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.
SEC Charges Opporty for 2018 ICO
This week, the Securities and Exchange Commission (SEC) continued its ICO crackdown. This time, the firm levied charges against project Opporty Founder and Brooklyn-resident Sergii Grybniak. The firm alleges that Grybniak broke the law when his firm raised approximately $600,000 during its 2018 ICO.
News of the charges first broke via Jan. 21 press release. In the release, the SEC reveals the charges laid against Grybniak in detail. Importantly, the primary charge is participating in the unregistered sale of securities. Additionally, the SEC claims that Grybniak made false statements in order to encourage more investor participation.
These statements include a myriad of exaggerated and completely fake claims. In one instance, Opporty claimed that its 2018 ICO was “100% SEC-compliant.” Unfortunately, this claim proved to be the tip of the iceberg. Apparently, Opporty also claimed to have thousands of “verified providers” who were ready to work with the platform.
This claim became so overblown that in one piece of marketing material, Opporty suggested it had a business database that included around 17 million participants. In actuality, the firm had no partnerships. Unfortunately, these claims served one main purpose, to push more investment capital into the ICO.
Major Software Firm
As if the shower of lies put forth weren’t enough, Opporty also made some very specific partnership claims that proved to be bunk as well. According to the SEC, the firm lied about a partnership with a major software company. This lie was to help ease investor doubt about the ability of developers to deliver on their hefty platform promises.
SEC Steps In – Opporty
It doesn’t take much research to see why Opporty ended up in the SEC’s crosshairs. Now, the SEC seeks injunctions against all future digital offerings by the company. On top of the cease-and-desist, regulators require Opporty to return all the funds the company raised during its 2018 ICO. Also, the firm is to face a variety of civil penalties for its actions.
Opporty executives sold the concept to investors as a blockchain-based ecosystem for small businesses. The platform was to provide these small-to-medium sized companies with access to advanced blockchain systems. For example, businesses could list their services and lock in their clients via smart contracts.
United States Investors
Aside from the obvious scamming that took place, Opporty made another key error in its strategy. You see, unlike many similar ICOs, the offering did not explicitly exclude U.S. investors from participating. The 2018 ICO included investments from around 200 US citizens. In this way, the firm invited the SEC to monitor its actions throughout its entire crowdfunding campaign.
An Oppurty Lost
Given the long list of violations this firm now faces, it’s easy to imagine a scenario in which Opporty decides to close its doors. Already, numerous SEC-charged firms have taken similar measures prior to refunding clients’ funds. For now, Opporty has a long legal battle and hefty fines to deal with. You can expect to hear more from this case as the SEC pursues its charges against Grybniak.
Disguises, Fake Identities, and an Illegal ICO – The SEC Looks to Lay Charges
The SEC is hard at work ousting, and holding accountable, those in the world of blockchain that have breached securities laws. Most recently, the SEC has turned their attention to an ICO hosted by a pair of companies operated by a duo of devious individuals.
- CG Blockchain Inc.
- BCT Inc.
This pairing of companies was marketed as developing technology to disrupt hedge funds, and the way they operate.
The Ring Leaders
- Boaz Manor (alias ‘Shaun Macdonald)
- Edith Pardo (alias ‘Edith Mehler’)
In all endeavours, it is believed that Boaz Manor was at the helm, with Edith Pardo acting as a ‘front-woman’, deflecting attention from Manor’s past.
In this particular case, the pair of companies, and the aforementioned individuals, are accused of facilitating/hosting a ‘fraudulent and unregistered offering of digital asset securities’.
$30 million worth of these securities were sold to investors, under the guise of a utility token ‘BCT’. Beyond simply selling illegal securities, those responsible flat out lied to their investors on a variety of fronts.
- Fake Identities
- Fake chain of command
- Product state of development
- Product Adoption
- Investments by founders
The list goes on. Simply put, they were not who they said they were, and the companies did not have a developed product gaining traction within the industry.
This next bit is not an everyday occurrence – rather, it was something you would see in a movie. Knowing full well that their activities were in violation of various securities based laws, Manor and Edith Pardo felt it prudent to hide their identities.
In order to do this, and distance themselves from their past activities (more on that, later), the pair went to great lengths. The SEC states,
“During the scheme, Manor employed a number of deceptive devices related to his fake identity and to the concealment of his background and role.”
Some of the tactics used to conceal their identities included dying hair, growing beards, attaining fake identification under the alias ‘Shaun MacDonald’, etc.
There are few reasons to justify hiding one’s identity in the manner that Manor did – either you’ve done something bad, or are doing something bad. In this particular case, Manor is guilty of both.
We’ve discussed the illegalities associated with his actions in the aforementioned ICO, however Manor has a history of such activity. Dating back to 2005 in Canada, Manor was found to be running a fraudulent hedge fund, valued at nearly $750 million.
When light was shed upon his operation, Manor proceeded to flee the great white north, becoming a fugitive in the process. After eventually returning, and completing a prison sentence of 1 year, Manor went on his way, staying out of the limelight until now.
Due to the great lengths gone to by the pair to partake in the aforementioned illegal activities, in addition to the sum of money raised, the SEC is taking a strong stance. The following is an excerpt from their court filing.
“Unless Defendants are restrained and enjoined, they will again engage in the acts, practices, transactions, and courses of business set forth in this Complaint or in acts, practices, transactions, and courses of business of similar type and object.”
The Securities and Exchange Commission is a United Stated based regulatory body, tasked with creating, an enforcing, regulation surrounding securities. The goal of which is to foster and maintain a fair, transparent, and efficient market for all participants.
Chairman, Jay Clayton, currently oversees company operations.
EMURGO Starts New Blockchain Task Force in Uzbekistan
This week, the blockchain arm of Cardano, EMURGO announced the creation of a special task force to assist the Uzbekistani government with security token integration. The newly developed team’s tasks will include researching, developing, and instituting new security token solutions into the market. Additionally, the team will guide Uzbeki officials on the creation of a regulatory framework to support a shift towards digital assets within the country’s financial sector.
News of the new taskforce first emerged via Cardano’s official blog. In the post, the company announced the creation of its new “strategic blockchain task force.” The post took a moment to describe the overall goals of the group. These goals include the development of a legal framework for STOs and security token trading. As such, the team will need to complete its market research in order to determine the best pathway towards providing solutions for the security token market locally.
Given the remarkable size and importance of the task at hand, it’s no surprise to learn that EMURGO made important strategic partnerships. To date, the firm works with the government of Uzbekistan’s National Agency of Project Management (NAPM), Infinity Blockchain Holdings and the KOBEA group.
KOBEA – Blockchain Education
Notably, the Korean-based blockchain firm, KOBEA will assist EMURGO in the development of an educational structure. The new blockchain-based courses will be available at universities and community centers in the very near future. This structure is necessary to further the local markets’ access to blockchain professionals.
Discussing the importance of the partnerships, the CEO of the EMURGO Group, Ken Kodama took a moment to express the “great honor” his firm feels after receiving the official go-ahead with the project. He also explained why Uzbekistan is one of the best places for blockchain development to occur. Notably, he touched on the government’s willingness to push the adoption of new technology. He even stated that “Uzbekistan is more willing than ever to adopt innovation.”
For its part, EMURGO will provide advisory services to the Uzbek government. Additionally, the firm will look into how to best integrate Cardano’s third generation blockchain into infrastructure projects. Blockchain infrastructure projects are on the rise. Despite the unprecedented growth within the sector over the last year, many analysts still see a lack of infrastructure as the main choke point towards full-scale blockchain adoption.
EMURGO and KOBEA
Interestingly, both EMURGO and KOBEA will provide additional insight into the digital asset banking markets. This data, coupled with a new educational initiative across all major Uzbek universities, should provide the country with a treasure trove of highly-trained professionals.
Cardano continues to impress with its 4th generation blockchain’s capabilities. Now, it appears that the firm has caught the attention of more than just your typical crypto investors. Given the sheer magnitude of its latest project, you can expect to see Cardano remain dominant in the crypto space for years to come.