Ex parte injunction
The Securities and Exchange Commission (“SEC“) announced today that it filed an emergency application ex parte in US Federal District Court in Manhattan, and after a hearing, obtained a temporary order over the initial coin offering (“ICO“) launched by Telegram Group, Inc. (“Telegram“), the messaging application, which raised $1.7 billion from investors around the world thus far.
According to the SEC, Telegram and its subsidiary, TON Issuer Inc., started to solicit money from investors for its ICO commencing in January 2018 to finance its operations, and its fund-raising activities were global and included the solicitation of funds from US investors. In January 2018, Telegram represented it was creating its own Blockchain called the Telegram Open Network. It is alleged to have sold 2.9 billion units to 171 investors, which in the ICO world translates into 2.9 billion digital currency tokens which were called Grams. Over 39 of those investors were resident in the US.
Part of the representation to investors, alleges the SEC, was the delivery of the Gram tokens to investors in a digital currency wallet by October 2019, ergo, the promise of liquidity and control of the investment, similar to a representation that an investor’s funds would be used to purchase shares that were liquid and tradable.
No registration of securities
Telegram allegedly did not register the offering or the sale of its ICO with the SEC. Part of the requirement of selling investments to the public, subject to an exemption, includes disclosing to investors the information they need to make informed decisions such as risk factors, the legality of the offering, the financial condition of the issuer, the expertise and experience of its management and information in respect of insiders, as well as any material information.
The white paper for the TON ICO is here.
It promises investors that with their investment, the issuer will create a multitude of Blockchains, and like EOS, it will approve limited validators to validate transactions on the Blockchain, thus making it, like EOS, not decentralized. It controls the validation participants and process. One of the applications of the TON is payments, and the TON is providing payments services globally using digital currencies. Holders of the Gram ICO would earn commissions (or dividends) from transactions, according to the White Paper. Page 132 of the White Paper confirms that Telegram considered its ICO an “investment.”
The SEC’s co-director of the SEC’s Division of Enforcement, Steven Peikin, said that “issuers cannot avoid federal securities laws by labeling products a token.”
TON Issuer Inc. is a BVI company whose directors are two relatives, Pavel Valerievich Durov, also the director of Telegram the app, and Nikolai Durov. In an SEC filing, they represent both to be resident in the BVI with a resident address at a law firm in the BVI, the same place the BVI corporate entity resides. It is the same address that appears in the Panama Papers for various entities. The filing for corporate purposes of residence in the BVI in respect of one director of the app, Telegram, is an attornment to the jurisdiction of BVI of that one director.
The SEC is seeking a permanent injunction, disgorgement of the proceeds of the ICO sales and civil penalties against the two corporate defendants.
The SEC’s investigation is being conducted by Daphna A. Waxman, Morgan B. Ward Doran and John O. Enright of the SEC’s Cyber Unit, and supervised by Carolyn Welshhans, Acting Chief of the SEC’s Cyber Unit and Lara Shalov Mehraban, Associate Regional Director of the New York Regional Office. The SEC’s litigation will be led by lawyers Jorge G. Tenreiro and Kevin McGrath.
Joint statement by SEC, CFTC and FinCEN
At the same time, the SEC, CFTC and FinCEN issued a joint statement in respect of the anti-money laundering and counter terrorist financing obligations of entities that engage in the business of money transmission (whether registered or not), including activities of accepting currency, funds or value, or selling securities, or providing exchange services, including ICOs that transmit and accept digital currencies on behalf of others as their business.
The way ICOs work is that no AML, CTF and sanctions vetting takes place at the time of the investment. That’s because investors, let’s say 20,000 of them, each send Ether or Bitcoin from their wallet, an exchange or a Trezor, to the pooled wallet of the ICO. Technology-wise, the ICO does not need to open an account and onboard each person that sends it digital currencies to invest before the financial transaction takes place. Legally they may have to, but as a matter of technology, they don’t and there is no correspondent bank like in banking, in the middle to gate-keep the system.
Most ICOs wouldn’t have the manpower to onboard for AML purposes, 20,000 people in a few days or even a few weeks. And they typically will not invest in being AML compliant. So they accept the investment via digital currencies into their wallet, not knowing from where it comes or who made the financial transaction, whether it is from a prohibited person or country, and even whether it is proceeds of crime and thus ICOs that have the promise of liquidity are high risk for financial crime, money laundering and terrorist financing.
There is no visibility on who the transactors are behind any of the transactions. Later, when an ICO has closed, some ICOs attempt to obtain and verify the ID of the transactors behind the transactions but they are few and far between.
This digital currency exchange, which has a trust charter with New York State and a BitLicence, both with fairly onerous financial crime and integrity compliance requirements, surprisingly agreed to list Telegram’s ICO but it’s unclear how that is possible if the digital currency is an unauthorized issuance of a securities. Trust charters, issued by bank regulators, require that financial institutions uphold the integrity of the financial system, including by not supporting activities under their licences or charters that are not legal and which could negativity impact integrity or the public’s perception of the rule of law. The concern is that digital currency exchanges take in digital currencies into their pooled wallet and keep it there, and on the administrative accounting side, all they do is ledger an individual account with its holdings. That means that when an exchange takes on an ICO that may be tainted, or be the proceeds of crime, it brings those proceeds into its pooled wallet and co-mingles it.
In the case of TON, the combination of the ICO and the offering of a global payments service in the absence of registration of any kind, and in the absence of any AML, CTF, sanctions processes in place, would have been of concern to any government regulator, considering the reach of the Telegram app, the countries in which it operates (such as Iran), and the anonymity with which it operates on the surface. Areas at high risk for terrorism would be of additional concern because of the real potential that the new digital currency payments function within the app could be used in theory for terrorist financing.
This article a few days before the injunction says that the TON ICO was not on the radar of any regulator.