In a New York courtroom Wednesday, Telegram, the operator of the eponymous 300 million-strong messenger app, will face the SEC to defend its claim that its $1.7 billion raise for its upcoming blockchain network, the Telegram Open Network, didn’t break securities law.
The stakes are high. If the court ultimately rules in the SEC’s favor, Telegram might have to pay a hefty fine—and even have to pay back the $1.7 billion to investors. If the court rules in Telegram’s favor, the message service will be able to launch its network after all. Telegram promised the SEC in October it would hold off until the case is settled.
The outcome of the hearing is certain to have ramifications far beyond Telegram, its investors, developers and users. Indeed, two industry bodies that represent the bulk of the largest blockchain companies, the Blockchain Association and the Digital Chamber, have filed letters to the court. And the Commodity Futures Trading Commission finally weighed in on the matter earlier today, though it refused to state an opinion.
“The US regulatory approach to selling instruments for fundraising is of tremendous importance to the entire industry. No question,” Drew Hinkes, an attorney with Carlton Fields and an adjunct professor at New York University’s Stern School of Business and School of Law, told Decrypt. “I can't think of a stakeholder who wouldn't be interested in the outcome of this,” he said.
A court ruling could set a legal precedent for how the SEC carries out crackdowns on unregistered security sales. Billions have been raised from token sales, the vast majority of which have not been registered at securities with the SEC.
Companies who raised funds through SAFTs—Simple Agreement for Future Tokens, where investors’ tokens are unlocked after a period of time—and the investors who funded them, will await the resolution of the case “with bated breath,” Nic Carter, partner at Castle Island Ventures, told Decrypt.
Crypto projects Filecoin, Dfinity, and Polkadot all raised millions through SAFTs, and Kik, which also has its own messenger app, is currently battling a similar issue with the SEC for its token, Kin. A ruling in favor of the SEC could make it easier for the agency to chase after such companies, impose penalties, or force them to give money back to investors.
And if a coin is a security under US law—as opposed to a currency, a commodity, or something else—it also means that financial service firms, like crypto exchanges, investment funds, and trading firms, might be subject to registration and licensing, according to the website of the Crypto Ratings Council, an industry body, led by Coinbase, that tries to work out whether tokens are securities in the absence of clear SEC guidelines.
The SEC has, so far, settled with several companies it’s chased for unregistered securities sales (the most high-profile case concluded in October, when the SEC settled with Block.one, which raised over $4 billion in its ICO for EOS in 2017). In settlements, the SEC has never forced the other party to accept or deny that a token sale constituted an unregistered securities offering, meaning there’s no strong legal precedent. But the court case against Telegram is likely to be different, according to industry lawyers.
Other ICOs flew “below the radar,” but the case against Telegram, whose messenger app has grown to near 300 million users since its launch in 2013, will have a greater impact, Roni Berkowitz, a partner at Porat, a Tel-Aviv based law firm, told Decrypt. Hinkes, the lawyer and adjunct professor, mentioned that “the parties have additional resources and they're employing sophisticated counsel.”
The result, per Hinkes: “A higher likelihood that they're willing to fight it out rather than settle.” David Gerard, a blockchain critic and the author of Attack of the 50 Foot Blockchain, agreed. “Telegram are much better-resourced than Kik, so should have much more legal firepower to apply to the problem,” he told Decrypt.
No matter which way the court rules, Hinkes believes it’s likely the case will be appealed, and the result of an appeal “may finally create some binding law.” That would create “certainty in the market,” and “clarity for issuers as to what the law does and does not require of them,” he said.
What’s being argued
Like the rest of the cases put forward by the SEC, this one revolves around the Howey Test, a 1946 U.S. Supreme Court yardstick to determine whether a token is a security. Per the Howey Test, an asset is a security if it is an “investment of money in a common enterprise,” and “comes with an expectation of profit derived solely from the effort of others.”
Here’s what will happen tomorrow, according to Hinkes: The SEC and Telegram will argue about three important issues: First, whether the Grams are a security. Second, when they became a security under US law. Third, whether Grams would still be considered a security under US law if and when TON goes live.
And according to Marc Boiron, a partner at law firm FisherBroyles, here’s how that will go:
The SEC will make the argument that the sale of the SAFT was also the sale of Grams. Telegram will then make the case that it did sell securities—that was the whole point of the SAFT—but the Grams underlying the SAFT weren't securities at the time they were sold: actually, they didn’t even exist, Telegram will argue, because the network hasn’t even been switched on. And, according to Telegram, Grams also will not be securities when the network is switched on.
Both the SEC and Telegram will try to dispose of the case through something called a motion for summary judgment. Essentially, said Hinkes, this says, “based on all of the facts applied to the law,” and based on evidence that neither parties dispute, that “there's no way that the other guy can possibly win on this claim.”
John Berry a partner at Munger Tolles & Olson LLP, told Decrypt that the judge, Kevin Castel, could decide that the evidence is enough to rule in either Telegram or the SEC’s favor, and deliver a written ruling in a matter of weeks. Or, the judge could decide that more work needs to be done, and the case would be sent to the Court of Appeals, who’d issue its verdict at a later date, resulting in binding law.
Boiron doesn’t “expect either side to just let it go,” he said, and, like Hinkes, thinks it’s likely the losing side will appeal the case, meaning it’s likely it’ll end up in the Court of Appeals, anyway.
For the SEC, a win for Telegram would be “their worst nightmare,” said Boiron. “You’ve got a ton of companies that did exactly what Telegram’s done in terms of selling SAFTs and then delivering tokens. It doesn't want to lose that argument,” he said.
Likewise, Telegram could have to give back its $1.7 billion raise, a potentially ruinous result for a company that’s struggling to monetize. Yankun Guo, who runs her own law office in Chicago, also doesn’t believe the judge will make a ruling. She told Decrypt that the SEC would also ask the court for a formal injunction order. This would extend the delay of TON’s launch, as well as its revenue stream.
All eyes will be on Kevin Castel for the hearing tomorrow, which starts at 10am Eastern Time. Decrypt will be there.