Mutability in Crypto and Recent Moves by the SEC

Scott Kupor

Over the last few weeks, we’ve seen a number of SEC actions surrounding crypto that provide some meaningful insight into the regulatory posture of the agency. Last week, the SEC filed an action to enjoin Telegram (creators of the Telegram Open Network, or “TON”) from distributing tokens (called “Grams”) that it had promised to purchasers of a prior investment contract.

In the week prior, the SEC entered into settlement agreements with two crypto companies — (creators of the EOSIO software that was the basis for the EOS blockchainmaker of EOS) and Nebulous (creators of SiaFunds and SiaCoins). and Nebulous acknowledged that each had violated the U.S. securities laws by raising capital without registering those securities or relying upon an exemption from registration. was assessed a $24 million fine by the SEC (less than 1% of the $4 billion it had raised in the offering); Nebulous was fined $225,000, twice the amount it has raised. The Telegram action was not a settlement, but rather an action by the SEC to prevent Telegram from distributing what the SEC deemed “securities”.

Being on the wrong side of an SEC injunctive or enforcement action is not cause for celebration; but, in this case, there may at least be a silver lining. For, despite the seriousness of these violations, these actions are very revealing about the regulatory landscape for crypto projects more generally.

But first, a quick recap.

We’ve written about this previously, but the key regulatory question overhanging crypto has been whether crypto tokens are securities under the Howey test, and suggested a framework for thinking about the characterization of a token based upon the lifecycle of a token. In the pre-network phase, the token sponsor may raise capital to fund the development of a network. This is exactly what Telegram, and Nebulous did: marketed a pre-network token to purchasers, the proceeds of which were intended to permit Telegram to build out TON, Nebulous to build out the ultimate crypto network for its file sharing services and for to build out a basis for a fully distributed network necessary for a proof of stake protocol.

As the SEC found in its settlement orders with and Nebulous, this sale of pre-network tokens was in fact a sale of securities: Purchasers invested money with an expectation of profit, which expectation relied on and Nebulous (the concerted effort of “others”) to in fact build and launch the network.

This was not a surprising finding from the SEC, but rather consistent with its other enforcement actions. Nonetheless, for companies and practitioners in the space, these settlement orders underscore the application of Howey to pre-network capital raises. Any capital raising efforts at this stage need to either comply with securities law registration requirements or be subject to an exemption from the securities laws.

Importantly, and distinct from the Telegram offering, and Nebulous raised money from unaccredited investors (these are investors are deemed “unsophisticated” because they don’t have a lot of money). Sales of unregistered securities to unaccredited are generally illegal in the U.S. (save some minor exceptions under the post-JOBS Act crowdsourcing rules); thus, the SEC’s findings.

In the Telegram case, however, Telegram sold to “sophisticated” investors through an exemption to the securities laws. Thus, the question for the SEC in this case was not whether the initial sale of the investment contract to these investors was permissible (unlike in the and Nebulous cases), but rather whether Telegram’s planned distribution of Grams to these purchasers was permissible.

And, therein is where the SEC actions provide some interesting insight — not for what the SEC in fact did, but rather for what the SEC did not do!

The agency didn’t require that or Nebulous shut down its or any related crypto networks. That is, while the SEC fined the organizations for the fundraising activities each had conducted in violation of the securities laws, it did not conclude that the ongoing operations of the respective networks violated the securities laws. In fact, it’s possible that the SEC viewed the launch of the EOS mainnet as independent of’s ERC-20 token sale, providing evidence of EOS mainnet’s decentralized and distributed structure and consistent with the SEC’s focus on decentralization. And the Nebulous waiver letter notes the level of activity and usage of Siacoin.

Why does this matter?

In June 2018, SEC Corporate Finance Director Hinman outlined his views on the application of Howey to crypto networks. He introduced the concept of “mutability” — that a token could be a security under some circumstances, but then change into a non-security in other circumstances. As noted above, in the pre-network stage, tokens will generally be characterized as securities in light of the “reliance on the efforts of others” prong of the Howey test. However, post-network launch — provided that the network is sufficiently decentralized — the nature of the token can change from security to non-security, owing to the fact that the holder of the token is no longer relying on the efforts of others (i.e., the corporation that may have originally launched the token). Rather, the success or failure of the token is reliant upon the value of the token as determined by the decentralized community versus a centralized and coordinated corporation.

While this speech is more than a year old, many in the industry did not know what to make of the probative value of the speech: was this simply a framework offered by Hinman or reflective of the stance the SEC would take when faced with mutable tokens?

We of course already knew that the SEC deemed Bitcoin and Ethereum as sufficiently decentralized so as not to be securities, but the SEC had never opined formally on the mutability question with regards to Ethereum. There has never been an enforcement action related to the original capital raising efforts that Ethereum did many years ago, so we didn’t have any official view from the SEC as to whether Ethereum had once been a security, but no longer was.

The and Nebulous settlements now shed some light on that important question.

While the SEC determined that’s ERC-20 token (the token sold in the offering that is the subject of the SEC’s Order) and Siafunds were “securities”, in neither case did the SEC’s actions address EOS or Siacoins. Had the SEC determined that EOS and Siacoins were still “securities”, we would have likely seen the SEC force the sponsors to cease and desist from allowing their respective tokens to trade. After all, securities cannot be traded other than through registered exchanges or under exemptions from the securities laws, neither of which is present in the EOS and Siacoins situations. Instead, the SEC fined the sponsors for their pre-network capital raising activities, but permitted them to continue the operation of the related networks. Thus, the concept of mutability may have some foundation at the SEC.

Of course, it’s important to recognize that settlements are very fact-specific and do not necessarily provide precedential value for other sponsors.

In fact, we know from the settlement, that the SEC’s decision was likely informed by the significant efforts that had taken post-capital raise to ensure that compliance and regulatory matters were first class citizens. also undertook specific efforts to attempt to exclude U.S. purchasers from the offering; the SEC may have viewed this favorably. We also know that the original purchasers from whom money was raised received ERC-20 tokens, but such tokens have effectively been retired and purchasers later received a separate EOS token. Thus, it’s not technically the case that the original ERC-20 tokens (which were securities) converted into EOS tokens (which are now deemed non-securities).

In addition, just because the SEC didn’t shut down the current trading of EOS tokens, it doesn’t automatically follow that they don’t deem them securities. Rather, the regulatory purview of the SEC — like most administrative agencies — enables them to act by negotiated settlement with a counterparty or by deciding to take that counterparty to court to see whether they can convince a judge to sanction a counterparty. It’s possible that the SEC determined that this was the best settlement it could achieve in the most expedient way, while avoiding the costs, time and vagaries of going to court.

Importantly, the SEC’s injunctive relief action against Telegram is also consistent with the above reading of the two settlement actions. As we mentioned previously, there is no dispute among either the SEC or Telegram as to the nature of the original capital raising process; Telegram sold an investment contract to sophisticated investors to enable them to use the proceeds of that offering to build TON. But, as of October 31, Telegram was intending to distribute Grams to these purchasers; the question now became whether the original investment contract (a security under Howey) had morphed from a security to something else based on the nature of TON’s operational status.

In support of its injunction motion, the SEC pointed to a few salient facts about TON/Grams: (i) the TON foundation, while operational, is controlled by the Telegram founders and thus not independent (or “distributed” in crypto terms) of Telegram and (ii) TON itself is not really operational (thus, we don’t have a “functioning network” in crypto terms) and (iii) although there are some lock-up provisions that restrict resale of some of the Grams that purchasers will be delivered, there is no utility in the network such that purchasers can really only sell their Grams for a potential profit versus utilizing them for some non-investment like function in TON.

In essence, the SEC argues (these are my words, not theirs) that there aren’t sufficient conditions to support mutability. We still have purchasers who continue to rely on the concerted efforts of others (because TON is not functional nor decentralized) with a primary expectation (or at least motivation) of profit versus utility.

It appears from the SEC’s application for injunctive relief that its primary concern was the fact that some of the Grams holders would be able to sell their holdings (post-October 31) for investment purposes. From the SEC’s application: “Once Grams reach the public markets, it will be virtually impossible to unwind the Offering, given that many purchasers’ identities will be shrouded in secrecy, and given the variety of unregulated markets where Grams may be sold, including platforms that promise anonymity and encryption capability to mask transactions.” Although not explicitly addressed by the SEC, this statement raises the question as to how the SEC might have felt about the distribution of Grams had there been a functioning network in which Grams holders might have been able to participate.

So, given all of that, what do these SEC actions offer in terms of the regulatory framework in which crypto networks operate:

  • Pre-network capital raises will be deemed securities — we knew this before, but now really know this! Either sell an investment contract to only accredited investors or register the securities with the SEC — those are the options.
  • But, the nature of a pre-network security may change to a post-network non-security if the network is sufficiently decentralized such that purchasers are no longer primarily relying on the coordinated efforts of others. We still don’t know precisely what the tipping point is for what “decentralized” means. Future enforcement actions or guidance from the SEC will be required to get more clarity, as this determination is at the sole discretion of the SEC.
  • And, while every analysis is fact specific, a sponsor’s activities to take regulatory compliance seriously does matter. The SEC acknowledges the presence of these efforts in the case and bemoans the absence of them in the Telegram action.

While reading the tea leaves is never perfect, the SEC’s actions here are helpful in providing some additional clarity to crypto network providers.


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