As discussed in the previous article, Telegram is a popular global instant messaging company. In 2018, it sold contractual rights to acquire a new crypto asset that it was developing (to be called Grams) to a group of accredited (and wealthy) investors around the world. Telegram raised about $1.7 billion from 171 investors, including 39 U.S. purchasers. This was a prelude to the planned launch of Grams, which was to occur about a year and a half later in October 2019.
This two-step process — where a crypto entrepreneur sells contractual rights to acquire a crypto asset upon launch in order to fund the development of the asset and its network — has come to be known as the Simple Agreement for Future Tokens, or SAFT, process.
SAFT uses a two-stage offering process similar to that employed by conventional businesses that sell Simple Agreements for Future Equities, or SAFEs. The sale of the contractual rights is acknowledged to involve a security and is, therefore, structured to comply with one of the available exemptions from registration contained in U.S. law. In Telegram’s case, as is typical, the claimed exemption was Regulation D, Rule 506(c). For this exemption, all purchasers are required to be accredited investors, verified by or on behalf of the issuer.
Although the SAFE process is widely accepted, the U.S. Securities and Exchange Commission objected to Telegram’s sale of contractual rights, filing to enjoin the issuance of Grams in October of 2019. On March 24, 2020, in a widely reported and closely followed decision, Judge Peter Castel imposed a sweeping preliminary injunction preventing Telegram from issuing its planned crypto asset, Grams.
The rationale of the court was that the entire process, from start to finish, was part of a single scheme, and the original purchasers of the SAFT were not buying for their own personal use but in order to facilitate the wider distribution of the asset. This, in the opinion of both the SEC and the court, meant that the SAFT purchasers were underwriters. Because they would resell most of the Grams as soon as they could to purchasers who were not all accredited, the entire offering violated U.S. securities laws.
This is a complicated and confusing legal argument, turning on some of the most intricate definitions in the securities law. In a serious oversimplification that will probably have securities lawyers cringing, all sales that are part of a single offering have to comply with the requirements of that offering.
In other words, if the exemption that the offering is relying upon requires all purchasers to be verified accredited investors, no sales that are part of that offering can be made to anyone who does not qualify. And, in order to make sure that the issuer of the securities is not sneakily evading the exemption’s requirements, the issuer cannot sell to an accredited investor only to have that person turn around and resell to someone else who does not qualify. A purchaser who does that is acting as an underwriter.
The hardest part is how to tell if a resale is really part of the original offering. That is where yet another confusing legal concept comes into play. If there are enough differences between the two sales, they are not supposed to be integrated or treated as part of the same offering. Instead, the securities will be deemed to have come to rest in the hands of the initial purchasers, and subsequent resales will not destroy the original exemption.
The so-called integration doctrine is supposed to turn on five factors:
- Are the sales part of the same plan of financing?
- Do they involve issuance of the same class of securities?
- Are they made at or about the same time?
- Do they involve the same kind of consideration?
- Are they made for the same general purpose?
You can go back through the Telegram opinion and not find any discussion of these factors, which the court evades by talking about the entire plan as a single scheme to sell not the contractual rights but the Grams.
In fact, if those factors were considered, it does not appear that Telegram’s sale of contractual rights should have been integrated with the sale of the Grams. Telegram raised the funds it needed to develop the Grams and work on the Telegram Open Network with the original sale of contractual rights.
Any future plans to issue or sell Grams were not finalized and would not fund the same activities. Contractual rights are clearly distinguishable from crypto assets. The sale of contractual rights took place more than a year before the crypto assets were to be available, and more than two years before the court issued its preliminary injunction.
This is critical because Rule 502 of Regulation D says that sales made more than six months before or more than six months after completion of a Regulation D offering are not to be integrated if there are no intervening sales.
While all sales are likely to involve payment of assets convertible into fiat currency, any earnings from the resale of Grams would benefit the original purchasers, not Telegram, and thus would not be for the same general purpose.
Many commentators over the years have objected to the integration doctrine as being unduly burdensome on fledgling businesses, as well as being cumbersome and difficult to apply consistently. In fact, in March 2020, the SEC proposed rules that would make it substantially less likely for integration to occur, including a safe harbor if sales occur more than 30 days before or 30 days after an offering.
Judge Castel’s approach in SEC v. Telegram appears to ignore all of this and, instead, treats sales of a different kind of interest occurring more than a year apart, for different purposes, as part of a single scheme because the resales are “foreseeable.” That is a ruling that, if followed and applied elsewhere, will only increase the burdens on innovative, startup businesses; push more companies overseas to avoid our overly restrictive and unpredictable requirements; limit U.S.’ investors’ ability to participate in new business; and further muddle an already confusing area of the law.
This is Part 2 of a three-part series on the legal case between the U.S. SEC and Telegram’s claims to be securities. Read Part 1 on introduction to the context here and Part 3 on the decision to apply U.S. requirements extraterritorially here.
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The opinions expressed are the author’s alone and do not necessarily reflect the views of the University or its affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.