On October 11, 2019, the Securities and Exchange Commission (the “Commission”) announced it filed a complaint and obtained a temporary restraining order against Telegram Group Inc. and its wholly-owned subsidiary TON Issuer Inc. (collectively, “Telegram”) relating to Telegram’s offering of tokens without registration in violation of the Federal securities laws. The action sends a strong signal that the Commission is paying close attention to SAFT-based digital token offerings and is willing to go to court to stop the subsequent public launch of underlying tokens if it appears that the tokens are not yet fully developed and where the expectation of profit necessarily still derives from the efforts of the issuer.
In late 2013, Telegram launched an encrypted messaging application called “Messenger” which today may have as many as 300 million monthly users worldwide and has become a ubiquitous messaging application for the cryptocurrency community. Telegram, however, doesn’t make money from Messenger; the app is free to users and Telegram has pledged not to sell ads or introduce subscription fees and never to give third parties access to user data. Although Messenger incorporates ad hoc functionality that lets users exchange goods and services for both fiat and digital currency, Telegram envisioned integrating the ability to exchange digital assets directly into Messenger. It concluded, though, that existing networks like the Bitcoin and Ethereum blockchains don’t have the capability to replace high-volume transaction mechanisms like credit cards and fiat currency. So in late 2017, Telegram announced its intention to develop “next-generation multi-blockchain” systems designed to host a new generation of cryptocurrencies and decentralized applications at a massive scale, calling it “Telegram Open Network” or “TON”.
Telegram began funding the development of the TON blockchain network in January 2018 with the sale to investors of Purchase Agreements for Cryptocurrency, a form of simple agreement for future tokens, or SAFT. Under the Purchase Agreements, each purchaser made an investment in exchange for a promise by Telegram to issue the investor a certain number of its new cryptocurrency token “Grams” following the development and launch of the TON network. Importantly, the Purchase Agreements also provided that if the Network Launch had not occurred by October 31, 2019, Telegram would be obligated to return the investment amounts to the investors.
SAFTs Under the Howey Test
A typical SAFT based ICO consists of two stages. First, the issuer developing the blockchain network seeks to fund its network development through the sale of SAFTs to investors, in which the issuer promises to issue network tokens to the investors upon completion of the development and when the tokens are functional and offered to the public, usually at a discount to the public offering price. The prevailing securities law approach to a SAFT is that the SAFT itself and the tokens issuable thereunder are generally considered to be an investment contract and thus a security, meaning that their offering must either be registered with the Commission or qualify for an exemption from registration such as under Rule 506 of Regulation D. However, the status of the tokens issuable to the public after the network launch requires a thorough analysis under the Howey test. The key issue in the Howey analysis is the last prong of Howey, namely whether the purchaser of the token following the network launch is expecting a profit through the efforts of others. If he is, it’s a security; if he isn’t, it’s not. Whether there is an expectation of profit through the efforts of others in turn depends on whether the network is fully developed and the token fully functional. If it is, it’s a utility token and any expectation of profit derives not from the efforts of the developers (who have completed their development) but rather on the myriad of factors that cause assets to increase or decrease in value in a free market.
Complaint and TRO
Not much attention in the Commission’s complaint against Telegram was given to the securities law compliance of the early 2018 offer and sale of Telegram’s Purchase Agreements. Those were offered and sold under the exemption provided under Rule 506(c) of Regulation D, and Telegram filed with the Commission the required Notice of Exempt Offering of Securities on Form D in February 2018 with respect to $850 million in proceeds and filed another Form D in March 2018 with respect to an additional $850 million in proceeds. By filing the Forms D, Telegram was effectively conceding that the Purchase Agreements and the Gram tokens issuable to the original investors thereunder were securities. Although Rule 506(c) requires that the issuer sell only to accredited investors and use reasonable methods to verify accredited investor status, there is no direct assertion in the Commission’s complaint that Telegram violated either of these requirements or any other aspect of Rule 506(c) in connection with the Purchase Agreements. The complaint does allege, however, that the Purchase Agreements did not contain proper disclosure, as required under Regulation D. But if the Purchase Agreements were offered only to accredited investors (as is required by Rule 506(c), Regulation D would allow Telegram to avoid providing the investors the specifically mandated disclosure otherwise set forth in Regulation D. Instead, Telegram would be allowed to determine for itself what information is material and how to deliver that disclosure (including by providing its investors “access” to information).
What is at issue, however, is whether the planned issuance of the Gram tokens to the public prior to October 31, 2019 is an offering and sale of securities. The complaint states that Telegram took the position that the Gram tokens were currency and not securities. Public purchasers of Gram tokens were not restricted from reselling them. There was no restrictive legend associated with the to-be-publicly-issued tokens, and no warning was communicated that the publicly issued tokens may not be resold without registration or exemption therefrom. This contrasts with the Purchase Agreements, which contained legends stating that “this security” (presumably the Purchase Agreements and the Gram tokens issuable thereunder) is not registered with the Commission and may not be resold without registration or exemption therefrom, which restrictions on reselling were enforced through smart contract-based lockups.
The Commission rejects Telegrams position that the publicly issuable Gram tokens were not securities. In its complaint, the Commission points out that the October 31 deadline was not tied to whether the Gram tokens could be used to buy any products or services, but solely to whether Telegram was able to launch the TON blockchain network. If Telegram launched the network and sold the tokens publicly before they were fully functional, the tokens would be deemed to be securities because the public investors’ expectation of profit would necessarily depend on Telegram’s ability to complete the development of the tokens, i.e., the profit expectation would be “through the efforts of others”. Because Telegram planned to “flood the U.S. capital markets with billions of Grams by October 31”, the SEC jumped in to stop it.
The complaint further alleges the Gram tokens are not a currency because they currently have no realistic currency uses. It asserts that Telegram sold Grams in amounts that far exceed any anticipated “use” on the TON Blockchain. Telegram also didn’t restrict sales to individuals who would actually “use” Grams. The complaint further alleges that Telegram led investors to reasonably expect that Telegram’s and others’ entrepreneurial and managerial efforts would drive the success or failure of Gram tokens and the TON network. Telegram’s offering documents made clear that Telegram’s work would continue for some years after delivery of Gram tokens on the new TON Blockchain and would remain critical for the foreseeable future. The offering documents also spoke of potential future uses for the Gram tokens, specifically as a medium of exchange for goods and services (or “cryptocurrency”), to purchase not-yet-developed tools on the TON network (e.g., network storage, blockchain-based domain names, identity-hiding services) and as a token for future unspecified uses that Telegram and other third parties may eventually develop. But none of these uses of Gram tokens existed at any time. There are not now and have never been any products or services that can be purchased with Gram tokens. Finally, the principal means by which investors would reasonably expect to profit is through their resale of the tokens.
The Commission’s TRO and complaint against Telegram should serve as a stark warning to SAFT-based digital token issuers that the Commission is paying close attention to the unique characteristics of post-network launch tokens and will not hesitate to go to court to seek enforcement if the publicly launched tokens are not fully functional. The Commission in the past has at least informally acknowledged the viability of SAFT-based offerings by allowing that a class of digital tokens originally sold in a securities offering could be later sold in a manner that does not constitute an offering of a security where there is no longer any central enterprise being invested in or where the token is sold only to be used to purchase a good or service available through the network on which it was created. See the Division of Corporation Finance William Hinman’s June 14, 2018 speech on this issue here and my blog post on that speech here . Whether a post-network launch token is deemed to be an investment contract and thus a security will require a facts and circumstances inquiry, and will focus largely on whether a third party drives the expectation of a return and whether the digital token is structured through contractual or technical methods so that it functions more like consumer items and less like a security. Issuers would do well to try to structure enough flexibility into their SAFTs so that they are not forced to launch prematurely by an arbitrarily chosen deadline, and instead try to negotiate into the SAFT the right to postpone the launch for a reasonable period of time without having to return funds, perhaps conditioned on the consent of the SAFT investors, if the token is not fully functional by the deadline date. In the Telegram complaint, the Commission emphasized that the Purchase Agreement deadline is not tied to any promise or guarantee that the Gram tokens could actually be used to buy goods and services and instead depends solely on Telegram’s ability to create and launch the TON blockchain network. Clearly, Telegram’s public statements that it intended to launch the public release of the Gram tokens prior to October 31 was motivated by its determination to avoid returning investment proceeds to the original purchasers. In addition or as an alternative to a deadline postponement mechanism, issuers should focus on avoiding unrealistic network launch deadlines. Finally, it appears that Telegram had refused to accept service of an administrative subpoena, and the TRO mentions this as one of the reasons for its necessity. Lesson here is that issuers fail to cooperate with SEC investigations at their own peril.