The Securities and Exchange Commission ("SEC") recently won a high-profile victory when a federal court held that there is a substantial likelihood that the SEC will prevail at trial in proving that "Grams"—the digital asset created and sold by Telegram Group Inc. and TON Issuer Inc. (collectively, "Telegram")—are securities. This decision continues the SEC's string of victories in convincing federal courts that many digital assets are securities. In our view, the decision also indirectly serves to further highlight the SEC's failure to take significant actions to support digital asset investors, issuers, financial professionals, and others who would like to hold, issue, invest in, and trade digital assets in compliance with applicable laws, including the federal securities laws.

The Telegram Decision. On March 24, U.S. District Judge P. Kevin Castel granted the SEC's request for a preliminary injunction preventing Telegram from proceeding with its distribution of Grams.¹ Telegram had intended to distribute 2.9 billion Grams to 175 sophisticated entities and high net-worth individuals ("Initial Purchasers") who, in early 2018, purchased rights to receive the Grams for $1.7 billion. The dollar and token amounts make this case—together with the SEC's action against Kik Interactive Inc. in the Southern District of New York—one of the most prominent SEC enforcement actions now working its way through the court system.²

Judge Castel agreed with the SEC that it had shown a substantial likelihood of ultimately proving that the sale of rights to receive Grams and the (now prohibited) distribution of Grams were part of larger scheme that violated the prohibitions on unregistered sales of securities in the Securities Act of 1933 (the "Securities Act"). Judge Castel noted that the scheme appeared to be "a disguised public distribution" and that the Initial Purchasers would effectively function as underwriters for the distribution of Grams to the public—meaning that, effectively, the exemption from the Securities Act's registration requirements that Telegram purportedly relied on was not available.

Takeaways from the Telegram Decision. Generally speaking, we think the Telegram Order should serve as a cautionary warning to token developers who wish to "pre-sell" tokens to a discreet group of investors, coupled with a promise or expectation that those investors will later be able to widely sell and distribute those tokens. Telegram's distribution approach appears, however, unique enough such that many token developers may not recognize substantial similarities between Telegram's approach and their own token projects.

Nevertheless, we believe that the Telegram Order provides members of the digital asset community with a few key takeaways:

1. The SEC and courts adjudicating controversies as to whether cryptographic tokens constitute securities under the federal securities laws continue to make clear that they believe that at least many tokens (and so far, virtually all tokens the federal courts have examined) are, in fact, securities. The Telegram Order is only one of a growing line of enforcement actions, settlement orders, and judicial opinions expressing this view.³
2. The SEC has put the token community in a difficult position. While the SEC has made it clear that it believes almost all tokens are securities (and the SEC is bringing at least some targeted enforcement actions to prove it), the SEC has not helped the token community establish an infrastructure that would allow for tokens to effectively function as securities. As we have discussed elsewhere, the SEC has not yet generally approved digital asset investment advisers, broker-dealers, registered funds, and registered ETFs.⁴ Further, the only markets in which U.S. investors can trade digital assets are unregulated exchanges and trading platforms, some of which may be acting illegally under U.S. federal securities laws. To date, the SEC has qualified only two public offerings of cryptographic tokens. We continue to urge the SEC to re-examine how it thinks about investor protection, fostering fair, orderly, and efficient markets, and facilitating capital formation in the digital asset space. Until the SEC does, members of the token community will continue to have a difficult path forward.
3. Given the above, we believe that the best way for most token developers to adapt to the current regulatory environment appears to be to continue to work within the existing frameworks established by SEC for analyzing whether cryptographic tokens are securities,⁵ while working toward achieving a state of decentralization. Consistent with the SEC's guidance, once a sufficient level of decentralization has been achieved, the developer can reasonably determine that its tokens are no longer securities.⁶ The most pressing issues will be how and when a token developer can appropriately make the determination that its network is sufficiently decentralized.

   We think the digital asset community—with the SEC if possible, but on its own if necessary—should collectively develop a thoughtful and legally sound framework for analyzing when a blockchain or blockchain application, and the related tokens, are sufficiently decentralized so that the tokens no longer are deemed to be securities. Even prior to the full development of such a framework, token developers should be, to the extent possible, working with their lawyers and others to develop a plan to achieve decentralization as quickly as reasonably possible.

[1] SEV v. Telegram Group Inc. (1:19-cv-09439-PKC), District Court, S.D. New York (opinion and order granting preliminary injunction) (the “Telegram Order”).

[2] See SEC vs. Kik Interactive, No. 19-cv-5244 (S.D.N.Y., filed June 4, 2018). The private litigation against Ripple Labs also garners substantial interest for the high-profiled defendant and dollar amounts involved. See In re Ripple Labs Inc. Litigation (18-cv-06753), U.S. District Court, Northern District of California.

[3] See In the Matter of CarrierEQ, Inc., d/b/a AirFox, Securities Act Release No. 10575 (Nov. 16, 2018), https://www.sec.gov/litigation/admin/2018/33-10575.pdf; In the Matter of Paragon Coin, Inc., Securities Act Release No. 10574 (Nov. 16, 2018), https://www.sec.gov/litigation/admin/2018/33-10574.pdf; In the Matter of Gladius Network LLC, Securities Act Release No. 10608 (Feb. 12, 2019), https://www.sec.gov/litigation/admin/2019/33-10608.pdf; In the Matter of Block.one, Securities Act Release No. 10714 (Sept. 30, 2019), https://www.sec.gov/litigation/admin/2019/33-10714.pdf; the Telegram Order; SEC vs. Kik Interactive, No. 19-cv-5244 (S.D.N.Y., filed June 4, 2018).

[4] See Rosenblum, Robert H., Caiazza, Amy B., Evenson, Taylor R., and Mann, Katherine, “Rethinking What It Means to Protect Investors in the Digital Asset Space” (Feb. 14, 2020).

[5] See Framework for “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.

[6] See id.; William Hinman, Director, Division of Corporate Finance, Securities and Exchange Comm’n, Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018).