A federal judge in New York has adopted a controversial position advocated by the U.S. Securities and Exchange Commission that threatens to eviscerate the ability of sellers of cryptocurrency tokens to rely on representations made to them by even the most sophisticated of purchasers. On March 24, Judge P. Kevin Castel of the Southern District of New York issued a decision that treated sophisticated venture capital firms and high net worth individuals who initially purchased a cryptocurrency known as "Grams" from Telegram (the company behind the popular Telegram Messenger application) as "underwriters" that were used to redistribute Grams to the public, despite the fact that Telegram did not ask these purchasers to redistribute the Grams, but rather required the purchasers to represent that they were not purchasing the cryptocurrency for redistribution.
Judge Castel's decision resolved the SEC's application for a preliminary injunction precluding Telegram from delivering Grams to a set of initial purchasers who had purchased them in 2018. Although he rejected the SEC's argument that a Gram – standing alone – was a security, Judge Castel concluded that the scheme by which Telegram sold 2.9 billion Grams for $1.7 billion in 2018, and which would have permitted those buyers to resell those Grams on the secondary market, was an investment contract, and therefore a security. On that basis, he granted the SEC's motion.
In evaluating whether Telegram had entered into an investment contract with Gram purchasers, and thus engaged in a securities offering, Judge Castel applied the test set forth by the Supreme Court in S.E.C. v. W.J. Howey, in which the Supreme Court had held that an investment contract is "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."
Judge Castel first concluded that the sale of Grams to initial purchasers, the eventual delivery of Grams to those purchasers, and expected resales of Grams by those initial purchasers on the secondary markets should all be treated as a single scheme under the Howey test. He rejected Telegram's argument that only the sale to initial purchasers – for which Telegram claimed an exemption – constituted a sale of a security, while the "functional consumptive uses" of Grams upon launch of the blockchain (known as the "TON Blockchain") would make Grams commodities, not securities.
Judge Castel then analyzed Telegram's "scheme" under the Howey test. As a threshold matter, while Telegram argued that the Howey analysis should be applied at the time of delivery of Grams – i.e., upon the launch of the TON Blockchain – he concluded that, under Howey, a court must examine "the series of understandings, transactions, and undertakings" at the time they were made.
Judge Castel concluded that the SEC had made a showing that the purchases were investments in a "common enterprise" for two reasons. First, he found that the SEC had made a showing of a common enterprise between the purchasers due to their assets being pooled and their fortunes linked (giving the enterprise "horizontal commonality"). He noted that Telegram pooled the money received from initial purchasers and used it to develop the TON Blockchain and its Messenger application, and that each purchaser's ability to profit was dependent upon the successful launch of the TON Blockchain. Post-launch, "[t]he plain economic reality" – a theme to which Judge Castel repeatedly returned – is that "Grams themselves continue to represent the Initial Purchasers' pooled funds" and if the TON Blockchain failed, "all Initial Purchasers would suffer a diminution in the value of their Grams."
Second, Judge Castel found that the SEC had made a showing of a common enterprise between the purchasers and Telegram due to the fortunes of the purchasers being tied to the fortunes of Telegram (giving the enterprise "strict vertical commonality"). He reasoned that "Telegram's own fortunes would suffer financial and reputational harm if the TON Blockchain failed prior to launch." Telegram's fortunes were therefore "inextricably linked" to the fortunes of the TON Blockchain, and thus to the initial purchasers of Grams. Interestingly, Judge Castel counted "critical reputational damage" as a risk to the fortunes of Telegram if the TON Blockchain failed to launch.
Judge Castel further concluded that the SEC showed a substantial likelihood of success in proving that the initial purchasers purchased Grams in 2018 with the expectation of profit. Rejecting Telegram's argument that the initial purchasers intended to use Grams as a currency, the judge concluded that several facets of the 2018 sale demonstrated "investment intent" on the part of initial purchasers, without which "the $1.7 billion paid to Telegram would not have been raised." He noted, among others, the significant discount at which Grams were sold in 2018; the ability of a foundation to which Telegram contributed Grams to repurchase Grams if the market price dropped; the fact that Grams sold were concentrated in the hands of only 175 initial purchasers; the structural incentives for 2018 Round 2 purchasers – who were not bound by any lockup period – to resell their Grams quickly; and the fact that 2018 Round 1 purchasers agreed to be bound by a lockup. Given these "economic realities," together with the fact that "Telegram's offering materials targeted buyers who possessed investment intent," Judge Castel concluded that "[c]onsumptive uses for Grams were not features that could reasonably be expected to appeal to the Initial Purchasers targeted by Telegram."
Judge Castel further determined that the SEC had made the requisite showing that initial purchasers' expectation of profits "was based upon the essential entrepreneurial and managerial efforts of Telegram." He observed that initial purchasers "provided capital to fund the TON Blockchain's development in exchange for future delivery of Grams, which they expected to resell for a profit." This "economic reality" was rendered "explicit" in Telegram's offering materials, which stated that Telegram would use the proceeds of the sale to develop the TON Blockchain. This made it reasonable for purchasers to expect that their ultimate profits depended on Telegram's efforts to "develop, launch and provide ongoing support of the TON Blockchain and Grams."
Critically, Judge Castel rejected Telegram's argument that its efforts could not impact the profits received by holders of Grams because Telegram would have no control over the TON Blockchain. He specifically found that if the entire Telegram team "decamped" to the British Virgin Islands after launch of the TON Blockchain and "ceased all further efforts to support the TON Blockchain," then the TON Blockchain and Grams "would likely lack the mass adoption, vibrancy, and utility that would enable the Initial Purchasers to earn their expected huge profits." He thus characterized each 2018 purchase of Grams as "a bet that Telegram could successfully encourage the mass adoption of Grams, thereby enabling a high potential return on the resales of Grams." In addition, Telegram's promotion of its intent to integrate the TON Blockchain with its Messenger app created a reasonable expectation among initial purchasers that they could continue to rely on Telegram's efforts post-launch.
Finally, Judge Castel concluded that the 2018 sales to initial purchasers did not fall within any exemption to the sale of unregistered securities. He found that the scheme was "a disguised public distribution" because Telegram did not intend for Grams "to come to rest with the 175 Initial Purchasers but to reach the public at large via post-launch resales by the Initial Purchasers." The initial purchasers were therefore functioning as "statutory underwriters."
Companies considering cryptocurrency token sales should note with caution the Court's rejection of the plain meaning of public statements and legal disclaimers in token sale agreements when these appeared to be inconsistent with the Court's findings of the true economic realities behind the token sales. The Court explicitly rejected Telegram's argument that a post on its website declaring that "Telegram will have no control over TON," and disclaimers such as that the purchaser "should NOT expect any profit based on your purchase or holding of Grams," supported a conclusion that the initial purchasers were not relying on Telegram's efforts to profit. The Court observed that such statements "are insufficient to negate the substantial evidence that a reasonable purchaser expected to profit from Grams upon their launch." The Court similarly rejected Telegram's reliance on a statement in the Gram Purchase Agreement in which purchasers represented that they were purchasing for their own account and not for resale. "[I]n evaluating [the] economic reality of this scheme, legal disclaimers do not control." Rather, the Court found that such representations "ring hollow in the face of the economic realities of the 2018 sales." The writing is now on the wall: courts may disregard disclaimers and representations by parties to cryptocurrency contracts if they do not comport with the preceived economic realities behind those contracts.
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