Blockchain and the Law

Court Sides with SEC in Ruling to Prevent Telegram from Distributing Grams

In the latest development in the ongoing dispute between the SEC and Telegram Group Inc. (Telegram), Judge P. Kevin Castel of the U.S. District Court for the Southern District of New York in a March 24, 2020 opinion granted the SEC’s motion for preliminary injunction to prevent Telegram from distributing Grams purchased in its initial coin offering (ICO).

The case between the SEC and Telegram began last October, when the SEC filed an emergency action to stop Telegram (and its wholly owned subsidiary TON Issuer Inc.) from continuing its offering of Grams. In 2018, Telegram had raised approximately $1.7 billion through the sale of its ICO to finance the creation of the Telegram Open Network (also known as the TON Blockchain). The SEC alleged that Grams were securities, which Telegram failed to register in accordance with Sections 5(a) and 5(c) of the U.S. Securities Act (Securities Act).

Earlier this month, Telegram submitted a letter to Judge Castel arguing that a recent decision of the California Court of Appeal, Second Division, in Siry Investment, L.P. v. Farkhondehpour supported its case against the SEC. In its letter, Telegram argued the Siry court’s opinion supported its central argument that Grams are not securities, but rather a commodity. Telegram suggested that the “economic reality” of Gram purchasers’ intent, reflected in language in the Gram Purchase Agreements that the purchasers would only sell Grams “in accordance with applicable securities laws,” undercuts the claim that the Grams are securities, since they did not intend for them to be securities.

The SEC adamantly disagreed in its response on March 9, asserting that the totality of the circumstances must be considered. Specifically, such “boilerplate” language did not reflect, one way or another, Telegram’s or the purchasers’ intent or actual economic reality, because the economic reality of the Purchase Agreements is a result of the total economic inducements and commercial realities of the transaction. In other words, the SEC continued to point to, among other things, Telegram’s statements during the ICO that the SEC believes led Gram purchasers to expect they could make a profit by buying Grams and selling them on the secondary public market.

In his opinion, Judge Castel agreed with the SEC and held that the Gram Purchase Agreements, Telegram’s implied promises to develop the TON Blockchain and the planned distribution of Grams, taken as a whole, required registration under the Securities Act (see our post here for more information on how the SEC analyzes whether digital assets are securities). He emphasized that the purchasers intended to invest in and then sell Grams for a profit on the secondary market, citing one investor who declared in an email that they “hoped for an increase in the value of Grams and an opportunity to eventually sell Grams if the value increased” and that they did “not believe that [they] intended to use Grams as currency or for consumptive purposes.” The purchasers wanted to maximize value through resale in the public markets, not simply to store or transfer value from Dollars or Euros to Grams.  As such, the court granted the SEC’s motion to enjoin Telegram from distributing Grams and held that Telegram’s ICO violated the Securities Act and required registration. Interestingly, the court also found that the purchasers were “statutory underwriters” (thus also limiting a potential exemption from registration).

Telegram filed a notice following the ruling indicating that it would appeal the court’s decision. Continued litigation might provide further guidance and will determine whether Telegram will ultimately prevail. Nonetheless, the court’s opinion here is important because it develops the regulatory landscape for ICOs by highlighting regulators’ focus on the totality of an issuer’s ICO, and not merely on the “labels” that issuer’s might use to distinguish and qualify certain portions of their offerings from exemption, as Telegram attempted to do here. Issuers considering future ICOs should keep this in mind.

Department of Homeland Security Lists Blockchain Managers Among “Critical Services Workers” During COVID-19 Response

On March 19, 2020, the U.S. Department of Homeland Security, Cybersecurity and Infrastructure Security Agency (CISA), issued Guidance on the essential critical infrastructure workforce needed to ensure national resilience during the COVID-19 response. CISA developed its initial list of critical infrastructure workers to help state and local officials determine which operations are essential to critical infrastructure as they attempt to balance public health with the need for continued operations in essential areas.

Along with more obvious critical infrastructure workers in sectors such as energy, transportation, public works, communications and healthcare, CISA’s advisory list expressly included blockchain workers involved in the agricultural and food distribution supply chain, namely: “Employees and firms supporting food, feed, and beverage distribution, including warehouse workers, vendor-managed inventory controllers and blockchain managers.”

As we noted in our Practice Note on Blockchain and Supply Chain Management, blockchain offers substantial benefits in the supply chain context. Several major blockchain-based supply chain implementations are currently in use across the country. These initiatives are designed to achieve higher levels of traceability and efficiency as compared to traditional supply chain processes and systems.

The inclusion of blockchain managers in CISA’s Guidance as critical infrastructure workers highlights blockchain’s already significant role in our supply chain ecosystem, and its importance in making this nation’s supply chains safer and more efficient.

We expect that the adoption of blockchain-based supply chain systems will increase dramatically, and that working through the current global health crisis will provide additional insight into how blockchain solutions can be used to mitigate the impact of unforeseen events. Blockchain technology is particularly useful, for example, in almost immediately identifying bottlenecks or supply chain participants that are impeded from performing their defined functions. Such a feature can significantly reduce delays and enable downstream consumers to identify alternative suppliers on a real-time basis to minimize disruption of their business. Clearly, the ability to respond in that way is extremely valuable, especially in times of global economic stress.

SEC Settles Charges Against Enigma MPC for its Unregistered ICO

On February 19, 2020, the U.S. Securities and Exchange Commission (SEC) settled charges against Enigma MPC (Enigma) related to Enigma’s 2017 issuance of “ENG Tokens”. The SEC found Enigma engaged in an unregistered initial coin offering (ICO), in which it offered and sold securities in violation of Sections 5(a) and 5(c) of the Securities Act of 1933 (Securities Act).

Under the settlement, Enigma is required to pay a $500,000 civil penalty. Additionally, Enigma agreed to return funds to investors who purchased ENG Tokens in the ICO and who timely assert a claim via the specified claims process, to register ENG Tokens as a class of securities, and to file periodic reports with the SEC. While Enigma agreed to the terms of the settlement, it did not admit nor deny the SEC’s findings. In a blog post, Enigma stated the “settlement clears the way for our development team to focus fully on our original and continued vision: building groundbreaking privacy solutions that improve the adoption and usability of decentralized technologies, for the benefit of all.”

According to the SEC’s order, Enigma conducted its ICO to raise funds to develop a platform for digital asset traders to test trading strategies, and to build a data marketplace for cryptocurrency-related, and other, data. From June to September 2017, Enigma issued 75 million ENG Tokens and raised digital assets (i.e., Bitcoin and Ether) valued at approximately $45 million.

The SEC determined the ENG Tokens were offered and sold as securities, applying its framework for evaluating whether the offer and sale of a digital asset is an “investment contract” (and therefore a security subject to regulation and whose offer and sale must be registered or qualify for an exemption). As might be expected, the SEC focused on the purchasers’ reasonable expectation of profit. Specifically, the SEC cited various representations Enigma made to investors in connection with the ICO, about the use of the raised capital to develop its products, and the potential success of such products and its business.

Further, the SEC’s order detailed that Enigma, as part of the offering, sold ENG Tokens both (1) in a “Pre-Sale,” at around a 10% discount, pursuant to purchase agreements (specifically, Simple Agreements for Future Tokens (SAFTs)), which were supposed to only be sold to accredited investors and (2) in a one-day “Crowd Sale” to general public investors. Though Enigma filed a Form D claiming an offering exemption under Rule 506(c) (the “general solicitation” exemption), the SEC did not agree that the offering satisfied this exemption.

Ultimately, the SEC determined Enigma was required, and failed, to register its ICO in accordance with the Securities Act. “All investors are entitled to receive certain information from issuers in connection with a securities offering, whether it involves more traditional assets or novel ones,” stated John T. Dugan, Associate Director for Enforcement in the SEC’s Boston Regional Office. “The remedies in [the SEC’s] order provide ICO investors with an opportunity to obtain compensation and provide investors with the information to which they are entitled as they make investment decisions.”

This is one of the SEC’s latest actions against the once popular ICO, which was used by entities to raise significant amounts of money without complying with U.S. securities laws. As the SEC continues to bring actions against ICOs, we expect to see more fundraising in the distributed ledger world conducted in compliance with the Securities Act, including, for example, through security token offerings (often referred to as STOs).

Trump Administration Plans to Introduce New AML Requirements for Cryptocurrencies

Treasury Secretary Steven Mnuchin remarked before a hearing of the Senate Finance Committee three weeks ago that “significant new requirements at FinCEN” for cryptocurrencies would be introduced quickly, in response to Senator Maggie Hassan’s (D-NH) question regarding the Treasury Department’s proposed use of budget increases for anti-money laundering (AML) and counterterrorism efforts (video of the Senate Finance committee available here, Senator Hassan’s question begins at 58:05). Mnuchin’s remarks reflect the government’s continued focus on AML and counterterrorism efforts. In October of last year, leaders of the Commodity Futures Trading Commission (CFTC), the Financial Crimes Enforcement Network (FinCEN) and the Securities and Exchange Commission (SEC) issued a joint statement regarding such efforts (explored in our post here).

Mnuchin’s comments reflect the same concerns he made in a statement last summer during a White House briefing regarding Libra, the cryptocurrency proposed by Facebook. Then, he stated that “… Libra could be misused by money launderers and terrorist financiers”. He also reiterated that “cryptocurrency money transmitters are subject to compliance examination just like every other U.S. bank” under the Bank Secrecy Act. The same concerns prompted the Financial Action Task Force to update their standards last June to recommend ”virtual asset service providers” (including online trading platforms and digital asset custodians) to verify the originator and beneficiary information, including for any transfers of $1,000 or more.

Regulators’ concerns about the link between cryptocurrencies and criminal activity, such as money laundering, are substantiated by the growing illicit use of cryptocurrencies. According to a report released in January by Chainanalysis, the amount of cryptocurrencies spent on “dark net markets” rose 70 percent in 2019 to an all-time high of $790 million. The New York Times recently highlighted the growth in ransomware attacks demanding Bitcoin.

Enforcement is also on the rise. Earlier this month, federal law enforcement arrested Larry Harmon, CEO of Coin Ninja, for allegedly participating in a $300 million money-laundering conspiracy by operating Helix, a “tumbler” that concealed the source or owner of Bitcoins. The indictment charged him with (i) conspiracy to launder monetary instruments, (ii) operating an unlicensed money transmitting business and (iii) money transmission without a license.

The U.S. government continues to focus on the use of digital assets for illicit means. While AML rules have traditionally applied to actors in the financial sector, some of which have applied to companies in the digital asset industry, we expect to see additional rules and regulations addressing illegal use. Companies should ensure compliance with current AML and counterterrorism rules and regulations, and should be prepared to take additional action in the future.

EU Commission’s “A European strategy for data” Includes Blockchain Shout-Out

On February 19, 2020, the European Commission (Commission) released a communication entitled “A European strategy for data”. It lays out a vision for a “European data space” and a plan – through legislation, technical standards and public-private initiatives – for the EU to become a future leader in data and to create a more permissive data economy. For a more in-depth summary, see our New Media and Technology Law Blog.

One interesting point (among others of course) is the Commission’s highlighting of blockchain technology in its report. First referencing blockchain on page 10, the Commission highlights blockchain on page 11 in a framed provision:

New decentralised digital technologies such as blockchain offer a further possibility for both individuals and companies to manage data flows and usage, based on individual free choice and self-determination. Such technologies will make dynamic data portability in real time possible for individuals and companies, along with various compensation models.

The use of blockchain as a means of controlling the access to, and use of, data elements is one of the oft-discussed means of securing access to personal data. However, certain core features of blockchains (such as “immutability”) raise challenges in the context of applicable laws, including, for example, the feasibility of compliance with data subjects’ rights to request deletion of their data from the blockchain pursuant to the California Consumer Privacy Act (CCPA) or the E.U.’s General Data Protection Regulation (GDPR) or other law or regulation.

It seems likely that such challenges and issues will be resolved, as has often been the case with new technologies, through technological innovation or the evolution of legal frameworks, and that the use of blockchain to manage the exchange of personal information will proliferate. It is interesting to see the Commission recognize that in its document.

Blockchain 51% Attacks – Lessons Learned for Developers and Trading Platform Operators

Once purely theoretical, “majority” or “51%” attacks on public blockchains have dealt participants a reality check: The fundamental assumption of Satoshi Nakamoto’s 2008 Bitcoin whitepaper (that computing power will remain sufficiently decentralized in blockchain networks that rely on a “proof-of-work” consensus mechanism) can in practice actually be exploited to enable double spending.

“The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes…. If a majority of CPU power is controlled by honest nodes, the honest chain will grow the fastest and outpace any competing chains. To modify a past block, an attacker would have to redo the proof-of-work of the block and all blocks after it and then catch up with and surpass the work of the honest nodes.” – Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System

These incidents have provided opportunities for developers of both public and private blockchains, as well as operators of blockchain-based digital asset trading platforms, to learn from the first generation of blockchain deployments. Continue Reading

Supply Chain Blockchain Initiative Receives Federal Antitrust Exemption

TradeLens – a blockchain based shipping consortium – received an important antitrust exemption last week from the Federal Maritime Commission.  The exemption allows five major container line shipping companies within the TradeLens consortium to cooperate in providing data for use on the TradeLens platform. The platform was developed by IBM and Maersk GTD.  Generally speaking, the TradeLens platform offers APIs for digital communication of supply chain event data and allows for sharing of documents with permissioned parties in the supply chain, with the intent of lowering costs associated with documentation and bureaucracy. The associated Cooperative Working Agreement (the “Agreement”), which became effective on February 6, 2020 when the deadline for the Federal Maritime Commission to reject the Agreement passed without incident, enables the various container line parties that are signatories to the Agreement to exchange information related to supply chain events and collaborate on further developing the platform without fear of antitrust exposure under federal law (e.g., the U.S. Shipping Act of 1984, as amended).

Under the Agreement, the parties are expressly permitted to discuss the “terms and conditions of the Parties’ provision of data to the platform, permitted uses of such data, and input into products and services to be offered on the [TradeLens platform]….”, as well as the terms surrounding the placement of bills of lading and similar documents on the blockchain.  The Agreement also authorizes the parties to collaborate on the data provided to the TradeLens developers and on establishing terms governing the storage, protection and use of data related to the operation of the platform. The Agreement carves out certain marketplace competition-related information from the antitrust exemption, however.  For instance, the Agreement does not authorize the parties to discuss “vessel capacity to be deployed by any of them” or terms and conditions or rates and charges related to providing ocean transportation services to their customers.

It is not surprising that we are seeing continued deployment of blockchain in the supply chain space, given the potential benefits of cost reduction, improved security of transactions and the increased ability to use data analytics to optimize distribution and logistics networks.  Still, as we’ve previously discussed in two of our Practice Notes, Blockchain and Supply Chain Management and Best Practices: Smart Contracts, and in various posts on our blog www.blockchainandthelaw.io, despite the potential advantages of adopting blockchain solutions in supply chains, legal and practical concerns need to be appropriately addressed for participants to fully realize those benefits.  Among those concerns, antitrust is front and center. When companies decide to test or operate a supply chain blockchain solution, it is necessarily a collaborative affair, raising potential antitrust issues (particularly when competitors within the same industry are collaborating and sharing data about their operations).  Thus, as the TradeLens Agreement illustrates, the success of a blockchain initiative depends not only on the technology but also on resolving some important legal issues to allow the necessary collaboration and interoperability.

LexBlog