By Derek Edward Schloss, Director of Strategy, Security Token Academy
*Author’s Note: The following is not legal advice, but an exploration and possible interpretation of the currently regulatory landscape for blockchain-based fundraising.
As it relates to the explosive blockchain industry, perhaps no theme has been dissected more than that of industry regulation.
On one hand, a number of projects have questioned whether digital assets can thrive in the U.S. without forward-thinking regulation. On the other hand, insiders argue that our regulators are doing their best to follow the laws enacted through the legislative process — really, it’s up to our lawmakers to draw the final boundaries.
The truth is likely somewhere in between.
In the midst of these arguments, the SEC has increased the volume of its “guidance by enforcement” actions, targeting bad-faith fundraisers and ICOs that have consciously ignored the presence of federal securities laws over the last few years. In 2018, the SEC doled out over a dozen enforcement actions involving digital assets and initial coin offerings. And although this year’s numbers aren’t yet available, several high-profile cases are shining light on the regulatory opacity many have criticized.
Of note, the SEC made headlines last quarter when it reached a $24 million settlement with Block.one, the firm behind the EOS blockchain. Block.one had previously sold tokens to fund the development of the EOS network, raising over $4 billion between 2017 and 2018. The SEC argued that a purchaser in the ICO would have had a reasonable expectation of future profit based on Block.one’s efforts, including its development of EOS software and promotion of the EOS blockchain, satisfying the presence of an investment contract under the Howey Test and U.S. federal securities laws. As a result of the offering’s status as a security, the SEC found that Block.one violated securities laws by not filing a registration statement for its initial offering, or qualifying for an exemption from registration.
While the $24 million settlement might appear significant, many in the blockchain community were quick to note that the amount represented less than 1% of the total capital raised during Block.one’s year-long ICO. Further, Block.one announced that the negotiated settlement resolved all ongoing matters between Block.one and the SEC, leading some to question whether the EOS token, which currently trades on exchanges and is used to power the EOS blockchain, no longer falls within the crosshairs of federal securities laws.
One day after the Block.one settlement was announced, the SEC settled with Nebulous over an unregistered token offering that took place in 2014. As part of the settlement, Nebulous did not have to register its Siacoin utility token as a security. Like the EOS token, the Siacoin token currently powers a blockchain network that’s fairly well used by a number of distributed parties (323 hosts in 43 different countries).
Two weeks later, messaging giant Telegram Inc. was sued by the SEC to enjoin the firm from flooding the U.S. capital markets with billions of Grams tokens previously sold to accredited investors. Telegram had raised $1.7 billion selling Gram tokens to over 170 accredited investors under a SAFT framework (Simple Agreement for Future Tokens). Like the intended utility of the EOS and Siacoin tokens, Grams tokens were intended to eventually power the TON network.
Read together, what exactly do these three cases tell us? It’s difficult to decipher. Certainly, we know that Block.one and Nebulous originally offered investment contracts to investors — those events were unquestionably illegal offers of unregistered securities. But reading between the lines, it’s also possible to argue that both project’s utility tokens (EOS tokens and Siacoin tokens) are not securities today, though both trade freely on cryptoasset exchanges.
Telegram’s case is more straightforward — its offering of (future) Grams tokens to investors was also deemed to be an investment contract security by the SEC, but unlike the EOS token, for example, Grams tokens appear to remain securities in the eyes of the regulatory body. As a result, the SEC successfully enjoined Telegram from flooding the U.S. capital markets with Grams tokens.
So how are Grams tokens still securities after their initial sale, while the analysis for EOS and Siacoin tokens more murky? In its emergency action against Telegram, the SEC found that because initial purchasers expected to “reap enormous profits” once the Grams market launched, there still existed an expectation of profit reliant on the future actions of Telegram, Inc. As a result, the SEC articulated that Grams tokens remained investment contract securities, as the prongs of the Howey Test remain satisfied.
As it relates to the EOS token, recall that the SEC’s Framework for “Investment Contract” Analysis of Digital Assets published in 2019 stated that digital assets previously sold as investment contract securities could be “reevaluated at the time of later offers or sales”. In these situations, if there exists no more “reliance on the effort of others”, nor a “reasonable expectation of profit” as it relates to the investment contract security, then it’s possible the prongs of Howey will not be satisfied, and the investment contract analysis will fail. In these select circumstances, future sales of the digital asset would not be classified as sales of a security.
With this framework in mind, if we attempt to chart a through-line across the three recent SEC actions, one possible (but certainly not definitive) conclusion is that the SEC views the EOS and Sia networks to be sufficiently decentralized as the networks exist today. What factors might play into that analysis? As the SEC’s William Hinman stated in June 2018, and as later codified in the SEC’s Framework in 2019, “if the network on which the token…is sufficiently decentralized — where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts — the assets may not represent an investment contract.” Applying this analysis, it’s plausible that the EOS token could have successfully transitioned from an investment contract at the point of their initial sale into something more akin to a commodity today.
Alternatively, as it relates to Telegram’s TON blockchain, it’s easier to conclude that the SEC believes there still exists a reasonable expectation of profit (held by token holders) enabled by the ongoing role of an active participant (here, Telegram Inc.). As a result, the TON blockchain does not yet meet the minimum threshold for sufficient decentralization. And, without a sufficiently decentralized network, Grams tokens must remain investment contract securities — the form they originally took during the initial offering to investors. There has been no transition under those facts.
Other takeaways? When looking at these three SEC actions together, one could argue that securities laws will always apply to investment contract sales of pre-launched network tokens, regardless of the offering’s form as a SAFT or direct token sale. This fact notwithstanding, the SEC could also be acknowledging the concept of “transitional” securities as a token’s underlying network decentralizes over time.
It’s also possible that these cases can be broadly interpreted as a win for security tokens as an initial fundraising mechanism. If pre-network digital assets must always be offered as investment contracts under federal securities laws, then the token being sold should be placed inside a security token wrapper, and the project’s fundraisers must file a registration statement for the securities offering, or qualify for an exemption from registration. In addition, if a network token aims to transition into a commodity-like digital asset sometime in the future — much like Ether, EOS, or Siacoin tokens — then the token must be imbued with security token transfer restrictions until that event occurs, so that all parties remain in compliance. Security token protocols offer issuers this type of transitional regulatory compliance.
Finally, it’s possible the next wave of digital asset regulation in the U.S. will be more fluid, more accessible, and more open than any of our current legacy constructs. A reading of these cases demonstrates that our U.S. regulators may be evolving their historically rigid interpretations of securities laws to meet this transformative technology head on.
What’s certain is that many questions still remain. For example, while we may have a better conceptual understanding of when sufficient decentralization is satisfied at the network level (Ethereum, EOS, Sia), and when it certainly is not satisfied (Telegram’s TON Blockchain), we still don’t know the exact point at which decentralization is reached during a network’s lifecycle, and as a result, when that network’s underlying token has officially transitioned out of security status.
Maybe that’s for our legislators to decide.
But whether you believe the SEC’s actions represent a loud warning for the industry, or a sign that our regulators are willing to play ball and speak the same language as the digital asset world, it’s undeniable that the increasing clarity provided will ensure the industry’s evolution — in one direction or another.
Propine Accepted into MAS FinTech Sandbox
It was recently announced that Propine has been accepted into the Monetary Authority of Singapore’s FinTech Sandbox.
This move sees Propine join iSTOX as a participant within the sandbox. While the iSTOX is working towards serving capital markets, Propine will be testing their custodial capabilities within the program.
Over time, Propine indicates that their goal is to develop a comprehensive suite of services, tailor built for the digital securities sector. The following are a few the capabilities expected to be offered through the platform.
- Asset Servicing
- Trade Settlement
A ‘FinTech Sandbox’ typically refers to a structured program, built to allow for the testing of new technologies and approaches towards the industry. The purpose of such programs is to allow for innovation to flourish, while ensuring that the public retains high levels of protection at all times.
Tuhina Singh, the Chief Executive Officer and Co-founder of Propine, commented on acceptance into MAS’s Fintech Sandbox:
“We are extremely glad that we are going to be a part of the Fintech sandbox. Singapore is one of the most progressive economies in terms of support and in providing a platform for innovative solutions such as ours to experiment, build and thrive. The regulatory sandbox is a great step for us as we move into a more organized and regulated world for blockchain. A supportive initiative like this will propel the country’s rich history of innovation to much greater heights along with growing companies such as ours”
Founded in 2018, Propine is a Singaporean company, which operates within the digital securities sector. Building off of a specialty in custody services, Propine is actively developing a comprehensive suite of services surrounding digital securities.
CEO, Tuhina Singh, currently oversees company operations.
The Monetary Authority of Singapore is a regulatory body which wears multiple hats. Their roles include acting as, not only the nation’s central bank, but as the financial sectors regulator.
These roles mean that the MAS is responsible for, not only the economic growth of Singapore, but for ensuring the protection of investors through compliance measures enforced within banking, insurance, capital markets, and more.
In Other News
Over the past two years, Singapore has managed to establish themselves as a leader within digital securities. They have managed to do so through the use of programs such as the FinTech Sandbox described here today. The following articles are examples of forward thinking steps involving Singapore and the MAS.
Blockstation Joins the IIROC
The tokenization platform, Blockstation announced on Oct 31, that it will accept a leadership role in the Investment Industry Regulatory Organization of Canada – IIROC. The news showcases a push for more regulations in the Canadian security token sector, as well as, stronger positioning of Blockstation in the market.
The IIROC is a Canadian self-regulatory body created to help further development in the security token sector. The group’s primary focuses include broker-dealers, trading, and the institution of Universal Market Integrity Rules (UMIR).
The IIROC includes a huge variety of professionals from various parts of the industry. As such, the group provides a rare opportunity for regulators to collaborate with leading financial, legal, and technological institutions across Canada.
Currently, the group includes regulators, crypto firms, law firms, and three of the largest banks in the country. Specifically, the Crypto-Asset Working Group members are:
- Stephen Allcock (Questrade Financial Group)
- Pam Draper (Bitvo)
- Robin Ford (Robin Ford Consulting)
- Andrew Grovestine (Canadian Securities Exchange)
- François Lavallée (National Bank Financial)
- Julie Mansi (Borden Ladner Gervais LLP)
- Felix Mazer (Coinsquare)
- Linda Montgomery (Coinchange Financial/Blockstation)
- Brian Mosoff (Ether Capital Corp.)
- Souvik Mukherjee (Scotia Wealth Management)
- Laurence Rose (Omega Securities Inc./ 4C Clearing Corporation)
- Duncan Rule (CIBC)
- Phil Sham (Aquanow)
- Sean Shore (Canadian Compliance & Regulatory Law)
- Paul Stapleton (Fidelity Clearing Canada)
- Dino Verbrugge (DV Trading LLC)
- Joseph Weinberg (Paycase Financial)
- Robert Whitaker (Blockchain Intelligence Group)
- Lara Wojahn (Dominion Bitcoin Mining Company Ltd.)
One of the main goals of IIROC is to develop a regulatory framework that supports a robust, thriving digital asset marketplace to further drive innovation in the space. Additionally, the body seeks to integrate more consumer and investor protections in the market.
Blockstation Joins the Team
Blockstation received an invitation to participate in the IIROC after the group recognized the firm as an industry leader in the region. Importantly, Blockstation has experience working with regulators in other jurisdictions to develop its platform.
Today, Blockstation operates a fully compliant tokenization platform. The services provided by the firm include an end-to-end solution for listing, tokenizing, trading, custodianship, clearing and settlement, and lifecycle management of tokenized assets. Specifically, the firm’s Marketing Advisor Linda Montgomery will lend her experience to the IIROC.
Blockstation Makes Headlines
Notably, Blockstation made headlines this week after the announcement that the firm will host a compliant digital securities ecosystem via the Jamaica Stock Exchange (JSE). This limited pilot will test the trading of Bitcoin (BTC) and Ethereum (ETH) according to an April 3, press release.
Jamaica Stock Exchange
The JSE first announced its crypto aspirations back in August. At that time, the JSE signed a master agreement with Blockstation. For its part, Blockstation would develop the tools for the trading of digital assets and security tokens on the JSE.
Blockstation Making Waves
Blockstation is a true pioneer in the Canadian crypto space. Now the firm seeks to help develop the fledgling STO sector into a major FinTech market. You can expect to hear more from these exciting developers as their JSE project continues. For now, Canada looks to be ready to take the next steps in blockchain adoption.
Veritaseum Hit with $8 Million in SEC Fines
In another example of the SEC turning up the heat on firms, the regulatory body hit Veritaseum and its CEO with hefty fines. Veritaseum had been embroiled in an SEC trial since earlier in the year. The SEC alleged the firm illegally sold securities to investors. Now the company must pay $8 million in fines and judgments as part of its retribution.
As previously reported, Veritaseum LLC, its CEO Reggie Middleton, and a sister firm, registered in NY, Veritaseum Inc. faced serious scrutiny from the SEC for its 2017 – 2018 ICO. During the unregistered coin offering, the firm secured $14.8 million in funding from investors.
By mid-2018, the SEC received numerous complaints of fraudulent activity on the part of Mr. Middleton. For example, the SEC report alleged Middleton downplayed the risks involved in the investment. Additionally, he misrepresented the tokens his company offered.
Tokens are not Coupons
On multiple occasions, he referred to the tokens as securities or software. The report states that at least on one occasion, he told investors the tokens were similar to gift cards.
On top of the troubling miss information campaign, Veritaseum had other shady incidents occur during its now controversial ICO. According to Middleton, the company was the victim of a hacker that stole $8 million from funds raised. Of course, these funds were never recovered. Consequently, the incident added to the black cloud accumulating over the Veritaseum camp.
In August of this year, the SEC responded to investor complaints. The regulatory body sent Middleton a cease-and-desist. As part of the complaint, Middleton’s ability to host an ICO or operate his firms was put on freeze.
SEC Enters Talks
The SEC entered official settlement talks with Veritaseum on OCT 9. This decision followed a postponement of the original trial date until Nov. 14, 2019, by the New York Eastern District Court.
According to reports, Veritaseum must now pay $8.4 million in disgorgement fines. Of these fines, $7,891,600.00 goes to defendant liabilities. Additionally, the company is liable for a civil penalty of up to $1 million and a prejudgment interest amount of $582,535.
Veritaseum Hit Hard
The news hit Veritaseum’s market value hard. Since the start of the trial, Veritaseum lost around 35% of its value. The token fell from around $25 per coin to $15, before rebounding slightly to $18.71.
SEC on the War Path
The SEC has been on a mission to crack down on ICOs from the 2017 crypto craze. Regulators already hit Sia with a $225,000 for its 2017 ICO in which the firm raised $120,000. EOS is another example of the SEC crackdown. The company must pay $24 million for its $4.1 billion 2017 ICO. While both firms faced charges for illegally selling securities, neither had such significant misrepresentation claims put against them as Veritaseum.
Veritaseum is Unique
In this manner, Veritaseum is significant. The firm is still operating but Middleton is no longer able to conduct blockchain crowdfunding ventures. It’s hard to say exactly what the long term effects of the settlement will be. For now, the crypto community must watch and wait patiently to see the results.