The Ripple SJ Order makes three main substantive holdings: (1) that institutional sales represented investment contract transactions, (2) that programmatic sales did not represent investment contract transactions, and (3) that “other distributions” (mainly, employee incentive compensation and “Xpring” program developer grants) did not constitute investment contract transactions. 

A brief overview of each of these sub-holdings follows:

• Institutional Sales.  Judge Torres found the Howey test met on all elements.[3]  In particular, institutional investors had a clear investment intent in the token-purchase transactions, and Ripple’s communications with this category of purchasers in specific were of a nature in keeping with investment promotion.  Therefore, the “investment of money” and expectation of profits “from the efforts of others” prongs were met. (Judge Torres found the Howey prongs “investment of money” and “common enterprise” prongs were easily met).
• Programmatic Sales. These sales were “blind bid/ask” transactions conducted by professional market-makers on Ripple’s behalf on cryptocurrency exchanges.  The court held that these sales failed the Howey test, primarily because purchasers in these transactions—which were bilaterally anonymous—could not have known they were investing in Ripple,[4] negating the “investment of money” prong. An immediate corollary, according to the court, was that Ripple could not have made any promises or offers to these purchasers.[5]  This undermined any reasonable expectation of profit “from the efforts of others.”  The court did note that there were numerous promotional public statements made over the years by Ripple and its principals, but (1) it hadn’t been established that the typical XRP purchaser was aware of, or motivated by these statements (or even aware of Ripple as a company); (2) many key communications that had been used to find an investment contract in the case of institutional buyers were not distributed publicly, and (3) Ripple’s public communications were too disparate, disjointed, and opaque, such that “generally less sophisticated” public investors were unlikely to “share[] similar ‘understandings and expectations’ [as institutional investors] and [be able to] parse through the multiple documents and statements that the SEC highlights.”
• Other Distributions. Judge Torres found that recipients in this category—exemplified by employees (receiving tokens as “incentive compensation”) and developers (receiving “grants” to develop XRP-based apps)—did not “pay money or “some tangible and definable consideration to Ripple” in exchange for their tokens.[6]  Thus, the “investment of money” prong was not met, and Howey fails as a whole. Secondarily, the judge noted that Ripple never received payments from these distributions; while not addressing any Howey prong directly, this rejoinder was in response to SEC assertions that these distributions were nonetheless “indirect public offerings” (further to which, the judge also pointed out that the SEC never formally claimed that these were underwriter transactions—as would be required to properly-propound such line of argument.[7]).

The Judge’s decision regarding institutional sales—a seeming clear negative for blockchain token-selling endeavors—was, in our view, the least surprising, and was the portion of the ruling with the narrowest implications. This is due to the fact that institutional sales represent token sales to the smallest, most professionalized, most formalized segment of the market for crypto tokens (indeed, such sales—after Ripple’s early trailblazing efforts—were typically only undertaken by other token issuers under explicit Securities Act exemptions, such as Rule 506(c), if only prophylactically).  All of these attributes are diametrically opposed to the “retail” segment of the token-sale market, and therefore, the legal implications of such sales bear the least applicability to it.  Yet, the retail segment is much more consequential, due to the much larger volume of transactions represented by (1) direct token sales by issuers to the general public, and (2) transactions on cryptocurrency exchanges (either engaged in by the issuer, or, more often between two third parties).

Judge Torres’ holdings regarding the second two categories of distributions (programmatic sales and “other distributions”), and their rationale, evince a fresh look taken in applying longstanding securities law precedents to blockchain token sales, and in doing so, provide compelling new support against overbroad applicability of the Howey test.  For example, both the programmatic sales and “other distributions” categories were held by Judge Torres to not meet the “investment of money” prong of Howey—one long assumed in most legal analyses to be met in most token-distribution scenarios, if only arguendo.  This point is most fully made by Judge Torres in the rationale for the “other distributions” transactions, where she cites to Int’l Bhd. of Teamsters v. Daniel[8]—an oft-referenced securities case which is typically taken for little more than the proposition that non-monetary consideration can constitute an “investment of money” in the Howey sense.  However, the Daniel supreme court actually came to the opposite conclusion when applying the rule to the facts of that case, and what’s more, spent virtually the entire opinion memorandum limiting the breadth of a non-monetary “investment of money.” Judge Torres was clearly citing Daniel for this set of propositions.   These include statements that, e.g.:

• “In every case the purchaser gave up some tangible and definable consideration in return for an interest that had substantially the characteristics of a security.”[9]
• “Even in those cases where the interest acquired had intermingled security and nonsecurity aspects, the interest obtained had ‘to a very substantial degree elements of investment contracts …’.”[10]
• “[Here,] the purported investment is a relatively insignificant part of an employee’s total and indivisible compensation package.”[11]
• “Only in the most abstract sense may it be said that an employee “exchanges’ some portion of his labor in return for these possible benefits. He surrenders his labor as a whole, and in return receives a compensation package [].  His decision to accept and retain covered employment may have only an attenuated relationship, if any, to perceived investment possibilities of a future pension. Looking at the economic realities, it seems clear that an employee is selling his labor primarily to obtain a livelihood, not making an investment.”[12]

Fully crediting these propositions from the Supreme Court (rather than taking them as disposable dicta)—as Judge Torres clearly does—leads directly to at least two apparent “investment of money” corollaries of significant import for the Ripple non-institutional sales categories; (1) a finding of an “investment of money” should be disfavored when it arises from a non-monetary (or other intangible or inchoate) purchase consideration transaction, and (2) a finding in favor of an “investment of money” should also be disfavored (or perhaps, impossible) when the putative investment forms a minor or ancillary part of the overall transaction.

The foregoing observations do not, however, mean the court’s findings are a clear “slam dunk” for Ripple in all (if any respects) regarding programmatic sales and “other distributions.”

For example, in Ripple’s summary judgment brief, it argued that the Howey test was inadequate (i.e., failed to comprehensively distill state securities “blue sky law” up to that point) in that it did not also require “a contract, post-sale obligations on the promoter, and the investor’s right to receive a profit.”[13]  Judge Torres ostensibly rejects these proposed augmentations of the longstanding Howey investment contract test, in doing so, focusing on the first element proposed by Ripple one: the requirement that there be a contract.[14]

However, we have trouble concurring with this stage-setting conclusion of Judge Torres, as, logically-speaking (1) an “investment contract” requires a contract (albeit, one of a particular class), and (2) the presence of some other type of contract in the overarching transaction in question does not mean that it, or a relevant portion thereof, is an investment contract.  Indeed, despite establishing this ostensible ground rule, Judge Torres then proceeds to apply Daniel as discussed above—that is, arguing precisely that the presence of some other type of encapsulating contract does not establish the presence of an investment contract.  Indeed, Judge Torres’ arguments against the presence of reasonable reliance for profits on the “efforts of others” in the programmatic sales context also necessarily entail that, despite accepting that contracts for token-sales were being concluded (i.e., on cryptocurrency exchanges), these same sales transactions (contracts) did not rise to the level of investment contracts.

Other aspects of the Judge’s ruling certainly are likely to be debated. For instance, regarding the programmatic sales category, one might argue that the point made by Judge Torres that general public purchasers of XRP were not shown (on the SEC’s evidence) to be sophisticated or capable enough (to derive a cognizable, reasonable expectation of profits from Ripple’s public statements) is a reason in favor of applying the protective cover of the Securities Act, rather than a reason against.  However, it remains true that the expectation of profits arising from the Howey efforts of others must be “reasonable,” and if public statements are too vague or contradictory to support a distinct expectation of profits, then this should, logically-speaking, undermine a reasonability test.  As has been held in limiting the application of Securities Act to any financial transaction, the Securities Act is not intended to be a universal panacea for all ostensible fraud on the public.[15]

Further underscoring how unsettled these legal nuances remain in application to blockchain token sales, the Ripple SJ Order was cited within mere days in another prominent case, SEC v. Terraform Labs,[16] in support of a no-investment contract argument which was part of Terraform’s motion to dismiss.  Judge Rakoff, in his dismissal denial order in that case, ostensibly rejects the Ripple SJ Order’s rationale, arguing that “the re-sale purchasers [not knowing] if their payments went to the defendant, as opposed to the third-party entity who sold them the coin” was irrelevant to an expectation of profit, because Howey makes no such distinction between purchasers.  That a purchaser bought the coins directly from the defendants or, instead, in a secondary resale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts. And it makes good sense that it did not. That a purchaser bought the coins directly from the defendants or, instead, in a secondary resale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts.[17]

It’s a fascinating (if express) rebuttal, not in least because Judge Torres specifically disclaimed applicability of her ruling to secondary market sales generally (i.e., third-party to third-party) in her findings on programmatic sales,[18] and focused instead on the Howey-weakening implications of bilateral anonymous transactions with Ripple itself.  Judge Rakoff in essence leaps directly from Torres’ more limited point, to its implications of for broader secondary market transactions—perhaps attempting to preemptively cut off further applicability of Torres’ findings and rationale.  However, the relevance of Judge Rakoff’s rebuttal argument seems circumscribed according to Rakoff’s very own construction of the relevant Terraform facts:

As part of this campaign, the defendants said that sales from purchases of all crypto-assets — no matter where the coins were purchased — would be fed back into the Terraform blockchain and would generate additional profits for all crypto-asset holders.[19]

This contrasts materially with the facts in Ripple, as recounted by Judge Torres (and discussed above): Ripple was (ostensibly) not making such explicit representations, therefore, it is reasonable to conclude that the “investment of money” and/or “efforts of others” Howey prongs might fail for disintermediated, cryptocurrency exchange-venued transactions in Ripple’s case, even if they might be met for Terraform.  Clearly, reasonable minds still have much to differ about in this arena.

In conclusion, we find that Judge Torres’ summary judgment ruling in Ripple has likely opened up some material “space” for blockchain token sales as legal non-investment contracts, but that the precise extent of this space is far from settled. What is truly novel in the evolution of crypto securities black-letter law is that this ruling marks a move beyond the prior blockchain securities case law status quo of egregious violations ending in settlements, as opposed to substantive issues being adjudicated to conclusion on their merits. In a sense, then, a gauntlet has been thrown down, and the challenge now has to be answered. The coming months will therefore likely rapidly progress towards resolution of the questions implicated in Judge Torres’ decision—a positive development in its own right.

[1] Securities and Exchange Commission v. Ripple Labs, Inc., Bradley Garlinghouse, and Christian A. Larsen, Case No. 1:20-cv-10832-AT-SN (hereinunder, SEC v. Ripple or Ripple); summary judgment order: doc. 874; 2023 WL 4507900.

[2] Ripple, doc. 887, filed August 9, 2023.

[3] Ripple SJ Order at 19-22.

[4] Id at 23.

[5] Id at 24.

[6] Id at 26; internal quotations removed.

[7] Id at 27.

[8] 439 U.S. 551 (1979); pincite to 560.

[9] Ibid.

[10] Ibid; citation to Variable Annuity Life Ins. Co. 359 US 65, 91 (1959) (BRENNAN, J., concurring) omitted in quotation.

[11] Ibid.

[12] Ibid.

[13] Ripple SJ Order at 12.

[14] Id at 12-13.

[15] See, e.g., Marine Bank v. Weaver, 455 U.S. 551, 556 (“The broad statutory definition of securities in the Securities Exchange Act of 1934 and the Securities Act of 1933 is preceded, however, by the statement that the terms mentioned are not to be considered securities if the context otherwise requires. Moreover, the Court is satisfied that Congress, in enacting the securities laws, did not intend to provide a broad federal remedy for all fraud”; internal citations and quotations omitted).

[16] Securities and Exchange Commission v. Terraform Labs PTE. LTD. and Do Hyeong Kwon, — F.Supp.3d —-, Case No. 23-CV-1346 (JSR) (hereinunder, SEC v. Terraform or Terraform; July 31, 2023 denial of dismissal order citation: 2023 WL 4858299; hereunder Terraform Dismissal Denial).

[17] Terraform Dismissal Denial at 15.

[18] Ripple SJ Order at 23 (fn. 16).

[19] Terraform Dismissal Denial at 15.

The post While Not The Final Word, Summary Judgment Ruling in SEC v. Ripple Case Is “Bullish” For Crypto appeared first on One Legal Square LTD.

EB: What is your role in OLS?

AD: Doing mostly team leads at this point. Started a year ago, and moved up from research to drafting. I’ve been on a few client calls. The initial client calls, but I mostly shepherd various projects to completion, you know, try to wrangle teams of attorneys to sort things through. And then I draft just to make sure it’s the last stop before it’s reviewed by the senior attorneys.

EB: Could you please give us a brief summary of your career path and what sparked your interest in the blockchain space?

AD: Sure. I’ve had a sort of a wild one. Originally, I was going to become a teacher out of law school. I was an adjunct professor at the University of Alabama School of Law. Did that for two years. Then I worked at a bank. I worked at MIT Bank, not utilizing my legal degree. And then I decided to take the bar. And after which, shortly after, I started working for the Department of Justice EDNY Civil Division, where I was part of a team that investigated a bank for the RMBS crash of ‘08. I did that from 2014 to 2018.

AD: And let’s see, in 2017, a friend of mine who went to the same law school put me in contact with Daniel Peake, I sent an email, started talking to him, and found out that Daniel Peake was looking for additional help with advising blockchain projects and companies. Then there was the big boom in ICOs with crypto projects, and initial coin offerings. And so, I was looking for something interesting, something new, something that invigorated my intellectual abilities. So, I jumped right in. I got myself familiar with the blockchain space, participated in a few different ICOs and various projects, and got what’s called CAMs certification, a compliance certification, for anti-money laundering. So, I did some compliance-related stuff, which led me to move over to Citibank as a compliance officer there. Around then, in 2018, is when the ICO crypto crash happened. And so the work seemed to have dried up a bit.

AD: And so I just moved into more of a regular compliance banking regulation. Did that for a year. Then I found myself a little bit intellectually stagnant and hit up Daniel again. And that’s how I got back into blockchain and started working for OLS.

EB: So has OLS helped propel you into the blockchain industry? If so, please give us an example.

AD: Yeah, it definitely propelled it. I’ve worked with dozens of different blockchain companies, mostly as an attorney, sometimes as a compliance officer, and I’ve worked with almost every type of blockchain project you could imagine, and not only just Ethereum, Solana, and Cardano. Seems like I’ve done it. It was just by fulfilling each client’s individual needs, which, while similar in a lot of respects, differ a lot depending on the circumstances. A lot of regulatory counsel, a lot of transactional. Blockchain has allowed me to work in a much wider swath of legal matters than I would in a traditional legal law firm. And we’re on this sort of unpaved or untrod snow where we’re sort of figuring out how this incredible technology interacts with state and traditional legal and regulatory frameworks.

EB: Could you please elaborate on any blockchain projects you have worked on, and can you share what you’ve learned from them?

AD: Yeah, if you go to the OLS website, for example, I was just checking out, you’ll see Hashflow on there. And that’s typical of the kind of work that I’ve done with OLS and OLS does, where we sort of analyze a particular digital asset and try to figure out whether it’s a security or not, where are the safeguards or potential dangerous thresholds for the individual products and how it interacts with the user base and what the regulatory ramifications might be. We go into the nuts and bolts. I mean, one thing that OLS has always prided itself on is that we go above and beyond in regards to how deep and intellectually rigorous the analysis we do on these products.

AD: We know these products. Every one of the attorneys in the law firm, has a MetaMask wallet, has a digital wallet, has done a little bit of swap trading, you know, has that same basic level of knowledge of the blockchain space. We’re relatively young, and so we sort of grew up with the stuff. For example, for Hashflow, we read the white papers like any attorney would, but we also join the platform, join the discord, just being part of the ecosystem, utilizing the digital assets, and getting a first-hand experience with actual digital data. As attorneys, it gives us that extra edge that helps propel a client’s interactions with regulatory authorities.

EB: Do you anticipate any regulatory changes occurring in the blockchain space?

AD: Oh, yeah. I mean, in the next year or two, there’s definitely going to be some sort of realignment. I mean, if you just look at the various proposed legal bills, CFTC, the SEC, there’s definitely something rumbling as far as creating these parameters for this type of technology. And so, you see even though we’re still a little bit in the dark when it comes to getting the right type of guidance from our regulatory legal authorities, you could definitely tell that there will be more of it and that we will have to pay way more attention to adhere to those regulations and laws. And so, yeah, definitely something’s got to be coming down the pipeline, and so we need to be ready for it.

EB: Do you have a specific method and how do you stay up to date with recent developments in the blockchain industry?

AD: Yeah, I mean, there’s an entire Twitter verse of crypto attorneys. There are websites like the block. What I like to do is not only stay in the attorney space but stay in the crypto enthusiasts or just crypto social media space. I follow particular people that I respect that actually have a head or deep knowledge of crypto and might even have a somewhat skeptical eye on particular projects or personalities. So yeah, just be on social media, and keep on reading white papers. And you tend to see that a lot of the stuff comes in waves. You know, as I mentioned, ICOs were very 2017, then DAOs were very last year. And so, these things come in waves. You need to be on top of it as an attorney or just as a person who wants to participate in the space.

AD: You just have to keep yourself up to date and with as many projects as you can.

EB: Based on your experience and knowledge, what is a problem you often see when a business tries to launch a blockchain project?

AD: I would say not taking into consideration that regulatory and legal authorities will be looking at your product. If you put a product out there that can be traded, that has some sort of economic characteristics that seem similar to more traditional types of products already present in the economic system, then you need to get your ducks lined in a row. You can’t just throw your product out into the wind. You have to prepare, seriously prepare your product with a legal analysis framework. And sometimes you just don’t see that. You don’t see that work happen ahead of time. The justification for doing so is not just pragmatic, it’s for moral reasons as well. These regulatory frameworks and protections and demands and requirements are there to make sure that people in the end aren’t being taken advantage of.

AD: An individual wanting to trade something, isn’t buying something that they aren’t aware of. And so like, these regulations are then supposed to be protecting people. And so as a corporation trying to put a product out there, then it behooves you to try to follow those strictures and get proper representation and advice.

EB: What advice would you give an attorney trying to learn more about this blockchain space?

Jawdah Tamir: Let’s see, like I said, keep apprised of regulatory and legal frameworks coming down the pipeline and the ones that exist. Try to pick up as much of a wide swath of legal knowledge and cases as you can. Because blockchain tends to touch on everything, almost everything. So you can’t kind of just specialize on, oh, I’m going to just work on this particular type of contract or even just transactional work. You’re going to have to work on regulatory analysis, you’re going to have to work on compliance, you’re going to have to work on having a little bit of knowledge on litigation, intellectual property. So you just have to keep your mind moving and you can’t stay still.

EB: That is excellent advice. Now, on the opposing spectrum, What advice would you give an entrepreneur thinking about launching a project in the blockchain industry?

AD: I would say, first of all, just pay attention to some of the biggest SEC-related regulatory rulings or communications, for example, SEC’s digital framework or the DAO report in 2017. I would ask them since you’re putting up a product out there that you would want to try to hire and bring along legal experts that are familiar with the field because, in some ways, you are going to have to deal with the legal framework or regulatory framework. You can’t do this by yourself. You’re going to need help.

EB: Are there any specific areas in the blockchain industry that you’re particularly interested in?

AD: As I said, I’m a compliance person. So not only am I an attorney but also have a previous history as a compliance specialist. And so once we get past the laying down of the legal structures, the regulations, laying down the parameters for how blockchain in general works, it’s going to be an everyday process of compliance. Putting together certain reports, sending reports to government authorities, putting certain notices of disclosures to individuals, to your user base. That sort of ordinary day-by-day thing might seem maybe boring to other people, but that’s the nitty-gritty of how people interact with corporations. And it’s something that I’m interested in growing and participating in and regularizing, setting up business-minded compliance departments or services for blockchain companies.

AD: So that’s the thing that right now I’m kind of really honing in on.

EB: It’s nice hearing you talk about a passion of yours, but besides the legal field, would you say you have any hobbies or interests outside of it?

AD: Yeah, I play base. I’m a bassist, playing in local bands. I’m absolutely into music. I love seeing shows. I love keeping up with music, even though I realized that the older I get, the less I know, which is always hilarious. I’m like, hey, you heard about this band? Yeah, that band was from 2004. I’m like, oh, wow, I’m really behind the times here. But, yeah, I love music. And so my apartment has keyboards and bass and stuff. I love to read, mostly nonfiction. And of course, regular prestige TV shows. Those are the things I like to do.

EB: Well, I expect a ticket to your future concerts.

AD: Hahaha, sure.

EB: Okay Ali, I think that concludes our interview. Thank you so much for allowing us this time.

The post Attorney Highlights With Jawdah Tamir appeared first on One Legal Square LTD.

       The Howey test is the standard used to determine whether a product is a security, and this test is a mixed question of fact and law – juries decide on the factual portion of such questions. Therefore, assuming the right to a jury trial is not waived, and the case gets past motions to dismiss, motions for summary judgment, motions in limine, and so forth, then the question of whether a product is a security is presented to a jury. The jury’s work of delineating the precise factual contours of these products and applying the law to them is their indispensable role.

       Audet v. Fraser is that rare case to make it past all of the motions and evidentiary hurdles mentioned above, leaving the jury to determine whether certain crypto-related products at issue were securities – specifically, whether they were investment contracts. The four products in question were Hashlets, Hashstakers, Hashpoints, and Paycoin. After a trial where the jury was presented with eight-days of evidence, Judge Shea instructed the jury on the elements of the Howey test and the sub-elements of vertical and horizontal commonality. The jury was specifically instructed that “[t]o establish that a Product [was] an ‘investment contract,’ the plaintiffs [had to] prove that there was, with regard to that Product: (1) an investment of money, (2) in a common enterprise; (3) with profits to be derived solely from the efforts of others.” The jury had to determine whether Howey test elements were satisfied based on the specific facts and circumstances of the case. 

That jury rendered a verdict finding that the four token products were not investment contracts because they did not satisfy the Howey test. Judge Shea granted a motion for a new trial for one of the four products, Paycoin, but denied the motion for the other three products, leaving the jury’s findings undisturbed. The importance of this outcome is that Hashlets were found to not be investment contracts and therefore not securities – which is in direct conflict with the SEC’s initial 2015 complaint in the case asserting that Hashlets were investment contracts, and thus securities.

The SEC’s 2015 complaint alleging securities fraud was lodged against Homero Joshua Garza (Garza), GAW Miners, LLC (GAW), and ZenMiner, LLC. In its complaint, the SEC described Hashlets as investment contracts that entitled investors to a share in the returns of GAW’s mining operations. However, this allegation that Hashlets were investment contracts was not adequately assessed by a court or put before a jury because Garza did not contest the SEC’s charges. Instead, Garza did not contest the case and a default judgment was entered against him. The plaintiffs in Audet relied heavily on the SEC’s initial allegations to argue that Hashlets were investment contracts.

       The outcome of Audet could be viewed as a loss for the SEC that should prompt some reflection should more cases reach a jury, considering that the vast majority of SEC enforcement actions in crypto are brought and settled in administrative proceedings or reach a settlement without proceeding to trial – let alone jury consideration – as to their merits.  This has led to a situation wherein many (if not most) observers have simply assumed the SEC’s scope of authority and both legal and factual positions regarding important considerations in crypto are more or less exactly as the SEC asserts and alleges.  But the outcome in the Audet case illustrates that the SEC’s views of a particular product, while often dispositive, could be tested by a jury who may reach a different conclusion when presented with specific facts and circumstances of the case.

The result of Audet regarding Hashlets is even more significant given that the court went into greater depth in its jury instructions on the Howey test compared to the norm. That is, the judge specifically provided clear instructions for the jury including nuanced instructions on the sub-elements of vertical and horizontal commonality.  While the case still continues, it is unlikely that the jury’s ostensibly erroneous verdict as to Paycoin will affect the outcome as to Hashlets, given the judge’s clear analysis embodied in the jury instructions.  We won’t know the final outcome as to Paycoin until a new trial is held, and any appeals are ultimately exhausted.

_______________________________________

 [1] See, e.g., Jarkesy v. SEC (5th Cir. May 2022), where the court held that a defendant in a securities fraud case has a Seventh Amendment right to a jury trial.

[2] 2022 WL 1912866 (D. Conn. June 3, 2022).

[3] SEC v. Howey Co., 328 U.S. 293 (1946)

[4] Audet   v. Fraser, 2022 WL 1912866, at 11 (D. Conn. June 3, 2022)[5] The motion was made under FRCP Rule 59[6] See https://www.sec.gov/litigation/complaints/2015/comp23415.pdf; case ended in a default judgment when defendants never responded to the SEC civil complaint.

The post Implications of SEC’s ‘Loss’ In Crypto Case, Audet v. Fraser appeared first on One Legal Square LTD.

NFT projects touch on various areas of law such as securities regulations, copyright, and trademarks. The U.S. Securities and Exchange Commission (“SEC”) is responsible for securities enforcement and exchange rules. The SEC may view certain digital assets, including some NFT projects as securities. If SEC deems a digital asset to be a security, then it must comply with SEC disclosure rules and several other regulations, which can be time-consuming and quite costly. Navigating securities regulation is crucial for NFT projects.

Securities law exists to protect the “uniformed” investor and to protect against an unfair, insider information advantages. The leading methodology to analyze whether your crypto project will be subject to securities law is through what is known as the Howey test. SEC v. W.J. Howey is a 1946 case from the U.S. Supreme Court that defined when an asset becomes an investment contract and, therefore, is considered a security. To make that determination, the Supreme Court in Howey introduced a four-part test: there must be: (i) an investment of money; (ii) in a common enterprise; (iii) with an expectation of profits; (iv) solely from the efforts of others (e.g., a promoter or third party). To be considered a security, all four factors must be met.[1]

In further securities analysis, the Crypto Rating Council (CRC) comprised a helpful framework for developing an understanding of how the SEC may consider a crypto project when determining its security status. This 36-question framework asks a series of yes/no questions that apply to any given token project and the questions are weighted by how strongly they affect the outcome of a token’s susceptibility to SEC investigation. A score of 1 on the framework means that a token project shares limited characteristics consistent with a security. The highest score, 5, describes an asset that has many characteristics consistent with a security. Generally speaking—per CRC recommendation—scores below 3 are usually deemed safe to list on an exchange.

An additional frontier that is pertinent to get familiar with as a crypto project builder is Intellectual Property (“IP”): Copyright and Trademark. An NFT is a unique digital certificate of ownership and authentication on the blockchain which is displayed as a file such as a JPEG, PDF, etc.. NFTs, like real estate, are one-of-a-kind and comprise very distinctive value. Their value can stem from several things, ranging from ownership history, rarity, or even some form of utility in society (such as memberships or VIP passes to events). As previously described, NFTs can represent various things like video, audio, documents, transactions, and more. Artwork, images, music, or any other types of original works of authorship fall in the realm of IP.

[1] See Edwards, 540 U.S. at 390.

Copyright law is long-established and there are several laws that prevent people from distributing, copying, transferring or profiting off other people’s original work; NFTs, while a new application of technology, is no exception. Copyright protections are granted to the author of creative works when those works are original and fixed in a tangible medium. Copyright law grants creators of any original creative work(s) a bundle of rights. These protective rights include the right to distribute, reproduce, display, perform, and to create derivative works based on that original work. With some exceptions, copyright rights generally go to the original creator of the work. Therefore, NFT project builders should be careful not to produce a token using a copy of a work created by someone else. A project builder attempting to use another’s original work needs to obtain either a license or authorization from the original creator of that work (or whoever is the copyright holder) to create that NFT. Otherwise, the project builder may get sued for copyright infringement. Buyers of digital tokens need to keep in mind that they are not buying copyright rights along with their NFTs, rather, they are buying a unique digital license to a media file. Buyers can get a better understanding of what exactly they are receiving when they purchase an NFT through the website’s Terms and Conditions. Terms and Conditions will control what kind of license is being granted when the NFT is minted. (Minting is the initial unique publishing of your token on the blockchain to make it purchasable.) Terms and Conditions are the legally binding agreement between the buyer and NFT project which outline the details, rules, responsibilities, and rights of each party. NFT Terms and Conditions are an imperative tool for creators to protect themselves and for buyers to understand their purchase.

If Copyright protects the assets we create, then Trademark can be understood to protect brands, slogans, and logos. A trademark is any “word, name, symbol, or device, or any combination thereof” used to identify a particular manufacturer or seller’s products and distinguish them from the products of another.[2] In Trademark law, the rule of thumb is the person who was first wins. Generally speaking, if a token project builder uses a name for their token that is similar to: another token project name; something in the tech market; something blockchain market; or something that is in a different market but is significantly like the project name, such that its likely to cause “consumer confusion” as to source and origin, then whoever uses it first wins. This means that the pre-existing mark owner has certain rights over subsequent mark users; however, trademark law is highly nuanced and as we are seeing these issues play out in real-time in cases like Yuga labs v. Ryder Ripps, there are exemptions to trademark infringement such as parody. Given the complexities of Trademark law, it is important to seek formal legal advice on these topics because such processes are rigorous, sophisticated, and the repercussions of making an error could be catastrophic to a project builder’s success.

NFT project builders must carefully navigate the vast array of applicable regulations that apply to NFTs. These projects are subject to securities law in how they function as a digital asset, contract law in how the Terms and Conditions apply, and IP laws in how the creator asset and branding is handled. Though the task may seem daunting, applying the Howey prongs, ensuring a low score on the CRC scorecard, drafting thoughtful clauses for the Terms and Conditions, obtaining proper copyright authorization, and immunizing your project from trademark infringement claims are crucial for a successful NFT project.

[2] See 15 U.S.C. § 1127, generally

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What is BlockFi? And what happened?

BlockFi is a crypto finance institution headquartered in New Jersey that allows its users to trade, hold, and borrow cryptocurrency through an array of their products. In March 2019, the company launched BlockFi Yield, which allowed users to lend their deposited cryptocurrency and, in exchange, receive interest paid monthly.  Some of these BlockFi Interest Accounts (“BIA”) offered an 9.5% annual yield, which dwarfs the average bank savings account rate of 0.06%. BlockFi would then pool investors’ crypto holdings together, and lend it to institutional borrowers. These borrowers would then pay interest to BlockFi, who would take a cut and redistribute the interest to the BIA holders. BlockFi would typically adjust the BIA rates monthly in correlation with how much yield the company received from lending to institutional borrowers.

The product was a hit. By March 2021, BlockFi held about $14.7 billion in BIA investor assets from over 500,000 investors. Since roughly November 2021, the SEC and 32 State Regulatory agencies have been investigating BlockFi for the offering and sale of these BIA accounts. The SEC settled with BlockFi, claiming that the company violated Section 5 and Section 17 of the Securities Act as well as Section 3 of the Investment Company Act. Ultimately, BlockFi agreed to pay a $100 million fine; $50 million will be paid to the SEC, and $50 million will be split between the 32 States who joined this action.

Going Forward for BlockFi

BlockFi must immediately stop offering new BIAs to the public but may continue to service existing ones. However, existing BIA holders cannot deposit more funds into these accounts. Additionally, BlockFi has 60 days (from 2/14/22) to comply with Section 7(a) of the Investment Company Act either through registration via Section 8(a) or by satisfying the Market Intermediary exception. The SEC may also grant a 30-day exception. After that, the SEC stated that BlockFi must file a Form S-1 registration and effectively become a publicly traded company. Additionally, the company intends to file a Form T-1 under the Trust Indenture Act (which describes the entity’s eligibility to act as a trustee under an indenture—a written agreement—with an issuer of debt securities, like bonds).

How did BlockFi Work? And How Will it be Structured?

Old Structure

New Structure

Let’s look at how the SEC applied some of the key securities law precedent to the company’s offering and sale of BlockFi Interest Accounts.

The SEC’s Howey Analysis of BIAs

The landmark case of SEC v. Howey is the primary tool used to determine whether certain transactions qualify as an “investment contract” under the Securities Act. If the transaction meets the 4 factors, it is considered a security and subject to regulation by the SEC. What are the 4 factors and how did the SEC apply them to BlockFi? A transaction is an investment contract if: (1) there is an investment of money; (2) an expectation of profits; (3) within a common enterprise; (4) where profit derives from the efforts of others;

The SEC stated that BlockFi’s BIAs constituted an “investment contract” under Howey because:

• [Investment of Money] BlockFi sold BIAs in exchange for the investment of money in the form of crypto assets.
• [Common Enterprise] Each investor’s fortune was tied to the fortunes of the other investors because BIA investor’s returns were a function of the pooling and deployment of the loaned crypt BlockFi deployed those loaned assets. Additionally, BlockFi’s fortune was linked to the investors because the company earned revenue for itself through its deployment of the loaned assets.
• [Expectation of Profits] BlockFi created an expectation that investors would receive profits from the company’s efforts through managing the crypto assets.
• [Efforts of Others] The company had complete control and ownership over the borrowed crypto assets, indicating that profit was derived from their efforts.

SEC’s Application of Reves

The Reves test is an additional test used to determine whether a note should be considered a security. In Reves v. Ernst & Young, the Supreme Court held that a note should be presumed a security unless it bears resemblance to examples of non-security notes. If there is no family resemblance, the court may also consider 4 factors; (1) the motivation of seller and buyer; (2) the plan of distribution of the instrument; (3) the reasonable expectations of the investing public; (4) the presence of an alternative regulatory regime. Here’s what the SEC said on the 4 factors:

• BlockFi offered and sold BIAs to obtain crypto assets for the general use of its business, namely, to run its lending and investment activities to pay interest to BIA investors, and purchasers bought BIAs to receive interest ranging from 0.1% to 9.5% on the loaned crypto assets.
• BIAs were offered and sold to a broad segment of the general public.
• BlockFi promoted BIAs as an investment, specifically as a way to earn a consistent return on crypto assets and for investors to “build their wealth.”
• No alternative regulatory scheme or other risk-reducing factors exist with respect to BIAs.

Implications on the Industry

Impact of Alleged Material Misrepresentations (outdated information on your website)

BlockFi’s website claimed that their loans were “typically” “over-collateralized”. In reality, less than 24% of their loan portfolio was over-collateralized throughout the past 3 years. The SEC further alleged that through “operational oversight, BlockFi’s personnel failed to take steps to update the website statement to accurately reflect” these facts. As such, the SEC alleged that BlockFi violated Section 17(a)(2)(misstatement and omission liability claim) and 17(a)(3) (so-called “scheme” liability). While there is not private right of action for Section 17(a) violations as has been implied under Section 10(b) and Rule 10b-5(b), liability can reach a broader range of activity because no specific intent is required.

This enforcement action underscores the need for ongoing diligence to ensure the accuracy of information presented and representations made about a crypto or DeFi project through promotional materials, social media posts, and on websites as proof of scienter is not required to trigger potential liability. Misrepresentation regarding the overall status of collateralization is tough to defend. It’s important to note that the standard for review for this violation is negligence. However, there is a silver lining (perhaps). If information asymmetry is the problem, then perhaps DeFi is the solution. Regardless, websites should make sure that any information regarding material information is accurate.

Investment Company Act Concerns and Dissent within the SEC

The SEC also found that BlockFi violated Section 7 of the Investment Company Act. More specifically, Section 7(A) of the Investment Company Act holds that it is unlawful for an unregistered investment company to offer or sell any security via interstate commerce. HOWEVER, there is a catch (here comes the silver lining). The Investment Company Act specifically excludes any company that is primarily a “market intermediary” as defined in Section 3(c)(2) of the act.  A market intermediary is any company that enters into transactions on both sides of the market. For example, a business that is primarily engaged in underwriting and distributing securities issued by others, acting as a broker, would likely fit this classification. By meeting this definition, lending platforms can avoid regulation under the ICA because they will not be considered an “Investment Company”. Ultimately, the SEC held that BlockFi has not been a “market intermediary”, but has the ability to become one.

SEC Commissioner, Hester Peirce, offered her dissent to this settlement decision and expressed her pause regarding the use of the market intermediary exception. For reference, there are 5 commissioners in the SEC. At the helm is the Chair – Gary Gensler. Commissioner Peirce expressed that the SEC was not always fair with good-faith actors like BlockFi.  She also offered great insight into the practical implications of this settlement. Peirce explained that BlockFi is possibly in a Catch-22 because the company may not be able to register as an investment company via Section 8(a) of the Investment Company Act since they issue debt securities. The dissenting commissioner further warned that this market intermediary exemption is rarely used and may be problematic when applied to crypto companies.

Additionally, Commissioner Peirce was very skeptical of the timeframe given to BlockFi. She explained that expecting BlockFi to provide sufficient evidence that the company falls within an exception within 60 (plus 30) days is “extremely ambitious”. Alternatively, she offered, that the Commission could create a more tailored regulatory framework for BlockFi (and presumably other BIA companies) under Section 6(c) of the Investment Company Act. While her dissent merely outlines her frustrations, it could be indication that further regulatory clarity is on its way. And since Biden’s executive order on March 9^th, the industry has its fingers crossed.

Applicability of BlockFi Settlement for DeFi Arrangements

            Although BlockFi markets itself as one, the company may not be the paradigm for DeFi Lending platforms. The BIA loans were received, pooled, and reinvested by BlockFi. Then the interest payments were collected and redistributed by BlockFi. This does not seem that decentralized. Therefore it is difficult to ascribe the direct ramifications on all DeFi platforms considering their difference in structure. This was not the first time that the SEC brought an enforcement action against a D.I.N.O. (DeFi In Name Only) Company.

In 2008, the SEC went after Prosper Marketplace, a Pier-to-Pier lending platform where the company connected lenders and borrowers, prohibiting them from disclosing their actual identities and connecting with each other directly. In the enforcement action, the SEC described how “Lenders rely on the efforts of Prosper because Prosper’s efforts are instrumental to realizing a return on the lenders’ investments.”  Alternatively, sufficiently decentralized platforms, where the company does not control loan terms, how loans are transacted, or how the loans are paid off, may be able to avoid a similar fate to BlockFi and Prosper.

More recently, in the SEC’s 2019 Framework for “Investment Contract” Analysis of Digital Assets statement, the agency stressed the importance of the Expectation of Profits and Efforts of Others prongs of Howey. However, this statement came at a time when the majority of the crypto space were Layer 1 token projects. It’s also important to note that it may be difficult to apply the Commonality test of Howey to DeFi platforms. Why? Because the decentralized nature of DeFi breaks the commonality between lenders, borrowers, and the platform. Additionally, it may be challenging to apply the Reves test to DeFi platforms. It is possible that DeFi could skirt away from the Reves test as a whole by making the argument that these loans are not notes. Typically, a note is a two-party negotiable instrument. With DeFi, the decentralized nature differs from the traditional bilateral structure since lenders and borrowers would be interacting directly with the protocol. Additionally, it is possible that companies only offer the interest accounts for 9 months per user in order to fall outside the statutory coverage.

SEC’s Recommended Pathway Going Forward

Although the SEC has claimed a crypto company was in violation of the Investment Company Act before, this is the first time the agency made allegations against a current crypto interest rate account company. The SEC’s recommended pathway for BlockFi and other crypto interest account offerors via Section 8(a) or an exception to the Investment Company Act is certainly novel. Previously, the SEC instructed the companies to file as a security under Section 12(g) of the 1934 Act and make timely reports as per Section 13(a) of the 1934 Act. Ultimately, however, BlockFi would have to file a Form S-1 and start the process of becoming a publicly-traded company.

Obviously, becoming a publicly-traded company is a massive undertaking… but what if you already are one? There is a question of whether this reopens the door for Coinbase Earn, Coinbase’s failed interest account platform. Remember, in order to become a market intermediary, BlockFi must borrow crypto from institutional lenders and/or high net-worth individuals. What could this mean for a company like Grayscale Trust, could they offer an additional product? Could we see players like SoFi make an Interest Account? Could we see cooperation among lending/borrowing companies to create more working capital in the space? Also, considering how costly it is for a company to go public, could we see crypto SPACs? Hopefully, regulatory clarity is on its way, DeFi companies can continue to offer competitive products, and the SEC can properly protect consumers.

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A November 27, 2018 order in the case of ICO-gone-wrong SEC v. BlockVest, LLC (SoCal U.S. District Court), caused quite a buzz, for the ostensible holding that it (tentatively, of course, as this was not a final order) deemed the “airdrop” method of token distribution (i.e., free giveaways) permissible in the U.S.  The order denied an asset freeze that had been requested by the SEC as part of a preliminary injunction.

Undoubtedly, the SEC not being granted the asset freeze was a little bit of fresh air for the beleaguered blockchain fundraising space.  But I have now had a chance to review the BlockVest order of 11/27, and I have to say, there seems to be almost no basis to read into the decision that it is an “approval of airdrops,” or anything even remotely similar.

Indeed, I find it hard to glean from the order anything other than a recognition that substantive, evidence-based objections were raised to the SEC’s allegations of reliance on BlockVest representations by the buyers/token recipients, and against the offer as a de facto security, and consequently, the court was merely denying the SEC the privilege of having its allegations carry for the purposes of a preliminary injunction (which is a very high standard).

In other words, for an injunction which includes an asset freeze, and thus impinges upon the accused’s ability to hire counsel to defend itself, the SEC isn’t entitled to have its view of the facts, and associated legal conclusions, mechanically adopted by the court.

Unfortunately,  it is likely that the presumptions on the same questions will swing the other way for overall case disposition on the merits (assuming no new facts are unearthed), as courts will give a wide berth to a regulatory organization within its own subject domain.  So don’t get out the champagne just yet.

Further, I don’t even see much basis for the construction of the actions underlying the case as “airdrops,” or really, very comparable to them at all.  Many of the alleged investors actually did pay something to BlockVest, and indeed wrote checks (with annotations indicating that these funds were for token purchases); others deposited funds (in the form of major cryptocurrencies) on the platform in exchange for “test tokens.” So not only was monetary consideration provided by many buyers (unlike in actual airdrops), but the tokens weren’t even “live” tokens intended for eventual general public circulation — clouding the basis for the “airdrop” interpretation on two additional counts (and take heed: a future, inchoate issuance of securities can be the basis for application of securities regulation; [1]).

There are other facts that undermine the “airdrops permissible” interpretation of this decision, such as BlockVest’s claim that it knew all the token recipients personally and invited them directly to test the platform (hardly a “general distribution” of tokens, for sure).

Perhaps this order is another brick in the wall in the trend against asset forfeiture, but at the end of the day, it may reflect little more than standard jurisprudence of a court that, refreshingly, didn’t allow itself to get caught up in anti-ICO hysteria.

Footnotes.

[1] Under § 2(4) of the Securities Act (15 USC § 77b(4)) (which refers to “one who proposes to issue any security”), a person is an “issuer” when such person promotes the sale of shares in to-be-created ventures. E.g.  publishers of “Mining Truth” were “issuers” of securities, where magazine included a paper to be signed by interested parties, labeled “indication of possible acceptance,” indicating that the signer may accept shares of stock in the proposed corporation;  SEC v Starmont (1939, DC Wash) 31 F Supp 264.

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It seems to me that neither event — let alone comparative lessons of the two — has been fully appreciated by the crypto community.   Thus, in this post, I wanted to highlight some main points of interest in each, and possible lessons in comparing and contrasting the two cases.

I. OVERVIEW OF “REG A+” AND BLOCKSTACK’S OFFERING

Blockstack was (in the US) a Regulation A (so-called “Reg A+”, since being expanded with the 2012  JOBS Act reforms) offering in the US which was qualified (“approved”) by the SEC on July 10, 2019 (see the offering circular here; filing index here).  Reg A+ allows for up to $50 million to be raised by an issuer per 12 months, not limited to accredited investors, in exchange for following somewhat scaled-back public company-like disclosures (thus, it is often called a “mini-IPO”).

In fact, a Reg A+ offering is, for most purposes, considered “registered” by the SEC (which will become key later in this post).  This is in contrast to offering exemptions, like the popular “private offering” (accredited investor-only) through Regulation D – Rule 506(c) offering.   Such exempt offerings are expressly not “registered”, and therefore, every subsequent transaction (i.e., resale) of the issued securities are presumed unlawful in the US, lacking any further exemption (or, simply, a registration, as in an IPO or Reg A+ filing).

This “all subsequent transactions presumed illegal” status is of course a heavy cross to bear, and many, many blockchain token issuers over the past few years (actual, and would-be; ICO and otherwise) have expended considerable resources (and incurred considerable brain damage) attempting to deal with this situation, and square it with their structure and plans (our clients, of course, have at least had some of their pain mitigated, and many have — in spite of the lack of bespoke regulations — had successful token raises).

Critically, this consideration has been front-and-center even for ostensible “utility token”-selling projects, because (1) “pre-sales” of utility tokens, or rights to them, prior to developing the promised network utility, are statutory sales of securities in the US under the Howey “investment contract” doctrine, and (2) even when network utility is created, it is almost never 100% clear if “sufficient utility” — not only in an absolute sense, but also relative to subjective purchaser (and SEC) expectations — has been established to mitigate any possibility of being deemed a security.

Add on top of that the fluid nature of blockchains and their coins/tokens globally, and the result is that a heck of a lot more ventures are worrying about US securities law than either their globally-facing posture or the nature of their blockchain tokens and networks might suggest.

Thus, a major blockchain token issuer that could “safely” permit general public token purchases and sales in the US (including resales) while still offering what is effectively a “utility token” would be a major breakthrough.

Enter Blockstack.   They were the first Reg A+ blockchain token offering of any kind to get approved by the SEC, and, quite fascinatingly, this was for a de facto utility token — not a security token, as nearly all observers had expected for the first approved Reg A+ project.  A security token would have been the “safe bet”.  But Blockstack (by all appearances) apparently really believed in the underlying model they had originally-envisioned, centered around the utility of their “Stacks” token, and its free-flowing role as critical to their network and constituent ecosystem — so they pushed to maintain their offering notwithstanding the token not really resembling a classical “security” on its fundamentals.

Now, I say “de facto” utility token because, what a Reg A+ offering (as with any securities exemption or registration) is expressly for is a security instrument.   Thus, technically, what Blockstack has done is file as a provisional security (in a “mini-IPO”), while fully-disclosing their plans to foster an evolution of the token to a pure “utility status” — at some indeterminate point in the future (implicitly, to the satisfaction of the SEC).  Their pathway to do doing such is moving the network to a “sufficiently decentralized” status.   (As far as a specific threshold condition, we don’t really know what “sufficiently decentralized” means in the SEC’s eyes in any precision yet — but Blockstack could very well be the first case wherein we find out.  On a related note, we’ve also argued here that being “sufficiently decentralized” shouldn’t be the only way for a blockchain token to become a non-security).

This indeterminate timing of the expected utility token status plus provisional treatment of the token as a security in the US is likely pretty important to the SEC’s approval of the offering.  Basically, Blockstack didn’t design their offering like a “ticking time bomb” — i.e., one which is (presumptively) a security now, but will “explode” at some specific point in the future (that is, explicitly circulate contrary to securities regulations) —  leaving the lawful securities trade status of potentially millions of (US) transactions in question.

When (and if) the Stacks token is ever deemed a non-security in the US, there will have already been a legal general public trading market for it in the US — as that is precisely what Reg A+ establishes.    In my read, this is the central concern of the SEC, much less so than whether the securities trading market infrastructure and associated panoply of compliance becomes redundant at some point in the future (because the token “is suddenly a utility token”).

Don’t get me wrong; it’s not as if Blockstack took a “no-brainer” option in undertaking a blockchain token offering this way — by their own recounting, they spent $5 million in legal and professional fees on getting this offering through (plus a 9-month review timeline — which likely doesn’t account for pre-filing lead-time during which internal discussions, legal and accounting advisory consultations, and informal interactions with the SEC were surely taking place).  (For comparison, $1-2 million for a traditional IPO is typical, so this was not “cheap” by virtually any standard).

But it was still a watershed accomplishment, and it will likely dramatically lower the cost for subsequent  Reg A+ blockchain token offerings (and simpler, plain-vanilla security token offerings, or STOs, will likely be even cheaper than offerings hewing closer to the Blockstack “model”).

Also, the offering did raise $23 million under Reg A+ (i.e., in the US), so it did “pay for itself”, and thus, was “rewarded” in the marketplace.  (Further, Crunchbase reports Blockstack raised a total of $93.8 million in 10 rounds, at least some of which was likely from Regulation S “offshore” sales, and so would not be counted along with the Reg A+ raised amount).

II. OVERVIEW OF TELEGRAM’S OFFERING AND SEC ENFORCEMENT

Telegram, the popular messaging app, went another direction with their blockchain token offering.  They did go to market well after the SEC’s July 2017 “DAO Report” (essentially warning the ICO sector that it was presumed-regulated, and that enforcement was coming).  And like many projects, Telegram responded by going the  path of performing their “pre-sale” of tokens (that is, their sale of presumptive utility tokens — but before the network and companion utility was developed) within the US in a manner meant to mollify the SEC, by (1) limiting the sales to accredited investors, (2) filing a Form D declaration pursuant to Regulation D Rule 506(c), and (3) requiring US purchasers (and to some extent, offshore purchasers) to agree to contractual resale restrictions and lock-ups for an initial period.

After this initial phase — specifically, upon a hard deadline of October 31, 2019 (if not postponed under certain conditions), Telegram was to deliver its “grams” tokens to all pre-sale investors and the general public, worldwide.

(A general note: Telegram — thanks to Regulation S of the Securities Act — was not generally restricted in pre-selling such token interests to non-US persons — and itself enjoys somewhat-limited SEC jurisdictional reach, given its status as a non-US company.  But in many ways, it clearly entered into US SEC jurisdiction.  I’ll touch on jurisdictional considerations again below).

By hopes, and at first-blush appearances, this plan was expected to insulate Telegram from charges of violating securities laws in the US with its pre-sale agreements — in particular, with respect to US purchasers of the SAFT interests (all of whom were limited to being accredited).  But as you probably can guess if you’re aware of the SEC’s lawsuit and injunction against Telegram of DATE, things did not go quite as planned.

The SEC took extraordinary action against Telegram with its suit filed on October 11, 2019 (complaint here ; cited as “Complaint” hereunder), seeking a TRO to completely enjoin (halt) Telegram’s distribution of Grams tokens worldwide until the merits of the offering were adjudicated.

(As a point of procedural detail, the court technically never granted the SEC’s requested TRO; on October 21 , Telegram and the SEC agreed to a stipulation and consent order that Telegram would voluntarily not “not offer, sell, deliver, or distribute ‘Grams’ to any person or entity” until the conclusion of a Feb. 18 & 19 2020 court hearing in the case.  I think it’s safe to assume that the SEC would have obtained the TRO even if it relied upon the unilateral power of the court — but perhaps not in time for the October 31st planned Grams distribution date.  Telegram’s SAFT purchasers also agreed to voluntarily postpone the distribution of Grams until after this hearing — sidestepping both questions of whom, if anyone, could still receive Grams, as well as whether the postponement could be unilaterally invoked by Telegram.)

(Please note that in all of the below, I am relying upon the SEC’s complaint for a recounting of the facts; which may not precisely hold.  Telegram has not yet filed a full answer which might dispute some material facts.  However, if even most of the facts are accurate, I believe the analysis and comments below are still on-point).

The SEC’s suit, at its core, is based upon two key concerns, which (in my own terms) boil down to:

1. the Grams token has virtually no way to be a full “utility token” by the October 31, 2019 delivery deadline, relative to how Grams was promoted and the offering was conducted (and probably also in any absolute sense; i.e., of meeting some basic threshold of utility); and
2. Telegram promoted and positioned the offering in such a way as to encourage — if not effectively guarantee — that many purchasers would act as mere “underwriters” for the initial offering; i.e., quickly “flipping” the tokens for a transnational profit, rather than as an investment in the inherent value of the token.

Addressing the first, and (I’d say) threshold concern: Telegram seems to have badly fumbled in making a strong “utility token” case, in both their communications and actual steps taken.  This left them “wide open” to the SEC’s charges.  See, e.g.,:

• “Grams are not a currency because they have no realistic currency uses at this time” (Complaint, p. 14);
• “Telegram sold and will deliver Grams in amounts that far exceed any anticipated ‘use’ on the TON Blockchain. For example, all but three of the United States Grams Initial Purchasers bought more than 2.5 million Grams each. Nor did or will Telegram restrict sales only to individuals who would actually “use” Grams (Complaint, p. 14);
• “The Whitepaper .. contained a detailed list of projects and steps that Telegram and its principals would take to make TON a reality. This included describing at length Telegram’s plans for the TON Blockchain … [it] also described a long list of services that Telegram would develop to improve the functionality of Messenger and of the TON Blockchain after its launch, but that … Telegram had no reasonable prospect for completion in advance of the delivery of Grams.” (emphasis mine; Complaint, p. 18);
• “The Whitepaper spoke of potential future products and services that investors could use in connection with Grams, but also made clear that these products were not available at the time the Offering began and would not be available by the time Defendants delivered Grams to Initial Purchasers.” (emphasis mine; Complaint, p. 24);
• “Like other Offering Documents, the Primers made clear that that Telegram’s work would continue for some years after delivery of Grams on the new TON Blockchain and would remain critical for the foreseeable future. Both documents, for example, included a timeline specifying that the ‘[l]aunch of TON Services, TON Storage, and TON Proxy’ would occur in the year after the ‘[l]aunch of Telegram Wallet.’ The 2017 Primer explained that Telegram’s vision will not be ‘implemented and deployed’ until ‘2021,‘ and that even then ‘the continuous evolution of the TON Blockchain will be maintained by the TON Foundation.’” (emphasis mine, Complaint, p. 19; see also p. 24);

As we always reiterate around here, if you do one thing in pitching a utility token offering, don’t state that you won’t get the utility done by the time you distribute the tokens (at least, if its to, or within reach of US purchasers).

Also fairly damning, the SEC observed that far more money was raised than even Telegram itself claimed it needed to develop the blockchain per se, and indeed, Telegram was completely open about the fact that a very large portion of the money would go to other purposes, e.g.:

• that Telegram would spend a large chunk of the raise on the core (non-blockchain) Messenger app which already exists: “… the $1.7 billion raised in the Offering so far exceeds what Defendants project they will need to develop the TON Blockchain… Defendants stated in offering documents … that Telegram would spend $520 million—or one-third of the funds raised—on Messenger alone between 2019 and 2021.” (Complaint, p. 14);
• “The 2017 Primer described Telegram’s need for ‘about $620 million to support continuing organic user growth’ for Messenger … ” (Complaint, p. 16);
• “The 2018 Primer similarly explained that Telegram intends ‘to use the proceeds raised from the offering for the development of the TON Blockchain, for the continued development and maintenance of Telegram Messenger, and for general corporate purposes.’” (Complaint, pp. 16-17)

This represents a significant tactical error, as funds not going to bringing about the initial core “utility” of the constructed blockchain network and token must inherently be a part of some long-term, generalized investment.

(For what it’s worth, I do not place great weight on many of the other “common enterprise” — as well as reliance upon “managerial and entrepreneurial efforts” — points made by the SEC; just because a venture is clearly a common enterprise per se managed by an inside team, it doesn’t mean that a token-purchaser is not purchasing for the sheer utility of that instrument.  This, and related points, are discussed further in this post. But the damage is clearly done with the above complaint points, most based upon express admissions of Telegram itself.)

Even assuming Telegram hadn’t made any of the missteps discussed above, it would still have a problem with respect to delivering grams tokens in an unrestricted, global public offering.  This would be based upon the reality that even if they assert the token was at the time of public delivery a utility token, any doubt as to such (especially in the mind of the SEC) would mean they are potentially unlawfully issuing a security publicly.  And if such is done globally, that means the US general public could be included (and, giving the regulators the benefit of the doubt, therein harmed).

As the SEC put it : “Defendants have committed to flood the U.S. capital markets with billions of Grams by October 31, 2019 … without filing a registration statement for the Grams as they are required to do under the Securities Act of 1933… [selling] billions of securities that will quickly come to rest in the hands of U.S. investors” (Complaint, pp. 1-2).

This is where it becomes apparent that having an exempt US offering of securities, i.e., which is a one-time, non-public event — and/or ostensibly restricted to non-US purchasers — falls short of what is needed to properly enable  US general public transactions (including resales).

III. COMPARATIVE DISCUSSION

Rule 144 under the Securities Act sets forth the holding period of “restricted securities” (most commonly, 1 year), and conditions for their permitted resales.   Rule 144 dovetails with the all-important Section 5 general prohibition on unregulated securities sales, combined with Section 4‘s carve-out of “transactions by any person other than an issuer, underwriter, or dealer,” to create an avenue for allowable resales for un-registered, “private” issuance securities,  as would presumptively be the case for the SAFTs sold by Telegram (and also, potentially, for the subsequently-distributed Grams tokens).

Further, after the 1 year restricted period, one would think these rules imply that restricted securities could trade freely in a “secondary market” (i.e., one consisting of resales, and resales of those resales, etc.)  — and, ignoring for a moment individual US state/territorial securities laws, they can — in principle.

The biggest catch, however (which was roundly invoked in the enforcement against Telegram), is the “underwriter or dealer” part.  If, in actuality, some of the private accredited purchasers (or the offshore purchasers) intend to re-sell their interests in grams to general-public US individuals, they are clearly falling outside the exemptions set up by Rule 144 and Section 4.   Worse, because there is no benefit of the doubt (and no safe harbor) as to not being an underwriter, the burden of proof is on the issuer as to whether every single sale instance is not to a de facto underwriter.  That means (1) it requires litigation (or exhaustive administrative back-and-forth) to prove this to the SEC, and (2) the only practical way to do so is to have procedural protections in place that make it impossible, or at least, vanishingly unlikely, for any purchaser to act as an “underwriter”.

This is where the SEC’s invocation of Telegram’s manner of sale is so devastating in its operation against them, especially that:

• The lock-ups didn’t run the entire 1 year in any instance (“Round One purchasers agreed that they could not, without Telegram’s prior written consent, offer, sell, or contract to sell Grams that they purchased except in a series of 25% tranches starting three months, six months, twelve months, and eighteen months after they received Grams. Round Two Gram Purchase Agreements included no such restrictions”; Complaint, p. 14);
• “Telegram also led the Initial Purchasers to expect profits by selling Grams to them at deep discounts from the price Telegram told them to expect on the day of launch, thereby encouraging those purchasers to immediately distribute Grams to the public… Under Telegram’s Formula, Defendants would price the first Gram at $0.10, and every subsequent Gram at an amount one-billionth higher than the prior sales price. As such, Telegram designed the price of Grams to increase ‘exponential[ly].’ Indeed, Telegram sold Grams to Initial Purchasers at a deep discount to an expected market price of $3.62 at launch.” (Complaint, p. 21);
• On at least one instance of pitching to a prospective purchaser in early 2018, “Telegram spoke of the ‘chance for 0x-50x’ returns on the investments,” a prospect which was explicitly cited by the investor in agreeing to purchase $27.5 million worth of Grams “that had no use and would have no use at the time of launch, demonstrating its intent to profit from the potential increase in value of Grams.” (Complaint, p. 23);
• “Telegram touted a readily available trading market for Grams, including one leveraging its hundreds of millions of Messenger users; sold Grams to Initial Purchasers at deeply discounted prices from its own projected secondary market price at launch; and promoted the future transferability of Grams into a liquid market”  and”[Telegram] told investors to expect a listing of Grams ‘at the major cryptocurrency exchanges’ in ‘January – March 2019,’ immediately after the ‘December 2018 [p]rojected date for [Grams] to be issued to all investors,’ making Grams almost immediately sellable in open markets, including to United States investors…” (Complaint, pp. 19-20);
• Many sales to offshore individuals lacked any meaningful tracking of the buyer’s identity, let alone their positioning with respect to the purchase; and grams trading activity was to be allowed — and indeed, promoted as being available on — offshore on run-of-the-mill cryptocurrency exchanges, complete with inadequate KYC of buyers (including, in some cases, not even blocking US individuals!) (see Complaint, p. 3, see also p. 28).

Even worse, the SEC argues (based in part upon the points above) that Telegram affirmatively launched the issuance as an underwriter issuance — in which case, purchasers subjectively not seeing themselves as underwriters is no defense!  (I think, when the SEC cites Telegram’s secondary market listings and touts of such (as well as its hyping of resales), it is at its strongest in making this argument.  But when it claims (as it does on page 26) that the Grams token cannot even become decentralized without underwriter-like resales, I think its case is on the weakest footing.  Similarly, I am also skeptical when it argues that lock-ups are actually evidence of users’ desires to resell, as it does on page 14 — this seems a bit like “having it both ways”).

(And, for what it’s worth, I do not believe the SEC’s repeated complaints of Telegram’s having 170 million users at the outset — and even criticisms of Telegram observing such explicitly as driving “value” or “demand” — are particularly strong.   One could just as easily argue that having such an established user base, scale, and experience of practice imply that the issuer is a mature business, and hence, token purchasers won’t need securities protections.  Compare to how a contract for a new cloud service by Google or its peers is not treated like a security, even if the service is novel.  Nevertheless, there were plenty of other defects, as discussed above).

In theory, all of the above issues would be nullified by the gram’s being, without a shadow of a doubt, a non-security, as of the planned release date of October 23, 2019.  But with any doubt as to its being a pure “utility token”, the above issues compounded the damage for Telegram, and in effect, handed the SEC justification to call for a worldwide halt to the grams distribution — even though the SEC can generally only enforce with respect to securities activity within the US!

These defects render in stark relief the securities compliance pathway taken by Blockstack.  With a Reg A+ filing, Blockstack nullified the temporal question of Stacks’ security status, while simultaneously “sterilizing” the US market with respect to all secondary market resales (whether originating within the US, or offshore — i.e., from run-of-the-mill cryptocurrency exchanges listing Stacks).

Having done a Reg A+ filing, secondary market resales of Stacks are simply allowed;  explicitly, what is issued in the original sale are not considered “restricted securities”.  As a result, the SEC (in my read) essentially doesn’t care whether the Stacks tokens trade on crypto exchanges overseas, because that is clearly not a public market in the US — and if US residents happen to be able to access these exchanges, that is no different than the same persons acquiring the tokens on the secondary market within the US (which, again, is allowed, under Reg A+).

The “catch” is that any organized, formal market-based trading of Stacks taking place in the US will have to be on a regulated securities exchange (at least, until such time as the SEC gives clear guidance that the Stacks token is no longer a security).   No such exchange exists and carries Stacks as of this writing, so only informal trading is allowed in the US in the meantime.  (A related, apparently-prophylactic practice I’m aware of, is that while Blockstack is indeed engaging professional crypto market-makers overseas, they are contractually-agreeing to terminate such relationships the moment a regulated securities exchange becomes available for Stacks tokens in the US.  My guess is that this eliminates potential claims that the issuer is unlawfully “conditioning the market” for the subject security in the US).

IV. CONCLUSION

All in all, for the amounts of money we are looking at being at stake in these two offerings, Reg A+ seems to be an overwhelmingly attractive pathway to address the Securities Act as applied by the SEC to the issuance of a pre-network, but prospective utility blockchain token.  While one can argue that the non-US company Telegram “shouldn’t have to care” about some obscure, untested (again, as applied) US regulatory election to their planned global blockchain token offering, the economics of the situation argues otherwise (particularly after initial funds were raised from US accredited and offshore investors to the tune of tens of millions of dollars).

Indeed, perhaps now that Blockstack has “blazed the way”, the SEC will work out a deal with Telegram that involves wrapping the (now-paused) Grams issuance in a Reg A+ offering (likely plus a fine).

Reg A+ as an affirmative “ICO” pathway aside, the cases of Telegram and Blockstack certainly have made vastly more apparent some important areas of SEC concern having to do with the “market-conditioning” aspects of global blockchain token offerings, as discussed above.

(* Article images courtesy of Wikimedia Commons; CC-by-SA 4.0.  Links here and here).

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