The SEC vs Telegram case, or Potential Death Sentence for All ICOs and Token Sales Ever Held in the US

Sergey Ostrovskiy
Apr 23, 2020 · 9 min read

In this article, Sergey Ostrovskiy, partner at AURUM Law Firm, analyses the preliminary injunction granted on March 24, 2020 by the New York District Court in the SEC vs Telegram case, which prohibits Telegram from distributing GRAM tokens for the TON Network, and reveals the possible consequences of the case for token sale projects and the crypto industry as a whole.

The information provided in this article does not, and is not intended to, constitute legal advice. This article is provided for informational purposes only. You should not act or refrain from acting on the basis of information contained herein. You should seek legal advice from your counsel with respect to any particular legal matter.

The fact that the US Securities and Exchange Commission (SEC) has a grudge against ICOs is hardly news, as representatives of the Commission have, on multiple occasions, argued that pretty much every token sale (ICO) held in the US has been illegal as they constitute offerings of unregistered securities.

The story began in 2016–2017 with The DAO case, when the SEC applied the so-called Howey Test (S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946)) to cryptographic tokens for the first time, claiming that digital tokens can be considered securities under US law. Basically, this meant that anyone selling tokens in the US might actually be selling unregistered securities, which is a violation of US federal security laws.

The SEC subsequently continued applying pressure on ICOs and token sale projects, introducing new cases and positions which were exacerbating the whole token sale situation and affecting the market, including the ‘Munchee Case’ in late 2017.

The above is why, shortly after the publication of the SEC’s report on The DAO case, all ICO projects which were smart enough to consult with the lawyers (which was most of them) ceased all token sales in the US. After all, no matter how much you want to raise money, you do not want to go to jail.

SAFT Project

As you can imagine, the blockchain industry was not ready to give up on fundraising in the US, so the lull did not last long. Our American colleagues invented a scheme that, in their opinion, made it possible to both continue selling “utility” tokens in the US and meet the requirements imposed by the SEC: the SAFT project.

In order to better understand the scheme and the legal side of the idea behind the SAFT project, we will first dwell on its key aspects:

The sale is structured via the SAFTs. Those familiar with the venture capital market have probably heard of the SAFE (Simple Agreement for Future Equity), an agreement that was developed by Y Combinator and became a classic instrument for venture investments in the Valley. The SAFT is essentially the SAFE with certain differences due to the nature of the transaction.

The issuer does not sell tokens to the investor. Instead, the investor purchases interest in the tokens (i.e. the right to receive tokens in the future) when the product is developed and functional enough to support the use of the token (some sort of a forward contract). As such, at the time of issuance, the token should be a commodity rather than a security.

The deal is structured in accordance with Regulation D which provides a number of exemptions from registration requirements, allowing issuers to offer and sell their securities without having to register the offering with the SEC. Reg D establishes certain restrictions and limitations with regards to the offering of, and subsequent transactions with, securities, including, for example, requirements of investors and their qualification.

From the legal perspective, as investors are purchasing interest in the tokens rather than the tokens themselves, only the sale of such interest should be deemed an offering and sale of securities, whereas the tokens are somewhat brought out of the scope of securities law application.

Then, once the product is launched, SAFTs get converted and investors are issued with their tokens, which can now be immediately used in the main product for which they are designated.

It should be noted that the SAFT project is intended to be used for structuring sales of “pure utility” tokens, i.e. tokens that do not grant their holders any of the rights that characterise classic securities, such as, for example, the right to participate in the distribution of profit or receive passive income. Otherwise, the token itself would fall under the definition of a security and the whole scheme would be useless.

The SAFT project indeed looked good; it was well-received by lawyers and became a fairly popular way of structuring ICOs and token sales in the US. For example, one of the soundest ICOs, the Filecoin ICO, was structured in accordance with the above scheme. Our US colleagues argued that the SAFT scheme is completely legal and safe in the US while giving their presentations on the structuring of ICOs at multiple industry conferences.

But, as the recent events have shown, the SAFT scheme may not be addressing some nuances, which will be discussed below.

At this point it should be noted that explanations of legal points throughout this article are presented in a simplified form; nuances, as well as some of the points, are omitted to simplify the text and narrow the focus.

Preliminary Injunction in SEC vs Telegram

The decision on the preliminary injunction against the distribution of GRAM tokens, which was delivered by the New York District Court in the case of Securities and Exchange Commission vs Telegram Group Inc. and TON Issuer Inc. (“SEC vs Telegram”) on March 24, 2020, gives serious reason to believe that a precedent will soon be set that may turn all these “completely legal” token sales into “completely illegal”.

A preliminary injunction is not a judgement on merits, meaning that the case itself is still pending before the court. Despite this, the reasoning for the decision is extremely interesting and deserves particular attention, as it will likely form the basis of the decision on the merits of the case and will, in turn, set a precedent.

So, let us now consider one of the conclusions that the court came to in its judgement, that which draws the greatest interest:

“[E]xamining the totality of the evidence and considering the economic realities, the Court finds that [] the 2018 Sales were part of a larger scheme, manifested by Telegram’s actions, conduct, statements, and understandings, to offer Grams to the Initial Purchasers with the intent and purpose that these Grams be distributed in a secondary public market, which is the offering of securities under Howey” (SEC vs Telegram, p. 38).

In my opinion, there are three essential points in this conclusion, and the judgement as a whole:

Under the Howey, not only the SAFT or the sale of interest in tokens are deemed to constitute an offering of securities, but the whole scheme, including the token purchase agreement, future delivery of tokens to initial investors and the resale of tokens to the public.

As the economic reality of the transaction shows that the tokens were purchased by initial investors to subsequently distribute those GRAMs into a secondary public market, which would be supported by Telegram’s ongoing efforts, Telegram failed to meet the requirements set forth by Regulation D, including the prohibition of the sale of securities to purchasers that intend to immediately resell them. This means that Telegram’s offering fails to qualify for exemptions provided under Reg D; in other words, no exemption may be applied to the sale of GRAMs.

The fact that the GRAMs will be issued after the TON Network is irrelevant, as the appropriate point at which to evaluate the scheme to sell and distribute GRAMs is the point at which the scheme’s participants had a meeting of the minds, i.e. at the time of the 2018 sales, rather than the date of delivery.

Below are a few noteworthy excerpts from the text of the decision:

“[T]he security in this case is not simply the Gram, which is little more than alphanumeric cryptographic sequence. Howey refers to an investment contract, i.e. a security, as “a contract, transaction or scheme,” using the term “scheme” in a descriptive, not pejorative, sense. Howey, 328 U.S. at 298–99. This case presents a “scheme” to be evaluated under Howey that consists of the full set of contracts, expectations, and understandings centered on the sales and distribution of the Gram. Howey requires an examination of the entirety of the parties’ understandings and expectations. Howey, 328 U.S. at 297–98 (declining to “treat[] the contracts and deeds as separate transactions”). Further, for the reasons discussed previously, the Court finds that the appropriate point at which to evaluate this scheme to sell and distribute Grams is at the point at which the scheme’s participants had a meeting of the minds, i.e. at the time of the 2018 Sales, rather than the date of delivery” (SEC vs Telegram, pp. 38–39).

“The Gram Purchase Agreements and the future delivery and resale of Grams are viewed in their totality for the purpose of the Howey analysis. In Howey, although the land purchase contracts and the service contracts were separate agreements that took effect at different points in time and a purchaser was not mandated to enter into both, the Court analyzed the entirety of the parties’ interaction, finding that the whole scheme comprised a single investment contract and, therefore, a security. Howey, 328 U.S. at 297–98 (reversing the lower court’s decision to “treat[] the contracts and deeds as separate transactions”). This Court finds as a fact that the economic reality is 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” (SEC vs Telegram, p. 18).

“[T]he Court finds that the SEC has shown a substantial likelihood of success in proving that the 2018 Sales were part of a larger scheme, manifested by Telegram’s actions, conduct, statements, and understandings, to offer Grams to the Initial Purchasers with the intent and purpose that these Grams be distributed in a secondary public market, which is the offering of securities under Howey” (SEC vs Telegram, p. 38).

Potential Impact of SEC vs Telegram on Token Sale/ICO Projects and the Industry

If the above prediction comes true and the court sides with the SEC, the impact of the case on the blockchain industry can hardly be overestimated.

Firstly, all projects that have ever conducted token sales as Reg D compliant offerings pursuant to SAFTs will be put at risk.

Even now, the SEC routinely goes after projects which have carried out sales of tokens in the US and forces them to settle, pay fines and refund purchasers. It is very likely that, if the SEC succeeds in the Telegram case, the number of such settlements and fines imposed will grow significantly.

Importantly, SEC vs Telegram is a case that might set a new precedent within the existing legislation and, as such, this precedent would be applicable to any similar token sales in the US, regardless of when they were held (i.e. from the very emergence of the ICOs).

Secondly, this will destroy the last legal way of selling utility tokens in the US.

Since all utility tokens (with rare exceptions) require a public secondary market and free circulation, there is no sense in selling these tokens as securities even pursuant to Regulation D.

Nevertheless, SEC vs Telegram will not affect the STOs (i.e. the issuance and sale of so-called ‘security tokens’). This type of tokens does not require public secondary market to the same extent as utility tokens do, meaning that security tokens may be offered in the US pursuant to Regulation D exemptions without harming the project.

In conclusion, the above situation might have positive implications: the ruling in the SEC vs Telegram case could push the US lawmakers to adopt special frameworks, bringing utility tokens out of the scope of securities regulation and allowing for their sale in the US. Furthermore, such laws have already been discussed.

Contact us if you have questions about structuring token sales and conducting token offerings.

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