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On The Case

SEC commissioner’s crypto enforcement proposal could impact landmark case v. Telegram

(Reuters) - On Feb. 19, U.S. District Judge Kevin Castel of Manhattan will hear competing motions for summary judgment in the Securities and Exchange Commission’s most significant enforcement action to date against a blockchain developer. The SEC will argue that entrepreneurs from the encrypted messaging app Telegram breached securities laws when they raised nearly $2 billion to develop a new blockchain platform. Telegram will counter that it wasn’t required to register its offering – and that the cryptocurrency tokens investors will receive are not in the SEC’s purview. Blockchain industry groups, as I told you last month, filed amicus briefs in the case, pleading with the SEC to provide clearer regulations for digital assets and to set out a better-defined path to launch blockchains.

It turns out that at least one SEC commissioner agrees with a lot of what Telegram and its backers have said.

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Last week, Commissioner Hester Peirce delivered a speech at the International Blockchain Congress in which she acknowledged the “regulatory Catch 22” for legitimate developers who want to build cryptocurrency networks without running afoul of U.S. securities laws. "The SEC’s approach in these cases has made it extremely difficult for a company to distribute a token without running into a charge that the company is engaged in a securities offering," the commissioner said.

Peirce proposed a new enforcement regime in which the SEC would grant network developers a three-year safe harbor to establish active, decentralized trading of their cryptocurrency tokens, according to a written version of the speech. Peirce’s plan would allow developers to raise capital by offering tokens to investors and would permit secondary transactions without treating the tokens as securities – exactly the rules that Telegram and the blockchain industry groups are pushing in the case before Judge Castel.

Commissioner Peirce did not mention the Telegram case in her speech, but Telegram’s lawyers at Skadden Arps Slate Meagher & Flom certainly took note of what she said. On Thursday, Telegram filed a letter to Judge Castel, alerting him about the speech and hinting that Peirce’s comments will figure in the company’s defense.

An SEC spokeswoman and Telegram counsel Alexander Drylewski of Skadden declined to comment on what impact, if any, Commissioner Peirce’s comments will have at next week’s hearing. But Judge Castel is clearly mulling the appropriate regulation of cryptocurrency: In an order issued last Thursday, he invited the Commodities Futures Trading Commission to opine on its role. Telegram has argued that cryptocurrency tokens should be regarded as commodities subject to CFTC regulation, rather than securities under the SEC’s jurisdiction.

It’s easier to understand the issues at stake in the Telegram case when you know some of the facts. Telegram’s founders believed they could develop a blockchain network that would be faster and more secure than Bitcoin or Ethereum, whose currencies have become so widely circulated that the SEC doesn’t regard them as securities. To build the network, Telegram conducted two private offerings to sophisticated institutional investors, raising $1.7 billion. In exchange, investors were slated to receive 2.9 billion digital tokens, known as Grams, that would eventually be used on the Telegram platform.

Telegram acknowledged that the contracts it offered to investors were securities, but it contended that its private placement was exempt from the SEC’s registration requirements. The company believes that Grams themselves are not securities. The whole point of the Telegram blockchain network, according to the company’s motion for summary judgment, is to create a new, widely circulated and decentralized digital currency that will function, like every currency, as a medium of exchange. Telegram said it has strived to reassure the SEC that Grams are not securities but has been stymied by the commission’s ill-defined standards for digital assets.

The SEC, meanwhile, sued Telegram in October to halt the launch of the blockchain platform before Grams could begin trading. According to the commission’s summary judgment brief, Grams can’t be disentangled from the investment contracts between Telegram and its investors. Under the U.S. Supreme Court’s definition of a security in 1946’s SEC v. Howey, the digital currency is a securities, like a stock certificate. So every transaction involving a Gram, in the SEC’s view, is subject to securities laws and must be conducted by a broker.

The two sides disagree on whether Telegram truly intends Grams to be so widely traded that the company and its investors won’t retain control of the market. The SEC said that Telegram planned to retain about 2 billion Grams, which would give the company the ability to affect the tokens’ market value. Telegram has said that its goal is an independent market and that it’s willing to assuage the SEC’s concerns. In fact, Telegram contends, it tried to work with the SEC in advance of its anticipated platform launch, but instead of providing guidance, the commission sued. (The SEC has said that Telegram only started talking to the commission after the SEC began investigating Telegram’s private offering.)

A centerpiece of the preliminary injunction hearing next week will be whether the SEC has provided clear rules for blockchain developers. Telegram has asserted an affirmative defense that the SEC’s view of digital assets is so imprecise that the company did not have constitutionally sufficient notice that its offering and anticipated launch of Grams trading was problematic. The SEC has moved to strike that defense, pointing to evidence that Telegram tinkered with its plans to avoid triggering securities laws.

Commissioner Peirce most definitely didn’t say the SEC’s guidance is unconstitutionally vague, but she did say that the commission’s rules are very difficult for legitimate entrepreneurs to navigate. “When we see people struggling to find a way both to comply with the law and accomplish their laudable objectives, we need to ask ourselves whether the law should change to enable them to pursue their efforts in confidence that they are doing so legally,” Peirce said in last week’s speech. She highlighted criticism that the SEC has “elided the distinction” between investment contracts to raise the capital to create a cryptocurrency network and the token that will subsequently trade through the network, citing the “disastrous consequences” when the SEC conflates tokens and investment contracts. That is precisely the argument that Telegram is advancing.

Obviously, Peirce is just one SEC commissioner and her proposed safe harbor for cryptocurrencies is still just an idea. Even if the SEC eventually adopts a version of Commissioner Peirce’s three-year pause on enforcement against blockchain developers that satisfy conditions intended to protect investors, it will be too late for Telegram, which is hoping to persuade Judge Castel to allow its platform to launch right away. But I have no doubt that Peirce’s speech will crop up at next week’s hearing. It’s not every day, after all, that an SEC commissioner essentially echoes the arguments of an SEC enforcement target.

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