SEC v. Telegram: The Final Nail in the SAFT’s Coffin

People involved in the open blockchain network and cryptocurrency space are eager for regulatory clarity in order for them to exploit the revolutionary potentials of the new technology. Lawyers contemplated how to advise their client with rapidly changed regulatory environment as newly no-action letters, enforcement actions, and settlements were often released by the Securities and Exchange Commission giving new indications and guidance.^[1] In February 2020, SEC commissioner Hester Peirce—who is known for her endorsement of blockchain technology—proposed a safe harbor for such projects. Her proposal included a three-year grace period from securities laws for entrepreneurs to raise funds, develop their blockchain, distribute the tokens for the wider public, and strive to reach the ultimate goal of becoming a sufficiently decentralized network in that period. However, the road to adopt such a proposal as a binding rule is long and steep.^[2]

Notwithstanding the regulator efforts, in October 2019 the SEC filed a complaint against Telegram Group Inc., (“Telegram”) seeking to bar Telegram  from issuing their developed TON blockchain native token named “GRAM” to the initial purchasers alleging an ongoing violation of the Securities Act of 1933 by engaging in unregistered offering of securities. Telegram, incorporated in the British Virgin Islands, is well-known for their flagship product, the Messenger app, whose user base is well beyond 300 million. The case was assigned to Judge Kevin Castel in the Southern District of New York, and a highly anticipated hearing was held on February 19, in which Telegram (represented by the law firm Skadden, Arps, Slate, Meagher & Flom LLP) and the SEC representative went toe to toe and laid out their oral arguments in a courtroom filled with inquisitive legal specialists, people from the industry, and journalists. The case was to produce the first judiciary ruling in an Initial Coin Offering (ICO) involving the use of SAFT like instrument to raise funds.^[3]

Telegram had entered into what is known as SAFT (Simple Agreement for Future Tokens) agreements with 175 purchasers from around the world in 2017, including investors from the U.S., raising $1.7 billion in exchange for a promise to deliver 2.9 billion GRAMS, the TON blockchain native tokens.^[4] The scheme was simply to raise the money, develop the technology, and deliver the newly minted GRAMS to the initial purchasers and later on to the public; thus, creating an ecosystem for users of Telegram to use with the novel decentralized application to be built on top of TON. Telegram claimed that they did not violate securities laws as the funds were raised by using regulation D exemption rule 506(c), and all initial purchasers are accredited investors.^[5] As mentioned earlier, the industry needs more clarity, particularly to the question of whether GRAMS themselves are considered securities or not. Undisputed by both sides, the SAFT agreement, which basically represent ownership of GRAMS, is actually a security; the SEC further contends that the court should focus on the economic reality and see it as single scheme to go around Section 5 registration process. Inherent to this scheme is that, for GRAMS to have value, and for the initial purchasers to realize their investment, GRAMS would have to be widely held by the public at some point in the future.^[6]

By applying the “Howey test” analysis, Judge Castel reached the conclusion that there was an investment of money (a $1.7 billion investment by the initial purchasers), in a common enterprise, which is the developing of the TON blockchain and the issuance of GRAMS with a reasonable expectation of a return on investment to be derived by the efforts of the Telegram team.^[7] Thus, Judge Castel carefully narrowed the scope of the ruling as much as possible and focused only on solving the problem in hand—realizing that Telegram scheme as a whole constitute an “investment contract,” which is defined as a security in section 2(a)(1) of the Securities Act. Judge Castel focused on the economic reality of the scheme where Telegram’s end goal was to widely distribute the GRAMS to the public in order to appreciate in value and make profit for investors. The initial purchasers were used as a conduit to reach such end goal at launch. Therefore, they were acting as the functional equivalent of statutory underwriters facilitating the distribution to the public, by reliance on Telegram efforts.^[8]

An important debated issue in this case concerns the lockup period and Rule 144 implication. In this case, presumably regardless of how long the initial purchasers hold on to the GRAMS, they cannot rely on the safe harbor of Rule 144.^[9] The key term here is “come to rest,” and initial purchasers’ investment never came to rest because it never had functionality in terms of market price and market valuation until it distributes the GRAMS further. Thus, they never took an investment risk as there was no trading risk with respect to GRAMS.^[10]