Better to be blessed first? Call for a measured approach with US regulators

As recent SEC enforcement actions make clear, years after the ICO boom, US regulators continue to pay close attention to ICOs and digital assets. Those in the blockchain and digital asset space should use caution and take heed of the many legal and regulatory obligations that may apply to their activities.

In recent months, the US Securities and Exchange Commission appears to be demonstrating an increased appetite to initiate enforcement proceedings and related actions against unregistered initial coin offerings – in one instance, halting a $1.7 billion ICO and, in another, levying against and ICO issuer a penalty equal to twice the amount of the funds raised in the offering.

Although, in mid-2017, with its 21A Report of Investigation concerning the DAO, the SEC first addressed squarely the issue that digital asset sales could constitute sales of investment contracts and, therefore, securities, the SEC’s more recent actions have addressed some of the world’s most successful ICOs and most prominent issuers. 

In our view, the SEC’s continued vigilance regarding ICOs underscores the importance for market participants contemplating a digital asset sale to cooperate with regulators and heed their warnings.  No matter the significance of a token issuer, the size of its contemplated ICO, or the jurisdiction in which the founders reside, companies must proceed cautiously and seek legal counsel to avoid violating US federal securities laws.

The Telegram offering

Restraining order

On October 11, 2019 the SEC obtained a temporary restraining order to block the Telegram Group Inc. and its wholly-owned subsidiary TON Issuer Inc. from distributing its digital tokens, “Grams”, to investors. Telegram intended to distribute approximately 2.9 billion Grams on October 31, 2019, at which time the tokens could have been sold into US markets, so the SEC moved to prevent this distribution from taking place. 

“The most hyped ICO”

Telegram is the operator of a popular mobile messenger application and had been conducting what has been called “the most hyped ICO in the history of ICOs.”  The alleged unregistered ICO of the company’s “Gram” token had already raised approximately US$1.7 billion globally and US$424.5 million from US investors to finance Telegram's business and the development of its new blockchain platform, TON Blockchain. 

The SEC complaint

The SEC complaint alleges Telegram failed to register offers and sales of Grams (which are viewed by the SEC as securities) in violation of the registration provisions of the Securities Act of 1933 (the “Securities Act”). 

In the SEC's opinion, Telegram failed to provide investors with sufficient information regarding Grams and Telegram's business operations, financial condition, risk factors and management, all of which are required by securities regulation in the US. 

Securities regulation exemption did not apply

Although Telegram has stated that it believed Grams were exempt from registration, as Grams were initially available only to a limited pool of accredited investors, the SEC determined this exemption did not apply as the initial investors were entitled to onward sell the Grams in the secondary coin trading market. 

Telegram countered that the Gram itself should not to be viewed as a "security" under the Securities Act, but rather as a "currency or commodity". However, the SEC determined that Grams are not a currency because they cannot be used to purchase any goods or services. 

SEC sanctions

The SEC has sought a temporary restraining order, a preliminary injunction, disgorgement with prejudgment interest, and civil penalties against Telegram. Hearings on the case have been scheduled for February 18 – 19, 2020. In the meantime, Telegram has agreed not to offer, sell or deliver any Grams until the conclusion of the hearings and have suspended their formal launch of TON Blockchain until April 2020. 

Investors have also approved the delay and even refused the offer of a partial refund from Telegram, signalling the appetite in the market to not be deterred. This case promises to address directly many of the key issues surrounding the application of US securities laws to offerings of digital assets.

The Nebulous offering

The unregistered ICO of convertible Sianotes

Nebulous is the developer of the decentralized cloud data storage network “Sia” and funded the storage network through an ICO in 2014. The company raised approximately US$120,000 through the sale of a digital asset notes called “Sianotes”, which were convertible into shares in Sia, called “Siastock” upon Sia’s launch. 

Nebulous did not register these sales with the SEC and the SEC’s cease-and-desist order found that they were held not to qualify for any exemption. 

Settlement with the SEC

After the company consented to the SEC order, Nebulous entered into a settlement with the SEC costing nearly twice the amount of the funds raised in the ICO – on September 30, 2019 the SEC announced settled charges against Nebulous, who were required to pay disgorgement of US$120,000, prejudgment interest of US$24,602, and a civil money penalty of US$80,000.

Key takeaways
  1. Token issuers need to stay on top of regulatory developments

    Both these actions highlight the need for token issuers to keep abreast of developments in the evolving US ICO regulatory landscape. For example, while SEC orders against Airfox and Paragon cited the DAO Report, their ICOs in 2017 were launched shortly following the publication of the report.

    Nebulous diverged significantly as the entire ICO process took place in 2014, years before the SEC’s publication of the report. The charges against Nebulous, resulting in a fine significantly in excess of the funds raised in the ICO, underline the importance for firms contemplating a sale of digital assets to seek well-informed legal counsel and stay updated with ongoing regulatory changes.
  2. Engagement with the SEC is prudent

    These developments also indicate open communication to negotiate a deal with the SEC is a more commercially prudent and cooperative way of remediating concerns with the agency as opposed to the more contentious, costly cases like the Kik offering. Nebulous has communicated and cooperated with the SEC in conducting future sales of Siastock. In contrast, the Telegram case has involved more discord with the SEC and is unlikely to be resolved without a protracted legal fight.
  3. Inventive structures do not avoid scrutiny

    Finally, both the Nebulous settlement and the Telegram case indicate that the use of inventive structures, such as the Simple Agreement for Future Tokens (a “SAFT”), is not a fail-safe method for avoiding the scrutiny of US securities laws.

    The SEC complaint filed against Telegram indicates that use of a SAFT may not cure a registration issue if the token otherwise satisfies the definition of an “investment contract” under US securities laws.

    Additionally, the Nebulous settlement warns that ineffective dual-token structures may heighten compliance risk since the token conversion as well as the initial offering may constitute regulated securities transactions.
What’s happening next?

Digital assets have been receiving increased attention from US regulators, contributing to the ongoing debate concerning emerging frameworks like SAFT. The SEC’s references to the relationship between Gram and the Telegram messenger network may also hold significant implications for other tokens issued by social media and messaging companies like Kik or the Facebook-led Libra project. 

Further developments in the Telegram litigation or future agency actions against other ICOs may add further clarity to ICO regulatory guidelines.