On March 24, 2020, Judge Kevin P. Castel of the U.S. District Court for the Southern District of New York granted the Securities and Exchange Commission’s (“SEC”) request for a preliminary injunction against Telegram Group, Inc. and TON Issuer, Inc. (together, “Telegram”), halting Telegram’s planned distribution of its Gram tokens. In doing so, the Court ruled that the SEC had “shown a substantial likelihood of success” in proving Telegram offered and sold securities in violation of §§ 5(a) and 5(c) of the Securities Act of 1933, specifically, investment contracts, under the test set forth in SEC. v. W.J. Howey Co., 328 U.S. 293 (1946) and its progeny, and that no exemption from registration applied.
In a letter following the decision, Telegram asked the court to clarify whether its order prohibited distribution of Grams to non-U.S. purchasers, arguing that only $435 million of the $1.7 billion raised came from U.S. purchasers and the remainder of its offering should not be subject to the U.S. securities laws. In the letter, Telegram said it would take steps to isolate U.S. purchasers while fulfilling its obligations to non-U.S. purchasers. However, the court rejected the request as both too late and missing the gravamen of the court’s analysis, that is, that “the ‘security’ was neither the Gram Purchase Agreement nor the Gram but the entire scheme that comprised the Gram Purchase Agreements and the accompanying understandings and undertakings made by Telegram, including the expectation and intention that the Initial Purchasers would distribute Grams into a secondary public market.” Judge Castel noted that Telegram had not explained how it would prevent such secondary sales or how it could modify the Gram Purchase Agreements to create such restrictions. Telegram has filed a notice of appeal.
Key Points of the Telegram Decision
Telegram argued the “interests in Grams” should be considered a separate transaction from the “delivery of Grams.” However, the court held that the Howey test requires it to examine the economic reality of the investment as a whole or, as the court put it, “the series of understandings, transactions, and undertakings at the time they were made,” including at the time when investors separated with their money.
The court held that the Grams themselves were “an integral part” of the securities offered, which “centered on Grams,” and that “the security in this case is not simply the Gram.” The court reserved the question of the status of Grams under the federal securities laws at delivery, but that was not a question the court had to reach for purposes of this decision. Judge Castel credited the SEC’s argument that the sale of Grams to private investors was “part of a larger scheme to distribute those Grams into a secondary public market.”
Telegram argued further that while the Pre-sale purchasers’ interests in Grams are a security, exempt from registration under Regulation D, the delivery of Grams to the Pre-sale purchasers would constitute a separate and distinct transaction — not a securities transaction — because upon launch the Grams would have “functional and consumptive uses,” for example, to store or transfer value, and therefore the Grams should be considered a commodity, not subject to securities laws. However, under the facts and circumstances of Telegram’s offering, the court was unconvinced, finding that reasonable purchasers would not have been willing to pay $1.7 billion to acquire Grams merely as a means of storing value.
Focusing on the Reference Price and the implicit intention on the part of Telegram to remain committed to the success of the TON Blockchain post-launch, the court noted Telegram led purchasers reasonably to expect to profit based upon its efforts “because these purchasers expect to reap whopping gains from the resale of Grams in the immediate post-launch period.” The court found Telegram’s scheme constituted a “disguised public distribution” as it created a structure that essentially assured that Grams would not come to rest with the initial purchasers. The court concluded Telegram failed to use reasonable care to ensure the Pre-sale purchasers were not underwriters, which undermined Telegram’s assertion that the Purchase Agreements constituted an exempt offering under Regulation D.
S&K Observations
The limited supply of Grams supports the finding that Grams essentially are shares in the TON Blockchain venture, and much of the Telegram court’s decision focused on the company’s plans to integrate Grams into its messaging app and promote Grams as one of the world’s leading cryptocurrencies.
In many respects, the facts and circumstances of the Telegram case are quite similar to those in the SEC’s case against Kik Interactive Inc. (“Kik”). Similar to Telegram, Kik sold the Kin tokens to raise capital for the company’s operations and to fund the development of the Kin ecosystem. Kik pitched Kin as an investment and promised to create demand for Kin by redesigning its messaging system to use the token, which had a limited supply and would be listed on secondary trading venues. On March 20, 2020, the SEC and Kik cross-moved for summary judgment. The court’s decision on those motions is pending.
The analysis of digital token offerings remains highly complex and involves a case-by-case review. Moreover, due to the mutable nature of digital assets, the analysis of the same asset can change over time. If you have any questions regarding issues that may arise in connection with an offering of digital assets or any other blockchain-related questions, please speak with your S&K contact attorney or any member of our Blockchain and Cryptocurrency Group.
