Case Note: SEC v Telegram Group Inc & TON Issuer Inc - USDC SDNY Case No 19-cv-9439 (PKC)

SEC takes action against Telegram

On 24 March 2020, a US District Court judge granted the SEC’s application for a temporary restraining order against Telegram Group and TON Issuer preventing those companies from proceeding any further with their plan to issue Gram tokens to investors.

The background facts were:

• Telegram is the proprietor of the successful Telegram messaging app.
• It established TON Issuer as a subsidiary.
• It planned to raise capital to build a new, faster, proof-of-stake blockchain network (TON) through token purchase agreements with sophisticated investors.
• It planned to use the money to fund the building of the new blockchain, and pay for the running and upgrading of the Messenger app. The plan was to integrate the network with the app by adding a built-in wallet to the app to hold Gram tokens.
• When the new network was available, Telegram would issue Gram tokens to the investors, who could then resell the tokens on exchanges. IThe investors were expected to make a profit. Telegram was going to assist the stability of the resale market by placing a portion of the tokens in a special fund.

As a scheme, there is really nothing wrong with this plan. The Telegram app has a user base of 300 million people, many of whom are already crypto users, and is an ideal launch pad for a new blockchain network. Many such networks have their own cryptocurrencies. Telegram has been operating for free for years, and to take it to the next level, the owners had to raise capital. It made sense to bring in investors, give them an opportunity to make a profit - which is why people make investments - and then see the tokens mature into an openly traded commodity.

US securities regulations - the SEC's view

The problem that faced Telegram was the US securities regulations, and the interpretation of those regulations held by the SEC. Despite Telegram engaging with the SEC over a period of time when designing the scheme, the SEC went ahead and filed an application for a restraining order with the Court alleging that, under the Howey test:

• The scheme has to be regarded as a whole, and included the downstream resale of the tokens to the public by the initial purchasers. Therefore, Telegram should have filed a registration statement with the SEC, despite the initial purchasers being sophisticated investors.
• The initial purchasers should be regarded as the resale agents of Telegram, called “underwriters”, meaning that their resale of the tokens to members of the public on exchanges would become part of an overall scheme designed and supported by Telegram.
• Although Telegram did file Form D exemption declarations with the SEC in relation to its investment contracts with the initial purchasers, claiming it was exempt from filing registration statements, these were ineffective because the entire scheme included the members of the public who would buy the tokens on exchanges. Telegram had not taken reasonable care to ensure the initial purchasers were not underwriters. For the protection of the future public buyers, a registration statement was required at the outset.

What the Court decided

The Court agreed with the SEC and granted the restraining order. The key court documents are available from Court Listener. The point was made to  the Court by Telegram that tokenisation is a new area of activity, and that the way the laws apply to digital securities is inconsistent: an asset that starts life as a security can develop into a currency. Telegram asserted that it had tried to obtain guidance from the SEC but that instead of giving useful guidance the SEC brought a court action against Telegram, passing on its role as a regulator and leaving it up to the Court to make up the rules, at great cost to Telegram.

Telegram took a risk that its plan would be interpreted by the SEC as a securities offering to the public. This legal landscape is full of uncertainties. One crucial example, for this case, is the concept of “underwriter”, which the SEC applied to make the initial purchasers into Telegram’s resale agents. Another is the SEC’s and the Court’s refusal to accept the initial purchase agreements and the later creation and sale of the tokens as separate events.

These choices doomed Telegram’s exemption declarations. Even though the SEC, through its public pronouncements, and the Court accepted that securities (investment contracts) can evolve into a currency or a commodity (tokens), this was of no assistance to Telegram once the SEC and the Court decided to view the initial purchasers as resellers within an overall plan designed and supported by Telegram.

Implications of the case 

Is it fair for the law to cast such a wide net, and turn initial investors in a token scheme into reselling agents of the token issuer? That is an important policy question. The concept of “underwriter” is essentially open-ended, and proved to be a trap for Telegram. Open-endedness in the law is not a good thing. It makes it harder for market players to understand what they are allowed and not allowed to do. And it gives the regulator a lot of latitude to make up the rules as it goes. Poorly defined and unpredictable rules could encourage token issuers to move to other jurisdictions with better defined rules, or to bar US purchasers from participating in the offerings, to avoid falling foul of US regulations. 

If the narrative presented by Telegram to the Court of continual engagement with the SEC in an effort to clarify its compliance obligations is correct, then the overall result is extremely disappointing. A project that would have created a useful new blockchain and currency, for the use of literally millions of people around the world, has been derailed by legal interpretations of difficult concepts that probably should have been defined better in the first place.

UPDATE: Since this post was first published, Telegram Group and the SEC have reached a settlement. Read about the settlement in this later Publish0x post.

[Photo credit: oil painting by Virginine Demont-Breton, Under the Orange Tree, a public domain image courtesy of Wikimedia Commons and Sotheby's. The Howey case, from which the Howey test discussed in this post is derived, comes from a US Supreme Court decision in 1946 that considered the sale of interests in land with citrus groves. This post is a a basic level, educational and informational discussion of legal concepts. It does not constitute legal advice for any person, nor does it create a lawyer/client relationship with any person. Although care has been taken to ensure that the law is described correctly at the time of publication, no guarantee of accuracy is provided.]