Telegram to SEC: Liar, liar, pants on fire!

The Securities and Exchange Commission doesn’t understand cryptocurrencies, is unfair, and is out of touch with what its own commissioners are saying in public.

That is the argument messaging service turned blockchain developer Telegram made in a November 13 filing asking a federal court to overturn the emergency restraining order that halted its planned cryptocurrency sale.

On October 11, the Securities and Exchange Commission (SEC) filed suit, claiming Telegram’s planned sale of 2.1 billion Gram coins—worth about $1.7 billion—was an unregistered and illegal securities offering.

The fight is the latest wrinkle in the SEC’s ongoing enforcement campaign that has classified almost every cryptocurrency launched in an initial coin offering (ICO) as a security, not a currency. 

What’s most striking about Telegram’s November 13 response to the SEC’s charges isn’t the aggressiveness but the tone. Despite the 10-figure sums involved, at times it comes across as a child sent to bed early giving the time-honored “it isn’t fair” and “but you said” defenses. 

Of course, it’s only fair of Modern Consensus to note that a great deal of the blockchain industry shares the complaints enumerated in Telegram’s filing, particularly those related to the SEC’s long-awaited and not-very-helpful “plain English” guidance on ICOs. That’s a complaint even one of its commissioners, Hester “Crypto Mom” Peirce, has made.

Another messaging service turned cryptocurrency issuer, Kik, is also fighting an SEC lawsuit over its $100 million ICO. Kik, however, has taken a tone best described as “outrage,” using phrases like “twisting the facts.”

For its part, the SEC’s Telegram suit takes the also time-honored position “you should have known better.”

You know what you did

Telegram’s 2017 ICO was one of the richest, netting $1.7 billion for the company in 2017. 

The goal of it’s blockchain project, Telegram Open Network (TON), is to leverage Telegram’s 300 million messaging service clients. While that is too small to compete with the giants like Facebook Messenger, it provides a potentially huge user base for a cryptocurrency.

The main use of the Gram tokens is to provide a currency for in-app payments, both for its own messaging clients and for DApps other developers will build on top of TON. They will be attracted, Telegram hopes, by the TON blockchain’s highly scalable design, among other features. 

What’s unusual about the Gram offering is that it was designed as a two-stage ICO. First came a pair of sales limited to what the SEC classifies as qualified—read rich or corporate—investors. Telegram agrees that was a securities sale, and said it is legal under the Regulation D exemption for qualified investor sales. The SEC disagrees with the Regulation D argument.

It is the planned second sale of Gram by initial investors to the general public that the SEC called an unregistered securities sale and stopped with the emergency restraining order. 

But you said…

The heart of Telegram’s argument is that the SEC has acknowledged that a currency is not a security and that a cryptocurrency that was initially a security can turn into a non-regulated currency, depending on whether it is purchased as an investment or a unit of value for commerce. 

In a June 2018 speech by William Hinman, the SEC’s director of corporate finance, the agency announced that it no longer considers Ether (ETH) coins a security. 

Telegram quotes that same by pointing out that in it, Hinman said the legal problems with an initial coin offering (ICO) can be bypassed by the very process Telegram used.

“I believe some industry participants are beginning to realize that, in some circumstances, it might be easier to start a blockchain-based enterprise in a more conventional way” than an ICO, Hinman said. “In other words, conduct the initial funding through a registered or exempt  [securities] offering and, once the network is up and running, distribute or offer blockchain-based tokens or coins to participants who need the functionality the network and digital assets offer. This allows the tokens or coins to be structured and offered in a way where it is evident that [post-blockchain launch] purchasers are not making an investment in the development of the enterprise.” 

The SEC takes the position that Telegram’s interpretation is not what the regulator said. A token isn’t a currency unless it can buy something, and none of the apps and services Telegram has talked about building on TON actually exist, it noted.

Beyond that, “Telegram sold and will deliver Grams in amounts that far exceed any anticipated use on the TON Blockchain,” the SEC’s filing said. 

The SEC has also been quick to say publicly “you were warned” in ICO cases, pointing to its July 25, 2017, DAO Report. In it, the agency concluded that The DAO’s ICO was an unlicensed securities sale, but took no legal action.

Instead, it “decided not to bring charges in this instance… but rather to caution the industry and market participants: the federal securities laws apply to those who offer and sell securities in the United States… regardless [of] whether they are distributed in certificated form or through distributed ledger technology.”

It isn’t fair!

Telegram’s “it isn’t fair” argument can be found in the second paragraph of its 35-page response to the SEC’s suit.

The SEC, it complained, “has engaged in improper ‘regulation by enforcement’ in this nascent area of the law, [and] failed to provide clear guidance and fair notice of its views as to what conduct constitutes a violation of the federal securities laws.”

Even worse, Telegram added, it had worked with the SEC for two years trying to get guidance, as the agency “was well aware.”

Instead, Telegram said, “the SEC never provided fair notice that it believed Telegram’s actions had violated and would violate the federal securities law, even as it knew Telegram was expending significant time and resources, including investor funds, to prepare to launch the TON Blockchain and Grams.”

The firm also quoted Rep. Warren Davidson (R-Ohio), who recently called the SEC’s approach “regulation by enforcement” that requires coin-issuers to “grovel” and has “all the charm and inefficiency of third-world power structures.”

The filing then brings out Telegram’s biggest big gun, President Donald Trump. In an executive order signed on October 9—two days before the SEC’s emergency restraining order—the President said, “[r]egulated parties must know in advance the rules by which the Federal Government will judge their action.” 

This means publishing them in the Federal Register, not relying on “guidance documents… to impose new standards of conduct.” Nor can non-compliance with a guidance document be deemed a violation of laws or regulations, it said.

It continued, “[u]nfortunately, departments and agencies in the executive branch have not always complied with these requirements. In addition, some agency practices with respect to enforcement actions and adjudications undermine the [law’s] goals of promoting accountability and ensuring fairness.”

Wherever the DAO Report falls on that standard, the SEC’s basic argument is that the Telegram ICO, like most others, is in violation of the 86-year-old Securities Act of 1933. And, that violation is made clear under the terms of the Supreme Court’s 1946 Howey Test, which defines a security. 

Between the two, the SEC is claiming that Telegram should have known that its second sale would violate the law.