SEC’s Lawsuit Against Telegram Raises Questions About Cryptocurrency “Presales” Under Regulation D

By: Ifrah Law

On October 11, 2019, the Securities and Exchange Commission (“SEC”) filed a lawsuit against Telegram Group, Inc. and TON Issuer, Inc. (“Telegram”), and simultaneously obtained a temporary restraining order preventing Telegram from issuing its “Gram” cryptocurrency, which had been scheduled for delivery on October 31, 2019.  The SEC claimed that the sale of Grams amount to an unregistered securities offering in violation of federal securities laws.

Telegram—the company behind a secure messaging application called Telegram Messenger, which was already popular in the blockchain community due to its security features—intended to deliver Grams in conjunction with the deployment of its TON Blockchain network.  Telegram’s plan was to leverage its existing Messenger user base to create a large, functioning blockchain network on which Grams would exist.

According to the SEC, Telegram raised approximately $1.7 billion in presales of Grams to a group of initial presale investors—including $424.5 million raised from 39 investors in the United States.  The SEC complaint did not specify this, but the presale was conducted via a Regulation D offering in which was limited to “accredited investors” with incomes of over $200,000 per year or a net worth of over $1 million, or to companies with over $5 million in assets.  Companies file a Form D with the SEC claiming that a certain offering is exempt from securities registration requirements.

According to reports at the time of the presale—which took place in early 2018—Telegram utilized “Simple Agreements for Future Tokens,” or “SAFTs,” which investors signed in exchange for delivery of tokens by the end of October 2019.  The SEC’s complaint alleges that presale purchasers paid between $0.37 and $1.33 per Gram while being informed that the “Reference Price” of Grams at the time of the launch of the TON Blockchain and token delivery would be $3.62 per Gram.

In spite of the purported exemption from registration requirements under Regulation D, the SEC took issue with Telegram’s offering in that Telegram clearly disclosed to investors that it planned to utilize funds from the presale to develop its blockchain technology—which was not a functioning network at the time of the sale—and pay related expenses.  The critical analysis in the SEC’s complaint is that:

“Grams are securities because the Initial Purchasers and subsequent investors expect to profit from Telegram’s work: the development of a TON “ecosystem,” integration with Messenger, and implementation of the new TON Blockchain. Grams are not a currency because, among other things, there are not any products or services that can be purchased with Grams. Rather, there is an expectation on the part of investors that they will profit if Telegram builds out the functionalities it has promised”.

The SEC complaint is silent as to the status of the TON Blockchain or its functionality as of the time of the complaint, although the SEC acknowledged that Telegram had spent $218 million on the development of TON Blockchain and Telegram Messenger in the time since the presale, which indicates that the TON Blockchain might well have been functional at the time of token delivery.  Given the funds raised and the time elapsed since the successful presale, along with the apparent development expenditures on TON Blockchain, any suggestion that the TON Blockchain is not functional may be based on dated facts.  Indeed, in its complaint, the SEC acknowledged that Telegram released a beta version of TON Blockchain in March 2019, indicating that the platform has been at least partially functional for at least half the year.

The SEC’s complaint relies heavily on a communication between Telegram and a U.S. investor in which Telegram referred to a “chance for 0x-50x” returns on the investments, in addition to other promotional materials suggesting that Grams will increase in value as the network grew.  This contention would support a conclusion that Grams are intended for investment purposes, but it is not alone dispositive.

In its complaint, the SEC complained not only that the presales amounted to illegal securities offerings (in spite of the Regulation D registration), but also that any resales of Grams by presale investors to the general public would additionally amount to an illegal unregistered offering, as the general public was not provided with the information typically required of a registered securities offering.  While the pre-sale SAFTs are clearly restricted securities, as discussed above, whether Grams constitute a security at all is an open question.

It is interesting to note that unlike many SEC enforcement actions regarding unregistered token sales, the only sales to have taken place thus far in the Telegram action were via SAFTs (although the SEC did not refer to SAFTs by their name in its complaint).  Because token delivery was imminent, the SEC filed its complaint and sought a temporary restraining order to prevent Grams from reaching the public marker, on the contention that “[o]nce Grams reach the public markets, it will be virtually impossible to unwind the Offering.”  While the conventional wisdom is that the sale of digital tokens via SAFTs to accredited investors may insulate a token issuer from running afoul of securities laws, the SEC appears to be taking the position as to Telegram that there is still securities law liability where re-sales of tokens by presale investors to the general public can suffer from the same maladies as the Regulation D presale.

The SEC’s approach to cryptocurrencies and digital tokens is still evolving, but based on the SEC’s limited enforcement history and published guidance, the SEC seems to place higher levels of scrutiny on sales of tokens where the underlying technology of platform has not yet been developed, where the intent is for tokens to be traded on secondary markets, and where representations regarding the potential for profit are made to investors.

It is understandable that businesses seeking to sell digital tokens attempt to avoid the SEC’s registration requirements, as registration can be an expensive process and often cost-prohibitive for start-up companies.  For businesses considering digital token sales of their own, one way to avoid the possibility of post-sale enforcement action by the SEC—without being subjected to registration requirements—could be to contact the SEC in advance of any sale with a detailed description of the digital token—including a description of the blockchain network, platform, digital token use, and sale procedures—in the hopes of obtaining a “no action” letter from the SEC.  A “no action” letter informs businesses that if a token sale proceeds as described, tokens will not be subjected to securities regulation.

Requests for “no action” letters are not new—as businesses have made them in other contexts for years, such as the example of sports teams seeking “no action” letters for the proposed sale of “personal seat licenses”—but few businesses have obtained “no action” letters in the context of a token sale.  This year, the SEC has issued its first two no action letters in the crypto context:   Pocketful of Quarters, Inc. obtained a no action letter in connection with its proposed sale of a digital gaming token and TurnKey Jet, Inc. received a no action letter regarding its proposal to deploy token technology in conjunction with a private jet service.

Given that responding to SEC subpoenas and potentially litigating against the SEC—a daunting task now facing Telegram—can be as or even more costly than complying with securities registration requirements, businesses would be well-advised to consider taking the “no action” letter approach with any planned token sale, especially during this ongoing period of SEC enforcement uncertainty.

As for Telegram, the next step is a hearing on October 24 before Judge P. Kevin Castel of the U.S. District Court for the Southern District of New York, during which the SEC will seek to have the temporary restraining order converted into a preliminary injunction.  If Telegram is able to succeed at the preliminary injunction hearing, however, that could mark a turning point in the ongoing tug-of-war between token issuers and the SEC.