How has the SEC’s Approach to Emerging Fintech Technologies Developed?
Loyola University Chicago School of Law, JD 2020
This October, the Securities and Exchange Commission filed an emergency action and obtained a temporary restraining order in the United States District Court for the Southern District of New York against two offshore entities, Telegram Group Inc. and its wholly-owned subsidiary, TON Issuer Inc. The SEC’s complaint asserted that the two offshore entities were conducting an unregistered offering of securities in the form of digital tokens in the United States and overseas, raising $1.7 billion to finance the businesses, including the development of its own blockchain the “Telegram Open Network” or “TON Blockchain.”
Between January and March of 2018, Telegram raised $1.7 billion from sales of 2.9 billion Grams to purchasers, including 39 U.S. purchasers. Telegram used the proceeds of this sale, which the SEC has classified as an initial offering, to finance the creation of its TON Blockchain. In its complaint, the SEC argues the Grams are securities as the initial purchasers and subsequent investors expect to profit from Telegram’s work, rather than currency since there are no products or services which can be purchased with Grams. This distinction is important; it’s a nod to the ongoing discussion in this regulatory space about digital tokens and their classification. The classification of a token as a security or a commodity determines the regulatory umbrella it falls under, the CFTC (currency) or the SEC (security). In the past, we’ve seen that digital currency companies whose product is in somewhat of a grey area can lead to jurisdiction debates between the two agencies. In the case of Telegram, according to the SEC, the product fits clearly within a security camp. The SEC’s test in their complaint seems clear-cut, but it may be more nebulous in practice.
Telegram, according to the SEC’s complaint, plans to deliver the Grams to its initial purchasers, who will then be able to resell them on the open market to the investing public. Telegram and its affiliates will facilitate these sales on a digital asset trading platform, at which point Telegram will have completed an unregistered offering with billions of Grams trading on multiple platforms. This process is a violation of sections 5(a) and 5(c) of the Securities Act, requiring securities issuers to register offers and sales of securities with the SEC. The SEC filed an injunction to prevent Telegram from “flooding the U.S. markets with digital tokens” that the SEC alleges were unlawfully sold.
Telegram’s response paints a different picture
Later in October, defendants filed their response to the SEC’s emergency application for a preliminary injunction. In their response, Telegram asserts that it “voluntarily engaged with, and solicited feedback from, the SEC regarding the development and planned launch of its decentralized blockchain platform… and grams.” Telegram contends that this was aligned with the SEC’s stated desire to engage with developers of digital asset technologies. Telegram produced thousands of pages of documents and communications with U.S. purchasers, five detailed legal memoranda regarding the securities questions at issues, participated in three in-person presentations where it elicited feedback, engaged in discussions related to the blockchain and Grams, and made modifications to operations after receiving the SEC’s feedback.
Telegram further states that despite their extensive efforts to comply and receive feedback from the SEC, and despite the SEC’s knowledge for 18 months that “if the TON Blockchain did not launch by October 31, 2019, Telegram would be obligated under its agreements with private purchasers to return the funds it raised” the SEC didn’t request delay, advise Telegram of its plan to seek injunctive relief, and waited until the last minute to file an application to enjoin their launch.
Telegram asserts that the SEC’s classification of Grams as a security is flawed and that it runs contrary to Supreme Court decisions. They argue that they never plan to offer securities to the public through an ICO, instead entering into private purchaser agreements with limited numbers of subscribers that provided for future payment of currency (Grams) following the completion and launch of the TON Blockchain. The Grams, Telegram asserts, will merely be a commodity like sugar or gold, not a security, once the TON Blockchain launches.
Is this the best approach?
Telegram has agreed not to offer, sell, or deliver Grams until the court resolves the case. The next hearing on this matter is scheduled for February 2020. This conflict highlights the difficulty that enforcement agencies like the SEC have had with emerging technologies in Fintech. Many argue that the SEC must “carefully tread” in areas of Fintech innovation and “not use enforcement authority as a sledgehammer to create new regulations where the law is unclear.” It seems, from the defendants’ reply, that they worked to receive feedback from the SEC and make necessary changes. Perhaps, in response to these Fintech technologies, the SEC should begin to find an intermediary that avoids a sledgehammer approach and focuses on a more streamlined and effective feedback and advisory arm that can help innovators in the “wild west” of Fintech meet compliance standards, which to some are nebulous.