Telegram vs. The SEC


On 12 May 2020, Telegram CEO Pavel Durov released a blog post announcing the end of the company’s ambitious TON (Telegram Open Network) project.  The cryptocurrency community had been closely watching the legal drama unfold, and the final outcome has sparked renewed anger against the US Securities and Exchange Commission (SEC).  To better understand the impact of the Telegram ruling, it is worth going back to the beginning, to understand what Durov had planned for TON and why he ran afoul of US regulation.

According to the company’s website, Telegram came into existence in October 2013, as the result of a competition for Android developers.  Built by the Durov brothers, Pavel and Nikolai, the app originally offered secured and encrypted messaging.  By February 2014, Telegram had gained significant traction and became the top free app in 46 different countries as well as the number one social networking app in the US, ahead of Facebook and WhatsApp.

Anyone familiar with cryptocurrency will remember 2018 as the year of the ICO (Initial Coin Offering) craze. In January of that year, rumours began flying that Telegram sought to sell its own Gram tokens in order to fund TON’s development.  By this point, the site claimed 180 million users, and served as the virtual meeting place for many cryptocurrency projects, investors, and traders.  In a 132 page white paper, Telegram laid out a vision for TON that included a platform for decentralised apps and smart contracts, a library of network addresses, a micropayments system, and the ability to connect to other blockchains.

Durov planned a two-stage process to raise the funds needed to develop a project of such immense scale.   Between January and March of 2018, Telegram sold Grams to private investors, eventually raising $1.7 billion from 175 “Initial Purchasers.” The second stage would have involved a public sale of Grams once TON became operational.

In order to understand the SEC’s objections to Telegram’s activity, it is helpful to take a historical detour to the US, which, in 1933, was suffering from the massive negative effects of the Great Depression. Following the 1929 stock market crash, the US government passed legislation intended to protect investors.  The Securities Act of 1933 required the sellers of securities to register sales with the SEC.  Registration ensured that sellers would provide critical information to prospective buyers, in order to guard against misinformation and fraud.

Sellers of securities could claim an exemption (referred to as “Rule 506 of Regulation D”)  from the SEC’s registration requirement if those sellers could demonstrate that they would transact exclusively with “accredited” investors.  Financially savvy individuals and institutions capable of independently developing their own understanding of the risks of the transaction would meet the definition of accredited investors.

Both the SEC and Telegram are willing to agree that the 2018 transaction between the company and the Initial Purchasers qualified as a sale of securities.  Furthermore, both parties agree that Telegram took the appropriate actions to ensure that the 175 Initial Purchasers met the accredited investors criteria.  But the two parties disagree about the nature of the Initial Purchasers potential subsequent actions.

In October of 2019, the SEC took emergency action to block the second phase of Telegram’s fund raising, which involved a public sale of Gram tokens.  Several months of written arguments and court proceedings followed, until finally in March 2020 U.S. District Judge P. Kevin Castel, of the Southern District of New York, ruled in favour of the SEC.

Critically, to qualify for the previously mentioned “Rule 506 of Regulation D” exemption from the registration requirement, the seller must demonstrate not only the financial sophistication of the Initial Purchasers, but must also show that the Initial Purchasers will hold those securities and not resell them.  Failing that, although the first “accredited” buyers of the security may have the education and wherewithal to understand and withstand the risks of their investment, if those first buyers then sell their investment to an open market comprised of many less sophisticated buyers, their actions will negate the point of the exception. 

As the crucial point in his decision, Judge Castel states, “Telegram knew and understood that reasonable purchasers would not be willing to pay $1.7 billion to acquire Grams merely as a means of storing or transferring value. Instead, Telegram developed a scheme to maximize the amount initial purchasers would be willing to pay Telegram by creating a structure to allow these purchasers to maximize the value they receive upon resale in the public markets.”

Castel points to several different pieces of evidence to support his conclusion. Telegram had stated the goal of establishing Grams as “the first mass market cryptocurrency.”  To achieve this objective, the 58% of all Grams sold in the 2018 sales would need to reach a much broader audience than the 175 Initial Purchasers. Telegram had established large discounts for the Initial Purchasers, and eliminated some of the lockup provisions, in order to prompt the resale of Grams shortly after launch.  Finally, Telegram sought partners for the initial sale, such as major venture capital firms, whose known strategy would involve quickly selling their allocation of Grams in order to record a profit.  

The Judge addressed the fact that Telegram’s marketing material specifically disclaimed any expectation that Initial Purchasers would act as broad distributors of the tokens.  Telegram documents stated, "you should NOT expect any profits based on your purchase or holding of Grams, and Telegram makes no promises that you will make any profits. Grams are intended to act as a medium of exchange between users in the TON ecosystem.”   However, the statements alone do not outweigh the overwhelming evidence demonstrating that, contrary to their written disclaimers, Telegram did expect the Initial Purchasers to broadly resell the Grams.

As a result, Telegram did not qualify for an exception to the registration required by the Securities Act. Rather than facilitating a private sale, Telegram had sold a security to Initial Purchasers who would widely distribute the securities, effectively creating a public sale.  Any public sale of securities requires registration with the SEC, which Telegram had failed to do. While Telegram had initially stated an intention to appeal, by May Durov posted the previously mentioned blog post announcing the definitive end of the TON project.

In conclusion, a couple of points are worth noting.  While reviled by many within the crypto community, the SEC’s stated mission is to protect investors. Their regulatory actions are rooted in the concept that “all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it.” Its decentralised nature may provide cryptocurrency developers, users, and investors with the exciting freedom to operate outside of traditional regulatory frameworks.  But the trade-off is the lack of protection for some ordinary investors, who have lost money due to scam ICOs or who have fallen victim to “pump and dump” schemes.

Perhaps more troubling is the way in which the Telegram drama highlights the power of the US regulatory system. Rather than simply prohibiting the sale of Grams to US residents or through US institutions, the central nature of the American capital markets system and the global dominance of the dollar mean that a ban in the US effectively amounts to a world-wide prohibition. Ironically, for many of the billions of citizens in the world who cannot vote for US officials and do not benefit from the protections afforded to US residents, the current tyranny of US institutions may lead to greater adoption of the very cryptocurrency solutions that the SEC has sought to regulate.