Background
In 2018, Telegram raised approximately $1.7 billion by entering into Gram purchase agreements (the “Purchase Agreements”) with investors to develop its Telegram Open Network Blockchain (the “TON Blockchain”). Telegram entered into these Purchase Agreements with 175 sophisticated entities and high net-worth investors in reliance on an exemption from registration under Rule 506(c) of Regulation D of the Securities Act of 1933 (the “Securities Act”). In return for the $1.7 billion, Telegram promised to deliver to these purchasers 2.9 billion Grams once the TON Blockchain was launched. Once the Grams were received by the initial purchasers, it was anticipated that these purchasers would resell Grams in the secondary market. Once the TON Blockchain is launched, Telegram believes that the Grams will have “functional consumptive uses” (i.e., could be used to store or transfer value) and will be a commodity, and therefore not subject to the securities laws. Telegram argued that the Court should determine whether Gram is a security at the time of delivery to the initial purchasers, and views the anticipated release of the Grams by the 175 initial purchasers into the secondary market as transactions wholly unrelated to the initial offering of Purchase Agreements.
The SEC, on the other hand, viewed the sales to the 175 initial purchasers and the planned distribution into the secondary market as a single transaction constituting a securities offering under the Securities Act for which no registration exemption is available. The SEC viewed the 175 initial purchasers as “underwriters” engaging in a distribution of Grams into the public markets. In addition, the SEC expressed the view that once the Grams were distributed into the public market, they would be supported by Telegram’s ongoing efforts.
The Court’s Decision
Applying the famed Howey2 test, the Court determined that the SEC showed a substantial likelihood of success3 in proving that Telegram’s actions would constitute a securities offering to which no exemption applied4 and granted the SEC’s request for an injunction, preventing Telegram from delivering the Grams to the initial purchasers. The Howey test, first articulated in a 1946 U.S. Supreme Court case, broadly interprets the term “investment contract” under the Securities Act as an (1) investment of money, (2) in a common enterprise with, (3) a reasonable expectation of profits (4) derived from the efforts of others.
The Court emphasized key factual findings in its assessment of the Grams.
First, the initial purchasers bought Grams in dollars and euros in 2018, which satisfied the “investment of money” prong under Howey.
Second, Telegram pooled the money received from the initial purchasers to develop the TON Blockchain. The financial investment of the initial purchasers was directly tied to the success of the TON Blockchain as a whole because each initial purchaser’s investment would be affected if the TON Blockchain failed. The Court believed this horizontal and vertical commonality would likely satisfy the “common enterprise” prong under Howey.
Third, the Court found that the initial purchasers had an expectation that their Grams would increase in value upon their resale to the public via the TON Blockchain. Since the sales to initial purchasers in 2018 were at prices significantly lower than the future advertised and expected price of the Grams after the launch of the TON Blockchain, the Court believed the initial purchasers had a substantial opportunity to profit on resale and that the initial purchasers acquired Grams with investment intent.5
Finally, the TON Blockchain was to be developed, launched and maintained by Telegram. At the time the initial purchasers made their investments, the TON Blockchain was not developed, so the purchasers were reliant on Telegram to develop the network. Once the TON Blockchain was launched, its success depended on the mass adoption by users of the Telegram Messenger application6 as a result of Telegram’s continued marketing and integration efforts. The Court found these facts gave the SEC a substantial likelihood of success in satisfying the final prongs under Howey.
Recent Filings
On March 24, 2020, Telegram filed a notice of appeal in the U.S. Court of Appeals for the Second Circuit. Telegram also filed a letter on March 27, 2020, to the Court requesting confirmation that the Court’s injunction applies only to U.S. sales of the Grams and not to the Purchase Agreements that Telegram entered into with non-U.S. investors. In submitting the letter, Telegram noted that there is a presumption against the extraterritorial application of U.S. securities laws as articulated by the Supreme Court in Morrison v. Nat’l Australia Bank Ltd.,7 and that Telegram entered into 70% of the Purchase Agreements with non-U.S. persons. Since Telegram—a non-U.S. entity—entered into these agreements with non-U.S. persons outside the United States, Telegram concluded that those transactions were outside the reach of the U.S. securities laws.8 The SEC responded to Telegram’s March 27 letter and characterized it as an attempt to ask the Court to reconsider its “unambiguous” decision on March 24.
The Court responded on April 1, 2020, denying Telegram’s application for an international carveout to the injunction. In granting the SEC’s request for a preliminary injunction, the Court found that the “security” at issue was neither the Purchase Agreements nor the Gram, but instead the entire scheme, which had both the expectation and intention that the initial purchasers would distribute Grams into the secondary market. The Court concluded that the intended release of Grams by the initial purchasers into the secondary market is likely to involve U.S. purchasers and therefore would likely satisfy Morrison’s transactional test.9
