Between Bridges by Gary DeWaal: March 30, 2020 (Unregistered Digital Securities Offering; Risk Management Breakdown; COVID-19)

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Published Date: March 29, 2020

Last week a federal district court ruled that a social media company’s initial fundraising to build a blockchain application as well as its later, proposed distribution of digital tokens to serve as virtual currency and for other legitimate purposes on the blockchain constituted an integrated unlawful offering of securities without a registration statement and granted a preliminary injunction banning the distribution as requested by the Securities and Exchange Commission. Separately, a futures commission merchant was sanctioned by the Chicago Mercantile Exchange as a result of a purported operational breakdown that enabled it to accept trades “far beyond” risk limits that should have been in place for the relevant account. As a result, the following matters are covered in this special edition of Between Bridges:


In October 2019, the SEC filed a complaint and obtained a temporary restraining order against defendants from delivering and making available Grams digital tokens to US persons. The SEC charged that, in early 2018, the defendants raised US $1.7 billion from 175 purchasers, including $424.5 million from 39 US persons, to fund the development of a proprietary blockchain – the Telegram Open Network – as well as their mobile messaging application, Telegram Messenger. In return for their investment, initial purchasers were expected to have received 2.9 billion Grams by October 31, 2019. The SEC claimed that the defendants’ offer and sale of Grams to US persons constituted an unregistered securities offering, and that Grams were securities because initial purchasers and subsequent investors expected to profit through Telegram’s efforts to develop TON, including to attract sellers and developers to use the blockchain and to promote Grams generally. 

Defendants conceded that their agreements with the initial purchasers were securities, but claimed they were issued pursuant to a lawful exemption from registration as they were sold in the US solely to highly qualified persons. However, defendants denied that their proposed distribution of Grams in October 2019 would have been part of an illegal securities offering because, when issued, Grams would have constituted a virtual currency and/or a commodity and not a security under federal law. The initial offering and the subsequent distribution should be viewed as two distinct transactions, claimed the defendants. (Click here for further details in the article “SEC Obtains TRO Against ICO to Support Social Media and Blockchain Platforms After Telegraphing Warnings” in the October 13, 2019 edition of Bridging the Week.)

The court rejected defendants’ argument, saying that the initial offering had to be viewed in the context of a “single scheme” to distribute Grams into a secondary public market supported by Telegram’s ongoing efforts. As a result, the court concluded that “the appropriate point at which to evaluate this scheme to sell and distribute Grams is at the point at which the scheme’s participants had a meeting of the minds, i.e., at the time of the 2018 sales, rather than the date of delivery.” Examined in this light, the court said the initial offering was a “disguised public distribution” requiring a registration statement.

Previously, defendants had voluntarily agreed to postpone distribution of Grams until resolution of the SEC’s motion. (Click here for background in the article “Defendants Formally Stipulate to a Delay in Digital Asset Distribution That SEC Alleged Constituted an Unregistered Offering” in the October 20, 2019 edition of Bridging the Week.)

In other legal and regulatory developments impacting cryptoassets:

Although the CFTC does not typically regulate spot transactions involving retail clients, retail commodity transactions on a leveraged or margin basis, or financed by the offeror, the counterparty or a person acting in concert with such persons on a similar basis may implicate certain Commission requirements – namely registration requirements by the offeror and a requirement that the products be traded on or subject to the rules of a designated (e.g., licensed) contract market. (Click here to access 7 U.S.C. § 2(c)(2)(D)(i).) The key is whether actual delivery of the commodity has occurred within 28 days of the transaction. If yes, CFTC registration and other requirements are not implicated. If no, CFTC registration and other requirements are implicated.

The CFTC initially proposed its interpretive guidance in December 2017. (Click here for background in the article “CFTC Proposes Interpretation to Make Clear: Retail Client + Virtual Currency Transaction + Financing + No Actual Delivery by 28 Days + No Registration = Trouble” in the December 17, 2017 edition of Bridging the Week.)

The final guidance is materially identical to its proposal except that it authorizes an offeror of virtual currency to a retail person to custody the digital asset at an affiliated depository provided the separate legal entity is: a financial institution that is predominantly operated to provide custody services and licensed to provide custody services, among other conditions. The final guidance, as did its proposal, provides five hypothetical examples of when actual delivery may or may have not occurred.

Although IOSCO acknowledged that stablecoins might be very different in construction and could reference disparate assets including fiat currencies, other real-world assets and other crypto-assets, or be algorithmically controlled, it designed a hypothetical stablecoin similar to Facebook’s proposed Libra digital coin that would be backed by a reserve fund of low volatility currencies, bank deposits and sovereign debt instruments to base its analysis. It proposed that for its studied stablecoin, a host of intermediaries would be involved in creating and redeeming the cryptoasset as well as making deposits to and receiving payments from the reserve fund. (Click here for details regarding Libra in the My View commentary to the article “Global AML Standards Setter Says Countries Should Require Virtual Asset Service Providers to Obtain and Transmit Certain Information Regarding Senders and Recipients for All Virtual Asset Transfers” in the June 23, 2019 edition of Bridging the Week.)

IOSCO concluded that its hypothetical stablecoin might implicate its principles governing systemic financial market infrastructures (FMIs), as well as principles, policies and/or recommendations related to money market funds, the protection of client assets, exchange-traded products, cryptoasset trading platforms, financial benchmarks, commodities derivatives markets, cooperation and mitigating market fragmentation and cyber resilience for FMIs, as well as other guidance. 

IOSCO indicated, however, that in considering how any particular stablecoin might touch existing principles and recommendations, the stablecoin “should be viewed holistically, considering its substance over its form, and considering the economic realities of the proposal.”

My View: Oranges are not securities, even under the 1946 Supreme Court decision, SEC v. WJ Howey, where initial purchasers bought contracts of sale coupled with service contracts for the growing of oranges that were intended to be sold to third parties. (Click here to access the decision in Howey). The Supreme Court held that the initial contracts of sale were investment contracts (and thus securities) because of the scheme that ultimately led to the sale of the oranges, but never intimated that the oranges themselves were by law, through alchemy or otherwise transformed from commodities into securities.

However, the court in Telegram adopted a different principle of transmutation in holding for the SEC. Not only were the initial contracts to support the creation of the TON Blockchain and Grams securities, ruled the court, but so were the Grams themselves, even though they were intended solely to function as a medium of exchange and other legitimate purposes on the TON Blockchain – i.e., as a commodity – and would only be distributed after the blockchain was entirely functional.

This magic might be attractive to Harry Houdini and his protégées, but it very well could sound the death knell of fundraising through exempt securities offerings to support the development of creative decentralized blockchain applications that rely on ancillary digital assets for legitimate on-chain purposes. Hopefully the court’s decision in Telegram engenders momentum for the SEC to consider adopting a rule proposed by Commissioner Hester Peirce in February this year to provide developers of digital networks, such as a blockchain or distributed ledger, a three-year grace period to develop the functionality or decentralization of the platform without implicating registration requirements of securities laws, provided certain conditions were satisfied. However, I am not optimistic.

Virtu Financial Global Markets LLC also agreed to pay a fine of US $65,000 to the New York Mercantile Exchange for purported system glitches that, on two occasions, caused a large volume of non-actionable messages to be sent to a market segment gateway used for the exchange’s energy futures products, causing latencies for other market participants of over one second. The first incident occurred on June 12, 2018, and was allegedly caused by an error in a modified version of an existing application installed a few days earlier, while the second incident occurred on June 18, 2018, purportedly when the firm was installing a fix to address the first incident, claimed NYMEX.


Compliance Weeds: In March 2016, staff of the Commodity Futures Trading Commission’s Division of Swap Dealer and Intermediary Oversight issued an advisory providing guidance regarding elements of an effective risk management program (RMP; click here to access the relevant CFTC advisory). 

Pursuant to applicable CFTC rule, futures commission merchants are required to establish, maintain and enforce risk management policies and procedures designed to monitor and manage the risks associated with their business (click here to access CFTC Rule 1.11). Among the risks FCMs should address in their RMP are market, credit, liquidity, foreign currency, legal, operational, settlement, segregation, technological and capital risks. Each FCM’s RMP must be administered by a risk management unit (RMU) that is independent of the firm’s business unit (BU) and reports directly to the FCM’s senior management. 

In the advisory, staff made specific recommendations or provided observations regarding elements of what it considers effective RMPs. Among other items, staff suggested that FCMs may want to include in their RMPs a description of how independence of the RMU is maintained from the BU; how often an FCM considers the adequacy of resources of the RMU; and a description of risk tolerance limits, including, for each risk type, the methodology to determine the limits and the procedure to ensure quarterly review and approval by senior management as well as annual approval by the FCM’s governing body.

Staff also made observations regarding the quarterly risk exposure reports that must be made to an FCM’s senior managers and governing body and provided to the CFTC. Among other things, staff observed that some FCMs disclose actual risk exposures for each period for each risk metric rather than just discuss breaches. According to staff, “[f]or example, the maximum, minimum, median and standard deviation for risk exposures could be provided or shown graphically over the course of the quarter.” 

Additionally, an FCM must broadly evaluate its risks when designing its RMP. An FCM must consider risks posed by affiliates, all lines of the FCM’s business, all other FCM trading activity and “must describe in detail how the RMP has been integrated into risk management at the consolidated entity level.” (Click here for further CFTC guidance on RMPs in the Federal Register release adopting CFTC Rule 1.11 (pgs. 68517 – 68521).)

Although the staff’s guidance was expressly limited to the application of its risk management program requirements to FCMs that handle customer funds, a similar requirement to maintain RMPs applies to swap dealers and major swap participants (click here to access the relevant CFTC Rule 23.600). Staff indicated that similar guidance might be issued to SDs and MSPs later; however, this has not happened yet. As a result, this FCM guidance should be considered by SDs and MSPs, by analogy, to evaluate the adequacy of their own RMPs. 

Other suggestions applied to member firms. These suggested good practices are useful and practical for all firms involved with financial services, whether FINRA members or not.

Our financial services industry is experiencing unprecedented volatility and derivative fall-out as well as difficulties occasioned by our working remotely. However, as challenging as our circumstances may be they are no match for the challenges of so many others.

The COVID-19 pandemic will pass, and at some point, we all will return to normalcy, although we cannot predict today what the new normal will look like. However, for some of our community, the challenges of our current times will have a longstanding impact. Let's not forget those persons.

More Briefly:

As of February 28, 2020, KOSPI 200 index’s largest constituent, Samsung, was 33.16 percent of the index’s weighting. Under applicable law a narrow-based security index includes an index “in which a component security comprises more than 30 percent of the index’s weighting.” (Click here to access 7 U.S. Code § 1a(35).)

Corrected: April 5, 2020 to reflect that on February 28, the weighting of Samsung was 33.16 percent; it had increased to over 30 percent weighting by the end of December 2019.

Additionally the SEC approved Cboe’s codification of prior guidance that off-floor transfers cannot net against other positions and no position may result in preferential haircut treatment or better margin treatment. Other codification of interpretations and rule amendments were also approved, including that approved transfers should be non-routine and non-recurring. (Click here to access Cboe Rules 6.7 and 6.8.)

For further information

Amended Cboe Transfer Trade Rules Approved by SEC:

Block Trade Guidance Issued by ICE Futures U.S.:

Cboe Transfer Trade Rules' Amendments Approved by SEC:

CFTC, SEC and Other Regulators Continue to Address Extraordinary Circumstances Prompted by COVID-19 Pandemic

FCM Sanctioned US $150,000 by CME for Alleged Risk Management System Breakdown Permitting Excessive Customer Trading

FINRA Issues Alert Addressing Unique Cybersecurity Concerns Arising From Conducting Business From Remote Locations:

ICE Clear Europe Proposes Rule Amendments to Accommodate Default Insurance:

IOSCO Posits Hypothetical Stablecoin Scenario to Inform International Regulators How Standard Principles of Oversight Might Apply:

KOSPI 200 – Non-US Stock Index Futures Today, Security Futures Contracts Tomorrow:

IOSCO Posits Hypothetical Stablecoin Scenario to Inform International Regulators How Standard Principles of Oversight Might Apply:

NYDFS Requires Regulated Virtual Currency Firms to Advise It of COVID-19 Preparedness Plan by April 9:

Retail Purchaser Possession and Control Critical to Actual Delivery Says CFTC in Final Guidance on What Constitutes Actual Delivery of Virtual Currencies:

US Court Rules in Favor of SEC in Telegram Lawsuit; Holds That “Grams” Digital Assets Promised as Part of Private Offering Constituted Securities:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of March 27, 2020. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or employees.

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Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.

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