September 29, 2020

Volume X, Number 273

September 28, 2020

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BitBlog Bi-Weekly Update: April 21, 2020

While the world at large shelters in place due to COVID-19 legal and regulatory activity of digital asset and the blockchain world is hopping. Below are a just a few stories of import and interest from the last few weeks, many of which are covered in more detail on the BitBlog. 

Hanging on the Telephone: Judge Enters Order Blocking Telegram ICO

In what may be the most important FinTech legal ruling of the last few weeks or potentially this year, Judge P. Kevin Castel of the Southern District of New York struck his gavel and “hung up” on Telegram’s contentious $1.7 billion initial coin offering (“ICO”). Judge Castel ruled Telegram's planned distribution of Grams, a digital asset to be used on the TON Blockchain, likely constitutes a securities offering under the Securities Act of 1933 (the “Securities Act”) and should not be afforded an exemption from registration. Castel granted the U.S. Securities and Exchange Commission (“SEC”) a preliminary injunction preventing Telegram’s distribution of its Gram tokens for the foreseeable future. Notably, Judge Castel found that “the economic reality is that the Gram Purchase Agreements and the anticipated distribution of Grams by the Initial Purchasers to the public via the TON Blockchain are part of a single scheme.”

Telegram argued that the ICO took place through two separate transactions; (1) the initial sale of a security exempt from registration with the SEC under the Securities Act pursuant to the safe harbor of Regulation D using a structure called a Simple Agreement for Future Tokens (“SAFT”); and (2) a planned distribution of the digital asset to be called Grams to the initial SAFT purchasers in the ICO. Telegram argued only the first of these transactions should be subject to securities laws because the later distribution of Grams did not constitute securities. Instead, Judge Castel preliminarily found that there is a reasonable likelihood that the two transactions will be treated as one under the securities law doctrine known as integration.  Because this is a preliminary finding, it has no precedential effect in or out of the case, but it does demonstrate the heavy odds that Telegram will have to overcome to win.

Judge Castel also rejected Telegram’s request to exclusively issue Grams outside of the United States. The court did not believe that Telegram could “implement safeguards” to prevent U.S persons from obtaining the Gram digital assets. Punctuating his decision, Judge Castel noted that since “the TON Blockchain was designed and is intended to grant anonymity to those who purchase or sell Grams […] any restriction as to whom a foreign Initial Purchaser could resell Grams would be of doubtful real-world enforceability.”

It’s The Fall That’s Gonna Kill You

Like Butch Cassidy and the Sundance Kid gloriously diving off a cliff, Telegram appears to have taken the fall and may be taking the infamous SAFT with it.  However, Telegram and supporters are making a number of important arguments about the regulation of digital assets.  The Blockchain Association recently filed an amicus brief [1] in the U.S. Court of Appeals for the Second Circuit Court in Telegram’s appeal of the order granting injunction, arguing that the SEC’s limited regulatory guidance and public statements encouraged the adoption of the SAFT.  While Polsinelli has actively discouraged the use of the SAFT since its rise to prominence, the editors of the BitBlog were happy to see the Blockchain Association echo concerns originally raised by Polsinelli FinTech and Regulation attorneys several years ago, that the SEC has failed to engage in formal rulemaking to address the regulation of digital assets.[2]

All About the Integration - SEC Says Kik Illegally Offered Securities

If proponents of the SAFT aren’t having a hard enough time with the Telegraph injunction, they should read the SEC's brief in support of motion for summary judgment in the Kik case. The SEC argues that even if Kik conducted two separate offerings of Kin, Kik still does not qualify for the Rule 506(c) exemption from registration of the securities because it cannot demonstrate that its “two” offerings should not be integrated and considered a single offering.

The Best Laid Plans: SEC Announces Examination Priorities for Regulation Best Interest and Form CRS

On June 5, 2019, the SEC adopted Regulation Best Interest (“Regulation Best Interest”), which establishes a new standard of conduct under the Securities Exchange Act of 1934 (“Exchange Act”) for broker-dealers and related individuals when making a recommendation for any securities transaction or securities investment strategy to a retail customer.[3]  In conjunction with the adoption of Regulation Best Interest, the SEC will require SEC registered broker-dealers and investment advisers to provide a brief customer or client relationship summary that provides information about the firm.[4]

On April 7, 2019, the SEC Office of Compliance Inspection and Examinations (“OCIE”) announced its areas of focus in 2020 for examining compliance by broker-dealers with Regulation Best Interest and Form CRS and by investment advisers with Form CRS.[5]  Polsinelli’s FinTech and Regulation Practice and Investment Funds Team have prepared a summary of the OCIE Risk alert.

New Crypto Lawsuits…Just Desserts For ICOs or Legal Obstacles to Claims?

On April 3, 2020, eleven lawsuits were filed in the Southern District of New York against a broad array of issuers and exchanges for allegedly offering and selling unregistered securities in violation of both federal and state securities laws during the ICO boom of 2017 and 2018.

These lawsuits seek billions of dollars in damages against a number of well-known crypto-companies. The lawsuits accuse these issuers and exchanges of selling digital assets without (i) registering with federal or state regulators or (ii) an applicable registration exemption. The cases also contend that crypto-trading platforms benefited financially from listing these illegally offered securities. The investors also allege that, in addition to selling unregistered securities, crypto-trading platforms manipulated the cryptocurrency markets for their own benefit.

While the suits are in their infancy, and the defendants have not yet raised any defenses, some argue these suits were filed outside of the applicable statute of limitations period.  Ordinarily, the statute of limitations for clams under the Securities Act is one year from discovery of the violation, but no more than three years after the offering for claims.  However, because the structure of many offerings included a long delay from the time that the alleged securities were offered until the digital assets were issued, plaintiffs are likely to argue that the three year limitations period should begin with the issuance of the digital assets rather than the offer date. Further, while state law claims were not alleged, many of states have statutes of limitation periods that exceed the Securities Act.

Hell Hath No Fury Like an ICO Investor Scorned

Richard B. Levin, Chair of the FinTech and Regulation Practice was recently quoted in Decryprt about the recent filings of class action lawsuits.  In the article Polsinelli and Levin were recognized for having predicted two years ago that a flurry of crypto class actions would be coming.  In the article, The ticking time bomb of ICO class-action suits, when asked about clams of some lawyers that the cases will be dismissed, Levin noted he does not agree and that the lawsuits could drag on for years and drain some of these companies of most of the money they raised in their token offerings.

SEC’s Proposal to Enhance, Modernize, and Harmonize Private Offering Rules

On March 4, 2020, published a proposed rule change “Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets” (the “Release”),[6] the SEC proposed amendments to several SEC rules providing exemptions from the registration requirements of the Securities Act of 1933, as amended (“Securities Act”).  The Proposals are intended to increase the utilization of infrequently relied upon private offering exemptions under the Securities Act and to harmonize various private offering exemptions and related SEC rules. Countless companies and investment funds, from blockchain focused early state companies to mature and well established companies, raise capital in reliance on one or more of the exemptions from the registration requirements of the Securities Act.

The Proposals are intended to meet evolving market needs by increasing the efficiency of the capital raising process by raising the ceiling on the amount of funds that could be raised in three infrequently used exemptions under the Securities Act: Regulation A, Regulation CF and Rule 504 of Regulation D.  The Proposals also seek to afford greater clarity around the SEC’s integration doctrine that can pose challenges for companies with ongoing or recurring financing needs.  Finally, the Proposals would harmonize certain rules common to many types of exempt offerings, with the intent to potentially make it easier for companies to avoid compliance pitfalls in their private capital raising initiatives.  Certain of the amendments proposed in the Release are outlined in an alert [LINK] written by members of Polsinelli’s Securities and Corporate Finance practice team. 

Libra… Reinvented

The Libra Project announced the digital currency structure would be revised to address concerns raised by lawmakers and regulators in a number of jurisdictions.  This is no surprise considering the regulatory headwind that Facebook has met from global regulators and lawmakers.  The new proposal includes a stable coin fixed to a single currency instead of the original one that was set to a basket of currencies. Another important change, though one that was becoming increasing obvious was the project is now planning to launch in phases and in consultation with regulators.

A Spoonful of Sugar Helps With Regulation
Financial Stability Board (“FSB”) Consultation on Global Stablecoins

In the spirit of cooperation with issuers, the FSB has published for consultation ten high-level recommendations to address the regulation of global stablecoins. The FSB noted stablecoins “have the potential to enhance the efficiency of the provision of financial services, but may also generate risks to financial stability.” The FSB’s recommendations call for regulation, supervision and oversight that takes into account the evolution of global stablecoins.

The consultation paper represents an important opportunity for FinTech firms, regulators, government officials, and academics to comment on the proper regulation of stanlecoins. The public consultation period closes on Wednesday July 15, 2020. The final recommendations will be published in October 2020.

il Grande Vecchio Would Be Mortified - Fraudsters Use Digital Asset Scam to Buy a Ferrari

The SEC recently obtained an order freezing the assets of a former state senator and two other fraudsters who bilked investors in and outside the U.S. The SEC alleges the defendants sold a purported digital asset called the “Meta 1 Coin” in an unregistered securities offering.  The defendants made false and misleading statements that the Meta 1 Coin was backed by a $1 billion art collection or $2 billion of gold, and that an accounting firm was auditing the gold. The defendants never distributed the Meta 1 Coins and used the more than $4.3 million in investor funds to pay personal expenses and funnel proceeds to two others parties.  Some of the investor funds were used to buy luxury automobiles.  

CFTC Chair on the line with the Chamber of Digital Commerce

CFTC Chair Heath Tarbert joined the Chamber of Digital Commerce through a webinar on Wednesday, April 7, 2020 to discuss the impact of COVID-19 on virtual currency activity in the current market. Among comments addressing general unrest in the state of the economy in connection with the current epidemic, Chair Tarbert mentioned that the CFTC is in full support of the cryptocurrency industry and stated that this time of crisis might present an opportunity for blockchain and digital assets to capitalize on situations where the majority of people are effectively homebound.

Though it may not be apparent yet, the past six weeks have been transformative for both the world at large and the regulation of digital asset. The decisions of courts and regulators further clarify, and perhaps limit, the terrain on which digital assets may be issued and traded. But things are changing rapidly and a digital currency or security that isn’t tied to the economic health of a nation could quickly find home in a necessary niche. Some key takeaways are that Fin-tech obviously does not in a vacuum and the essential qualities of block-chain and distributed ledger technology are uniquely suited to this time.

Court Tells Asylum Seeker His Fear of Retaliation by Ukraine Doesn’t Justify Concealing Funds through Cryptocurrency

Volodymyr Kvashuk, a Ukrainian citizen seeking asylum in the United States, was convicted for defrauding Microsoft of more than $10 million. Mr. Kvashuk used a program to steal gift cards from Microsoft, his then employer, and converted the funds to cryptocurrency. On appeal, Mr. Kvashuk argued the court’s exclusion of his asylum application undermined his conviction—that he had used cryptocurrency to conceal funds not as a means for fraud, but instead to avoid detection by Ukrainian authorities, who he feared would retaliate if his asylum application were discovered. But the court was unconvinced, for one, by the lack of evidence supporting Mr. Kvashuk’s assertion that his actions were motivated by fear of foreign persecution. The court upheld the conviction but opened the door for future asylum seekers to justify questionable use of cryptocurrency. For the full BitBlog post, click here.

CryptoCharacters Podcast

Ep 20 - Dr. Shreni Zinzuwadia - COVID-19 Symptoms, Treatment, Prevention

Given the spread of COVID-19, Polsinelli shareholder, BitBlog contributor, and host of the CryptoCharacters podcast, Jason Nagi recently interviewed a veteran Emergency Room physician, Dr. Shreni Zinzuwadia, practicing in northern New Jersey — the second hardest hit COVID-19 location in the nation.  They discuss what doctors are doing to fight the spread of COVID-19, including simple tests for when you should seek treatment in the current environment, and the medical community’s current understanding of the virus.  Watch or listen to this important Episode (Ep. 20) of Crypto-Characters: Dr. Shreni Zinzuwadia- COVID-19, Symptoms, Treatment, and Prevention.

Ep 19 (pt 1) - René Dreifuss - Radical MMA/The Martial Podcast - Innovation and the Martial Way

Listen to Jason’s interview with René Dreifuss, Head Coach of Radical MMA and host of The Martial Podcast. René, who holds a master’s degree from Columbia University in Japanese Studies, is a black belt in the innovative martial art of Brazilian Jiu Jitsu and a mixed martial artist. Get René’s take on martial arts as a path to self-improvement and strategic thinking. Learn the importance of leaving your comfort zone to improve efficiency and effectiveness, and how information technology has allowed people across the world to jointly develop new martial arts techniques and counters.


[1] Blockchain Association’s Amicus Brief

[2] Rulemaking petition regarding the regulation of digital assets and blockchain technology

[3] Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 34-86031 (June 5, 2019), 84 Fed. Reg. 33318 (July 12, 2019), available at: https://www.govinfo.gov/content/pkg/FR-2019-07-12/pdf/2019-12164.pdf. The SEC has also prepared a Regulation Best Interest Small Entity Compliance Guide, available at: https://www.sec.gov/info/smallbus/secg/regulation-best-interest and FINRA has prepared guidance on Regulation Best Interest, available at: https://www.finra.org/rules-guidance/key-topics/regulation-best-interest.

[4] Exchange Act Release No. 86032, Form CRS Relationship Summary, Amendment to Form ADV (final rule) (June 5, 2019), 84 Fed. Reg. 33492 (July 12, 2019), available at: https://www.sec.gov/rules/final/2019/34-86032.pdf, Form ADV Instructions, available at: https://www.sec.gov/rules/final/2019/34-86032-appendix-a.pdf and Form CRS Instructions, available at: https://www.sec.gov/rules/final/2019/34-86032-appendix-b.pdf.  

[5] Risk Alert: Examinations that Focus on Compliance with Regulation Best Interest (April 7, 2019), available at: https://www.sec.gov/files/Risk%20Alert-%20Regulation%20Best%20Interest%20Exams.pdf, and Risk Alert: Examinations that Focus on Compliance with Form CRS (April 7, 2019, available at: https://www.sec.gov/files/Risk%20Alert%20-%20Form%20CRS%20Exams.pdf (collectively, the “OCIE Alerts”).

[6] Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, Exchange Act Release 33-10763 (March 4, 2020), 85 Fed. Reg. 17956 (March 31, 2020), available at: https://www.govinfo.gov/content/pkg/FR-2020-03-31/pdf/2020-04799.pdf.

© Polsinelli PC, Polsinelli LLP in CaliforniaNational Law Review, Volume X, Number 112

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About this Author

Stephen A. Rutenberg Shareholder Polsinelli New York Bankruptcy and Financial Restructuring Bankruptcy Litigation Capital Markets ,Commercial Lending ,Debt and Claims Trading, Financial Services, Insolvency, Financial Technology FinTech and Regulation
Shareholder

Stephen Rutenberg’s practice focuses on the intersection of special situations investing and FinTech including cryptocurrency and blockchain technology. 

A significant component of Stephen’s practice relates to his work in the distressed debt market, representing clients in the purchase and sale of loans and securities of distressed and bankrupt companies. Recent representations include advising on the purchase, sale and financing of bankruptcy trade claims in several major chapter 11 cases, including Lehman Brothers, and the MF Global and Icelandic bank liquidations. He works with...

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Richard Levin brings his experience as a senior legal and compliance officer on Wall Street and in London to bear in advising clients on corporate, securities and regulatory issues. A problem-solver by nature, his practice focuses on helping financial services and technology (FinTech) clients identify and address regulatory issues as they build their businesses.  

The FinTech sector is experiencing rapid changes that are producing innovative new technologies: digital currencies, blockchain technology, peer to peer lending, robo advisors, crowdfunding portals, and electronic trading platforms. These changes are challenging early stage companies and established financial services firms to understand the legal and regulatory issues associated with the development of these innovative technologies. Polsinelli is at the vanguard of these changes.

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Daniel L. McAvoy Shareholder Investment Funds Securities & Corporate Finance Mergers, Acquisitions and Divestitures Corporate and Transactional Joint Ventures and Strategic Alliances
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Dan McAvoy focuses his practice on private closed-end investment funds, corporate finance and M&A with a focus on private investment fund transactions, including complex GP-led restructurings and secondary transactions. Dan is a trusted adviser to numerous investment advisers, fund sponsors and investors, and has represented a range of companies, from startups to Fortune 500 companies. Dan has also represented portfolio companies and sponsors through all parts of the corporate life cycle, including formation, venture financings, add-ons, stock sales, asset sales, private and...

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Jason A. Nagi, Polsinelli, Distressed note purchases lawyer, Real estate matters attorney
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Jason Nagi helps clients find the most efficient route to their desired result and clients have relied on him to get them what they need – in and out of the courtroom – for more than a decade.

He has significant experience representing parties involved in the following matters:

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Carter D. Gage Associate Corporate and Transactional Investment Funds
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As an associate in the Corporate and Transactional practice, clients rely on Carter Gage to deliver a wide range of legal services during the life cycle of the client’s business. His practice focuses on advising clients on mergers and acquisitions and general corporate and transactional matters, ranging from selecting the appropriate choice of entity to dispositions and exit strategy. 

Carter focuses on building quality relationships with clients in order to better understand their needs and better project what issues their businesses might encounter in the future. He believes that...

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