A new opinion provides insight into the SEC’s regulation-through-enforcement approach toward ICOs. Digging into the facts of a potentially billion-dollar cryptocurrency raises questions, and provides a few answers, about cryptocurrency sales.
In SEC v. Telegram Group Inc. & TON Issuer Inc., 19-cv-9439 (PKC) (S.D.N.Y. Mar. 24, 2020), the district court ruled in favor of the SEC in a motion for preliminary injunction against the issuance of a new cryptocurrency by Telegram Group Inc. (Telegram). The court found that the SEC showed a substantial likelihood of success in proving that Telegram’s plan to distribute the cryptocurrency would be an offering of securities to which no exemption applies. Telegram’s cryptocurrency would have been one of the most important in the industry, and the court’s ruling provides insight into the legal treatment of cryptocurrency, in particular the nature of decentralization and blockchain governance.
Telegram runs a messaging service (Messenger) popular in cryptocurrency circles due to its heavy encryption and distributed server network. It is used worldwide and claims a user base of 300 million. The company runs largely without charging fees or displaying advertisements and is funded from the founders’ personal wealth. In 2017, the company began to develop a blockchain and a digital asset—the TON (Telegram Open Network) Blockchain and Grams, respectively, to be integrated with Messenger. The distribution of the Grams is the focus of the SEC’s enforcement action.
Grams Token Distribution Plan
The initial supply of Grams was intended to be limited to five billion, all of which would be initially held by Telegram. Telegram intended to distribute the Grams in several rounds.
Initial Purchasers. Round one consisted of the sale of 2.25 billion Grams to 81 purchasers (Round 1 Purchasers) for $850 million, or approximately $0.38 per Gram. Round 1 Purchasers were subject to a staged lockup period, ending three, six, twelve, and eighteen months after launch of the TON Blockchain. In round two, Telegram sold 700 million Grams to 94 purchasers (Round 2 Purchasers, and together with the Round 1 Purchasers, the Initial Purchasers) for $850 million, or approximately $1.33 per Gram. In total, the Initial Purchasers would hold 58 percent of the Grams upon launch of the network. Telegram filed Form Ds for the sales to Initial Purchasers and claimed an exemption under Rule 506(c).
Incentive Reserve. According to promotional materials, Telegram intended to retain four percent of the Grams for Telegram developers building the TON Blockchain, including one percent for each of the two founders. Further, Telegram stated that 10 percent of Grams would be reserved for incentive programs, such as distributions to Messenger users.
TON Foundation. The remaining unallocated Grams, about 28 percent, were intended to be transferred to a to-be-created nonprofit, the TON Foundation. The TON Foundation would be tasked with control of such reserve and maintaining governance functions for the TON Blockchain. The TON Foundation would be controlled by a board, including the Telegram founders. If the TON Foundation is not established, then the reserve would be locked indefinitely.
The SEC’s Preliminary Injunction
Prior to the establishment of the TON Blockchain and distribution of the Grams, the SEC filed for a preliminary injunction in the Southern District of New York. The SEC claimed that such distribution would constitute an unregistered offering of securities under section 5 of the Securities Act of 1933 (the Securities Act). On March 24, 2020, the court granted the SEC’s motion for a preliminary injunction and found that the SEC showed a substantial likelihood of success in proving that the sales to the Initial Purchasers are part of a larger scheme to distribute those Grams into a secondary public market. In essence, the Initial Purchasers are “underwriters” under the Securities Act; therefore, Telegram is not entitled to rely on the exemption under Rule 506(c) of Regulation D.
Howey Analysis. Section 2(a)(1) of the Securities Act defines a “security” to include an “investment contract.” In turn, under the Howey test, the Supreme Court defined an “investment contract” as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946). Essentially, there are four prongs to the test: (1) investment of money, (2) common enterprise, (3) expectation of profit, and (4) efforts of another.
Two factors were key to the court’s finding that the distribution of Grams constituted an offering of securities. One, the success and continued development of the TON Blockchain, and therefore the functionality and usability of the Grams, was tied directly to Telegram’s operations and support. The proceeds from the sales to the Initial Purchasers was used to cover Telegram’s expenses, and the reserve would provide price support. Further, the success of the project depended on Messenger’s popularity among a large user base. Two, the Initial Purchasers did not seek to obtain the Grams for consumption, but for resale to the general public. Despite representations in the purchase agreements to the contrary, the court found that the economic incentives of the transaction evidenced an investment intent and expectation of profit.
Telegram argued that even if the sale to the Initial Purchasers was a security offering, once the Grams are available upon launch of the TON Blockchain, they would be commodities with a consumptive purpose, not securities. The court disagreed and found that the initial contracts must be considered along with all related expectations and understandings, including subsequent distribution of the Grams. Viewed as a whole, the sale to the Initial Purchasers was with the purpose of a sale in the public market. Therefore, the court found the transaction to be “a disguised public distribution” and not eligible for exemption from registration under section 4(a)(2).
Endorsement of Decentralization Defense. Without citation, the court stated that “[i]n the abstract, an investment of money in a cryptocurrency utilized by members of a decentralized community connected via blockchain technology, which itself is administered by this community of users rather than by a common enterprise, is not likely to be deemed a security under the familiar test laid out in [the Howey test].” This is a seeming endorsement of the SEC’s position that a cryptocurrency on a “sufficiently decentralized” blockchain would not be considered a security.
William Hinman, Director of the SEC’s Division of Corporate Finance, has stated that:
If the network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts—the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.
If a cryptocurrency is decentralized, the last prong of Howey, whether the expectation of profit stems from the efforts of others presumably would not be satisfied. Although there is no accepted definition of “sufficient decentralization,” the court in the Telegram case suggests a test: whether the cryptocurrency would have the same “mass adoption, vibrancy and utility” that would enable the expected profits even if the issuer moved offshore and ceased operations. In the court’s opinion, the TON Blockchain failed this test.
The test as stated leaves something to be desired; it is vague and may not be reasonably attainable. Establishing a decentralized network would take time before there was sufficient adoption in the developer community to ensure such a test could be met. Even in the cases of Bitcoin and Ethereum (which are generally accepted as decentralized), the networks likely would have failed this test initially. Further, one could imagine an open-source protocol where the initial development team is unable to enact unilateral changes, either due to legal or technology restrictions, and there is involvement by a wider developer community, yet the cryptocurrency still relies on the initial team for its “vibrancy.”
Importance of Token Governance. In considering the “common enterprise” prong of the Howey test, one factor was that Telegram intended for the Gram reserve to be held by a to-be-established TON Foundation. Such foundation would hold the reserve—in effect providing monetary policy for the token—and hold governance responsibility for the TON Blockchain. The court found fault with this plan, however. One, Telegram was under no legal obligation to create the TON Foundation or transfer the Gram reserve if created. Two, even if the TON Foundation was created and the reserve transferred, there was no requirement that Telegram appoint an independent board.
Establishing a foundation to manage blockchain governance can help ensure the independence and integrity of the blockchain and related tokens. As with the Ethereum Foundation, a foundation can promote and support a cryptocurrency that is otherwise fully decentralized. Yet, as the court points out, there is a risk of capture by the token issuer if governance roles and rules are not established and enforceable prior to issuance. Further, if the foundation is responsible for sale of the token, there is a risk that it would find itself liable for violation of the securities laws. Nevertheless, a legally existing and independent foundation with established rules could weaken an argument that a cryptocurrency is an investment in a common enterprise.
Evaluate Distribution Scheme Based on Economic Reality. Finally, it is important to note that the court focused much more on the economic reality of the token distribution than the terms of the purchase agreements. In particular, the court found that economic incentives, such as discounts and lockup periods, were intended to ensure the resale and wider public distribution of the Grams—“a disguised public distribution.” Further, the nature of the sales displayed an investment intent, including the fact that the initial purchasers were professional investors, such as VC firms, that bought large numbers of Grams. This is despite inclusion of appropriate legal representations in the purchase agreements.
The opinion was well-reasoned and should be influential either on appeal or in future ICO cases. In the face of the preliminary injunction, Telegram is already considering appealing the decision or selling the Grams solely to non-U.S. purchasers. Although the future of the TON Blockchain is unclear, this ruling should provide insight for legal practitioners and developers of future cryptocurrencies.
 Alex Fader is the Chief Legal Officer, Salt Blockchain Inc., and Chair, Corporate Counsel Subcommittee of the CBA Business Law Section ([email protected]). The views expressed in this article reflect the author’s own and do not reflect the views of Salt Blockchain Inc.
 Notably, the CFTC weighed in on the commodity versus security question as well. In a February 18, 2020 letter to the judge in this case, the CFTC stated:
Digital currency is a commodity. See, e.g., CFTC v. My Big Coin Pay, Inc., 334 F. Supp. 3d 492, 495-98 (D. Mass. 2018) (citing cases); In re BFXNA Inc. d/b/a Bitfinex, CFTC Dkt. No. 16-19, 2016 WL 3137612, at *5 (CFTC June 2, 2016) (“Bitcoin and other virtual currencies are ... properly defined as commodities.”). However, the Commodity Exchange Act (“CEA”), 7 U.S.C. §§ 1-26, provides that many securities are commodities to which the securities laws apply. Thus, any given digital asset may or may not be subject to the securities laws, but that does not depend on whether the asset is a commodity. It depends on whether the asset is a "security" within the meaning of the '33 Act itself.
Robert A. Schwartz, Deputy General Counsel, Litigation, Enforcement & Adjudication, CFTC, Letter to Judge Castel, Re: SEC v. Telegram Group, Inc., et al., No. 1:19-cv-09439 (PKC) (Feb. 18, 2020).
 Nikhilesh De, Telegram Appeals Court Ruling Barring Gram Token Distribution, CoinDesk (Mar. 25, 2020).
 Anna Baydakova, Telegram Hopes It Can Still Sell Tokens to Non-US Investors After Court Ruling, Yahoo Fin. (Mar. 30, 2020).