District Court of Southern District of New York Rules in Favour of SEC Finding Against Telegram Group Inc.

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Moshiuzzaman
Moshiuzzaman holds a 2:1 LL.B degree from BPP University (UK). He is currently pursuing the CFA chartership and working as an independent legal researcher at the American Society of International Law (ASIL)

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The United States District Court for the Southern District of New York rules in favour of the Securities and Exchange Commission (SEC) holding that Telegram Group Inc violated Securities law for their launch of cryptocurrencies. 

Background

Telegram Inc is a popular cloud-based instant messaging and video telephone company. The company gained tremendous popularity amongst cryptocurrency enthusiasts in 2017 when they declared to launch their version of cryptocurrencies, called “Gram” along with a new platform to trade the currencies – known as the Telegraph Open Network (TON) Issuer Inc, which was to be used in conjunction with the Telegram messaging application. 

In essence, Telegram sought to raise funds for the new crypto asset in two phases. In the first phase, Telegram began by selling contractual rights to investors to acquire Gram(s), if and when they were successfully launched. These were regarded as securities for their investment, although the contracts Telegram issued did not expressly use this terminology. In the second phase, Telegram was to launch these Gram(s) themselves. The process collectively is regarded as a Simple Agreement for Future Tokens, or SAFT for short – again, Telegram did not use this term in the contracts they issued to investors.

Telegram understood that the sale of contractual rights of such nature would be regarded as “securities” by US regulators, notably the Securities and Exchange Commission. As it is illegal to sell securities in the United States without having them registered with the Securities and Exchange Commission (SEC), or unless they are exempted from such registration, those sales were limited to be sold only to verified accredited investors to comply with one of the available exemptions from registration. Put, this meant that only wealthy individuals or entities could investment in these contractors. 

By 2018, Telegram had amassed $1.7 billion through private placements of these investment contracts according to an exemption from registration under Regulation D of the Securities Act of 1993 in exchange for delivering 2.9 billion Gram(s) once it had developed and launched the TON Network. Notably, only 39 of the 171 Initial Purchasers were in the United States. Although Telegram had not planned to conduct a separate public distribution of Gram(s) at the time of the proposed network was being developed, it did intend to “air drop” a small proportion of the overall 5 billion Gram(s).

The SEC sought to block the distribution of these Gram(s) to Initial Purchasers on the ground that it was anticipated that upon issuance, the Initial Purchasers would act as “underwriters” and resell the Gram(s) into a secondary public market in an unregistered offering of securities. Telegram rejected the characterization, asserting that any such resales would be transactions wholly unrelated to the initial sales and distributions and that they would not constitute securities offerings. With the proceeds collected, Telegram promptly set about finalizing the development of the Gram(s). In late October 2019, just before Telegram was about to begin its second phase and launch Gram(s), the SEC initiated proceedings in the District Court of the Southern District of New York (SDNY). The court granted a temporary restraining order, and Telegram and the SEC squared off. 

The Federal Court for the SDNY 

In court, Telegram argued that it had complied with the requirements under the United States laws by registering the contractual rights and waiting to issue Gram(s) until they were functional. At that point, the company argued, that Gram(s) did not amount to securities. Alternatively, the SEC contended that the entire plot to distribute Gram(s), which was not registered or exempted from registration amounted to a single “scheme”. They reasoned that because there was an available scheme, the original purchasers of the contractual rights would be “underwriters” acting for Telegram. Thus the entire distribution would be tainted because the ultimate purchasers would not all qualify as accredited investors.

On the 24th of March 2020, Judge Peter Castle ruled in favour of the SEC. Shortly thereafter, after being told by the judge that the injunction applied to all sales regardless of where in the world the original purchasers might be located, Telegram abandoned its plans and settled with the SEC, agreeing to pay a fine of $18.5 million to the SEC and to return $1.2 billion – the remaining proceeds from the sale of contractual rights to the original purchasers.

Lessons from the decision 

This is not the first time that the SEC has gone after an entrepreneur over cryptocurrencies or objected to the use of SAFT processes. Neither is it the first time that the Commission has intervened in the absence of any claimed fraud nor is it the first time the SEC has sought to reach crypto-entrepreneurs operating primarily overseas. It is, however, the first time the SEC has prevailed on the position that a SAFT, or for that matter any sale of contractual rights to acquire a crypto asset when launched, has to be integrated with the eventual sales or resales of the asset because the original purchasers are underwriters. 

Although the decision in the case was reached on a motion for preliminary judgment, because there is no appeal, the ruling is binding on Telegram and is currently the most recent indication of how broadly the SEC intends to pursue SAFT distributions and how courts might react. As regards to crypto sales using the SAFT mechanism, it is irrelevant what entrepreneurs refer their cryptocurrency, i.e. contractual rights as in the case for Telegram. The decision shows that the SEC is hostile to the SAFT process. The result in the case, even though fact-specific, clearly demonstrates that the SEC has taken the general proposition that both phases of a SAFT distribution can constitute as a single offering, especially when the purchasers of the contractual rights have the immediate power to resell crypto assets that are issued to them. Moreover, merely deciding to limit initial sales to non-citizens outside the boundaries of the US is not enough to assure that the SEC will not intervene. Efforts by Telegram to limit the scope of the preliminary injunction were mostly unsuccessful, which means that the company was not allowed to proceed with selling Gram(s) anywhere in the world. 

Click to see the full judgment.


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