Lawyers' View | From the Telegram ban, see the legal risks of ICO in the US

Author: Luo Tao

The legal battle between Telegram and the US Securities and Exchange Commission (SEC) is intensifying. On October 11, 2019, the SEC issued an emergency ban prohibiting Telegram from selling Gram tokens on the grounds of "Issuing Grams of Illegal Digital Asset Securities." Up to six months of litigation.

Ciondesk's April 2 message showed that Judge P. Kevin Castel once again rejected Telegram's request to issue Gram tokens to non-US investors. Once again, from the results, the US court finally supported the SEC's view that the token issuance behavior provided the possibility of Gram token flow to the secondary market.

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The forced shelving of the Gram issuance plan reflects the conflict between the initial coin offering (ICO) and legal compliance. In this regard, we will review the Telegram case.

Origin of the case

The co-founder of Telegram has been working on a blockchain platform designed to facilitate payments and host decentralized applications at a high level of scalability since 2017. Gram is the general token issued by Telegram based on the TON blockchain system, and buyers do not need to rely on the traditional acquisition method of "mining".

In the two rounds of private token sales held in February 2018 and March 2018, Telegram raised $ 1.7 billion in funds from 171 initial buyers through SAFT (Future Token Simple Agreement). The huge volume has received widespread public attention, and the release project was originally expected to be officially launched at the end of October 2019.

On October 11, 2019, the SEC intervened to interrupt the token issuance process by issuing "Important Digital Asset Securities Grams". The SEC believes that US $ 424.5 million of the US $ 1.7 billion raised by Telegram came from US investors, and the token issuance method clearly violated the registration and issuance requirements of the US Securities Act of 1933. Telegram has always adhered to the compliance of the issuance procedures, so the SEC filed a lawsuit in the US Federal Court.

The US Securities Act of 1933 provides

The Securities Law prohibits securities issuers from publicly selling unregistered securities. It also prohibits the purchase of securities from issuers and conducting unregistered public sales again. Those who conduct resale are called "underwriters." The latter article is not known in the field of encryption. In short, if an issuer sells securities to an underwriter, when the underwriter makes these securities publicly available to a third party, both the issuer and the underwriter violate the law.

Can Gram tokens be included in the scope of the 1933 Securities Law?

• Telegram's view-negative

First, the two $ 850 million issuances are in compliance with the exemption rules of the Securities Act of 1933. Since Gram is only sold to qualified investors, the product does not need to be registered with the SEC or obtained SEC certification.

Third, Telegram always regards Gram token as a practical tool with "consumer use". Tokens do not constitute securities in essence, and should belong to commodities.

Thirdly, both Telegram's sales disclaimer and public statement emphasize the consumption of Gram tokens rather than other coins, so the resale after the first batch of purchasers has nothing to do with Telegram.

Fourth, Telegram ’s lawyers assured the judges that the first batch of buyers had enough interest in the “decentralized community” blockchain to use the Gram token as a currency, rather than intending to make profits through the Gram token, so it was Gram tokens should be linked to profit expectations based on the purchase or holding of tokens.

• SEC's view-yes

The issuance of Gram tokens will enable its buyers and Telegram to sell billions of Gram tokens to the US market. Once resale (secondary market transactions) occurs, Telegram will issue unregistered securities to multiple platforms. Can not control. At the same time, the purpose of the Gram transaction is to create secondary profits for investors, and the initial offering (ICO) will create space for resale to obtain non-compliant profits.

Although a one-year lock-up period was established after the initial issue of Telegram (ICO), Telegram did not provide a reasonable reason and necessary restrictions for the lock-up period, so that the initial purchaser became a "underwriter" without registration, in disguise is the first purchase The resale of tokens and the creation of secondary markets have created conditions.

At the same time, the company's disclaimer is more like advising investors and does not ensure that resale will not occur.

Therefore, the Gram token should be included in the supervision of the Securities Law.

• Court response-yes

The court supported the SEC ’s view, but the judge clearly pointed out that the focus of the discussion in this case was not on the determination of the nature of the Gram token, but on the issuance conditions of the digital currency. The Howey test has flexibility as a method for regulators to evaluate securities. Focus on economic substance, not limited to labels.

The Howey test is a standard used by the US Supreme Court in a 1946 decision (SEC v. Howey) to determine whether a particular transaction constitutes a securities offering. This standard determines whether a cryptocurrency should be regulated as a security.

The test results show, “Considering the economic reality of the Howey test, the court held that reselling Gram to the secondary public market without the necessary registration statement would be an integral part of the sale of securities.”

The judge compared the Gram token to gold in the analysis, saying that the seller will not ask whether the individual is interested in gold before selling the precious metal, and the buyer usually guesses the value of this precious metal, and the rational buyer is not Will be willing to pay $ 1.7 billion to buy Gram "just as a storage or transfer value tool".

At the same time, the judge denied the exemption of the exemption statement, and pointed out that Telegram did not fulfill its duty of care and did not take reasonable measures to avoid the buyer ’s resale behavior, which did not comply with Section 4 (a) of the Securities Act (2) or section 506 (c) exemption conditions.

In the end, the court ruled that the SEC had successfully proved that the Gram purchase agreement, Telegram's implied undertaking and its understanding with early buyers (including attempts to resell Gram to the open market) constituted (conditions for) the issuance of securities, and therefore should be followed Issuance requirements of the Securities Law.

It should be noted that although Telegram's issuance plan leverages the SAFT agreement, and SAFT itself is an investment contract or securities, neither the SEC nor the court has relaxed regulation due to its particularity. On the contrary, Howey is added to the SAFT agreement. Test to verify economic substance. As the SEC pays more attention to SAFT, the intensity of supervision will inevitably increase, which also sounds the alarm for those who want to use SAFT to avoid being regulated by the US Securities Act. Although this case can only be used as a reference for the case, from the perspective of the court's determination, the possibility of currency issuance in the United States is highly regulated, and the issuer can no longer have the luck.

Does the ban apply to non-US investors?

Telegram appealed the SEC ’s lack of jurisdiction over overseas investors, asking the court to clarify whether more than $ 1.2 billion from non-US investors should be regulated by the US Securities Act, and expressed its willingness to The purchase behavior imposes restrictions to ensure that these tokens will not eventually fall into the hands of US investors in order to continue to fulfill their obligations to non-US investors.

But this argument did not convince the judge. The judge said that it was too late for Telegram to raise the issue of jurisdiction. They focused on the original purchaser and their purchase agreement, ignoring the center of the court's opinion. And Telegram did not actually explain how he would be able to prevent secondary sales, nor how he could legally modify the Gram purchase agreement to set this limit. Fundamentally, the original design of the TON blockchain is to provide anonymity for those who buy or sell Gram tokens, and investors can easily deny that they own a US address.

A senior lawyer in the blockchain field said that the judge clearly understood the nature of blockchain technology and emphasized that Telegram “underestimated the importance of its request for clarification and overestimated the effectiveness of its proposed US geofencing.” It is clear The judge fully agreed with the SEC ’s view that Telegram ’s argument on extraterritoriality after the ban was “too few and too late”, and his response to Telegram ’s “request for clarification” also showed admirable technical rationality and suspicion because he knew The measures proposed by Telegram did not fundamentally limit the possibility of distributing Gram to wallets on the Ton blockchain protocol through other channels.

Thinking from the ban

1. Squeeze the fundraising space of private enterprises

The Federal Court finally supported the SEC ’s interpretation and analysis, and denied Telegram ’s reasons for defense. Telegram claimed that it was an orderly sale of Gram tokens to qualified investors in accordance with the exemption rules of the Securities Act, and the purchaser only replaced Gram tokens. The currency is used as a currency, and further determines that Telegram essentially creates an opportunity for the token to flow to the secondary market, and the only way for investors to profit from the token is through resale. This view of all investors as "underwriters" ignores the provisions of Regulation 144 and may have an impact on the normal financing activities of private companies in the future.

Regulation No. 144 is a subsidiary transaction rule under the 1933 Securities Act of the United States, and is the most practical one of the laws and rules aimed at protecting public investors. It is to make more than 10% of the listed company's major shareholders, the company's senior management, directors and other related parties and those who obtain stocks from related parties must follow strict disclosure procedures when selling stocks. And such stocks are "restricted securities"

The SEC has a subjective tendency in the determination. In this case, Telegram set a holding period in accordance with Regulation 144 in the purchase agreement. However, the SEC ignored this provision and equated the investor ’s profit expectations with the uninformed public. Resale of this behavior, the latter is obviously not allowed. This kind of thinking will cause investors to fail to sell securities even if they meet the legal requirements. Investors' profit expectations can only be achieved by keeping the securities in their own hands, which obviously violates the normal trading logic. Investors are also worried about the series of responsibilities and risks that the resale will cause, reducing their investment desire, which will make it difficult for private companies to raise funds from investors. There is a view that the efforts made by the SEC and the courts to regulate the order of securities transactions and to safeguard the legitimate rights and interests of investors are understandable, but this method of law enforcement skips the existing legal provisions after all, which discourages the initial investors ’investment willingness , Squeezing the space for private companies to obtain funds, and cannot fundamentally solve the problem. To standardize the issuance of cryptocurrencies, it is necessary to face existing laws and regulations and make corresponding legislative adjustments in accordance with the characteristics of cryptocurrencies.

2. Obstruct the function of the public chain

The blockchain function allows many participants to participate in the community through an incentive mechanism. The incentive tool is usually a valuable token. Unless participants can use tokens for their intended purpose or convert them into fiat currency, participants will not want to own these tokens. One cannot separate tokens from having value characteristics that can be converted into fiat currency. In addition, the validity and practicality of the decentralized protocol requires the widespread issuance of tokens, which requires the developers of the blockchain system to widely distribute these tokens. If each token is required to have "security", the massive issuance of tokens will become extremely difficult, and the excessive supervision imposed by the SEC on the issuance of tokens will hinder the realization of public chain functions.

latest progress

The Blockchain Association, a major industry association in the US crypto industry, submitted a briefing on April 3 to express its support for Telegram and accused the SEC of deviating from its own guidelines in the legal issuance of digital assets. The association stated that Telegram had applied for an exemption under Regulation D at the initial stage and worked hard to operate within the expectations of the SEC, including based on the SAFT (Future Token Simple Agreement) framework, and the enforcement posture of the case and the position of the local court and the SEC ’s previous position The statement runs counter to each other.

For Telegram, the SEC's order to stop issuing Gram tokens is also unacceptable.

“Ignoring the Commission ’s previous statement and allowing it to order the cessation of the sale of Grams (which caused huge losses to Telegram, investors and many other projects) constitutes an 'unfair accident' and an institution should not be allowed to suddenly Appear in front of the public. "

Judging from the court's attitude, the briefing has little influence on reversing the ruling.

Where will Telegram go?

The Federal Court's ruling cut Telegram's last life-saving straw, and its attempt to switch to the non-US investor market was rejected. The secondary market's resale path was cut off, and the primary market investors' desire to withdraw funds became stronger. Yakov Barinsky, head of the Russian investment agency Hash CIB, said, "I now see at least 10 of all investors, tending to choose to get back 72% of the previous investment amount." The best option for Telegram is to follow suit Block.one, reached a settlement agreement with the SEC. Without similar practices, the TON wallet can no longer be integrated into the Telegram application.

Under the huge regulatory pressure, Telegram executives still hold a more optimistic attitude, thinking that the SEC cannot stop the release of TON. The TON community has tried to enable TON without Telegram ’s participation. The person in charge of Spain stated: “Since all network codes are available, anyone can start TON, and no one can prevent any other entity, individual or community from initiating TON because TON is a decentralized open source solution. "

But without Telegram's blessing, is TON still attractive to investors? How can we ensure that we are free from regulatory restrictions? None of this is known.

As April 30, 2020, the deadline for the delayed launch of the Telegram project is getting closer and closer, what measures Telegram will take to deal with the crisis is worthy of attention.

Telegram ban is not alone

The huge regulatory pressure of the SEC has caused difficulties in the ICO plan in the United States. Telegram is not the only company targeted by the SEC. With the rise of cryptocurrency, the SEC has sued dozens of illegal ICO projects. Like Telegram, in 2019, Block.one was issued a $ 24 million fine by the SEC for unregistered ICOs to resolve related allegations. Block.one was forced to reach a settlement with the SEC.

As a competitor of Telegram, the "global digital currency" Libra plan created by Facebook was also strongly attacked by the SEC, and it was difficult for Facebook to resist the strong regulatory pressure and was forced to transform the Libra plan.

In contrast, Kik took a tough stance against the SEC's allegations and always insisted that KIN is a currency rather than a security. At present, Kik is still working hard to promote the litigation process. It wants to legalize the name of the cryptocurrency and calls for the clarity of cryptocurrency supervision.

However, including the Telegram case, the SEC has not clearly sorted out and interpreted the legal provisions of the cryptocurrency ICO. Moreover, the issuer's understanding of the properties of the cryptocurrency and the SEC are misaligned. Although the Howy test is introduced, the SEC in a stronger position has certain control over the test, and the test results are difficult to convince everyone. While most blockchain companies are relatively small in size, it is clearly not the best choice to compete with the SEC.

At this stage, the safest way to conduct a cryptocurrency ICO in the United States is still to follow the law and register the cryptocurrency as a security according to the Securities Law, otherwise there will be a high probability of being targeted by the SEC, and the SEC is likely to follow the IPO The procedures are reviewed, so it seems unrealistic to complete the ICO in a short time, and more projects may need to be transferred to other countries with more tolerant supervision.

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