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How does an entrepreneur create a new decentralized, blockchain-based ecosystem without running afoul of the law? It’s not easy. In 2018, Brothers Pavel and Nicolai Durov, founders of the popular Telegram Messenger messaging platform (“Messenger”), decided to give it a shot. They proposed a new blockchain network called TON Blockchain that would integrate with Messenger – something that seemed like a natural fit at the time given Messenger’s popularity with the blockchain and crypto communities. They are reported to have raised US $1.7 billion through sales to sophisticated investors of the right to receive a digital asset called “Grams.” The proceeds of these sales were intended to be used to finance the development of the TON Blockchain. According to the terms of sale, the investors would take possession of their Grams when the TON Blockchain was launched. Things did not go according to plan.
On October 11, 2019, the Securities and Exchange Commission (SEC) sought a temporary restraining order (TRO) against Telegram and TON Issuer Inc. (collectively, “Telegram”), enjoining them from offering, selling, delivering or distributing “Grams” to any person or entity. The SEC argued that Telegram planned to “floo[d] United States markets with billions of . . . Grams through an unregistered offering of securities.” The SEC admonished that “[w]ithout a registration statement in place, Telegram’s planned distribution would violate the federal securities laws and deprive investors of the information available in a registered offering.” The District Court for the Southern District of New York Court issued the TRO and thus the distribution of Grams did not occur as planned.
But a TRO is only a stop-gap measure.
All eyes will be on the Southern District on February 18th when the Court hears arguments from the SEC and Telegram in connection with the SEC’s pending application for injunctive relief, as well as the parties’ cross-motions for summary judgment. The hearing will likely center on these three key questions: whether the digital asset, Grams, is a “security” and, if so, when did it become one, and will it still be a security at the time of the launch of the TON Blockchain. Due to the novel issues that are raised by the case, the rulings will reverberate within the blockchain industry and far beyond.
Based on the pleadings made by the parties, the relevant facts are as follows: In 2013, the brothers Pavel and Nicolai Durov launched Messenger, a free app that allows users to communicate in chats and telephone calls. In 2018, at the peak of the boom for “initial coin offerings,” Telegram decided to sell “Grams” to sophisticated investors to raise money to launch the TON Blockchain. The purchased Grams were to be delivered at the launch of the TON Blockchain, but no later than October 31, 2019.
There were two rounds of fundraising. In total, Telegram raised more than $1.7 billion from 171 investors, including $424.5 million from 39 U.S. investors. Investors entered into purchase agreements (the “Purchase Agreements”) with Telegram pursuant to which Telegram promised to provide 2.9 billion Grams (out of the 5 billion that were created) by no later than October 31, 2019, the date by which Telegram would launch the TON Blockchain (the “offering”).
The only material differences between the terms of the Purchase Agreements for the two rounds were lock-up provisions and the price of Grams. The investors from the first round were not permitted to sell their Grams immediately upon receiving them. Instead, they were required to wait 3 months, and then they could only sell their Grams in 25% increments, staggered over 18 months. The second set of investors were not limited in their ability to sell Grams immediately upon receipt. The price that the first group paid was $0.37 each, while the second group of investors paid $1.33 per Gram. Based on the number of Grams sold in the offering and the number that Telegram expected to make available at launch, Telegram estimated that the price of Grams in the open market after launch would be $3.62. It is undisputed by either side that the commercial arrangements represented by the Purchase Agreements constitute “investment contracts” and thus “securities.”
In their offering materials, Telegram stated that it was raising funds to create a massive blockchain-based network that would support a new cryptocurrency. The materials also stated that Telegram would serve as a launchpad for the TON Blockchain because Telegram would integrate TON into Messenger, to leverage Telegram’s massive user base and developed ecosystem. Telegram has subsequently announced that it does not intend to integrate with Messenger.
The Parties’ Arguments
The SEC makes two overarching arguments. First, Telegram’s offer to institutional investors constitutes an unregistered offer and sale of securities. The SEC asserts that the well-known “Howey test” (which provides the criteria for what constitutes an “investment contract” – a type of security in the U.S.) applies as of the date of the Purchase Agreements relating to the sale of the Grams. The SEC also asserts that even if the Howey analysis were to be conducted at the time of the proposed launch of the TON Blockchain, Grams themselves would still be considered investment contracts (and thus securities). The second argument is that Telegram engaged in, and is continuing to engage in, a public distribution of Grams to which no exemption applies. The SEC alleges that Telegram has taken steps to and seeks to complete a public distribution of Grams with the initial investors serving merely as middlemen or distributors of Grams to the general public.
Telegram counters that Grams themselves are not securities and that, even if they were, the question as to whether they are securities must be considered at the time of the launch of the network on which they are to be used, not beforehand. The defendants assert that at launch Grams will not meet the criteria for what constitutes an investment contract under the Howey test. They argue that, post-launch, purchasers of Grams will not have an expectation of profits based on the managerial efforts of others because Telegram has disclaimed any promise of future efforts and, besides, any future undertaking would not be considered essential. Telegram also asserts that there will not be a common enterprise in Grams following launch because of the decentralized nature of the TON Blockchain network.
Andrew Hinkes, a lawyer at Carlton Fields and Adjunct Professor at NYU School of Law offers that, “the SEC has acknowledged that it does not consider bitcoin and ether to be securities. So, if the TON Blockchain were to be sufficiently decentralized, however that is defined, the Court should similarly find the digital asset Grams to be a commodity, but such a conclusion can only be reached after a factual inquiry based on the evidence.”
Blockchain Industry Associations Weigh In
Two amicus briefs were filed in the case, one by the Chamber of Digital Commerce and the other by the Blockchain Association, two Washington, DC-based trade groups. Both briefs appear broadly to support Telegram’s position. The Chamber’s brief cites a long line of case law which they argue requires the Court to analyze Grams based on their own inherent legal and economic characteristics – i.e., independently from the Purchase Agreement. In the Chamber’s view, the analysis is comprised of two separate questions, namely: (i) whether an investment contract is being offered in a securities transaction; and (ii) whether the subject of the investment contract (Grams) is a commodity or another type of asset that can be sold in an ordinary commercial transaction (although the Chamber’s brief does not express a view either way on the outcome if that analysis were applied to Grams).
Both the Digital Chamber and the Blockchain Association ask the Court to consider whether the SEC regulations are the appropriate framework to regulate transactions by third parties involving Grams. In different ways, both amicus briefs suggest that Grams are more similar to commodities than they are to securities.
This is a pivotal case for anyone following blockchain technology in the U.S. It is the first time a federal court will have the opportunity to opine as to whether the digital asset underlying a purchase agreement that constitutes an “investment contract” should be considered a security where fraud has not been alleged against the party selling the digital assets.
Lewis Cohen, co-founder of blockchain and crypto-focused DLx Law, wrote a seminal article on this subject, called ‘Ain’t Misbehavin’: An Examination of Broadway Tickets and Blockchain Tokens.” Speaking about the Telegram case, Cohen explains, “it is recognized that Grams themselves are simply instances of computer code with no financial terms or other inherent features that would cause them to be treated as ‘securities’ apart from the fact that they were sold pursuant to the Purchase Agreements. To classify Grams themselves as securities, the Court would need to impute the benefits of the ‘investment contract’ represented by the Purchase Agreements onto the Grams. This would require the creation of a judicial fiction, a form of rough justice since the parties did not contemplate such an arrangement contractually.”
While many might agree that the federal securities laws should apply in some respects to the transactions involving Grams, what seems to be causing the most concern is the SEC’s position labeling Grams themselves as “securities.” If the Court agrees that Grams themselves are securities, then secondary non-issuer transactions, must comply with the securities laws. Alternatively, if the Grams themselves are not securities, it becomes more difficult and cumbersome (impossible?) to apply the Howey test to the terms of every transaction of sale of Grams as they are sold and resold.
So, perhaps the Court will create a fiction that Grams themselves are securities to achieve the SEC’s objective of investor protection. But taken to its logical extreme that could have unwanted results due to the regulatory burden that such a finding would cause for all parties seeking to interact using Grams.
Since the Court already granted the SEC a TRO, the defendants will need to overcome the Court’s implicit determination that Grams are securities. The defendants will have their work cut out for them. The facts and optics are not good. The defendants sold Grams to the initial investors at such a deep discount and provided a small lock-up period for only half the investors. The defendants structured the sale so that sophisticated investors would become a conduit for moving Grams to the general public in the secondary market. In fact, the defendants appear to have made sure that the investors would have every incentive to sell off (one could even say, “dump”) their Grams on the general public as soon as they were able to do so.
The Court might find that Grams were not securities at the time that the Purchase Agreements were entered into, but that they should be considered securities when they are made available to the sophisticated investors at the launch of the TON Blockchain, particularly if the TON Blockchain has not been deemed “sufficiently decentralized” which is a vague concept suggested by the SEC staff and not yet addressed in any judicial decision. Should the Court make such a finding, it would likely grant the SEC’s requested injunction.
On the other hand, the Court could take a page from the amicus brief filed by the Chamber of Digital Commerce and rule that, although the Purchase Agreements are investment contracts, the subject matter of those agreements – Grams – are not themselves securities, and never were. With such a ruling, the Court could still find that certain secondary transactions in Grams (such as resales by the investors who originally purchased the Grams from Telegram) are also investment contracts and subject to the securities laws by applying the Howey test to those transactions. Since the resale transactions would not be limited to accredited investors, such an approach would effectively mandate the registration of those resale transactions with the SEC which would be a way to provide important investor protections. This would imply a conclusion that the initial investors were effectively complicit in what could be considered a scheme to get Grams into the hands of the general public without SEC registration. I suspect we will have to wait for another case to get guidance on this question. But then again, perhaps the Court will surprise us. I only know that I’ll be sitting in the courtroom on February 18th, to take it all in.