On March 24, 2020, Judge Castel of the United States District Court for the Southern District of New York issued an order granting the SEC’s motion to enjoin Telegram Group, Inc. and its affiliate corporation TON Issuer, Inc. (collectively, “Telegram”) from distributing “Gram” tokens – a digital cryptocurrency to be used in connection with the TON blockchain and the Telegram platform (“Grams”). This article explores the legal basis of the SEC’s position and the counterarguments made by Telegram leading to the Judge’s decision to prevent Telegram from issuing the tokens promised to purchasers.

The Facts

In 2018, Telegram received approximately $1.7 billion from 175 sophisticated entities and high-net-worth individuals in exchange for a promise to deliver Grams at a later date. The sales were conducted in two phases, and Telegram filed for an exemption from registration under 506(c) of Regulation D.

The TON Blockchain

After Telegram’s founders failed to monetize their popular messaging app, they set out on a new venture – the development of the TON blockchain, a “Proof of Stake” system. A proof of stake method of consensus allows validator nodes (computers running full versions of the blockchain software) to earn rewards for authenticating new blocks and voting on rule changes. Validators for the TON blockchain would earn Grams for their services and would be required to stake at least 100,000 Grams as collateral. Initially, the supply of Grams would be limited to 5mm tokens. Each Gram sold would be priced slightly higher than the last.

Telegram Sells Tokens to Initial Purchasers

Telegram sold “interests in Grams” to initial purchasers in two sales, one ending in February (First Sale) and one ending in March (Second Sale). Under the purchase agreements executed in the First Sale, the initial purchasers received a right to Grams in the future when and if the team successfully launched the TON blockchain.

The purchase agreements also included a lock-up provision prohibiting the initial purchasers from selling the Grams unless sold per the following schedule: 1/4 of the grams received could be sold within 3 months of their receipt; the remaining 3/4 could be sold within 6, 12, and 18 months, respectively, of the launch of the TON blockchain. The Purchase Agreements executed in the Second Sale did not include a lock-up provision. The Court noted this distinction in its Howey test analysis (discussed below) and held it supported the SEC’s argument that purchasers expected profits from their purchase of Grams.

Telegram did not register either sales and claimed the exemption provided under Rule 506(c) of Regulation D, which permits the offer and sale of securities without registration if such offers and sales are made only to accredited investors. This exemption also permits general solicitation and advertising of the offering, an important permission since Telegram sought to market their sale of Grams. Following its sales of the Grams Tokens, Telegram developed the TON blockchain and prepared to deliver the Grams to the initial purchasers by its deadline of October 31, 2019.

The Law

Registration Requirement for Offers and Sales of Securities

U.S. securities laws prohibit the offer and sale of securities unless such securities are registered (under a public offering) or exempt from registration. Specifically, Section 5 of the Securities Act prohibits the offer, sale, or delivery after the sale of any security without an effective or filed registration statement. 15 U.S.C. § 77e(a), (c). A “security” is an investment contract. Under the Howey Test, the Supreme Court defined an “investment contract” as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946).

Rule 506(c) Exemption

Offers and sales of securities by an issuer that satisfy the conditions of Rule 506 of Regulation D are not deemed public offerings within the meaning of section 4(a)(2) of the Securities Act. Rule Rule 506(c) of Regulation D is an exemption that permits the offer and sale of securities to accredited investors only but prohibits resales to non-accredited investors for one year. Additionally, an issuer relying on 506(c) must “exercise reasonable care to assure that the purchasers of the securities are not “underwriters” within the meaning of section 2(a)(11) of the Securities Act. This requirement is the crux of the decision in this case.

Analysis

Judge Castel offered the following straightforward summary of the transactions conducted by Telegram:

Telegram entered into agreements and understandings with the Initial Purchasers who provided upfront capital in exchange for the future delivery of a discounted asset, Grams, which, upon receipt (and the expiration of the lockup periods for Round One Purchasers), would be resold in a public market with the expectation that the Initial Purchasers would earn a profit. A reasonable Initial Purchaser understands and expects that they will only profit if the reputation, skill, and involvement of Telegram and its founders remain behind the enterprise, including through the sale of Grams from the Initial Purchasers into the public market.

SEC Argument

The SEC argued that the 175 initial purchasers constitute “underwriters” ready to engage in a distribution of Grams in the public market, whose participants would have been deprived of the information that a registration statement would reveal. Essentially, Telegram’s private sale was window-dressing for the planned secondary offering that would occur using the initial purchasers as conduits to access the public market.

According to the opinion, Telegram argued that the transactions should be viewed separately and argued: (1) the purchase agreements granting initial purchasers a right to receive Grams in the future constitute securities contracts, and Telegram’s offer and sale complied with the requirements of Rule 506(c) making these transactions exempt from registration; and (2) the delivery of the Grams to purchasers upon the launch of the TON blockchain does not constitute a sale of securities because the Grams will have functional consumptive uses and, therefore, would be considered a commodity.

This argument is a bit nuanced. Essentially, Telegram is arguing it sold securities when it sold the contracts for Grams, but its delivery of the Grams would not be the delivery of a security. It would deliver a commodity that purchasers could transact with on the TON blockchain. If the Grams constitute a commodity, then the prohibitions on resale do not apply since such regulations only apply to securities.

This argument is well-supported by commentary from a speech given in June of 2018 (six months after the initial sale) by former SEC Commissioner William Hinman, who stated that digital assets, such as Bitcoin or ETH, transacted on sufficiently decentralized networks are not securities. Generally, a decentralized network will be one in which the actions or efforts of a centralized third party are not required. Commissioner Hinman even stated, “digital assets with utility that function solely as a means of exchange in a decentralized network could be packaged and sold as an investment strategy that can be a security.”

With this backdrop, we can see Telegram’s angle. Though these remarks were made 6-months after Telegram executed the purchase agreements, perhaps there were communications between the SEC and Telegram at this time that led the company to their two-step strategy – sell the purchase agreements; quickly decentralize. If it could sell interests in the Grams to qualified investors in compliance with securities laws, it could deliver a commodity with no restrictions on resale and rely on the initial purchasers to sell the Grams without filing a registration statement.

The Court did not buy Telegram’s argument and refused to bifurcate the sale of interests in Grams and the intended delivery. Judge Castel determined the economic realities of the transactions as a whole constitute a single scheme constraining it to evaluate the offer, sale, purchase, and delivery under Howey.

In holding that the SEC showed a substantial likelihood of success that the delivery of Grams would constitute violations of securities laws, the court made three findings:

(1) the transactions and undertakings by and between Telegram and the initial purchasers constitute a security under Howey;

(2) the Grams are not evaluated upon the launch of the TON blockchain; and

(3) the Grams Sales to Initial Purchasers do not fall within an exemption and constitute a violation of securities laws.

Howey Analysis

For brevity, I will provide an outline of the court’s application of the Howey test to the facts on the record. Importantly, the court determined that the analysis should apply at the time of the sale of the interests in Grams rather than at the time of the release of the Grams tokens.

1. Investment of Money in a Common Enterprise

• Telegram collected investments of money and pooled the funds of the initial purchasers to develop the TON blockchain and expand the success of the Messenger app.
• The ability of each initial purchaser to profit on his or her investment depended on the successful launch of the TON blockchain, thereby establishing horizontal commonality at the time of the sales.
• The Court also found that horizontal commonality existed after the launch of the TON blockchain because the Grams continued to represent pooled funds of the initial purchasers that remain tied to the success of each other’s fortunes and of the TON blockchain.
• The SEC made a substantial showing of strict vertical commonality between the purchasers and Telegram existed since both parties’ fortunes were dependent on the successful development and launch of the TON blockchain. This was evident from the offering materials circulated by Telegram, which stated that it would hold a reserve of 28% of all Grams following the launch of the TON blockchain. Although Telegram argued it intended to transfer the reserve to its foundation or lock the reserve forever, it was under no legal or contractual obligation to do so. If it retained the reserve, its financial success would be linked to the success of the TON blockchain.
• Interestingly, the Court also made mention of various non-monetary benefits that Telegram and its founders would receive upon the successful launch of the TON blockchain, implying that “fortunes” need not be monetary. Such benefits included increased goodwill in the business, the ability to attract new talent, and the potential to raise capital for the messaging platform. This language suggests that strict vertical commonality exists where, upon the successful launch of a blockchain, non-monetary benefits may be imparted on key persons and affiliates of a token issuer.

2. Expectation of Profits

• Discounts. Sales prices were discounted from future sale prices .38, .33 vs. 3.62.
• Telegram’s Price Control Powers. Telegram’s TON Foundation could stabilize the price of grams by purchasing them on the open market, establishing a price floor.
• The size and concentration of initial purchases reflect investment intent, not consumptive intent. The fact that individuals were willing to purchase millions of dollars’ worth of Grams indicates investment intent.
• The Terms of the Purchase Agreements Show Investment Intent. The lockup prohibiting the sale by initial purchasers granted an exclusive window for the Round Two Purchasers—who paid considerably more per Gram—to resell Grams and profit from their investment before Grams owned by the First Sale purchasers could be sold into the market and thereby place downward pressure on the price of Grams. This exclusive window creates a structural incentive for the Second Sale purchasers to resell their holdings of Grams quickly and indicates that they likely bought Grams with investment intent.
• Lock-Up Periods. The existence of the lockups in the First Sale negates the likelihood that a reasonable purchaser of Grams made such a purchase for his or her consumptive use. The Judge practically questioned what rational person would agree to freeze millions of dollars for up to 18 months (following a lengthy development period) if the purchaser’s intended to obtain a substitute for fiat currency.
• Economic Realities. The economic reality of the transaction is that wide adoption, as boasted by Telegram, would increase the value of the Grams.

3. Efforts of Others

• The initial purchasers were reliant on Telegram’s essential efforts to develop the TON blockchain.
• Telegram advertised the development of the TON blockchain as creating a mass-market opportunity for Grams. According to the opinion, this instilled initial purchasers with the view that they could profit from purchasing the Grams.

Conclusion

The Court found that the SEC showed a substantial likelihood of success in proving that the contracts and understandings at issue, including the sale of 2.9 billion Grams to 175 purchasers in exchange for $1.7 billion, are part of a larger scheme to distribute those Grams into a secondary public market, which would be supported by Telegram’s ongoing efforts. Considering the economic realities under the Howey test, the Court found that the resale of Grams into the secondary public market would be an integral part of the sale of securities without a required registration statement.

This case is ongoing and this ruling does not reflect a final decision in the matter, but it shows a clear view of Judge Castel’s take on the matter in the late stages of this litigation, teeing up a potential settlement by Telegram. It also provides a well-written analysis of the various securities laws that can be applied to the sale of digital assets before the development of a decentralized network and illustrates that the economic realities of a series of transactions will be viewed as a whole under the Howey test.

The author of this article is Tyler Harttraft, Esq., a partner at Bull Blockchain Law. Tyler represents token issuers, digital asset exchanges, and other businesses specifically focused on projects related to blockchain technology, digital assets, and virtual currency activities. To schedule a consultation, you can email tyler@bullblockchainlaw.com.