What the court must consider in the Telegram appeal case

The Blockchain Association filed an amicus brief Friday in the Second Circuit Court of Appeals, supporting Telegram in its appeal from a district court’s preliminary injunction decision last week. In its brief, the Blockchain Association argues that the district court erred by conflating Telegram’s private placement and the future sales of blockchain tokens in its decision to temporarily block the distribution of Grams while the SEC’s lawsuit against Telegram is pending.

The district court ruled on March 24 that the SEC had “shown a substantial likelihood of success in proving that the contracts and understandings at issue, including the sale of 2.9 billion Grams to 175 purchasers in exchange for $1.7 billion, are part of a larger scheme to distribute those Grams into a secondary public market, which would be supported by Telegram’s ongoing efforts.” The court’s order was not a final decision on the merits, but rather a decision to prevent Telegram’s distribution of the Grams while the case is pending based in part on a determination that the SEC is likely to succeed on the merits.

The Blockchain Association agreed with some of the narrower aspects of the district court’s decision. The court noted — correctly — that a token itself is “little more than [an] alphanumeric cryptographic sequence.” The Blockchain Association also agreed with the district court’s statement that “[c]ryptocurrencies (sometimes called tokens or digital assets) are a lawful means of storing or transferring value and may fluctuate in value as any commodity would. In the abstract, an investment of money in a cryptocurrency utilized by members of a decentralized community connected via blockchain technology, which itself is administered by this community of users rather than by a common enterprise, is not likely to be deemed a security under the familiar test laid out in [Howey].”

However, as the Blockchain Association explained in its brief, the district court erred by conflating Telegram’s private placement investment contract with the underlying token.

Indeed, the SEC’s own statements have acknowledged this distinction. The SEC’s Director of Corporation Finance William Hinman has stated that a “token — or coin or whatever the digital information packet is called — all by itself is not a security, just as the orange groves in Howey were not.” SEC Commissioner Hester Peirce has explained that “conflating the two concepts [of the investment contract and the underlying asset] has limited secondary trading and has had disastrous consequences for the ability of token networks to become functional.”

Similarly, the SEC has repeatedly acknowledged that the securities status of an asset is not fixed. According to SEC Director Hinman, “a digital asset can, over time, become something other than a security,” and “the analysis of whether something is a security is not static.” For example, according to Hinman, an instrument ceases to satisfy the Howey test when “the network on which the token or coin is to function is sufficiently decentralized.” Similarly, SEC Chairman Jay Clayton has explained that cryptocurrency “can evolve toward or away from a security…. Just because it’s a security today doesn’t mean it’ll be a security tomorrow, and vice-versa.”

SEC Chairman Jay Clayton used the analogy of theater ticket presales to explain the concept: if a theater company were to promise discounted tickets to individuals willing to invest in a future, yet-to-be-developed show, that transaction would likely be considered an investment contract and therefore a security. However, once the show had been developed and the early investors had received their discounted tickets, the tickets themselves would not be considered securities.

The analogy holds in the Telegram case: no one disputes that Telegram’s privately placed contracts to deliver Grams to accredited investors amounted to investment contracts and therefore securities. As such, Telegram entered into these contracts only with accredited investors in compliance with Regulation D.

The sale and delivery of Grams — assets that the district court acknowledged are not securities (like theater tickets or Howey’s oranges) — does not violate the U.S. securities laws, the Blockchain Association explained. Rather, purchase agreements like Telegram’s are designed specifically to comply with the letter and spirit of the SEC’s existing securities rules allowing limited sales to early sophisticated investors. By refusing to analyze the Grams under the Howey Test and preventing their distribution, the Court has only added to the conflicting and confusing body of U.S. law with respect to digital assets.

The Blockchain Association’s Second Circuit amicus brief is available here.