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This article was originally published on CoinTelegraph.
In February, United States Securities and Exchange Commission Commissioner Hester Peirce was asked to give her opinion on the SEC’s case against Telegram. She declined to comment at the time, as SEC officials do not speak publicly about ongoing enforcement actions. In late July, however, with the Telegram case settled, Commissioner Peirce gave a speech titled “Not Braking and Breaking” that pointedly questioned the approach taken by the SEC in the Telegram case. Concluding her remarks, Commissioner Peirce asked:
“Who did we protect by bringing this action? The initial purchasers, who were accredited investors? The members of the public, many of whom are outside the United States, who would have bought the Grams and used them to buy and sell goods and services on the TON Blockchain? Did they really look to U.S. securities laws for protection? Would-be innovators, who will now take additional steps to avoid the United States?”
With this speech, Commissioner Pierce made a powerful case for re-examining the way in which securities regulation in the U.S. is applied to the sale and subsequent transfer of the digital tokens necessary for open blockchain networks to operate. There are a number of ways this can be accomplished, including through the creation of the “safe harbor” for crypto projects Commissioner Peirce proposed back in February this year. The safe harbor would give projects a three-year grace period before federal securities laws could potentially be applied to them. Were the safe harbor to be adopted by the full Commission, innovators seeking to establish decentralized open blockchain networks would have a lengthy period for their projects to gain community support before either potentially bearing the full burden of SEC compliance or demonstrating that such compliance is not necessary.
Had the safe harbor been in place last year when Telegram was preparing to launch, this grace period would have been a game-changer and perhaps led to a very different result for the Telegram Open Network, or TON. Many have observed that five years ago, the Ethereum network launched in a manner similar to what Telegram proposed. A skeptic might argue that the key difference between the Ethereum and Telegram launches was their timing (or, more specifically, the stage of network development the two projects had reached when they caught the attention of the SEC).
So, what can we conclude about blockchain network launches from these two signal examples — one a tremendous success, the other snuffed out before users could have the opportunity to make their views known?
When do securities laws apply to token sales?
In mid-2018, the director of the SEC’s corporate finance division, William Hinman, gave a speech at a crypto summit that caught many market observers by surprise. In his speech, Hinman sought to address the question of “whether a digital asset offered as a security can, over time, become something other than a security.” Throughout his speech, Director Hinman took pains to focus on the transactions in which digital assets are sold as well as whether these transactions are “securities transactions” and thus subject to compliance with federal securities law.
When and whether securities laws apply to transactions in blockchain tokens remains an essential question for the sector. Categorizing the sale of a digital token as a securities transaction would have an outsized impact on how the token can be offered, who can purchase it, how it is traded, its tax implications and beyond.
On the one hand, if a token can be sold without the transaction implicating federal securities laws, it is just like any other asset we are familiar with — a pair of sneakers, say — and it can be traded between any two users privately at any time and in any amount without any particular securities law compliance required, albeit subject to commercial and common law norms and expectations and statutory fraud laws.
But if the sale of a token is considered a securities transaction, this changes the situation for everyone involved. For example, those facilitating these transactions may be treated as “broker-dealers,” meaning that they have to meet a variety of complex legal requirements. On top of that, every transaction by a broker-dealer must be recorded, which requires comprehensive record-keeping and customer information-gathering.
More confusion, less clarity
In addition, the venues where these transactions occur may be treated as securities exchanges — a classification bringing with it an onslaught of regulation. At a minimum, this approach would likely dramatically reduce the token’s liquidity and usability. In some cases, applying securities laws to transactions within a token could potentially crush the blockchain project altogether.
Although the SEC have released a Section 21(a) report, two no-action letters and a “framework” document, most of the SEC’s guidance on this question has been in the form of enforcement actions — telling blockchain proponents what they can’t do, rather than what they can do.
Commissioner Peirce criticized this approach in her recent speech. Analogizing blockchain innovators with the man who invented roller skates (and who had a very public humiliation by crashing into a mirror while demonstrating his invention), Commissioner Peirce noted:
“I would prefer that we not only hold accountable the reckless innovators who skate among mirrors while playing the violin, but also attempt to provide the more cautious innovators some guidance on how to avoid the hall of mirrors and on what we consider to be adequate braking technology.”
So how are we to know when securities laws apply to transactions in which blockchain tokens are sold?
Initial sales of tokens
As a starting point, it is important to understand the basics of the U.S. concept of an “investment contract.” An investment contract is a transaction (or “scheme”) that at first glance appears to be a normal commercial sale of some asset or another between two private parties. However, as the now-famous Howey case made clear, when examined more closely, these schemes differ from most commercial asset sales — the buyer is not buying the asset for the buyer’s own “consumptive” use of the asset. Rather, the buyer is looking to profit from the transaction due to the seller’s efforts where the buyer and seller have formed some sort of “common enterprise.”
Examples of assets sold in transactions characterized as investment contracts by courts include beavers, whiskey and bank CDs. When a commercial transaction does not work out as hoped for, crying “Investment contract!” is a much more likely way for the buyer to get some money back from the seller.
When an asset that initially has little or no functional use (like the typical blockchain token prior to network launch) is being sold not to persons who have a genuine reason to use the token for its stated purpose following launch but, rather, to those who expect to hold the tokens for a period of time in order to profit from price appreciation resulting from efforts of the developers of the token promoting the benefits of the network, the scheme will likely satisfy the Howey test and would generally be considered an “investment contract” and thus a type of securities transaction. Almost all blockchain networks will likely need an initial source of funding for development and this pattern is one that has been used to get started.
One way we know that the securities laws likely apply to most blockchain network launches is that even Commissioner Peirce feels that a “safe harbor” is needed for these initial token sales to avoid the securities laws otherwise applying to these transactions. Where it gets interesting is when an initial purchaser of tokens from the development team seeks to resell those tokens.
Secondary token transactions
It is at this point that the 70-plus years of case law following the Supreme Court’s decision in Howey fails us. Why? Because case law arises as the result of the resolution of a dispute. The many cases looking at when a purported commercial sale of a given asset should be treated as an “investment contract” (and therefore a securities transaction) almost always arise from a failed transaction where the buyer did not receive the return they had expected from the asset, and thus sued the seller to get their money back. Therefore, courts have not had to consider whether secondary transactions in relevant assets (e.g., the beavers, whiskey or bank CDs) by the purchaser not involving the original seller and not transferring any of the original seller’s promises about the asset are also “securities transactions.”
Many blockchain projects raise just that question, though: Should resales of the relevant asset — the blockchain token — without a transfer of any promises made by the development team to the initial purchaser also be treated as securities transactions? If the underlying asset was any of those involved in the many post-Howey “investment contract” cases on record (the beavers, etc.), we doubt that the question would even arise, much less be answered in the affirmative. Should blockchain tokens be any different?
The SEC position
The enforcement staff of the SEC certainly think so. In the Telegram litigation as well as in numerous other enforcement actions by the SEC, papers filed in court make clear that the enforcement staff believe that not only are these transactions “securities transactions” (as suggested by director Hinman), but also that the blockchain tokens themselves are “securities” and that the development teams are the “issuers” of these securities. Interestingly, though, Judge Castel in the Telegram case did not endorse this position, stating in contrast:
“But focusing upon the Initial Purchasers and their Gram Purchase Agreements misses one of the central points of the Court’s Opinion and Order, specifically, that the “security” was neither the Gram Purchase Agreement nor the Gram [token] but the entire scheme that comprised the Gram Purchase Agreements and the accompanying understandings and undertakings made by Telegram, including the expectation and intention that the Initial Purchasers would distribute Grams into a secondary public market.”
Notwithstanding the above wording, other statements by Judge Castel in his Telegram opinions were sufficiently vague so as to sow some confusion as to his ultimate position on this crucial point. Importantly, because the Grams were never distributed, Judge Castel only had to deal with the initial distribution scheme. This allowed him to find that the scheme constituted an investment contract without having to address the SEC’s argument that the Grams themselves were securities in order to decide the matter. Although Judge Castel declined to find that the Grams themselves were securities, he did leave room for the SEC to continue to take the position that secondary transactions in tokens are securities transactions (and the tokens themselves are securities).
Blockchain tokens as traditional assets
However, there is another point to consider. One thing all “securities” must have is an “issuer.” This is a crucial distinction between a security and a more traditional asset. In the case of a security, if the issuer of the security — whether debt or equity — is liquidated and ceases to exist, the security ceases to exist as well. You can’t have one without the other.
Likewise, in the investment contract context, if a promoter that made the undertakings to a buyer to induce a purchase by the buyer of a given asset being sold by the promoter in connection with the scheme ceases to exist, so too does the “investment contract” between the promoter and the buyer.
However, the “object” of the promoter’s scheme (i.e., the asset the promoter sold) will continue to live on, as is the case with other traditional assets once created. Whether tangible or intangible, “non-security” assets exist long after their creator may have shuffled off this mortal coil — literally or figuratively. For example, a patent right for a drug created by a pharmaceutical company will continue to exist — and may be sold and transferred — even if the company that developed the drug was dissolved.
Looking again at many typical blockchain tokens (including the Grams to be used on the TON network), most seem to rather clearly look more like traditional (non-security) assets in this respect — the initial development team for a blockchain project that was deemed the “issuer” of the tokens may be liquidated or may just disband and move on, but the relevant tokens will continue to exist as long as there are computers maintaining nodes for the relevant blockchain.
The SEC’s distinction between a security and a non-security
So how does the SEC reconcile this distinction? Through a novel and, to date, untested theory — that at some point a blockchain token can “morph” from being a “security” and become a traditional “non-security” asset based on factors extrinsic to the token. A number of factors are put forward by the SEC for this purpose including, most pertinently, whether the management of the network is “sufficiently decentralized,” and whether the token has a bona fide commercial purpose.
Although the commissioners and staff of the SEC have worked hard to elucidate these concepts through the Token Framework and other written statements, various enforcement actions, many public appearances, and countless private meetings with market participants, the standards put forward by the SEC for distinguishing token sale transactions that should properly be considered securities transactions from those that should not are still unclear.
By importing new concepts like “sufficiently decentralized” and “commercial purpose” into federal securities jurisprudence without any history of case law support, we should not be surprised that confusion and uncertainty result.
Is it all about the timing?
So where did things go wrong for Telegram? Why is it that the SEC considered Grams securities and Ether not — at least by the time director Hinman gave his speech? The key difference could appear to be timing.
Regulators looked at the Ethereum network roughly three years after its launch, whereas with Telegram, the scrutiny came before launch. Those three years made a huge difference. That time gave the Ethereum network a chance to become more decentralized and to build up a significant consumer usage of its token.
Meanwhile, Telegram’s TON network never had the opportunity to prove itself. It was not given the time to achieve decentralization — whatever that may have meant for the project — or to build up an economy around its tokens. Because of that, the project was over before it began. No wonder Commissioner Pierce raised the questions she did.
The timing issue makes it too easy for the skeptics in the blockchain community to argue that the only way to proceed after Telegram is to build as fast as possible with the hope of following the Ethereum model and “outrunning” SEC enforcement activity. This is not a good result for both the SEC, who will increasingly find themselves playing “whack-a-mole” with blockchain projects trying to slip under its radar, and for blockchain projects, who must live with the possibility that they may wake up one day to find themselves the target of the next Telegram-style enforcement action.
Only time will tell how the question of whether secondary sales of tokens will be considered securities transactions — and the tokens themselves will be considered securities — will be resolved. Courts considering the issue will need to balance the legitimate concerns around investor protection put forward by the enforcement staff of the SEC with the pressing questions raised by Commissioner Peirce in her aforementioned speech.
Of even more pressing interest to the blockchain community is the difficult question of how a new decentralized blockchain network can be launched following the Telegram decision. Commissioner Peirce’s safe harbor proposal is still out there — will the other Commissioners be open to giving that approach serious consideration? If not, is a new legislative framework needed? Although U.S. regulators have generally not been friendly toward a “sandbox” concept (where novel business models can be tested in a relaxed regulatory environment with a high level of oversight), could this break the logjam?
What can be said now, though, is that the uncertainty as to how these issues will be resolved is hampering innovation without a clear case having been made for concomitant investor protection benefits. We believe that the vast majority of innovators and technologists in the blockchain community want to comply with the law and do things the “right” way. The time has come for policymakers and regulators to step up, engage in more dialogue, and provide a workable pathway that allows blockchain technology to develop and grow here in the U.S.
The unwary among us need and deserve appropriate protections, especially where potentially confusing new technologies are involved, but these protections must not unduly interfere with the equal need to foster critical and necessary innovation. Other jurisdictions are finding ways of balancing these competing concerns. We believe that the U.S. can, too.
Now is the time for a new relationship to be forged among crypto projects, their advisors, trade groups, policymakers and regulators to achieve this goal. And we should all take a moment to applaud Commissioner Pierce for leading the way.
This article was co-authored by Dean Steinbeck and Lewis Cohen.
Lewis Cohen is a partner and co-founder at DLx Law, a law firm that focuses on the use of blockchain and tokenization across all aspects of the capital markets. Lewis is a frequent public speaker on the topic of blockchain and the financial markets and was recently named in “Band 1” as one of three top-ranked lawyers in the blockchain space in the United States by leading independent firm, Chambers & Partners.