Shearman & Sterling | Fintech 2020 | Telegram Settles With SEC, Agreeing to Return $1.2 Billion to Investors and Pay Penalty
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  • Telegram Settles With SEC, Agreeing to Return $1.2 Billion to Investors and Pay Penalty
    On June 26, 2020, the U.S. Securities and Exchange Commission (“SEC”) received court approval of its settlement with Telegram Group Inc., and its wholly owned subsidiary TON Issuer Inc. (collectively, “Telegram”), of charges that it conducted an unregistered offering of its digital token, “Grams,” in violation of the federal securities laws.  Telegram agreed to return more than $1.2 billion to investors, and to pay an $18.5 million civil penalty.  The settlement follows a March 2020 order from Judge Kevin Castel of the U.S. District Court for the Southern District of New York granting the SEC’s motion for a preliminary injunction and enjoining Telegram from delivering Grams to all potential buyers.  Shortly after the order, Telegram announced that the project  would be shut down largely due to the SEC’s action.

    Telegram was founded in 2013, and the company subsequently launched Telegram Messenger, a messaging app offering end-to-end encryption that became popular among the global cryptocurrency community.  In addition, in 2017 Telegram began developing a propriety blockchain network, the Telegram Open Network (or “TON”) which would be accessible via its native digital token, the “Gram.”  In order to finance the development of the TON, from January through March 2018, Telegram raised roughly $1.7 billion via two initial offerings to accredited investors that were purportedly exempt from registration pursuant to SEC Rule 506(c).  In exchange for the funds raised in these initial offerings, participants received “interests in Grams” - the right to buy Grams at a roughly 70% discount to the price of the Grams at an eventual public sale.  Telegram intended to use the funds raised from the initial offerings to build the TON, and envisioned later offering Grams to the public as utility tokens that had functional use on the TON and therefore would not qualify as securities.  Telegram was prepared to launch the TON and distribute Grams to the initial purchasers in October 2019 when the SEC filed suit seeking to enjoin the offering.

    After substantial briefing by the parties, on March 24, 2020 Judge Castel granted the SEC’s motion for a preliminary injunction and rejected Telegram’s argument that the initial offering of “interests in Grams” and sale and delivery of Grams constitute two distinct transactions.  The court concluded that “economic reality” of the transaction, when viewed in its totality, is a single scheme to sell an unregistered security pursuant to the U.S. Supreme Court’s rule articulated in SEC v. W. J. Howey Co., 328 U.S. 293 (1946) (“Howey”).  The court first determined that under the federal securities laws the point in time to evaluate whether Grams are securities is when the “interests in Grams” were first offered or sold.  At that point, the court held the offer to sell Grams satisfied all four components of the Howey test: a) the initial purchasers made an investment of money; b) in a common enterprise; c) with the expectation of profit; d) based upon the efforts of another.  With respect to the expectation of profit prong, the court rejected the argument that the Grams were acquired for use or consumption, rather than profit, and found that at the time of the 2018 sale a “reasonable investor . . . would have purchased Grams with investment intent” because of, among other reasons, the “significant discount” at which the Grams were sold.  The court also found that Telegram’s offering materials, which touted potential capital appreciation from the resale of Grams, and the subjective views of certain initial purchasers as expressed in internal memoranda and email, support a finding that the Grams were purchased with a reasonable expectation of profit.

    After the Court granted a preliminary injunction, Telegram sought to clarify whether the injunction applied to non-US-based purchasers, given that only $424 million of the $1.7 billion raised came from US-based investors.  The SEC argued that the scope of the injunction requested by the SEC, and granted by the court clearly applies to all persons or entities to whom Gram might be delivered, and that an injunction should not be limited to only US-based purchasers given evidence that some non-US-based buyers resold their interests to investors in the United States.  The Court reconfirmed that the injunction applied to all potential purchasers, domestic or international, both because the resale of Grams in the secondary market would likely involve US purchasers, and because Telegram failed to raise this issue in earlier briefing despite being on notice of the scope of the injunction sought by the SEC. 

    The decision to enjoin all purchases internationally, however, did not go unnoticed by SEC Commissioner Hester Pierce.  Speaking remotely at Singapore Blockchain Week on July 21, 2020, Commissioner Pierce publicly disagreed with the SEC’s approach in the Telegram action, noting that the “sweeping injunctive relief against a non-U.S. company, in a case where one-quarter of the funds came from U.S. investors, reasonably might raise some concerns among our international colleagues.” As one of the first decisions to reach this issue, and given the resulting closure of the Telegram project, it remains to be seen if the SEC will continue to pursue, or other courts will permit the far-reaching scope of the injunctive relief granted here.