After flexing its enforcement muscle in going after Kik ( you can read our feature on Kik here), the Securities and Exchange Commission ("SEC") is continuing its show of force in the crypto space. On October 11, 2019, the SEC filed a complaint against Telegram Group Inc. ("Telegram") and TON Issuer Inc., for US federal securities law violations in connection with an initial coin offering ("ICO") (the "Complaint").
What is Telegram?
Telegram, one of the world's biggest social media platforms, recently announced that it was behind the Telegram Open Network ("TON"). TON is marketed as a fully decentralized online communication platform that would also offer file sharing and anonymous browsing. To fund this project, Telegram decided to issue tokens to investors through an ICO. These tokens, called Grams, would ultimately be used as currency for products and services offered on TON.
Between January and March 2018, Grams were sold to accredited investors through "Gram Purchase Agreements" ("GRA"), which Telegram admitted are investment contracts. The GRA functioned in a similar way to the well-known Simple Agreement for Future Token (or "SAFT") in that investors would not receive the Grams right away, but only at a future date when TON would be functional. Telegram sold approximately 2.9 billion Grams for a total of roughly US$1.7 billion, making it the third biggest ICO of all time.
The Complaint
In the Complaint, the SEC invokes a violation of Sections 5(a) and 5(b) of the Securities Act of 1933 (the "Securities Act"). The SEC is asking the court to prevent Telegram from launching TON and releasing Grams to the general public, as well as disgorgement of all gains and a prohibition for Telegram from participating in any other offering of digital asset securities. The SEC stated that one of the goals of the Complaint is to "prevent Telegram from flooding the U.S. markets with digital tokens that we allege were unlawfully sold," while also claiming that investors were not provided with sufficient information regarding Telegram's operations, its financial conditions, risk factors of their investment, and management of Telegram.
The Complaint is based on marketing materials that the SEC was able to obtain directly from investors after the SEC reached out to them in September 2019. The Complaint points out several key aspects that are of interest, including the many promises made by Telegram, such as the possibility of a 50x return on investment. From the SEC's point of view, given that the TON ecosystem was still not functional, Grams sold to investors had no value other than the expected profit investors will make when TON becomes functional. Telegram also spoke at length about its highly-skilled engineering team that would continue to develop TON and new products and services for which Grams would be used, drawing on the "efforts of others" aspect of the Howey Test (the test for determining whether an offering is a security).
While the initial sale of Grams was made to accredited investors, the SEC took issue with the fact that as soon as TON launches, those investors could flood the market with their Grams. This would effectively skirt regulations surrounding traditional exempt offerings. The SEC also made a point of saying that it was always Telegram's intention to go ahead with a public distribution and that this distribution of Grams to public investors would be "accomplished without furnishing ultimate purchasers the information about Telegram and Grams required in a registration statement." Thus, from the SEC's point of view, the GRA and the subsequent public release of Grams upon the TON operational launch are sales of securities requiring that investors be provided with adequate disclosures regarding both Grams and Telegram itself. An emergency restraining order was granted on October 11, 2019, preventing Telegram from going ahead with the TON launch.
Had this taken place in Canada, and given the fact that Telegram is not and would likely not become a reporting issuer, Grams would be subject to an indefinite restricted period, as per National Instrument 45-102 – Resale of Securities. As such, any initial investor in the ICO would have to rely on a prospectus exemption to resell their Grams after the TON launch. In our view, Canadian securities regulators would take a stance similar to that of the SEC regarding Telegram's ICO.
Telegram's Response
In response to the Complaint, Telegram sent a letter to investors in which it mentions that they had been trying to obtain feedback from the SEC for the past 18 months and that they disagree with the SEC's legal position regarding their ICO. Investors were also informed that Telegram is actively working on a solution. The GRA provides a "force majeure" clause that would allow Telegram to avoid any liability for any delay caused by an action by a government authority. In addition, Telegram has also announced a temporary halt on all of its work on TON pending the resolution of the Complaint and has deleted all posts from its Telegram channel. Telegram filed an answer on November 12, 2019, in which they refute all of the SEC's allegations and claim that the SEC is engaging in "regulation by enforcement" that goes against publicly-expressed views of the SEC's own officials. In this new filing, Telegram asks the court to dismiss the SEC's claim. The hearings on the Complaint will take place on February 18 and 19, 2020.
Our Take
The Complaint is another indication that issuers cannot avoid United States federal securities laws just by labeling their product a cryptocurrency or a digital token. This sends a strong message that regardless of marketing terminology used in promotional campaigns, the SEC will look at the capital raise itself in its simplest form. The SEC's focus on marketing material is not new, but their efforts to go directly to the investors to obtain additional information to build their case shows that token issuers need to be careful to frame their message so that it is compliant with securities laws. The Complaint is also a signal that much like the Kik ICO, doing an initial raise with accredited investors through a SAFT is not a bullet-proof way to avoid any sort of enforcement action.
While some regulators have developed new regulations or have put forth changes to existing regulations – for example the new money service business rules in Canada – there is still much regulatory uncertainty in the ICO process, which puts many token issuers at risk of enforcement actions. Token issuers should be acutely aware that esoteric structuring of ICOs could potentially lead to severe liability if not enough time is spent making sure that projects pass regulatory muster.
We strongly encourage anyone venturing into this space to consult their counsel and their local securities regulator for guidance. Miller Thomson's cryptoasset experts can help you navigate the intricacies of ICOs and obtain guidance from provincial and territorial securities regulators.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
