SEC vs. Telegram Case, or a Death Sentence for All ICOs and Token Sales Ever Held in the US

On March 24, 2020, the New York District Court issued a decision in the "SEC vs. Telegram" case, imposing a temporary ban on the issuance of GRAM tokens for the TON Network platform. Sergey Ostrovskiy dissects the decision and assesses the potential repercussions of this legal case for the token sale projects and the crypto industry at large.

What Happenned?

The United States Securities and Exchange Commission's (SEC) aversion to ICOs is old news. The commission's representatives have repeatedly stated that virtually all tokens sold in the US are securities.

This saga began with "the DAO" case in 2016–2017, when the SEC first applied the so-called “Howey test” (a precedent from S.E.C. v. W.J. Howey Co., 328 U.S. 293e, 298–99 (1946)), declaring that digital units of account could be considered securities in the US. In essence, this meant that any project selling tokens in the States was conducting the sale of unregistered securities, thus violating federal securities law.

Subsequently, the SEC continued to intensify pressure on token sale projects, leading to new cases and positions that compounded the situation for ICOs in the US, like the ‘Munchee case’, which Aurum reported on back in 2017.

Following the SEC's report on The DAO case, all ICO projects that had the wherewithal to consult with lawyers, which were the majority, reduced or completely ceased selling tokens in the US. While they were keen to raise funds, no one wanted to risk prison.

The SAFT Project

Predictably, the blockchain industry was not ready to completely forego fundraising in the US, and a quiet period was short-lived. Our American colleagues "invented" a wonderful scheme that they believed would manage the situation and skirt US securities law: the SAFT project.

To better understand the legal side of this scheme, let's first look at its key aspects:

The deal was formalized through a “SAFT” agreement. Those familiar with the venture market have probably heard of “SAFE” (Simple Agreement for Future Equity) — an agreement developed by Y Combinator that has become a classic tool for structuring venture investments in the Valley. Lawyers took SAFE, changed one word (I exaggerate), and turned it into SAFT — Simple Agreement for Future Tokens.

The company did not sell tokens to the investor but the right to receive tokens in the future, after the main product launch (essentially, a forward contract). The SEC has repeatedly pointed out that a "non-functioning" token, i.e., one that cannot be used immediately after issuance, is a security because it is sold solely to raise funds for the project launch, and buyers acquire it for speculative purposes. The “deferred” token release was meant to circumvent this problem.

The sale was structured under “Regulation D”. This regulation establishes a series of exceptions allowing the sale of securities in the US without registration, provided that a special notice (Form D) is filed with the SEC, and a number of other requirements, including investor qualifications, are met.

Legally, the essence of the SAFT scheme was as follows: since the issuing company sells not the tokens themselves but the right to receive tokens in the future (after the product launch), only the sale of such a right (to receive tokens) is considered the sale of securities. The sale was structured using a simplified procedure, utilizing one of the exceptions provided by Regulation D, which was supposed to exempt the “future” tokens from regulatory restrictions.

After the product launch, the issuing company converted the SAFT and transferred the tokens to buyers, which by then were supposed to have the status of a commodity, not a security.

It is worth noting that this scheme was designed only for 'utility' tokens, which have practical properties within the product and do not grant holders any rights typical for securities, such as the right to receive dividends or passive income. Otherwise, the token itself also falls under the definition of a security, rendering the entire endeavor pointless.

The SAFT scheme indeed looked good, so it was well-received by lawyers and became a fairly popular way to structure ICOs and sell tokens in the US. For example, this is how the famous Filecoin ICO was structured. Many of our colleagues, speaking at lectures on conducting ICOs in the US, have said that selling tokens in the US through the above scheme is completely safe and legal.

However, as recent events have shown, the scheme probably did not take into account a number of nuances, which we will examine below.

Let me note that the explanation of legal points above and further in the text is presented in a somewhat simplified form, and several nuances have been omitted to simplify the material and to focus attention on the key points.

Temporary Restriction in the SEC vs. Telegram Case

The decision on the temporary ban on the issuance of GRAM tokens, issued by the New York District Court on March 24, 2020, in the case of Securities and Exchange Commission vs. Telegram Group Inc. and TON Issuer Inc. ("SEC vs. Telegram"), provides serious grounds to believe that a precedent may soon be set, turning all these "completely legal" token sales into completely illegal ones.

The temporary ban is not a final ruling, meaning the case is still under court review. Nevertheless, the rationale behind the decision is extremely interesting and deserves attention as it will likely form the basis for the final decision and set a precedent.

Let's consider one of the conclusions the court arrived at in its decision, which is of the greatest interest:

There are three key points of significance here:

• The investment contract according to the Howey test should not be seen as the SAFT agreement or the sale of tokens/rights to tokens alone but the entire scheme, including SAFT, token issuance, and planned resale, as a single operation.

• Since it is evident that tokens were acquired by primary investors for resale, and Telegram planned to distribute GRAM tokens among the general public, Telegram violated the conditions of the Reg D exemption—prohibition of selling securities to investors who acquire them for resale—hence, Telegram is not entitled to use the exemptions provided by Regulation D (Telegram intended to use Rule 506(c), which allows selling securities only to so-called "accredited" investors who acquire the securities without the intention of immediate resale).

• The fact that token issuance is to occur after the product launch does not affect the qualification of the relations, as the Howey test analysis is conducted at the time the parties reached an agreement.

Here are a few excerpts from the court's decision to note, the translation is authorial:

The Significance of the SEC vs. Telegram Case for Token Sale Projects and the Industry

If the decision in SEC vs. Telegram goes against the latter, the impact of this case on the blockchain and crypto industry is hard to overstate. Primarily at risk will be all projects that have ever sold their tokens in the US using the SAFT and Reg D compliant offering scheme.

Even now, the SEC sporadically "goes after" projects that once conducted token sales in the US, and compels them to settle, pay fines, and refund investors. It's likely that the number of such settlements and projects to which the SEC has claims will increase significantly.

It's important to understand that the question of the possibility of applying the precedent to relationships existing before its emergence will not be raised: the decision will create a precedent based on legislation that has been in effect for nearly a century, meaning—this precedent could be applied to any token sale in the US from the very beginning of the "ICO hype" to the present day.