S.E.C. Regulates Initial Coin Offerings
“Crypto crime”—that is, crime involving cryptocurrencies and other digital assets, including fraud and hacking—has cost investors approximately $4.3 billion in 2019 alone. That number may rise as cryptocurrencies become more popular and accessible to the public. If cryptocurrencies and other digital assets are unregulated, companies and individuals can continue to prey on unsuspecting investors and steal their hard-earned cash.
Fortunately, the Securities and Exchange Commission (“SEC”) has taken the position that initial coin offerings (“ICO”) are covered by the Securities Act of 1933 (“Securities Act”), and the agency has consequently claimed the authority to protect investors in digital assets. The SEC has used its enforcement powers to prevent fraudulent ICOs and return money to investors before the money is lost for good. However, the SEC’s position that ICOs are within the SEC’s purview has not yet been confirmed by a court. S.E.C. v. Telegram Group Inc., No. 1:19-cv-09439 (S.D.N.Y.) is therefore poised to be a monumental case that can affirm the SEC’s enforcement powers over digital assets and protect investors.
1. The SEC Has Previously Found that ICOs are Subject to SEC Regulations.
The SEC has developed a framework for deciding whether an ICO is an “investment contract” and therefore a “security” regulated by the SEC. The SEC reviews the ICO and determines whether there is an investment of money in a common enterprise with a reasonable expectation of profits. Since an ICO can have many different properties, the SEC analyzes the ICOs individually to see whether the test is met and the ICO is an “investment contract.”
Simply, in an ICO, a company raises funds by offering a new cryptocurrency token to investors. Typically, the company promises that the funds raised will be used for the creation of a product or service, and once that product or service is built, the company will deliver tokens to the investors.
As mentioned, each ICO is different. The company will generally publish a “whitepaper” to market the ICO and explain how the company will use the funds raised and what the rights of the tokens are. The company may obligate themselves to develop an innovative product or impose a minor obligation on themselves in exchange for the investment. Further, the company can generate a variety of rights for the tokens, including “rights to profits, shares of assets, rights to use certain services provided by the issuer, and/or voting rights.”
Finally, the tokens may have different uses to the investor. When the token is delivered, the investor can either hold the token and hope it appreciates in value, trade the token for other digital assets, redeem the token for a fiat currency (i.e., a U.S. dollar), or use the token in exchange for products or services.
Companies frequently do not abide by SEC regulations during these ICOs. This creates a potential to defraud investors as the company may not disclose all the risks of investing in the company through the ICO or the company may raise money and not create the intended product or service.
Therefore, the SEC has investigated and fined several companies who have met the test above for their unregistered ICOs:
- On September 29, 2017 The SEC charged Maksim Zaslavkiy and his two companies, REcoin Group Foundation and DRC World for selling unregistered securities through an ICO when neither had any real operations.
- On December 11, 2017, the SEC halted Munchee Inc.’s ICO as it constituted unregistered securities offers. The SEC decided not to pursue penalties because Munchee returned all proceeds to investors and the SEC action occurred before any tokens were delivered to investors.
- On September 30, 2019, the SEC settled charges with Block.one for a $24 million penalty for conducting an unregistered ICO.
- On December 11, 2019 the SEC charged Eran Eyal, founder of UnitedData Inc., for conducting a fraudulent unregistered ICO and scamming investors by never creating a functional platform.
However, these enforcement actions were all settled before a court had to decide whether an ICO is within the SECs’ purview.
2. The SEC’s Lawsuit Against Telegram Will Force the Southern District of New York to Decide This Issue.
In S.E.C. v. Telegram Group Inc., 1:19-cv-09439 (S.D.N.Y.), the SEC alleges Telegram Group, Inc. (“Telegram”) conducted an unregistered ICO in violation of the Securities Act. On January 13, 2020, the SEC filed a motion for summary judgment on liability, alleging that Telegram’s ICO was a security offering, and that Telegram is not exempt from the registration requirement imposed by the Securities Act. The SEC’s motion is currently pending before Judge P. Kevin Castel.
A. Background Information about Telegram and its Initial Coin Offering
Telegram owns “Telegram Messenger,” a private and free messaging platform with approximately 300 million monthly users. To raise cash to maintain Messenger’s services and create new products, Telegram conducted a private ICO. Between January and March 2018, Telegram raised approximately $1.7 billion in fiat and digital currencies from 171 investors in exchange for the issuance of a token called a “Gram.”
Telegram issued the Grams to investors once it developed and launched the TON Network, a blockchain that would be able to host a new generation of cryptocurrencies and process payments at rates that could compete with credit cards and fiat currency.
Telegram promised to use the funds to develop a TON wallet (a digital wallet where users could send, receive, exchange and buy cryptocurrencies and Grams), the Grams themselves, and other Telegram related products. Telegram’s vision was to integrate the TON Network with its Messenger application and create products and services that would require the use of Grams, so the demand for and value of Grams would increase.
As part of its ICO, Telegram did not file registration papers that would provide “important information about [Telegram’s] business operations, financial condition, risk factors and management.” Telegram also did not restrict investors from distributing the Grams to the public.
B. The SEC’s Motion for Summary Judgment
The SEC moved for partial summary judgment arguing, among others, that (1) the ICO is an “investment contract” and therefore a “security” that is regulated by the Securities Act, and (2) Telegram is not exempt from the required registration.
Under Section 5(a) and (c) of the Securities Act, it is “unlawful for any person” to “sell” a “security” unless a registration statement is in effect or has been filed. As there was no dispute that Telegram did not file a registration statement and that Grams were sold, the question that the court needs to consider is whether Telegram sold a “security” under the Securities Act. A “security” regulated by the Securities Act includes “investment contracts,” which involves “ an investment of money  in a common enterprise  with profits to come solely from the efforts of others.”
The SEC alleges that the ICO satisfies the three-part Howey test and the ICO is an investment contract. First, Telegram obtained an investment of money by receiving $1.7 billion in funds through its ICO. Second, the investors of the Grams and Telegram employees who also were distributed Grams all had a strong economic incentive for the value of Grams to appreciate. And third, the investors relied on the Telegram team to create products and services to drive up the demand and value of the Grams. Thus, the SEC concludes that the ICO was an investment contract.
However, even if the ICO was an investment contract, if the Grams offered through the ICO were only distributed to accredited investors and were not further distributed to the public, Telegram would be exempt from the registration requirements. Telegram had claimed this exemption.
The SEC states that the Grams issued to investors were intended to be distributed to the public and thus the exemption is inapplicable. First, Telegram did restrict investors from further distributing the Grams once they are sold. Second, the investors bought the Grams at a lower price than the planned price that the Grams would be offered to the public, creating an incentive for the investors to capitalize on the appreciation of the Grams. Third, Telegram only distributed 60% of the Grams to investors, and plans to distribute some of the remaining Grams to the public. For those reasons, the SEC alleges that Telegram’s ICO was not exempt from the registration requirements, and that Telegram fraudulently held an unregistered ICO.
3. Why this Decision is Important to Whistleblowers
The SEC relies on the assistance of whistleblowers to protect investors from predatory company tactics and rewards them with between 10% and 30% of any recovery that the SEC collects. To submit a tip to the SEC anonymously and receive an award, an attorney must submit the information on the whistleblower’s behalf. Thus, not only are whistleblowers preventing innocent investors from being defrauded, there is a potentially lucrative reward for them.
Whistleblowers should be aware that the SEC will investigate fraudulent actions by companies in digital assets. Further, if the Court agrees with the SEC, whistleblowers can be assured that their company’s failure to abide by the SEC’s regulations in an ICO, even when there is no other evidence of fraud, may be illegal. Whistleblowers are often key to the ongoing battle against fraud.
 Paul Vigna and Eun Young Jeong, Cryptocurrency Scams Took in More Than $4 Billion in 2019, Wall Street Journal (Feb. 8, 2020), https://www.wsj.com/articles/cryptocurrency-scams-took-in-more-than-4-billion-in-2019-11581184800.
 See Framework for “Investment Contract” Analysis of Digital Assets, U.S. Sec. & Exch. Comm. (Apr. 3, 2019), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.
 Complaint at ¶ 30, S.E.C. v. Telegram Group Inc., No. 1:19-cv-09439 (S.D.N.Y.), ECF No. 1 (hereinafter “Complaint”).
 Press Release, SEC Exposes Two Initial Coin Offerings Purportedly Backed by Real Estate and Diamonds 2017-185, U.S. Sec. & Exch. Comm. (Sept. 29, 2017), https://www.sec.gov/news/press-release/2017-185-0
 Press Release, Company Halts ICO After SEC Raises Registration Concerns 2017-227, U.S. Sec. & Exch. Comm. (Dec. 11, 2017), https://www.sec.gov/news/press-release/2017-227
 Press Release, SEC Orders Blockchain Company to Pay $24 Million Penalty for Unregistered ICO 2019-202, U.S. Sec. & Exch. Comm. (Sept. 30, 2019), https://www.sec.gov/news/press-release/2019-202
 Press Release, SEC Charges Founder, Digital-Asset Issuer With Fraudulent ICO 2019-259, U.S. Sec. & Exch. Comm. (Dec. 11, 2019), https://www.sec.gov/news/press-release/2019-259
 Note that at least two other pending cases also present the question whether an ICO is a security regulated by the Securities Act. See S.E.C. v. Blockvest, LLC, No. 18-cv-2287, 2019 WL 625163, at *1 (S.D. Cal. Feb. 14, 2019); S.E.C. v. PlexCorps, No. 17-CV-70072018 WL 4299983, at *1 (E.D.N.Y. Aug. 9, 2018).
 Complaint at ¶¶ 37, 41.
 Plaintiff’s Mot. for Summ. Judgment at 24, S.E.C. v. Telegram Group Inc., 1:19-cv-09439, (S.D.N.Y. 2020), ECF No. 79 (hereinafter “Mot. for Summ. Judgment”).
 Complaint at ¶¶ 83, 97.
 Id. at ¶1.
 Mot. for Summ. Judgment at 14.
 15 U.S.C. §§ 77e(a), (c).
 Mot. for Summ. Judgment at 16.
 S.E.C. v. W.J. Howey Co., 328 U.S. 293, 301 (1946)
 Mot. for Summ. Judgment at 22–26.
 17 C.F.R. §§ 230.505(c), 230.502(d).
 Mot. for Summ. Judgment at 31.
 Id. at 31.
 17 C.F.R. § 240.21F-5(b).
 17 C.F.R. § 240.21F-9(c).