John Reed Stark

In a series of recent actions, the SEC has demonstrated its aggressive approach toward cryptocurrency regulation and enforcement. In the following guest post, John Reed Stark, President of John Reed Stark Consulting and former Chief of the SEC’s Office of Internet Enforcement, takes a detailed look at the SEC’s recent actions and considers the actions’ implications. A version of this article originally appeared on Securities Docket. I would like to thank John for his willingness to allow me to publish his article on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is John’s article.




This month the U.S. Securities and Exchange Commission (SEC) initiated three illuminating regulatory and enforcement crypto-related actions, celebrating a virtual Octoberfest of crypto-related initiatives and proclamations.


Specifically, the SEC reinforced their cryptocurrency hardline by:

  • Filing an enforcement action seeking an emergency temporary restraining order against Telegram Group and its wholly owned subsidiary Ton Issuer, Inc, halting their $1.7 billion ongoing digital token offering for its failure to register the offering with the SEC;
  • Denying Bitwise Asset Management’s bid to launch a bitcoin exchange-traded fund, stating that the SEC was not convinced the “real bitcoin market” can be resistant to manipulation or fraud; and
  • Releasing a Joint Statement together with the heads of the Commodities Futures Trading Commission (CFTC) and the Financial Crimes Enforcement Network (FinCen), urging anyone dealing with digital currencies to ensure they are adhering to obligations under anti-money laundering and countering the financing of terrorism regulations, regardless of what those digital assets are called.

Over the past several years, the SEC has steadily risen to become perhaps the most effective and outspoken crypto-police force in the world. The SEC has brought a broad range of cryptocurrency-related enforcement actions and turned out a number of thoughtful, forward-thinking and comprehensive regulatory pronouncements. Concurrently, SEC Chairman Jay Clayton has launched his own anti-crypto crusade, bravely taking center stage and plainly asserting that cryptocurrency tokens looked and acted like securities and were susceptible to fraud and chicanery by insiders, management and better-informed traders and market participants.



Some examples of Chairman Clayton’s more biting cryptoisms over the past three years include:

  • “I have yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security . . . there is also a distinct lack of information about many online platforms that list and trade virtual coins or tokens offered and sold in ICOs.” (November 9, 2017, speaking at an SEC Conference);
  • “I believe every ICO I have ever seen is a security . . . ICOs should be regulated like securities offerings. End of Story” (February 6, 2018, testifying before the Senate Banking, Housing and Urban Affairs Committee);
  • “Let me turn to what is a security. A token, a digital asset where I give you my money and you go off and make a venture… And in return for me giving you my money, you’re going to give me a return in the secondary market by selling the token to somebody . . .  That is a security. We regulate the offering of that security and we regulate the trading of that security. That’s our job and we’ve been doing it for a long time. We built a $19 trillion economy and a securities market that is the envy of the world — all done by following these rules.” (June 6th, 2018, during a CNBC interview); and
  • “If investors think there’s the same rigor around cryptocurrency price discovery as there is on the Nasdaq or New York Stock Exchange … they are sorely mistaken.” (September 19, 2019, speaking at the Delivering Alpha Conference). 

Clearly, Chairman Clayton has adopted a dogmatic yet commonsensical approach to crypto-regulation. This article discusses the SEC’s three recent October regulatory and enforcement crypto-maneuvers and offers some thoughts going forward for the cryptocurrency marketplace.


The Telegram TRO


Dating back to as early as 2014, the SEC began bringing enforcement actions relating to cryptocurrency, and with its October 11, 2019 filing of SEC v. Telegram Group, Inc. and Ton Issuer Inc. which sought a temporary restraining order (TRO), the SEC has reached yet another crypto-related milestone.


Without alleging any fraud by any of the defendants, the Honorable Judge P. Kevin Pastel of the United States District Court for the Southern District of New York signed the emergency judicially decreed temporary restraining order, and also granted the SEC expedited discovery and other emergency relief. The SEC’s sole allegation in the Telegram matter is that the defendants were in the midst of an alleged unregistered, ongoing digital token offering in the U.S. that needed to be stopped dead in its tracks, before investors experienced any further harm. This was quite a victory; the SEC rarely, if ever, has brought an enforcement action involving such a large amount of money without any allegation of a swindle, scam or other form of deception.


Telegram, a popular encrypted messaging app, is used world-wide, including by Hong Kong protesters wishing to cloak themselves against detection and monitoring by authorities. The SEC alleges that both offshore Telegram defendants raised over $1.7 billion from investors, making it one of the largest and most well-known token offerings in crypto-history.


According to the SEC’s complaint, Telegram and TON began raising capital in January 2018 to finance the companies’ business, including the development of their own blockchain, the “Telegram Open Network” or “TON Blockchain,” as well as the mobile messaging application Telegram Messenger. Defendants sold approximately 2.9 billion digital tokens called “Grams” at discounted prices to 171 initial purchasers worldwide, including more than 1 billion Grams to 39 U.S. purchasers.


Per the SEC, Telegram promised to deliver the Grams to the initial purchasers upon the launch of its blockchain by no later than October 31, 2019, at which time the purchasers and Telegram will be able to sell billions of Grams into U.S. markets. The complaint alleges that defendants failed to register their offers and sales of Grams, which are securities, in violation of the registration provisions of the Securities Act of 1933.



Stephanie Avakian, Co-Director of the SEC’s Division of Enforcement stated:


“Our emergency action today is intended to prevent Telegram from flooding the U.S. markets with digital tokens that we allege were unlawfully sold . . . We allege that the defendants have failed to provide investors with information regarding Grams and Telegram’s business operations, financial condition, risk factors, and management that the securities laws require.”


Steven Peikin, the other Co-Director of the SEC’s Division of Enforcement stated:


“We have repeatedly stated that issuers cannot avoid the federal securities laws just by labeling their product a cryptocurrency or a digital token . . . Telegram seeks to obtain the benefits of a public offering without complying with the long-established disclosure responsibilities designed to protect the investing public.”


Telegram Fights Back, But Loses (Badly)

On October 16, 2019, Skadden Arps, Slate, Meagher and Flom, counsel to Telegram, filed a response to the SEC, arguing that the SEC’s emergency injunction was unwarranted, throwing a Hail Mary and asking the court to deny the SEC’s motion to enforce a post-TRO subpoena. Telegram argued that its upcoming Gram token was not a security, and that the SEC should not be able to force the company to produce documents or witnesses about its blockchain project.


However, on the same day, in an October 16th, 2019 Declaration executed by Skadden, Telegram consented to the TRO and agreed that they “shall not offer, sell or deliver Grams to any person or entity for a period of five (5) months beginning on the date of this Stipulation, and shall provide thirty (30) calendar days’ notice to the SEC before offering, selling, or delivering Grams to any person or entity following the five month period.” Telegram’s surrender and complete capitulation allowed for the preliminary injunction hearing to be postponed until February 18–19, 2020 (pushed forward from the TRO hearing originally scheduled for October 24, 2020). Meanwhile, expedited discovery continues which will likely become an onerous and costly burden for Telegram — and could reveal further inculpatory or exculpatory evidence.


Even though Telegram has now consented to the SEC’s TRO, promising to halt its offering until the February 2020 preliminary injunction hearing, it is still worth reviewing the SEC’s response to Skadden’s original opposition motion, which the SEC filed in the form of an October 17, 2019 letter to the court. The SEC’s letter reveals just how strongly the SEC believes in its position and gives Skadden a preview of things to come.



In the detailed letter, the SEC reiterated that Telegram has violated the securities laws by selling Grams, which are “securities” under the Securities Act, to certain investors, including buyers in the U.S., without any applicable exemption from registration. The SEC insists that Telegram has not only violated the U.S. securities laws but also stresses that the company is likely to violate the law again.


As an aside, Skadden’s October 16th Declaration also attached email correspondence between the SEC and Skadden, offering a rare glimpse into the desperate flurry of communications from Skadden to the SEC, all occurring amid the harsh reality of the impossible schedule of court ordered expedited discovery facing the defendants:



Telegram Contacts its Investors

According to several online crypto-publications, since the SEC TRO, Telegram has sent at least two emails to investors.


In the first email to investors, reportedly dated October 16, 2019, Telegram explained that the SEC lawsuit has rendered the timing of its token offering unachievable and asked investors to grant the company an extension of time to get its network running. Telegram further offered investors the chance to approve the date change, adding that if the majority of Telegram’s token holders disagree with the delay, they will receive 77 percent of their investment back.


In the second email to investors, reportedly dated October 19, 2019, Telegram encouraged investors to view the February 2020 SEC hearing as “a positive step.” Specifically, Telegram reassures investors that the recent rescheduling of hearings until February is actually good news while maintaining that the company will not be distributing Gram tokens until that time. The Telegram team also explained why the February 2020 hearings would resolve the situation more satisfactorily than the originally scheduled October 2019 hearing. According to Cointelegraph, Telegram stated in the letter:


“Telegram views this development as a positive step towards resolving this matter through the court system in an expeditious manner, and we and our advisers will be using the time to ensure that Telegram’s position is presented and supported as strongly as possible at the February hearing  . . . The February hearing is different from the one previously scheduled for October 24, because in the February hearing Telegram anticipates asking the court to rule on the core argument that Grams are not securities. The October 24 hearing, in contrast, was only to consider whether a delay should have been mandated, without conclusively resolving the core argument.”


Whether Telegram’s questionable spin on the SEC TRO passes the straight face test is beside the point. Clearly, the SEC is digging in on its cryptocurrency crackdown, remaining dogged and engaged.


Furthermore, the rigorous requirements of expedited discovery are now underway for Telegram — and could even lead to additional charges. In short, Telegram has a serious fight on its hands.


The SEC Bitwise ETF Denial

The criminalities associated with cryptocurrency’s use are almost as egregious and disturbing as the criminalities associated with its valuations. Bitcoin and other cryptocurrency’s anarchistic valuations remain generally unregulated and without any meaningful oversight, leaving them easily susceptible to fraud and chicanery by insiders, management and better-informed traders and market participants.


For the typical cryptocurrency trading platform, there is no central regulatory authority; no state or federal team of bank auditors and compliance experts scrutinizing transactions and policing for manipulation; and no existing federal licensure – it’s not just the Wild West, it’s global economic anarchy.


Along these lines, researchers from the University of Texas found that manipulation in the cryptocurrency market is rampant and much of the run-up in Bitcoin’s price during 2017 was due to manipulation orchestrated by the Hong Kong exchange Bitfinex. In a 66-page paper, the authors found that tether was used to buy bitcoin at key moments when it was declining, which helped “stabilize and manipulate” the cryptocurrency’s price. This is yet another reason for bitcoins wildly fluctuating valuations – which during in the past two years has gone from $19,000 to $3,200 and back up to over $11,000.


Similarly, a recently published report by Arcane Research notes bitcoin’s price routinely drops shortly before the Chicago Mercantile Exchange (CME) monthly futures contracts expire. This pattern has existed since January, 2018 and the writers assert that the timing and volume of decline are too significant to be mere coincidence. The report explains a number of scenarios where manipulation may be at work, but does not present any specific, concrete proof.



Thus, it should come as no surprise that the SEC yet again rejected an application for a bitcoin exchange-traded fund or so-called ETF.


ETF’s are baskets of different types of investments that are pooled together into a single entity, which then offers shares to investors that are subsequently traded on major stock exchanges.

Each share of an ETF gives its owner a proportional stake in the total assets of the ETF. ETFs have taken the investing world by storm. All told, investors have put about $3.5 trillion into ETFs as of October 2018 and hundreds of different ETFs are available for purchase.


Specifically, on October 9, 2019, the SEC denied Bitwise Asset Management’s bid to launch a bitcoin exchange-traded fund, stating in its order:


“The Commission is disapproving this proposed rule change because, as discussed below, NYSE Arca has not met its burden under the Exchange Act and the Commission’s Rules of Practice to demonstrate that its proposal is consistent with the requirements of Exchange Act Section 6(b)(5), and, in particular, the requirement that the rules of a national securities exchange be ‘designed to prevent fraudulent and manipulative acts and practices.”


In its application, Bitwise claimed to have identified the 5% of platforms that carry “real trading volume” and pledged to ensure that their ETF would track that tranche of the bitcoin spot market. Bitwise also promised to enter into a surveillance agreement with a large enough portion of the regulated bitcoin futures market to meet SEC requirements. But the SEC was not convinced.


Had the SEC granted Bitwise’s ETF application, the SEC would have been encouraging and facilitating main street investor trading in the oft-manipulated, federally unregulated, chaotic, secretive and fractured international cryptocurrency marketplace. Clearly, the shadowy world of cryptocurrency would have taken on an air of legitimacy that the SEC is simply not ready to sanction.


No Bitcoin ETF Approvals to Date

The SEC has yet to approve any bitcoin-related ETFs, although several proposals have been put before the agency. For instance, in July 2018, The SEC denied an application for the Winklevoss brothers and their company, BZX, to launch a bitcoin-based ETF, citing concerns about the lack of oversight in the underlying bitcoin market.



One SEC commissioner, Hester Pierce, dubbed the “SEC Crypto-mom” by her supporters, dissented from the BZX denial, asserting that she believed BZX’s proposal met the standard for approval and expressed her concern that the SEC’s approach undermines investor protection by precluding greater institutionalization of the bitcoin market.” Commissioner Pierce stated at the time:


“More institutional participation would ameliorate many of the commission’s concerns with the bitcoin market that underlie its disapproval order . . . More generally, the commission’s interpretation and application of the statutory standard sends a strong signal that innovation is unwelcome in our markets, a signal that may have effects far beyond the fate of bitcoin ETPs.”




Commissioner Pierce’s dissent not only contested the disapproval of what would have been the first exchange-traded vehicle of cryptocurrency, but it also became the rallying cry for bitcoin believers who argue that it’s not the role of regulators to tell investors where they can invest.


However, among government officials, Commissioner Pierce may not have many supporters. Even President Trump would disagree with her. When it comes to cryptocurrency, President Trump is surprisingly aligned with Congressional and Senate Democrats, even going so far as to tweet about his disdain and dislike of bitcoin and other cryptocurrencies.


Bitwise ETF Epilogue

Despite some support on its fringes from Commissioner Pierce, the SEC has remained reluctant to approve any sort of cryptocurrency ETF. Now, after the SEC’s Bitwise rejection, the SEC has only one bitcoin ETF proposal currently sitting before it, filed by Wilshire Phoenix and NYSE Arca.



Meanwhile, according to a news release published on October 9, 2019, Bitwise remains surprisingly upbeat about their progress and promisers to re-apply. The Bitwise news release states:


“We deeply appreciate the SEC’s careful review. The detailed feedback they have provided in the Order provides critical context and a clear pathway for ETF applicants to continue moving forward on efforts to list a bitcoin ETF.  . .  We look forward to continuing to productively engage with the SEC to resolve their remaining concerns, and intend to re-file as soon as appropriate.”


The SEC, CFTC and FinCen Joint Statement on Activities Involving Digital Assets

On October 11, 2019, the SEC, CFTC and FinCen released an unusual and rare Joint Statement urging anyone dealing with digital currencies to ensure they are adhering to obligations under anti-money laundering and countering the financing of terrorism regulations, regardless of what those digital assets are called.


The Joint Statement addressed the various labels and terminologies that are used to describe digital currencies, clarifying that their regulatory treatment is determined by the underlying facts, circumstances, uses, and economic realities, and not the label or terminology used to describe them:


“Regardless of the label or terminology that market participants may use, or the level or type of technology employed, it is the facts and circumstances underlying an asset, activity or service, including its economic reality and use (whether intended or organically developed or repurposed), that determines the general categorization of an asset, the specific regulatory treatment of the activity involving the asset, and whether the persons involved are ‘financial institutions’ for purposes of the BSA.”


The Joint Statement emphasized that all financial firms, under each of the three regulator’s purview, must meet their anti-money laundering and countering the financing of terrorism (AML/CFT) obligations under the Bank Secrecy Act (BSA). The Joint Statement also explained in particular that AML/CFT requirements for broker-dealers “apply very broadly and without regard to whether the particular transaction at issue involves a ‘security’ or a ‘commodity’ as those terms are defined under federal laws.


MSB Requirements

By way of background, pursuant to BSA, transactions involving traditional financial firms, such as banks, brokers and dealers, and money service businesses (MSBs), are subject to strict federal and state AML laws and regulations aimed at detecting and reporting suspicious activity, including money laundering and terrorist financing, as well as securities fraud and market manipulation.


MSBs are broadly defined, and have historically been recognized by FinCEN to include: (1) currency dealers or exchangers; (2) check cashers; (3) issuers of traveler’s checks, money orders, or stored value; (4) sellers or redeemers of traveler’s checks, money orders, or stored value; and (5) money transmitters.


MSBs have been required to register with FinCEN since 1999, when the MSB regulations first went into effect. An entity acting as an MSB that fails to register (by filing a Registration of Money Services Business, and renewing the registration every two years per 31 U.S.C. § 5330 and 31 C.F.R. § 1022.380), is subject to civil money penalties and possible criminal prosecution.


The BSA and its implementing regulations require an MSB to develop, implement and maintain an effective written AML program that is reasonably designed to prevent the MSB from being used to facilitate money laundering and the financing of terrorist activities. Since cryptocurrency financial intermediaries provide financial services, they are also mandated by AML regulations to verify their customer’s identity before offering their services, also known as KYC.


Financial institutions often blur the lines between KYC processes and AML practice. In KYC, each client is required to provide verifiable and credible identification credentials in order to use a cryptocurrency company’s service. Customer Due Diligence (CDD) is a basic KYC process where customer’s data such as proof of identity and address is gathered and used to evaluate the customer’s risk profile. Enhanced Due Diligence (EDD) is an advanced KYC procedure for high-risk customers, prone to money laundering and financing of terrorism. Transaction monitoring is a key element of EDD.


AML programs typically include a system of internal controls to ensure ongoing compliance with the BSA; independent testing of BSA/AML compliance; a designated BSA compliance officer to oversee compliance efforts; training for appropriate personnel; and a customer identification program. Thus, to ensure AML compliance, financial firms start with KYC, by obtaining clearly identifiable information about a prospective client, and identifying any potential risks of association.



Cryptocurrency Firms, AML and KYC


The Joint Statement is clearly a shot across the bow for cryptocurrency trading “exchanges” and other platforms. Adhering to AML, CFTC, KYC and the rest of the alphabet soup of rigorous financial regulatory requirements, requires among other things, meticulously recording transactions; definitively knowing who customers are; and promptly and efficiently reporting suspicious activity to law enforcement.


Yet given the identification and verification challenges associated with the global locations, pseudo-anonymity, encryption, decentralization and historically criminal tendencies of typical cryptocurrency users, cryptocurrency intermediaries face extraordinary challenges meeting AML/CFT/KYC obligations.


Along these lines, the New York State Attorney General’s office (NYAG) asked 14 popular crypto trading platforms to respond to answer a detailed questionnaire covering a wide range of topics, from trading fees to anti-money-laundering policies to methods for keeping customer assets secure. Ten chose to comply, and the September, 2018 report of their responses illuminates the shadowy inner workings of cryptocurrency trading platforms, raising serious questions regarding the growing connection between cryptocurrency and money laundering — as well as a range of market manipulation concerns. Not only do cryptocurrency firms typically lack the sophisticated technological compliance infrastructure of traditional U.S. financial institutions, but they are also often misguided when it comes to their AML/KYC and other related BSA compliance responsibilities.


For cryptocurrency firms, the Joint Statement is yet another stark reminder that FinCEN’s AML requirements combined with state law MSB licensing and bonding requirements create a hefty, burdensome and onerous federal and state regulatory burden and concern for crypto-intermediaries



Looking Ahead

Historically the SEC has successfully kept themselves above the fray when it comes to partisan wrangling and bickering, especially when it comes to investor protection. But in the last several years, political infighting has unfortunately become more common among SEC commissioners.


For instance, consider the current fiasco at the Public Company Accounting Oversight Board (PCAOB), which apparently is rooted in a disagreement over regulatory priorities. One board member, Kathleen Hamm, an extraordinarily well-respected and seasoned former legal finance professional, SEC Enforcement division assistant director, U.S. Treasury official and Georgetown Law School adjunct law professor, was not reappointed, after serving barely two years of the tail end of a five year term — despite her willingness to stay on. Normally this sort of term extension is an automatic.


Instead, the SEC replaced Hamm with a far less experienced White House aide and former Republican Senate Banking Committee staffer, and then anointed conservative libertarian SEC Commissioner Pierce to serve as the primary supervisor of the PCAOB board members. Yes, the same SEC Commissioner Pierce mentioned above, who in addition to her support for bitcoin ETF’s, is also an outspoken proponent of rolling back compliance with Section 404(b) of the Sarbanes-Oxley Act.


Departing PCAOB senior employees (some of whom claim that they were pushed out) were reportedly even bullied into signing non-disparagement agreements in exchange for six months of continued compensation. Unheard of for a government agency, non-disparagement agreements are suspicious to say the least, and perhaps even unenforceable.


Meanwhile, the PCAOB has issued 27% fewer audit-inspection reports this year; has not had a permanent general counsel or enforcement director for 16 months; and has around 50 permanent positions currently vacant. This odd PCAOB gerrymandering and slowdown offers a rare glimpse into the political tensions and fractures within the SEC, and seems like an ominous sign for the SEC enforcement program.


However, thanks to SEC Chairman Jay Clayton, with respect to issues of cryptocurrency, the SEC has thankfully remained true to its roots as the investor’s advocate. Chairman Clayton’s steady stream of crypto-related enforcement actions; multiple crypto-related public statements, speeches and regulatory pronouncements; and thoughtful collaboration with other regulatory agencies, has been both heroic and relentless.


Chairman Clayton clearly understands the dark side of cryptocurrency. Need a fake I.D., a bottle of opiates, a cache of credit card numbers or a thousand social security numbers? Need a way to collect a ransomware payment? Need to fund terrorist-related activities? Need to hire a hitman? Need to finance an election tampering scheme? Cryptocurrencies like bitcoin have become the payment method of choice for these, and a slew of other, criminal enterprises.


Moreover, Chairman Clayton has spent the bulk of his entire professional lifetime counseling companies regarding corporate finance and market infrastructure. He therefore undoubtedly also appreciates the virtual driver’s-ed film of possible securities law violations rampant within the cryptocurrency marketplace, raising legal questions and regulatory issues from every angle.


My take is that so long as Jay Clayton chairs the SEC, the cryptocurrency market will thankfully remain stuck and temporized by aggressive SEC enforcement. Furthermore, all cryptocurrency market players should take heed, especially the lawyers who serve as counsel for crypto-related transactions.


By allowing their crypto-clients to peddle unlawful securities and violate a broad range of securities laws, lawyers are failing in their role as gatekeepers. Just consider the many aggrieved parties involved in the Telegram digital coin offering, who already probably paid millions, or perhaps even tens of millions in legal fees. Now, Telegram is stuck with the massive costs associated with the TRO, which will undoubtedly add even more millions of dollars to their legal bills.


By providing the kind of legal advice that can land a client into the SEC’s investigative, regulatory and prosecutorial crosshairs, lawyers risk more than just their reputations and livelihoods. Sooner or later cryptocurrency players who become SEC defendants are going to turn on their lawyers and begin pointing fingers.


Not a pretty picture no matter what the crypto-lawyer’s defense and no matter how much the crypto-lawyer’s good faith.


John Reed Stark is president of John Reed Stark Consulting LLC, a data breach response and digital compliance firm. Formerly, Mr. Stark served for almost 20 years in the Enforcement Division of the U.S. Securities and Exchange Commission, the last 11 of which as Chief of its Office of Internet Enforcement. He currently teaches a cyber-law course as a Senior Lecturing Fellow at Duke Law School. Mr. Stark also worked for 15 years as an Adjunct Professor of Law at the Georgetown University Law Center, where he taught several courses on the juxtaposition of law, technology and crime, and for five years as managing director of global data breach response firm, Stroz Friedberg, including three years heading its Washington, D.C. office. Mr. Stark is the author of “The Cybersecurity Due Diligence Handbook.”