On March 24, Judge P. Kevin Castel of the U.S. District Court for the Southern District of New York granted the Securities and Exchange Commission’s (SEC) motion for a preliminary injunction in the closely followed Telegram case. The preliminary injunction continues to prevent the delivery by Telegram Group Inc. and TON Issuer (collectively, Telegram) of “Grams,” a new cryptocurrency intended to be delivered in connection with the launch of the Telegram Open Network Blockchain (TON Blockchain), to the purchasers in private placements conducted in 2018. Given the lack of judicial precedent in this area as well as the size and profile of the Telegram project, these proceedings have been closely watched as industry participants look for clear guidance and a path forward that satisfies regulatory requirements.
The court conducted a fact-intensive inquiry and largely adopted the approach advocated by the SEC, based on the particular facts and circumstances in this case, and viewed the transactions as a single distribution, starting with the private placements of Grams purchase contracts (agreements to deliver Grams upon launch of the TON Blockchain) to accredited investors (the initial purchasers) in 2018, through the intended delivery of Grams to those initial purchasers at launch of the TON Blockchain and ultimately the sales by those initial purchasers in the secondary marketplace. The court looked at the series of transactions, undertakings and understandings in their totality and applied the Howey test (discussed below) at the time the offers and sales were made to the initial purchasers.
The court’s order and opinion can be found here.
We have previously written about the background of these proceedings, and additional details can be found here. In short, Telegram, a global messaging platform, raised $1.7 billion in 2018 through sales of purchase agreements to 175 initial purchasers that provided for the delivery of Grams upon launch of the TON Blockchain. Telegram took the position that the sale of the purchase agreements to the initial purchasers was a private placement, exempt from the registration requirements of the Securities Act of 1933. In October 2019, as Telegram was about to launch the TON Blockchain and deliver the Grams to the initial purchasers, the SEC halted the distribution, alleging it would constitute an illegal, unregistered securities offering.
It is generally accepted that the Howey investment contract test is the proper framework under which to assess whether blockchain-based token offerings constitute securities offerings. As adopted by the U.S. Supreme Court, a contract, scheme or transaction is deemed an investment contract and thus a security if it involves (1) an investment of money (2) in a common enterprise (3) with the expectation of profit (4) from the essential efforts of another.
At one end of the spectrum, most would acknowledge that purchase agreements sold to initial purchasers constitute investment contracts under the Howey test – the initial purchasers are investing at an early stage of a project, hoping to profit from the efforts of the management group that will build and launch the network using the funds raised. At the other end of the spectrum, at some point when a network is fully developed and operating, the purchase and use of tokens may be sufficiently consumptive in nature and/or the network may be sufficiently decentralized that at least the third and/or fourth prong of the Howey test would not be satisfied.
Bridging the gap between the two ends of this spectrum creates significant regulatory challenges for those seeking to launch decentralized networks involving blockchain-based tokens. See our discussion of this regulatory Catch-22 and SEC Commissioner Hester Peirce’s token safe harbor proposal here.
The Court’s Ruling
To obtain a preliminary injunction, the SEC must make a substantial showing of the likelihood of success in proving a current violation of the securities law and a substantial showing of a risk of future harm in the absence of such an injunction. The SEC is not required to show risk of irreparable injury or the unavailability of remedies at law, as is required of private litigants.
Telegram argued that the purchase contracts were separate and distinct from the Grams and the Howey test should be applied to each individually – in the case of the purchase contracts, at the time of their sale, and in the case of the Grams, at the time of their distribution upon launch of the TON Blockchain. The court, however, made a finding of fact that the Gram purchase agreements and the anticipated distribution of Grams by the initial purchasers to the public via the TON Blockchain are part of a single scheme, and it applied the Howey test collectively to the contracts, expectations and understandings centered on the sales and distribution of the Grams, viewed at the time of the investment by the initial purchasers in 2018. The court found that “[t]he Grams would not and were not intended to come to rest with the [i]nitial [p]urchasers but instead were intended to move from the [i]nitial [p]urchasers to the general public … and the [i]nitial [p]urchasers, who acted as mere conduits to the general public, are underwriters.” The court emphasized the importance of the economic realities of the transactions and gave weight to implied understandings and reasonable expectations over explicit disclaimers.
As to the four-factor Howey test application:
- The parties did not dispute that there was an investment of money.
- The court concluded that the SEC made a substantial showing of horizontal commonality and strict vertical commonality.
- The court found, based on the totality of the evidence, that a reasonable initial purchaser would have purchased Grams with investment intent, and it made findings that (i) $1.7 billion paid to Telegram would not have been raised but for the expected ability to resell Grams into the secondary market; (ii) Grams were sold at a significant discount compared with the expected price after launch, and Telegram promoted the TON Foundation’s power to support the market price of Grams; (iii) the size and concentration of their Gram purchases indicate that the initial purchasers purchased with investment, not consumptive, intent; and (iv) the lockups negated the likelihood that a simple agreement for future tokens (SAFT) purchaser bought Grams for consumptive use.
- The court found that the SEC has shown a substantial likelihood of success in proving that at the time of the 2018 sales, a reasonable initial purchaser’s expectation of profits from the purchase of Grams was based on the essential entrepreneurial and managerial efforts of Telegram, and it made findings that (i) Grams do not exist and did not exist at the time of the 2018 sales; (ii) SAFT purchasers provided capital to fund the TON Blockchain’s development in exchange for the future delivery of Grams, which they expect to resell for a profit; (iii) the offering materials stated Telegram’s commitment to develop this project, making initial purchasers entirely reliant on Telegram’s efforts to develop, launch and provide ongoing support for the TON Blockchain and Grams; (iv) investors knew that the integration of the TON Blockchain with Telegram Messenger, which was advertised by Telegram, represented the key to Grams’ mass adoption and expected Telegram to use Telegram Messenger to encourage the growth of the TON ecosystem; and (v) a lockup period imposed on critical employees indicates they will play a critical role in the ongoing success of the entity.
The court’s approach, if broadly adopted to wide-ranging facts and circumstances, could prove very challenging for those attempting to launch decentralized networks involving blockchain-based tokens. In a typical sale of purchase agreements for future delivery of tokens to accredited investors, the purchasers almost certainly will expect to profit from the efforts of the management or promotional group in the prelaunch period. However, a key issue, and one that the court did not directly address, is the distinction between management’s prelaunch efforts and postlaunch efforts and the significance of the postlaunch efforts to the analysis. The court spent significant time discussing the factual background that would give rise to a reasonable expectation of continued management efforts through and following launch, so it appears implied that expectations regarding postlaunch managerial efforts continue to be very important to the analysis.
Supporting this view, the court explained that “Telegram, as a matter of fact rather than legal obligation, will be the guiding force behind the TON Blockchain for the immediate postlaunch period while the [initial purchasers] unload their Grams into the secondary market.” In another passage, the court noted that “to realize a return on their investment, the [i]nitial [p]urchasers were entirely reliant on Telegram’s efforts to develop, launch, and provide ongoing support for the TON Blockchain and Grams[,]” and continued on to “find that if, immediately after launch, Telegram and its team decamped to the British Virgin Islands, where Telegram is incorporated, and ceased all further efforts to support the TON Blockchain, the TON Blockchain and Grams would exist in some form but would likely lack the mass adoption, vibrancy, and utility that would enable the [i]nitial [p]urchasers to earn their expected huge profits.”
It is important to remember that this is one court’s view and only at a preliminary stage of the proceedings. However, given the lack of judicial precedent in this area, it is understandable that the industry will pay close attention to this decision, and we will continue to monitor developments in the Telegram case as well as in other cases that will surely arise.
Regardless of whether a court applies the Howey test to the entire series of transactions as a single larger distribution, the analysis appears to continue to turn, in large degree, on the factual question of whether or not there are reasonable expectations of significant postlaunch efforts from the management team such that the fourth prong would be satisfied. In the court’s view, those expectations should be viewed through the lens of the initial purchasers at the time of their investment. Under the view that Telegram advocated for, but the court rejected, those expectations should have been measured from the perspective of the purchasers of Grams at and following launch of the TON Blockchain. Notably, the court found Telegram’s postlaunch efforts sufficient on their own to satisfy the fourth prong.
Lastly, we emphasize that the particular facts and circumstances are very important to the analysis, regardless of the framework applied. While a detailed review of the factual background is beyond the scope of this alert, it is worth noting that the court cited various facts and circumstances unique to the Telegram case that were relevant to the last three prongs of the Howey test underpinning the court’s decision.