In a decision dated March 24, 2020, Judge Kevin Castel of the Southern District of New York granted a preliminary injunction request by the U.S. Securities and Exchange Commission preventing the distribution to purchasers of $1.7 billion worth of cryptocurrency called “Grams.”
In 2018, Telegram sold “interests in Grams” to 175 entities and high-net-worth individuals. These “Gram Purchase Agreements” entitled the initial purchasers to receive an allotment of Grams upon launch of the TON Blockchain. Each Purchase Agreement contained representations and warranties from the purchaser that they were buying for investment purposes only and did not intend to distribute the Grams.
Not surprisingly, the court’s decision on the issue of whether Telegram sold a “security” applied the well-known Howey test, under which an investment contract exists when there is (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the efforts of others. The court initially recognized that cryptocurrencies are not necessarily securities, stating:
Cryptocurrencies (sometimes called tokens or digital assets) are a lawful means of storing or transferring value and may fluctuate in value as any commodity would. In the abstract, an investment of money in a cryptocurrency utilized by members of a decentralized community connected via blockchain technology, which itself is administered by this community of users rather than by a common enterprise, is not likely to be deemed a security under the familiar test laid out in S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946). The SEC, for example, does not contend that Bitcoins transferred on the Bitcoin blockchain are securities.
But the Howey test was nevertheless satisfied under the facts here.
The two sides conceded that the first Howey factor applied. As to the second, the SEC sufficiently established that the fortunes of Gram purchasers were tied to each other (horizontal commonality) and the purchasers’ fortunes were tied to the success of Telegram (vertical commonality). With respect to third factor, the court found a reasonable expectation of profits by purchasers because (1) “at the time of the 2018 Sales to the Initial Purchasers, a reasonable investor, situated in the position of the Initial Purchasers, would have purchased Grams with investment intent” and (2) “without the expected ability to resell Grams into the secondary market, the $1.7 billion paid to Telegram would not have been raised.”
As to the fourth factor, the court found that the SEC had shown a substantial likelihood of success in proving that, at the time of the sales, a reasonable Initial Purchaser’s expectation of profits from their purchase of Grams was based upon the essential entrepreneurial and managerial efforts of Telegram. As Telegram had noted, Grams do not exist and did not exist at the time of the initial sales. (Doc. 71 at 7, 39). But the Initial Purchasers provided capital to fund the TON Blockchain’s development in exchange for the future delivery of Grams, which they expected to resell for a profit. The offering materials recognized this economic reality and made Telegram’s commitment to develop this project explicit. Thus, according to the court, to realize a return on their investment, the Initial Purchasers were entirely reliant on Telegram’s efforts to develop, launch, and provide ongoing support for the TON Blockchain and Grams.
The court ultimately found the SEC had shown a substantial likelihood of success in proving that the Gram Purchase Agreements amount to the distribution of securities, thereby requiring compliance with section 5 of the Securities Act, which Telegram had not done. In addition, Telegram failed to establish an exemption to the registration requirement. Thus, the court granted the preliminary injunction preventing the distribution to purchasers of $1.7 billion worth of the Grams cryptocurrency.
In a letter dated March 30, 2020, Telegram sought clarification of the injunction. It argued that, under the Supreme Court’s decision inMorrison v. Nat’l Australia Bank Ltd., 561 U.S. 247, 267-68 (2010), the injunction should not have extraterritorial effect. According to Telegram, only $424.5 million of the $1.7 billion that Telegram raised came through purchase agreements with U.S.-based purchasers. The remaining over 70% was raised through Purchase Agreements with foreign purchasers outside the United States through contracts containing foreign choice-of- law provisions.
The Commission’s letter in response argued that the documents submitted in connection with the motion made absolutely clear that the requested injunction was going to apply to “any person or entity.” Thus, according to the SEC, in the guise of seeking clarification, Defendants were actually seeking reconsideration of the court’s decision, without any basis for doing so. The SEC also argued that Morrison did not help Telegram in any event. Morrison is applicable to so-called “f-cubed” transactions—sales of securities by non-U.S. issuers to non-U.S. purchasers on non-U.S. markets. Here, according to the SEC, it had made a substantial showing that Telegram was about to engage in an unregistered sale of securities into United States markets to United States investors, using both foreign and domestic conduit underwriters, rendering Morrison inapplicable.
On April 1, 2020, the court issued an Order denying Telegram’s application. The court said that Telegram had not demonstrated how its proposed solution would solve the problem of the original agreements being a violation of the law. The court also noted the following: “One would expect a party opposing a preliminary injunction to include an argument in its very fulsome submissions that the grant of the requested injunction would be needless, overbroad, unworkable, apply extraterritorially, or any other argument it wished. In its opposition to the preliminary injunction, Telegram raised no objection to the form of the injunction and never cited the Morrison case.”