One of the essential matters confronting participants in cryptoasset markets is the need to understand how cryptoassets are characterised for regulatory purposes. Issuers, brokers, exchange platforms, payments service providers, investors and others will all need to consider the extent to which a given token falls within the perimeter of regulators in the relevant jurisdictions as this may have a substantial impact upon their obligations and/or rights within the market.
The characterisation of tokens is currently the subject are high-value litigation before a New York Court in relation to 'Grams' issued by Telegram Group, a privately owned BVI company headquartered in Dubai. In January 2018, Telegram, through its subsidiary TON Issuer, began raising capital to finance the development of its 'TON Blockchain', a system which, according to the TON ICO whitepaper, is 'designed to host a new generation of cryptocurrencies and decentralised applications, at a massive scale'.
During an initial offering in January to March 2018, Telegram offered investors future rights to receive Grams via Gram Purchase Agreements (GPAs) and committed to deliver the Grams in conjunction with the launch of the TON Blockchain by no later than 31 October 2019. Telegram is said to have raised approximately $1.7bn from the initial offering stage, of which $424.5m was raised from investors based in the US.
SEC steps in
However, on 11 October 2019, the Securities and Exchange Commission (SEC), the body with regulatory authority over the USA securities markets, filed an emergency action in the New York District Court seeking judgment and an injunction permanently prohibiting the issue of Grams.
In essence, the SEC has taken the view that Grams are securities and therefore fall within its regulatory purview. The consequence of this, the SEC argues, is that the initial offer and sale violated federal securities law and was illegal for failure to comply with that law. The SEC also argues that any future unregistered offer and sale of Grams will also be illegal.
Telegram takes the position that the rights to future Grams sold under the GPAs are distinct from the Grams themselves in that the former were sold pursuant to investment contracts and are therefore securities, whilst the latter are not because, once issued, Grams will operate as a simple medium of exchange like a currency.
Telegram then argues that because the GPAs were sold only to a limited class of sophisticated investors and not to the general public, the initial offering did not breach federal securities law. The SEC rejects this on the basis that the GPAs and Grams are indivisible for regulatory purposes and Grams will be available via secondary markets to the general public upon issue.
A hearing has been listed to take place on 18 and 19 February for a final determination. Until then, Telegram has agreed not to offer, sell or deliver any tokens until the conclusion of the hearing.
The decision will clearly be of critical importance to Telegram and the 171 investors who entered into the GPAs. However, it may well also provide an interesting perspective on the characterisation of token sales and, specifically, whether regulators should draw a distinction between, on the one hand, ‘rights to future tokens’ and, on the other, the tokens themselves.
In the UK, the Financial Conduct Authority has issued a report distinguishing between security tokens, which are regulated, and exchange tokens (ie cryptocurrencies), which are not. Although the FCA’s report is clear that each token is considered on a ‘case-by case’ basis, this distinction might suggest that the FCA would take the view that, on the assumption that the ultimate token operates as a simple medium of exchange, the ‘right to a future token’ may fall within its regulatory perimeter whereas the token itself may not.
It is hoped that cases such as the Telegram case and guidance such as that provided by the FCA will gradually lead to greater certainty and confidence in the cryptoassets market.
For now, however, in the event that the SEC succeeds, the consequences for Telegram and/or the investors could be very serious. Market participants should therefore ensure they take proper advice on the relevant regulations and be wary of the risks of operating in the relatively nascent cryptoassets market.
Peter Stewart is an Associate at law firm Cooke Young and Keidan.