In the latest development in the ongoing dispute between the SEC and Telegram Group Inc. (Telegram), Judge P. Kevin Castel of the U.S. District Court for the Southern District of New York in a March 24, 2020 opinion granted the SEC’s motion for preliminary injunction to prevent Telegram from distributing Grams purchased in its initial coin offering (ICO).

The case between the SEC and Telegram began last October, when the SEC filed an emergency action to stop Telegram (and its wholly owned subsidiary TON Issuer Inc.) from continuing its offering of Grams. In 2018, Telegram had raised approximately $1.7 billion through the sale of its ICO to finance the creation of the Telegram Open Network (also known as the TON Blockchain). The SEC alleged that Grams were securities, which Telegram failed to register in accordance with Sections 5(a) and 5(c) of the U.S. Securities Act (Securities Act).

Earlier this month, Telegram submitted a letter to Judge Castel arguing that a recent decision of the California Court of Appeal, Second Division, in Siry Investment, L.P. v. Farkhondehpour supported its case against the SEC. In its letter, Telegram argued the Siry court’s opinion supported its central argument that Grams are not securities, but rather a commodity. Telegram suggested that the “economic reality” of Gram purchasers’ intent, reflected in language in the Gram Purchase Agreements that the purchasers would only sell Grams “in accordance with applicable securities laws,” undercuts the claim that the Grams are securities, since they did not intend for them to be securities.

The SEC adamantly disagreed in its response on March 9, asserting that the totality of the circumstances must be considered. Specifically, such “boilerplate” language did not reflect, one way or another, Telegram’s or the purchasers’ intent or actual economic reality, because the economic reality of the Purchase Agreements is a result of the total economic inducements and commercial realities of the transaction. In other words, the SEC continued to point to, among other things, Telegram’s statements during the ICO that the SEC believes led Gram purchasers to expect they could make a profit by buying Grams and selling them on the secondary public market.

In his opinion, Judge Castel agreed with the SEC and held that the Gram Purchase Agreements, Telegram’s implied promises to develop the TON Blockchain and the planned distribution of Grams, taken as a whole, required registration under the Securities Act (see our post here for more information on how the SEC analyzes whether digital assets are securities). He emphasized that the purchasers intended to invest in and then sell Grams for a profit on the secondary market, citing one investor who declared in an email that they “hoped for an increase in the value of Grams and an opportunity to eventually sell Grams if the value increased” and that they did “not believe that [they] intended to use Grams as currency or for consumptive purposes.” The purchasers wanted to maximize value through resale in the public markets, not simply to store or transfer value from Dollars or Euros to Grams.  As such, the court granted the SEC’s motion to enjoin Telegram from distributing Grams and held that Telegram’s ICO violated the Securities Act and required registration. Interestingly, the court also found that the purchasers were “statutory underwriters” (thus also limiting a potential exemption from registration).

Telegram filed a notice following the ruling indicating that it would appeal the court’s decision. Continued litigation might provide further guidance and will determine whether Telegram will ultimately prevail. Nonetheless, the court’s opinion here is important because it develops the regulatory landscape for ICOs by highlighting regulators’ focus on the totality of an issuer’s ICO, and not merely on the “labels” that issuer’s might use to distinguish and qualify certain portions of their offerings for an exemption from registration, as Telegram attempted to do here. Issuers considering future ICOs should keep this in mind.