What makes something a “distributed ledger or blockchain technology-based” security?
SEC Commissioner Hester Peirce has published a speech delivered to the Blockchain Association of Singapore. Unable to attend in person due to COVID-19, Commissioner Peirce visited with the Association virtually, addressing the hot topic of digital assets in the US and when one of these assets crosses the line to become a security. Something that remains somewhat obfuscated due to a lack of clear rules.
Peirce is perhaps the most innovation-friendly Commissioner the SEC has seen in years as she approaches challenging topics with a thoughtful process that can, at times, test established regulatory confines. On this occasion, Peirce questions the validity of the Howey Test regarding digital assets and advocating, once again, on behalf of a safe harbor to allow blockchain innovation to thrive.
Speaking specifically about Telegram, a digital asset issuer that filed a Form D to raise capital for the issuance of tokens but ended up afoul of the SEC, Peirce found the recent settlement of the case an “unsatisfying culmination of an enforcement action” that she did not support from the beginning.
To quote Peirce:
“Telegram had built an operational network, made good faith efforts to comply with the federal securities laws in raising funds to build that network, and engaged extensively with the SEC staff. With the assistance of sophisticated counsel, Telegram used the Simple Agreement for Future Tokens (SAFT) offering structure, which divides the creation of the network and the delivery of the tokens into at least two distinct stages. First, Telegram raised funds to develop the blockchain technology underlying the Grams by selling interests in the anticipated Grams to accredited investors. In return for providing the necessary funds, the accredited investors would receive an allotment of Grams upon the launch of the TON Blockchain. According to Telegram, this first stage—raising funds from accredited investors in a private offering—involved a securities transaction conducted in reliance on Rule 506(c)—a frequently used exemption from our registration requirements.”
Unfortunately, it was the second stage of the Telegram offering that led the digital asset issuer to fall afoul of the rules.
“In one view, the second stage was to begin with the launch of the TON Blockchain and end when Telegram delivered the Grams to the accredited investors. The accredited investors then could resell the Grams, subject to certain previously agreed-upon lockup restrictions. In Telegram’s view, these resale transactions by the accredited investors would not involve a security, but rather a digital currency, which could be used for buying and selling goods and services on the functional TON Blockchain. As network effects took hold, the value of that digital currency, of course, would go up.”
The court had decided that the SEC had shown a substantial likelihood that Telegram’s sales were part of a larger plan to unlawfully distribute the tokens to the public secondary market and thus potentially in breach of securities law.
Peirce explains that the token is not itself a security but a medium of exchange to be utilized on a functional blockchain network. In her opinion, once issued and having a consumptive use, they should be salable to purchasers outside of a securities transaction:
“This approach treats as separate the capital raising necessary to build the platform, which is conducted pursuant to the securities laws, and the resale of a functional token to consumers in secondary transactions after the platform is functional, which is not conducted pursuant to the securities laws.”
In the end, the courts determined that the Gram purchase agreements, Telegram’s delivery of the Grams upon launch of the TON Blockchain, and the accredited investors’ resale of the Grams, “were a single scheme that constituted an investment contract under the securities laws.”
Peirce’s comments present a fascinating polemic that challenges the Commission on actions that, on the surface, appear to do more harm than good. Telegram abandoned its project financed by accredited investors willing to shoulder the risk to fund a blockchain network backed by the highly popular global social networking platform. Peirce notes that Telegram had “built an operational network, made good faith efforts to comply with the federal securities laws in raising funds to build that network, and engaged extensively with the SEC staff.” Apparently discussing the project in advance with the SEC seeking implicit approval was for naught.