In an initial coin offering (“ICO”), digital assets called coins or tokens are created and issued in order to fund and operate a blockchain-based application. The number and dollar volume of ICOs exploded in the 2017-2018 timeframe, as the value of bitcoin, the most widely-used cryptocurrency, reached $19,000 per coin in December 2017. The U.S. Securities and Exchange Commission (the “SEC”) arose from its slumber in mid-2017 and issued The DAO Report, which concluded that the tokens issued in The DAO’s 2016 ICO were securities under the federal securities laws and should have been registered with the SEC in order to give U.S. investors the protections of the extensive disclosure required in a public offering prospectus. The SEC, in The DAO Report and its recent Framework of ‘Investment Contract’ Analysis of Digital Assets (the “Framework”) explains that a token or other digital asset may be a “security” within the meaning of the U.S. Securities Act of 1933 (the “Securities Act”) because of the 1946 Supreme Court Case, SEC v. W.J. Howey Co. (“Howey”). A digital coin or token may be considered a security if it is an “investment contract” under the Securities Act. In Howey, the Supreme Court defined an “investment contract” as an investment of money in a common enterprise with an expectation of profits, derived primarily from the entrepreneurial and managerial efforts of others. A number of enforcement actions by the SEC against ICO issuers have followed The DAO Report, including a recent action against Kik Interactive Inc. (the “Kik Action”), which closed a $100 million ICO in 2017 and a recent $24 million settlement with Block.one, which issued billions of dollars of tokens in 2017 and 2018.

On October 11, 2019, the SEC continued its assault on unregistered ICOs with the filing of an action in the U.S. District Court for the Southern District of New York against Telegram Group Inc. and its affiliates (“Telegram”). Telegram and its Russian founders, Pavel and Nikolai Durov, raised about $1.7 billion in a 2018 ICO through the sale of tokens called “Grams” to investors in the U.S. and abroad. There were 39 U.S. purchasers who provided $424.5 million in funding. Telegram intended to use the proceeds from its ICO to create its own blockchain called the “Telegraph Open Network” or “TON Blockchain”. Telegram committed to deliver Grams to the initial investors by October 31, 2019, but the SEC has asked the court to enjoin the issuance of the Grams as well as disgorge the funds raised, with prejudgment interest and civil penalties.

Telegram, according to the SEC, conceded that the “Gram Purchase Agreements” entered into with the investors in 2018 were indeed securities, since they constituted “investment contracts” under Howey. The Gram Purchase Agreements contained restrictive legends regarding their transfer and entitled investors to delivery of Grams in conjunction with the launch of the TON Blockchain by no later than October 31, 2019. In an effort to claim an exemption under the federal securities laws for the issuance of the Gram Purchase Agreements, Telegram filed an SEC Form D in March 2018. However, Telegram claimed that the Grams themselves, “without which the [Gram Purchase Agreements] have no value or purpose, were not securities but merely currency like bitcoin. No restrictive legends were placed on Grams, nor were purchasers told they could not be freely resold in the U.S., although some Grams purchasers agreed to contractual lockups.

The SEC had little trouble concluding that the Grams tokens meet the Howey test for an investment contract. The “expectation of profits” prong of Howey was supported by Telegram’s marketing of Grams at a deep discount from the projected secondary market price, as well as Telegram’s efforts to create a trading market for Grams on a number of digital-asset trading platforms (colloquially referred to as “exchanges”). Neither did the “efforts of others” prong of Howey trouble the SEC, which noted that the TON Foundation, an entity controlled by the Durov brothers, would receive the proceeds of the Gram sales and would control the development and operation of the TON Blockchain and a majority of the supply of outstanding Grams after the offering.

The SEC goes on to allege that the initial investors, who were due to receive Grams by the end of October, intended to resell Grams that they purchased at a steep discount to the investing public. As a result, they would be “underwriters” within the meaning of the securities laws, and their resales of these securities would violate the Securities Act unless registered with the SEC.

The SEC’s Telegram complaint echoes the SEC’s position in the Kik Action, where Kik, like Telegram, tried to use SEC Rule 506(c) for an exemption from what was, in reality, an initial public offering. In the Kik Action, the SEC alleged that an earlier SAFT (Simple Agreement for Future Tokens) offering under 506(c) was integrated into a later offering of tokens to the public, thereby blowing up the exemption. In the Telegram complaint, a 506(c) exemption for the earlier Gram Purchase Agreement offering was of no use in the public offering of Grams that Telegram had planned from the start.

Also notable in both the Kik and Telegram actions is the importance of the centralization or decentralization of the network development. As in the Kik action, purchasers of Grams would be wholly reliant on the TON Foundation for the development of the TON Blockchain, thereby satisfying the “efforts of others” prong of Howey. Contrast the favorable “no-action” letter the SEC sent to Pocketful of Quarters, which had already fully financed and developed its universal gaming token. Moreover, the undeveloped state of the TON ecosystem meant that the Grams tokens had no use or utility other than as a vehicle for investor profits.

As a final observation, Telegram appears to have made no effort to geofence its ICO from U.S. investors, and, in fact, focused selling efforts into the U.S. and directed payments of funds in U.S. dollars through a correspondent bank in the Southern District of New York.  By contrast, Block.one, which raised $4 billion in its 2017 ICO, reportedly had put geofencing in place to keep out U.S. investors. Some commentators credit that fact for Block.one’s relatively paltry fine ($24 million) and other favorable settlement terms.