SEC vs Telegram: A Battle That Could Be Avoided
In 2018, Telegram raised $1.7 billion through an ICO in exchange for the future delivery of 2.9 billion Gram tokens to 175 investors. While Grams could realistically be sold with a premium on the secondary market, Telegram argued that the agreement was in line with the definition of a private placement of securities that is subject to an exception to Regulation D 506(c).
On October 11, the SEC secured a temporary ban on the distribution of Gram among investors through a federal court. The agency argued that the asset is a security, and that Telegram violated U.S. law during the ICO.
Telegram challenged this claim but agreed to postpone the launch of the network until the case is settled with the SEC.
To better understand the implication of the ruling and the possible scenarios for resolution, we talked to Gordon Einstein, the legal expert in all things crypto and the founding partner at CryptoLaw Partners.
According to a preliminary ruling, a court in the Southern District of New York agreed with SEC’s argument that Telegram sold unregistered securities and ordered the company to refrain from the planned distribution of Gram tokens.
The judge concluded that the regulator was sufficiently convincing in its assessment that the Gram sale met the signs of an offer of securities according to the Howey test. Under pressure from SEC, Telegram agreed to postpone the launch from the end of October to April 30, 2020 and offered dissenting investors to return 77% of the invested funds. The current court decision may actually make the temporary ban on the distribution of Gram tokens permanent. Gordon Einstein believes that while this may not be the end of Gram, it is still in a very tight spot:
“The U.S. Federal district court granted the SEC’s application for a preliminary injunction. It did not grant a permanent injunction. They just said ‘You have to stop what you’re doing now. For now. Until you either get this appealed or you get a trial.’ So that does not automatically mean that the distribution of Grams is over, but it is pretty serious.”
The court concluded that Telegram realized that primary buyers were not paying $1.7 billion for the purchase of Gram, only as a means of storage and transfer of value. Instead, according to the court, Telegram manufactured a scheme that allowed it to maximize both the funds raised from primary investors and the profits that they could make when reselling tokens.
Was Telegram Looking for a Loophole?
The lawyers of the company insisted that the initial agreements with the buyers did correspond to the definition of investment contracts, however, the secondary sale of tokens did not, and these events were not related.
“The court did not get to whether the newly created Gram would be a security. I think they bypassed this issue. Telegram is claiming strongly that upon the launch of the network Grams are not securities because they have consumptive use and value. That may be true. I didn’t see the court getting there.
“What the court did say was that the Gram purchase agreements and therefore Grams when initially sold back in 2018 were securities at that time. And that the people who participated in the two rounds of initial purchases were buying those agreements (and by implication the Grams) with an eye towards distributing them towards the public. So SEC is claiming (and the court seems to agree with them) that all those investors were actually underwriters. And if they are underwriters, and TON issuer didn’t make sure that they weren’t underwriters, then the Regulation D exemptions that Telegram in time was relying on, rule 506(c), didn’t apply.”
According to Gordon Einstein, there may be inconsistencies in this ruling.
“The court really implied that those venture capital firms, those initial bulk buyers, were buying the right to purchase Grams with an eye towards distributing them towards the public. All these people signed agreements saying this wasn’t the case.
“It’s a little bit strange. For example, someone invests early in a housing project with the idea of having a bunch of houses when it’s complete. If they then sell those houses to the public are they an underwriter? I mean, the initial purchase agreement may be security but it’s truly hard to argue that the house that comes out of it is a security. I think the court went a little too far there.”
He also reminded that this decision went against the forming consensus on the possibility of a token’s evolution over time.
“They’re going against what commissioner Hinman said at Yahoo a year ago, that Ethereum, even if it was initially a security, probably evolved into no longer being a security because it is sufficiently decentralized and distributed. So are they really claiming that these Grams are going to forever be trapped in what they would have been in 2018 and not what they are in 2020?
“It’s inconsistent and deadening towards innovation because failing to recognize that these things evolve over time. Gram sold before the network was functional may have been a security but after the network gets functional it’s not because it does have consumptive value.”
Is Telegram Fighting Back?
Representatives of the messenger believe that the decision on the ban relates exclusively to agreements with investors in Gram from the United States. And that would cover less than 30% of the funds received during the token sale.
Since most of the contracts were concluded with non-US investors outside the United States, the Gram issuer again questioned the authority of the SEC in this case.
“Defendants respectfully seek clarity with respect to the scope of the injunction, see Fed. R. Civ. P. 65(d); in particular, that the Order does not apply to Defendants’ Purchase Agreements entered into abroad with non-U.S. Private Placement investors not subject to U.S. securities laws,” they said in a statement.
SEC appealed to the court with a request not to limit the ban on the planned distribution of Gram tokens to U.S. investors only. It emphasized that the company’s request to “clarify” could be a disguised attempt to reduce the scope of the ban. The regulator also noted that Telegram is seeking to limit the application of a court order by not taking measures to prevent Gram tokens from outside the United States from entering the country’s secondary market.
“The SEC respectfully requests that the Court deny Telegram’s attempt to limit the scope of the injunction,” the statement said.
What Happens Next?
There are several possible scenarios going forward.
According to the contract of sale of Gram tokens, primary investors will have the right to receive their money back if the TON network is not launched before April 30. Some TON investors have already announced their readiness to leave the project. But surprisingly some experts believe this may not even be a bad thing.
“That’s like a form of judo on the SEC’s and the court’s arguments. They didn’t get to the point of saying that Gram issued today will be a security. Once the network’s active maybe Gram becomes a commodity. So if Telegram refunds all the early investors’ money and sells all these functional Grams to the world, what’s to stop them?” says Gordon Einstein.
Another thing to consider is that TON may be launched not even by Telegram but by any unaffiliated group as the code is open-source and available on Github.
Was There a Better Way to Do It?
In retrospect, Telegram did not handle the legal part of the token sale very well. Could it be done in a safer and more productive way? Gordon Einstein believes that it could have.
“When you’re getting people to fund the creation of your network, you do not want to sell tokens to them. You want to sell them equity in your company, the one that is going to sell the tokens. You then use these funds to build the network and once it’s built, then this entity sells the tokens. Maybe at that time, it distributes tokens to the shareholders as dividends or as a bonus. At the very least they’re getting the benefit of that initial sale but maybe they’re getting more of a long term position also.
“Another thing where Durov brothers made a mistake was they spoke early about creating a non-profit foundation to manage the project going forward. But they didn’t actually do it. And secondly, they talked about this foundation buying and selling Grams to support its price. That’s a problem because it creates an expectation of profits or at least expectation of limited losses on the part of initial investors. If Gram was completely free-floating and not supported, it would take away the argument that investors’ downsides were protected.
“Also, the court made a big deal that everyone buying tokens because Telegram was so great and the Durov brothers were so great. By the way, the court seems to like the Durov brothers and appreciates what they’ve done with Telegram and how smart they are. And the court pointed out that neither one of them made any money off the Telegram app. They spent their Vkontakte money and supported Telegram, maybe up to $200 mln so far. If they created a truly independent foundation and put the money into the foundation and the foundation’s mission was to increase the functionality of the platform and they stepped back from it, they’d have a stronger argument.”
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