution of HempCoin, and misleading statements in RMTN’s financial statements. Ayre is charged with the ‘unlawful distribution of an unregistered security’, as HempCoin was not registered with the SEC nor did the issuer  use a registration exemption.

The same day as the FINRA announcement, the SEC issued two separate cease-and-desist orders. The first cease-and-desist order was issued to a cryptocurrency hedge fund, Crypto Asset Management (“CAM”) who misrepresented itself as the “first regulated crypto asset fund in the United States”. The SEC claims that the CAM has not registered with the SEC and “willfully” misrepresented itself as having the proper credentials to trade and hold securities. The second cease-and-desist order was issued to self-proclaimed “ICO Superstore” TokenLot, for failing to register with the SEC. The heads of TokenLot have agreed to pay a fine to settle the charges that they acted as an unregistered broker-dealer for the sale of tokens. Similar to most investigations, these two have already been resolved via the payment of fines. These two cases may signal that the SEC is beginning to go after companies that have failed to comply with securities laws out of negligence, rather than overt fraudulent activities.

Although the SEC has previously issued statements that Bitcoin and Ethereum are not securities, to date, the SEC has declined to issue broad or narrow classifications or taxonomies as to which cryptocurrencies are securities, and which are not. It is worth remembering, however, that, ultimately, the SEC is only a regulatory body that enforces the law. Thus, these issues will likely be left to the courts to ultimately decide.

On September 11, 2018, a New York federal judge in U.S. v. Zaslavskiy ruled that U.S. securities laws applied to prosecuting fraud allegations involving cryptocurrency. Zaslavsky was charged in November 2017 for securities fraud related to two ICOs:  ReCoin and DRC. In February 2018, Zaslavsky filed a motion to dismiss claiming that he did not commit securities fraud because ReCoin and DRC are not securities and that the U.S. securities laws are unconstitutionally vague because an ordinary person would not have known that his conduct was illegal under current securities laws. The judge denied his motion to dismiss on the grounds that ReCoin and DRC are, in fact, securities assuming the Department of Justice’s allegations are true, and the U.S. securities laws are not so vague as to be unconstitutional. The judge’s denial of Zaslavskiy’s motion to dismiss means the case will proceed to trial. Zaslavskiy is expected to argue that the relevant tokens were not investment contracts under the Howey Test.

These three announcements issued on the same day demonstrate how seriously regulators and courts are taking cryptocurrency despite their late start and lack of definitive guidance surrounding the law to date. We will keep monitoring these developments as more announcements are made.


Commentary by Stan Sater
 & Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected] 

jeff

Do ICO’s Seek an Expectation of Profit Solely from the Efforts of Others?

In our most recent blog post, we discussed the second prong of the Howey test – a “common enterprise” – and the US Circuit Courts’ fragmentation on the issue and lack of uniform definition. In this third and final part of our series pulling apart the Howey Test, we’re looking at the third and fourth prongs of the Test. These final two prongs, typically read together, are (collectively) “with an expectation of profits solely from the efforts of others”. The expectation of profits element focuses on the type of return that the investor seeks on their investment. This return inquiry is easily satisfied by an increase in capital or participation in earnings on invested funds. As mentioned, however, the return or profit must depend on the “efforts of others”, which goes to the passive nature of the investment return. Remember, the Howey company was selling plots of land on its citrus grove to people who had no intention of farming the land and depended on the Howey company to produce profits. These investors were expecting a passive return with no intention of consuming the oranges produced (i.e., this was not a pre-sale for the underlying future oranges which goes to consumptive use v. speculative use).

 

The SEC Wants to Talk About Your Control Issues

 

The “solely from the efforts of others” inquiry is a fact-specific analysis of the economic realities of the transaction. In sum, the more an investor controls the business operations of the project, the less likely an investment contract exists. The critical question to ask is whether the efforts of individuals other than the investor are “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”. In determining an investor’s control over the profitability of the investment, a court may look at:

  • the investor’s contribution of time and effort to the success of the project;
  • the investor’s rights under the investment agreement;
  • the investor’s access to information about the project; and
  • and the investor’s level of sophistication.

This analysis brings into focus the timing of the investment. If promoters promoted the investment and then made no further efforts after the investment, it is likely that no investment contract exists.

In the modern context of security ‘token’ sales that we have been examining, an appreciation in value via secondary market trading, in theory, should not be used as weighing in favor of the token being an investment contract. Additionally, a court may consider the adequacy of financing of the investment as well as the level of speculation and the nature of the risks in the transaction.

 

Getting Over Control Issues

 

With respect to securitized token offerings, it’s fun to talk about monetary gains, decentralization, openness, lambos, etc., but more time needs to be spent around architecting the proper token governance schemes. Because this is a fact-specific analysis, each token project must think granularly in terms of why a token is necessary; what does the token do; what is a token purchaser receiving (voting rights, effectively a license to use the network, ability to contribute to the network, etc.); how is this information being communicated (i.e., Telegram, Reddit, Twitter, Slack, Medium, YouTube, Podcasts, etc.); and how knowledgeable are the pre-functional platform investors (accredited investors, professional knowledgeable investors, ordinary public investors).

Unfortunately, there is no bright-line rule, and there is likely not going to be one for some time. In the decade since cryptocurrency has existed, only two cryptocurrencies (Bitcoin and Ethereum) have been declared not securities.

 

Exploring the Other Side

 

We have talked in this series of posts, in some detail, about transparency from the team building the network, but next, we should finish by focuses on how traditional finance disclosures work for large, private investors.

Meltem Demirors, a prominent cryptocurrency investor, has openly talked about the notion of this “shitcoin waterfall”. The shitcoin waterfall is when an ICO raises a pre-pre-sale round from VCs at a very steep discount. Then, the project raises a pre-sale where the initial investors now have tokens that are valued at 50-100x more than the previous round. The white paper is likely then revised with “crypto-famous” investors listed as advisors, and the white paper reads like any other marketing brochure. Next, the project does an ICO followed by an exchange listing for the general public. Coinciding with the exchange listing, these early investors are dumping their heavily discounted tokens on the average consumer. Meanwhile, most ICOs fail within four months.

Should large, early investors in an ICO be subjected to disclosures about token exits? Such disclosures would help regulators evaluate whether or not these early investors are pumping and dumping coins on the average retail investors. The same is true with self-dealing issues in respect to projects and team members contributing back into their ICO for more of their tokens, thereby inflating the ICO raise. While we share in the enthusiasm and promises of cryptocurrency, current ICO practices are less than noble or open to everyone despite what is propagated at overpriced conferences. As more empirical data comes to light, the legal landscape will begin to adjust for these projects.

 

Series Post-Script

 

The broad variables discussed throughout this series of blog posts on the Howey test offers arguments on why some tokens are considered securities and the gaps in the legal knowledge that need to be overcome. As noted in Coin Center’s recent Framework for Securities Regulation of Cryptocurrency, “the Howey test happens to also be an effective guide for determining whether a token possess heightened risks to users. The more a given token’s software and community variables allow it to fit the definition of a security, the more need there may be to protect its users with regulation.”. In theory, the more decentralized and transparent the network, the less risky it is to hold the token as it functions more like a commodity as price fluctuation is due to the market rather than one entity behind the project.

The reason we started the blog series with the facts of Howey was because the facts are easily substitutable. However, there is a mental shift around digital things that must be explained to regulators and token issuers in order to advance the ecosystem. Sometimes, acting and failing to act can have the same consequences; a didactic that the SEC already knows very well in its views on disclosure. For now, an understanding of the past and careful self-regulation based on our understanding of prior law will have to do.

 


Commentary by Stan Sater
 & Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]

jeff

What is a Common Enterprise and is Bitcoin or Ethereum one?

In our most recent blog post, we discussed the first prong of the Howey test – an “investment of money” – through the lens of so-called ‘airdrops’. Moving on to the second prong – a “common enterprise” – requires us to take a step back and consider multiple angles. While courts, generally, have been quick to find a common enterprise despite the U.S. Courts fragmentation on the test, new cryptocurrency based projects, as open-source, add a level of consideration that is worth exploring.

 

Not Split – Fragmented

The circuits are fragmented in evaluating the “common enterprise” element, and we are left with three approaches: (1) horizontal commonality, (2) broad vertical commonality, and (3) narrow vertical commonality.

The horizontal commonality test is relatively straightforward. The test requires a pooling of funds in a common venture and a pro rata distribution of profits. The test is not worried about any promoters (which, in this context, means the issuer and its principal(s)). Thus, an investor’s assets must be joined with other investors where each investor shares the risk of loss and profits according to their investment. To date, the U.S. Circuit Courts of Appeal that follow the horizontal commonality test include the First, Second, Third (affirmed, but no opinion by the Third Circuit Court), Fourth, Sixth, and Seventh Circuits. Note – We have only include the circuit courts because these courts are one tier below the U.S. Supreme Court regarding what decisions hold the most weight in the U.S. legal system.

Vertical commonalty focuses on the vertical relationship between the investor and the promoter. Under this test, a common enterprise exists where the investor is dependent on the promoter’s efforts or expertise for investment returns. There are two approaches the vertical commonality:  (1) broad vertical commonality, and (2) narrow vertical commonality.

The only requirement under broad vertical commonality test is that “the investors are dependent upon the expertise of efforts of the investment promotor for their returns”. This test is perhaps the easiest to satisfy because there is typically always an information asymmetry between the promoter and the investor. The key question to ask, therefore, is does the investor rely on the promoter’s expertise? Both the Fifth and Eleventh Circuits follow the broad vertical commonality test.

The narrow vertical commonality test only finds support from one circuit – the Ninth Circuit. Under this test, the court only looks at whether or not the investor’s profits are linked with the profits of the promoter. Put another way, a common enterprise exists if the investor’s success or failure is directly correlated with that of the promoter’s.

 

Where Does That Leave Us?

When we look at Bitcoin and Ethereum, we have to ask who exactly are the ‘promoters’? One of the primary concerns in regulating securities is information asymmetries that lead to investors being taken advantage of by promoters. Remember, the Securities and Exchange Commission (SEC) has a three-part mission:  (1) protect investors; (2) maintain fair, orderly, and efficient markets; and (3) facilitate capital formation. Therefore, companies offering securities must tell the truth about its business, what securities they are selling, and the risks involved in investing in the company’s securities.

Evaluating Bitcoin and Ethereum under the same test, a central organization, clearly, does not exist. For Bitcoin, there was no ICO and has perhaps been sufficiently decentralized since its inception according to the SEC. For Ethereum, perhaps at the ICO stage, a central entity existed that investors relied on, making it (possibly) a security. However, we are now three years removed from that, and Ethereum has been, to all intents and purposes, deemed to be not a security. In the current state, anyone can write proposals on GitHub, fork the code, contribute upstream to Ethereum, etc. In truly permissionless, decentralized systems, has everyone become a ‘promoter’? The investment of money is not in a common enterprise, but rather an investment of money for tokens to participate in the growth of a network or base protocol. Unlike the familiar examples above, however, the issue with most ICOs is that the platforms are not built and there is a core team that is developing the software pre-release in a silo. Therefore, the investor is dependent on the team for the network to be built, and the funds from the ICO are going towards the team to continue the development of the network.

Many people in cryptocurrency are expecting the next big announcement to come from the SEC or the CFTC. We believe, however, that the next large moment of legal clarity will come, rather, from the courts via the numerous civil lawsuits developing. The U.S. Supreme Court has, to date, declined to take on this circuit court fragmentation directly. Perhaps this is because the facts and circumstances of the prior cases do not warrant a novel decision around the commonality question. However, the way we have seen cryptocurrency evolving and expect it to continue evolving, the time has come to settle the issue of what is a common enterprise.


Commentary by Stan Sater
 & Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]

jeff