On SEC vs. Telegram

A Judge has granted the SEC an injunction against the public distribution of Grams, tokens intended to be used on Telegram’s long-promised blockchain network. As we wrote in Coin Center’s Framework for Securities Laws published in 2016, the SEC should

Take action necessary to protect investors against cryptocurrencies well-fitted to the Howey test, presenting greater risks to users [such as] open but heavily marketed pre-sales or sales of pre-mined cryptocurrencies with a small and non-diverse mining and developer community when the facts indicate that profits come primarily from the efforts of this discrete and profit-motivated group.

But should also

Avoid chilling promising innovations that are ill-fitted to the Howey test, presenting less risk to users [such as] highly decentralized cryptocurrencies (e.g. Bitcoin) because of a lack of vertical commonality or a discernible third party or promoter upon whose efforts investors rely.

Judge Castel’s opinion is clear, well-reasoned, and generally matches these two policy objectives. It helps us begin to find that long-sought brighter line for securities policy in the cryptocurrency space; many may not like where that line falls, but it is clarity.

Judge Castel focuses on the continued efforts that Telegram has implicitly promised investors in Grams, indicating that profits will come primarily from their future work. And, wisely, also articulates the broader notion that mere cryptocurrencies—apart from pre-sales—are not securities:

Cryptocurrencies (sometimes called tokens or digital assets) are a lawful means of storing or transferring value and may fluctuate in value as any commodity would. In 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 S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946). The SEC, for example, does not contend that Bitcoins transferred on the Bitcoin blockchain are securities. The record developed on the motion for a preliminary injunction presents a very different picture.

What is most interesting about this opinion is how the Judge separates the analysis of the investment contract (the presale agreement) from the token itself. Judge Castel finds that

While helpful as a shorthand reference, the security in this case is not simply the Gram, which is little more than alphanumeric cryptographic sequence. Howey refers to an investment contract, i.e. a security, as “a contract, transaction or scheme,” using the term “scheme” in a descriptive, not pejorative, sense. Howey, 328 U.S. at 298–99. This case presents a “scheme” to be evaluated under Howey that consists of the full set of contracts, expectations, and understandings centered on the sales and distribution of the Gram. Howey requires an examination of the entirety of the parties’ understandings and expectations. Howey, 328 U.S. at 297–98 (declining to “treat[] the contracts and deeds as separate transactions”). Further, for the reasons discussed previously, the Court finds that the appropriate point at which to evaluate this scheme to sell and distribute Grams is at the point at which the scheme’s participants had a meeting of the minds, i.e. at the time of the 2018 Sales, rather than the date of delivery.

As we argued in the 2018 update to our Framework:

A fundamental difference, however, exists between the agreement to buy and sell a future token and the token itself if it has achieved a genuine level of functionality and decentralization. Running the analysis twice, both may turn out to be securities, or neither, or merely the pre-sale agreement, if the token that eventually reached the wild achieved a genuine level of functionality and decentralization making it rather indistinguishable from Bitcoin or some other token that never had a pre-sale.

Again, Judge Castel is analyzing the pre-sale scheme as a whole. If the hypothetical future Grams were functional and transferable on a running decentralized network, and if there were not continued promises to maintain that network, then those Grams might not be securities. But that does not appear to be the fact pattern in this case. According to the opinion, the pre-sale and the impending distribution to the public are, together, likely to be a non-compliant offering of securities, and even hypothetical future Grams will be, according to Judge Castel, dependent on the efforts of the promoters for their value.

The novelty in this case, and in the SEC’s complaint, is the allegation that the purchasers of the presale arrangement are underwriters. In other words they are alleged to be part of the very scheme to ultimately sell tokens to the public. As such, they would not, according to the opinion, get the benefit of safe-harbors from SEC regulation (506c) that would apply if the pre-sale was truly a mere promise of future tokens to an investor buying them for their own purposes (rather than with a coordinated intent to distribute them to the public). This may be a finding that several early proponents of the so-called SAFT (simple agreement for future tokens) model of token distribution neglected to predict or protect against. As we wrote when SAFTs were taking off in 2017:

[W]hile the SAFT legal structure is a smart and promising way to address the uncertainty in the law, it is still untested. Eventually the SAFT term will end, and—if all goes to plan—the buyers will receive actual tokens that have a consumptive use on the decentralized computing platform. At that point it is still an open question whether those tokens fit the definition of securities here in the U.S., although existing useful tokens like bitcoin and ether are in the same boat and seem, at this point, a poor fit for classification as securities. Only if the resultant tokens don’t qualify as securities upon the termination of the SAFT can they be freely sold to U.S. persons hoping to use the network’s functionality (and regardless of whether they are wealthy and accredited investors).

In this case, Judge Castel is granting an injunction to prevent Telegram from distributing the tokens at the conclusion of the SAFT. Implicit in that finding is that Grams will still be securities even when the network is up and running. Again, that revolves around continued promises made by the centralized Gram developers and promoters. What’s new to us in this analysis is the notion that early investors can also be a part of that centralized scheme as underwriters. Projects should take note.

This holding does not suggest that a pre-sold token will always be a security. As Jerry wrote in a 2017 CoinDesk op-ed:

[T]here is no “transformation” of a token from a security to a commodity. What we have instead are two separate things: a SAFT instrument that is and will always be a security, and a token that never was and won’t ever be a security. This is more than an academic distinction. Transformation is unheard of, while a two-step approach is novel, but not inconceivable.

The two step approach holds, but the underwriter analysis suggests that step one could include the moment that tokens are sold by SAFT investors to the general public. Step two remains an analysis of the token once the network is actually running and decentralized. Treating SAFT investors as underwriters could make it a bit more difficult to get to that point, however, as Commissioner Peirce has suggested there could be a “regulatory Catch 22” inherent in this policy. If you can’t get the tokens out to the general public, how can you ever have a decentralized network?

The underwriter analysis could be bad news for people who were trying to be compliant with the information available to them at the time. Many projects have been attempting to “do it right” as Chairman Clayton remarked in Congressional testimony. But these approaches vary, from Reg D to Reg A+, and reflect divergent opinions and risk tolerances from reasonable projects and their attorneys. New information about the likelihood of investors being underwriters could mean that some of those approaches are now less promising. In general, it’s also important to note that this will remain a fact-specific inquiry. We can only infer so much from the specific case of Telegram; other projects have very different facts. This lingering uncertainty and potential for surprise is exactly why a safe harbor for parties acting in good faith, as Commissioner Peirce has proposed, makes so much sense.

Speaking generally, however, and as we’ve frequently argued, the best way to minimize regulatory risk remains to simply avoid presales altogether. As we wrote in 2017:

• A project could simply not pre-sell a token. The network token could emerge exclusively through mining or in return for valuable participation in the decentralized computing platform. This is how Bitcoin, Litecoin, and many others have done it.
• A project could refrain from making any sales before the network is live and only sell tokens once the computing system is delivering functional utility in return for tokens. At that point the project’s tokens will be appraised with respect to securities laws just as a SAFT project’s tokens will be appraised upon termination of the SAFT. SteemIt, a decentralized social media reddit project, took this approach.
• A project could incorporate as a normal company and raise money for development by selling equity or promising tokens to a small number of accredited investors, and then when the network is built some share of tokens that emerge on the platform could be allocated to the development company in return for performing that early work and research. This is generally the approach taken by Zcash.

And in general, “There are many possible alternatives. None are guaranteed to ‘pass the Howey Test’ because that’s not how securities law works unless the relevant regulators issue bright-line guidance about how they intend to apply a flexible test.” Today’s ruling is part of the process to create that brighter line.