Regulating Telegram’s ICO: how to make every mistake with the SEC
Telegram provides a case study in how not to architect a SEC compliant project. While from the outside, the SEC hasn’t been very clear on how to create a utility token, there is in fact a compliant path that has been followed by companies like Hedera Hashgraph which shows the problem is less with the SEC and more with Telegram’s blundering approach.
Security into a Utility
A SAFT (simple agreement for future tokens) offering is governed by securities laws, and US issuers, including Telegram, are careful to abide by the private placement exemption. Telegram’s problem wasn’t in raising money or in building its technology, but in having GRAMs designated as utilities or commodities.
This designation is important because if coins are designated as securities, a whole host of regulatory compliance is required which impairs their use for powering networks.
So what does the SEC look for in determining how when to treat a coin as a utility instead of a security?
Decentralization Requirement
A key area of SEC focus is that of decentralization. Typically, a company raises capital via a security and uses the funds to build the network technology. After the network launches, the SEC focuses on the decentralization of the network’s control and ongoing development.
This requirement for decentralization is foundational to the SEC’s approach but can be difficult for entrepreneurs to understand and presents compliance challenges.
The Ethereum Foundation, for example, has been deemed sufficiently decentralized because it incorporates the input of the community to develop and prioritize technical updates, and because the updates must be accepted by a majority of the independent (decentralized) miners who have proven to be no pushovers.
What doesn’t work, however, is Telegram’s approach of a foundation that is controlled by the same individuals that raised the funds and are building the technology. Just creating a foundation doesn’t result in decentralization.
Efforts of Others and Functionality
Related to decentralization is the critical importance that ‘efforts of others’ (i.e. not the company) drives value increase after network launch. The SEC’s complaint against Telegram specifically cites its founders representing that their stakes in coins would ensure that they were highly motivated to make the network successful and valuable.
While seeming obvious in the for-profit world, the important difference with a utility coin is that rather than the efforts of the founders, it is the users and the community that should be driving any increase in value.
Of nearly equal importance, when the coin is released to investors, the network should have functionality and the coin should immediately have the use for which it is intended. Projects can develop on test nets or with test coins in advance of the actual coins being released, but need to have material day one functionality.
How many independent applications were ready day one for Telegram? Hedera had over a dozen live, independent applications on day one and in week 4 was doing 70% of Ethereum’s transaction volume.
Coin Release and Investor Base
The SEC also cares that the volume of coins released bears some relationship to near term expectations of use. In the Telegram complaint, the SEC was concerned about the ‘dumping’ of coins on the market; referencing the 26% of supply that would be released on day 1 that would seem to be far, far in excess of any day 1 application use.
Hedera released just 1% on day one, an additional 1% over the following week, and the remainder will gradually be released over the next 15 years.
Finally, SEC Commissioner Hester Pierce stated that the number of US investors in a project is relevant, and the SEC cited the $400mm of US sourced investment in Telegram as an issue. The largely successful steps EOS took to restrict its offering to non US investors likely influenced the small fine they paid.
Telegram
Telegram seems to have checked every single box on what not to do: raising from US investors, centralized governance by a foundation controlled by the two Telegram founders, promising to drive value and development post launch (not the efforts of others), releasing a large amount of coins on day one far in excess of any potential use… on a network that was going to have few live third party applications while allegedly working closely with exchanges to be listed.
They were zero for six; Telegram and their attorneys missed literally every single signal from the SEC. Later steps such as the focus on ecosystem development likely were too little too late.
Difficulty is the Point
If meeting all of these conditions seem difficult, that is partly the point. The SEC’s job is to protect investors, and it looks suspiciously upon any attempts to avoid the codified practice of investor protections.
To someone with a hammer, everything looks like a nail, and the SEC sees securities wherever it turns; only in very specific circumstances will it make exceptions. But the SEC actually has had to figure out a way for coins to be treated as utilities because if it doesn’t, then they will have granted Ethereum a monopoly.
Nobody thinks that is the outcome the SEC wants, and their allowance of coin listings from projects like Hedera demonstrates that it works to follow the emerging guidelines. Telegram claims the SEC is unreasonable, but a closer looks shows they have only themselves to blame.
