A recent decision out of the Southern District of New York emphasizes the importance of considering all obligations under the federal securities laws for any transaction that might involve a “security.” Despite SEC statements that most forms of cryptocurrency will not be considered securities, this decision blocked a cryptocurrency sale for failure to meet securities registration requirements, making clear that the application of the securities laws in this area will depend on the specific circumstances of each transaction.
According to the decision in Securities and Exchange Commission v. Telegram Group, Inc., et al.1 Defendants Telegram Group Inc. and TON Issuer Inc. (collectively “Telegram”) created a form of cryptocurrency called “Grams” and sold them to a group of 175 initial purchasers for a total of $1.7 billion (the “Initial Sale”). Telegram planned to deliver the Grams sold pursuant to the Initial Sale once Telegram had created and successfully launched a corresponding blockchain (a widely distributed ledger or account of transactions that serves as the means of validating the authenticity of cryptocurrency). Once distributed, the initial purchasers could distribute and resell their Grams to the secondary market (the “Resale”).
Telegram did not file a registration statement for either the Initial Sale or the Resale. With respect to the Initial Sale, Telegram took the position that if the Grams were considered a security under the federal securities laws and thus subject to the registration requirements of the Securities Act of 1933 (the “Securities Act”), the transaction was exempt from the filing requirements under Section 4(a)(2) of the Securities Act because it was not a public offering. Telegram argued that the Initial Sale should be considered a transaction separate from the Resale, and that the Resale was also exempt from the registration requirements set forth in the Securities Act because the Grams, as a cryptocurrency, were intended to be used to store and transfer value (and not purchased with the expectation of profit) and therefore would be considered commodities and not securities.
The court disagreed with Telegram’s arguments, and granted the SEC’s request for a preliminary injunction blocking the delivery of Grams pursuant to the Initial Sale. The court viewed the entirety of the transactions, i.e., the Initial Sale and Resale, holistically and described it as “a larger scheme to distribute [the] Grams into a secondary public market.”2 The court found that the SEC had shown a substantial likelihood of success in proving that this scheme was intended to be a public offering (and the Section 4(a)(2) exemption did not apply), reasoning that Telegram served as the force behind the blockchain that would allow the Grams to reach the secondary market, and pointing out that the success of the blockchain was so important to the value of the Grams that Telegram agreed to return any unspent funds to the initial purchasers in the event that the blockchain was not successfully launched by a contractual deadline.3 Thus, even during the Initial Sale, Telegram’s goal was to distribute the Grams to the general public.
Second, the court applied the test set forth by the Supreme Court in S.E.C. v. W.J. Howey Co.4 to conclude that the SEC had shown a substantial likelihood of success in proving that the Grams are a security subject to the Securities Act registration requirements. Under the Howey test, an investment contract is considered a “security” if it is an investment of money in a common enterprise with the expectation of profit from the essential efforts of another. While the court acknowledged that, in the abstract, an investment of money in a cryptocurrency utilized by members of a decentralized community is not likely to be deemed a security, the purchases of the Grams were investment contracts due to the common enterprise devised by Telegram. In the context of this enterprise, the initial purchasers effectively served as underwriters for the distribution of the Grams to the public, which was done with the expectation of a profit and through the efforts of Telegram.
Importantly, the court reached its conclusion that the Grams were likely to be considered securities purchased with the expectation of a profit, rather than strictly as a form of currency, despite the fact that Telegram issued disclaimers and public statements emphasizing the consumptive use of the Grams and rejecting any expectation of profit. The court found that the totality of the evidence, including promotional materials and the type of investors to whom the Grams were sold, indicated that the SEC had a substantial likelihood of success in proving that a reasonable purchaser expected to profit from the Grams upon the Resale and, accordingly, the Grams should be considered securities under the Howey test.
Although the Telegram Group decision addresses a specific manner of issuing cryptocurrency, it also serves as a broader reminder of the expansive reach of the securities laws, and that regardless of how companies view or choose to describe their products or offerings, the SEC and courts will carefully review the substance and mechanics of the underlying transaction to determine whether the securities laws apply.
1 No. 1:19-cv-09439, 2020 WL 140035 (S.D.N.Y. Mar. 24, 2020).
2 Id. at *1.
3 Id. at *11.
4 328 U.S. 293 (1946).