The Southern District of New York granted the SEC’s request for a preliminary injunction halting a coin offering in Securities and Exchange Commission v. Telegram Group Inc. et al. Among other things, the Court found that the SEC has shown a substantial likelihood of success in proving that Telegram’s plan to distribute Grams was an offering of securities under the Howey test to which no exemption applies.
As an aside, this is post No. 2,000 on Dodd-Frank.com.
In the first round of sales, or the Round One Sales, Telegram sold approximately 2.25 billion coins called Grams to 81 purchasers, or the Initial Purchasers, for $850 million, which included $385.5 million from 34 U.S. purchasers. The Grams were to be delivered when, as, and if an application called the TON Blockchain launched. The price per Gram was approximately $0.38. The Gram Purchase Agreements for Round One Sales included a lockup provision, which barred resale of Grams after their delivery to the Initial Purchaser. Three months after receiving the purchased and delivered Grams, the Round One Purchaser would be permitted to resell up to one quarter of its allotment of Grams. The remaining three quarters of the Grams would be free of restrictions in three equal tranches: 6, 12, and 18 months after the launch of the TON Blockchain. By February 2, 2018, the SEC had contacted Telegram regarding the Round One Sales. On February 13, 2018, Telegram filed a Form D for the Round One Sales, claiming an exemption under Rule 506(c).
Telegram argued that there were two distinct sets of transactions at issue in this case, one subject to the securities laws and one that is not. In Telegram’s view, the first set of transactions was the offer and sale of the “interests in Grams,” as embodied in the Gram Purchase Agreements, to the Initial Purchasers. While Telegram conceded that the Initial Purchasers’ “interest in a Grams” are a security, it claimed an exemption from registration under Regulation D. Telegram argued that a second and distinct set of transactions was the delivery of the newly created Grams to the Initial Purchasers upon the launch of the TON Blockchain. Telegram stressed that, because, upon launch, Grams would have “functional consumptive uses” (i.e. could be used to store or transfer value), Grams would be a commodity and, therefore, not subject to the securities laws.
The Court found the scheme the scheme was “a disguised public distribution.” Telegram did not intend for the Grams to come to rest with the Initial Purchasers. Telegram built economic incentives into the sales, including large discounts and differential lockups, to ensure that the Initial Purchasers resold Grams soon after launch. One requirement of Rule 506(c) exemption is that the issuer “exercise reasonable care to assure that the purchasers of the securities are not underwriters within the meaning of section 2(a)(11) of the [Securities] Act,” which in turns requires a“[r]easonable inquiry to determine if the purchaser is acquiring the securities for himself or for other persons.”
Telegram argued that, even if Initial Purchasers are statutory underwriters, it complied with Rule 502(d) by taking reasonable care to ensure that the Initial Purchasers were purchasing for themselves and not to resell to their Grams to others. Specifically, Telegram pointed to a representation and warranty in each Gram Purchase Agreement that required the Initial Purchasers to warrant that they were “purchasing the Tokens for [their] own account and not with a view towards, or for resale in connection with, the sale or distribution.” However, in evaluating economic reality of this scheme, legal disclaimers do not control. The representation and warranty that the Initial Purchasers purchased without a view towards resale rings hollow in the face of the economic realities of the 2018 Sales. From Telegram’s perspective, it was critical that the Initial Purchasers could flip their Grams in a post-launch secondary market because this feature would increase the amount of money it could raise.
The Court did not find that Telegram violated any laws but only granted the SEC’s motion for a preliminary injunction.