SEC’s motion for a preliminary injunction is granted, prohibiting delivery of Telegram tokens to purchasers.

By Stephen P. Wink, Shaun MusukaCarolina Bernal and Deric Behar

On March 24, the Court in the Southern District of New York sided with the SEC and granted an injunction prohibiting Telegram Group Inc. and TON Issuer Inc. (together, Telegram) from delivering Telegram’s digital token, “Grams,” to 175 entities and high-net-worth individuals (Initial Purchasers).

As we previously discussed after the SEC filed its complaint, Telegram entered into agreements with the Initial Purchasers (Gram Interest Agreements), where, in exchange for US$1.7 billion from the Initial Purchasers, Telegram provided a promise to deliver Grams to the Initial Purchasers upon the launch of its blockchain (TON Blockchain).

To obtain a preliminary injunction, private litigants must show risk of irreparable harm or the unavailability of legal remedies. In this case, the Court stated that the SEC needed to show “the likelihood of success in proving a current violation of the securities law as well as a substantial showing of a risk of future harm in the absence of such an injunction.”

After establishing the standard for granting a preliminary injunction, the Court turned to the now all too familiar Howey analysis to establish whether Grams constitute an investment contract – a type of security. For a scheme to qualify as an investment contract under Howey, there needs to be (1) an investment of money (2) in a common enterprise (3) with the expectation of profit (4) from the essential efforts of another.

Going through each prong of Howey, the Court reached the conclusion that the Telegram scheme constitutes an investment contract, requiring either registration or an applicable exemption in order to comply with securities laws. Prong 1 was satisfied because the initial purchasers parted with US$1.7 billion in exchange for the Gram Interests. Prong 2 can be satisfied through either horizontal or vertical commonality. “Horizontal commonality is established when the investors’ assets are pooled and the fortunes of each investor is tied to the fortunes of other investors as well as to the success of the overall enterprise.” Vertical commonality “requires that the fortunes of the investors be tied to the fortunes of the promoter.” The court found both types of commonality to be present, given that if development of the TON Blockchain failed prior to launch, all Initial Purchasers would be affected and Telegram would also suffer “financial and reputational harm.”

The Court also found prong 3 to be satisfied, noting that reasonable investors would not pay US$1.7 billion for Grams unless there was an expectation to reap greater profits by reselling Grams to the public. Finally, for prong 4, the Court highlighted that such expectation of profit could only be based on the “entrepreneurial and managerial efforts of Telegram,” noting that the Grams offering materials “made Telegram’s commitment to develop this project explicit” and that investors expected Grams to be integrated into Telegram’s messenger app which currently boasts 300 million monthly users.

Of course, Telegram had conceded that the original sale of the Gram Interest Agreements, which were similar to the now infamous Simple Agreement for Tokens (SAFT), may have been a securities offering, but argued that the delivery of the underlying Grams at launch was not. In Telegram’s view, the Gram Interest Agreements were validly issued under the private placement exemption from registration. And, Telegram argued that, because upon launch of the TON Blockchain, the Grams would have functional consumptive uses, they should not be deemed securities. The Court was unconvinced, noting 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” and that it was a “disguised public offering.” The Initial Purchasers consisted of venture funds and other investors who were led to expect a profit upon the resale of Grams. The Court concluded that such Initial Purchasers were effectively acting as underwriters and that the sale of Grams to them was “the first step in an ongoing public distribution of securities,” for which no exemption from registration was available. (See What SEC’s Lawsuit Against Kik Teaches Us About Token Presale Agreements).

Following delivery of the opinion, Telegram’s counsel appealed and also submitted a letter to the Court on March 27 asking that the Court clarify the extraterritorial scope of the injunction. The letter noted that 70% of the funds raised in the offering came from Initial Purchasers outside the United States, and thus these transactions should be outside the reach of US securities laws. The SEC responded on March 30, arguing that the Court order was unambiguous in its application to “any person or entity” and that Telegram’s request is an attempt to “improperly narrow” the injunction. In the SEC’s view, Telegram is unable to prevent the flowback of Grams into the US because it did not conduct sufficient KYC, is unaware of who currently holds the Gram Interests, and could not prevent US persons from buying Grams on online trading platforms.

In a swift response on April 1, the Court upheld the full scope of the injunction, maintaining that Telegram could not – practically speaking – restrict foreign Initial Purchasers from reselling Grams into the US. The judge also reemphasized that the “security” was the entire scheme, consisting of the agreements and “the accompanying understandings and undertakings made by Telegram, including the expectation and intention that the Initial Purchasers would distribute Grams into a secondary public market.” For the Court, focusing solely on the status of the Grams was misplaced.

With the Court wading into the debate, some commentators had hoped to receive some further clarity on the path tokens should take to not constitute securities. Unfortunately, those hopes were not met, but buried in the 44 page opinion is a brief hint of what might be:

Cryptocurrencies (sometimes called tokens or digital assets) are a lawful means of storing or transferring value and may fluctuate in value as any commodity would. In the abstract, an investment of money in a cryptocurrency utilized by members of a decentralized community connected via blockchain technology, which itself is administered by this community of users rather than by a common enterprise, is not likely to be deemed a security under the familiar test laid out in S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946). The SEC, for example, does not contend that Bitcoins transferred on the Bitcoin blockchain are securities.

Among the takeaways here, the Court has again vindicated our sense as to the ineffectiveness of the SAFT. The SEC’s view of what constitutes a single plan of financing has real merit, and despite some good arguments to the contrary (such as the amicus filing of the Chamber of Digital Commerce) we have long thought that it is best to entirely divorce capital raising from token sales. While this remains good advice, we continue to be convinced that there remains a clear path to non-securities sales of certain tokens on functioning platforms. This decision (as well as our discussions with the SEC staff) does not cause us to waiver in that belief.