Court to Telegram: $1.7 billion gram token sale is likely illegal

You know you’re in trouble when the judge hearing your case refers to your business plan as a “scheme.”

That’s the position messaging app turned blockchain developer Telegram found itself in on March 24, after Judge P. Kevin Castel of the Federal District Court for the Southern District of New York issued a preliminary injunction stopping the planned resale of 2.9 billion gram tokens to the general public.

“The Court finds that the SEC has shown a substantial likelihood of success in proving that the contracts and understandings at issue… are part of a larger scheme to distribute those Grams into a secondary public market, which would be supported by Telegram’s ongoing efforts,” Castel wrote.

In 2018, Telegram held what it admits was securities sale, raising $1.7 billion from 175 “accredited”—or rich—investors. That was exempt from SEC registration requirement under the much laxer Regulation D, which allows securities sales to accredited investors with far fewer hoops to jump through, Telegram claimed.

The plan was for those 175 buyers to resell the tokens to the general public when the Telegram Open Network, or TON, blockchain launched on Oct. 31, 2019. At that point, Telegram argued, they would be utility tokens used to buy goods and services, and transfer value on the TON blockchain. Telegram said that would make grams commodities, not securities.

After the SEC won its Oct. 16 emergency injunction, the launch date was pushed back to April 30.

Something for nothing

Judge Castel found that the 175 initial investors, “expected to profit from Telegram’s continued support for Grams and the underlying TON Blockchain through the distribution of Grams by the Initial Purchasers to the public.” That fits the four-part Howey test that defines what is and is not a security, he said.

That second sale was “an integral part” of the gram ICO, Judge Castel said. “Telegram knew and understood that reasonable purchasers would not be willing to pay $1.7 billion to acquire Grams merely as a means of storing or transferring value,” he added. “Instead, Telegram developed a scheme to maximize the amount initial purchasers would be willing to pay Telegram by creating a structure to allow these purchasers to maximize the value they receive upon resale in the public markets.”

Castel also called shenanigans on Telegram’s argument that the terms of sale to those 175 buyers required them to “warrant that they were ‘purchasing the Tokens for [their] own account and not with a view towards’” reselling them at a profit.

“From Telegram’s perspective, it was critical that the Initial Purchasers could flip their Grams in a post-launch secondary market because this feature would increase the amount of money it could raise,” Castel said.

The bigger picture

Judge Castel’s ruling—while far from final—puts more than the future of Telegram’s TON blockchain into doubt.

While many companies settled with the SEC, or simply returned investors’ money, Telegram and another messaging app firm, Kik, have chosen to fight what they call “regulation by enforcement.”

That has turned the lawsuits into test cases of the SEC enforcement power over cryptocurrency ICOs.

In January, the Chamber of Digital Commerce filed an amicus curiae—friend of the court—brief asking the court to create “a clear legal distinction between a transaction determined to be an investment contract and the digital asset that is the subject of the investment contract.”

Without legal clarity, it said, companies in many industries would be afraid to “develop or use blockchain technology,” for fear of violating federal securities law not only during an ICO, but every time a digital asset is used on their blockchains.

Lack of clarity

While the CDC did not actually support or oppose Telegram’s specific argument, the Blockchain Association’s amicus brief did.

But its basic goal was the same as the CDC.

In a statement about the brief, the Blockchain Association said that it told the court that the “lack of clear rules governing digital assets threatens to stifle innovation and push investment overseas.”

That’s not an idle threat. According to a recent report by CBInsights, China’s share of blockchain deal funding rose 20% while the U.S.’s share declined by 20% since 2015.

In the brief, the Blockchain Association quoted SEC Commissioner Hester Peirce, who “has likened the SEC’s guidance on this question to a Jackson Pollock [SIC] painting: ‘splashing lots of factors on the canvas without any clear message.'”

As a result, the group said, “the industry has been forced to hunt for regulatory clues among the SEC’s conflicting statements, Commissioner and staff speeches, no-action letters, closed-door meetings with the SEC, and nonprecedential settlements.”

Given that “backdrop of uncertainty and inconsistency,” the Blockchain Association argued, Judge Castel “should give no deference to the SEC’s litigation positions.”

Judge calls shenanigans

Judge Castel said that the 175 initial investors, “expected to profit from Telegram’s continued support for Grams and the underlying TON Blockchain through the distribution of Grams by the Initial Purchasers to the public.” That fits the four-part Howey test that defines what is and is not a security, he said.

Castel also called shenanigans on Telegram’s argument that the terms of sale to the 175 initial buyers required them to “warrant that they were ‘purchasing the Tokens for [their] own account and not with a view towards’” reselling them at a profit.