TON investors could be left in the cold due to a reimbursement clause in the contract. Legal experts weigh in.
Telegram’s grand entry into the cryptocurrency world is in limbo. After months of rumors, hype and anticipation, Telegram Open Network’s (TON) titan $1.7 billion sales round was declared illegal by the United States Securities and Exchange Commission (SEC).
Just days before the Oct. 16 public token distribution, the SEC dealt Telegram a crippling blow by issuing an emergency action and restraining order. Down, but not out, Telegram is now officially postponing the TON launch date. But after a “force majeure” clause in the purchase agreement was made public, investors are concerned that Telegram could shirk its obligations to return funds from Gram token sales in the event of a delay.
The road to the SEC gatekeepers is strewn with slain projects, many dreamed up by bigger and wealthier players than the Durov brothers. For a while, at least, Pavel and Nikolai seemed to have sidestepped dealing with the SEC altogether. But as always, when dealing with the SEC, the devil is in the details.
After withdrawing to reassess its options, Telegram hit back with a strongly worded legal challenge to the SEC, requesting to deny the commission’s injunction. The firm argued that it has voluntarily engaged with the authority for the past 18 months, only to be slapped with the ban at the eleventh hour. The legal challenge shows Telegram isn’t going anywhere without a fight.
Telegram files legal rebuttal
Telegram announced it would analyze its options in the aftermath of the SEC emergency action. A few days of ominous silence followed, broken only by the forthright legal challenge from Telegram filed on Oct. 16. In the filing, Telegram formally requested the United States District Court for the Southern District of New York to deny the SEC’s request for a preliminary injunction.
Published with only two days to spare before the counterclaim window closes, the filing does not mince its words, stating that the “SEC’s instant application is an ‘emergency of its own making.’” Telegram appears to lay the blame at the feet of the SEC, claiming that it had gone above and beyond to assist the commission:
“Telegram produced to the SEC thousands of pages of documents and communications with U.S. purchasers; submitted five detailed legal memoranda regarding the securities question at issue; participated in three in-person presentations during which it answered hundreds of questions and requested feedback; regularly engaged in email and telephone discussions regarding a wide range of topics relating to the TON Blockchain and Grams; and made modifications to the technology and operation of the TON Blockchain in response to the SEC’s stated concerns.”
Telegram also suggested that the SEC deliberately left their legal action until the last minute with the firm’s obligation to reimburse investors in mind:
“The SEC (i) never requested that Telegram delay the launch of the TON Blockchain; (ii) never advised Telegram of its intention to seek injunctive relief; and (iii) waited until the eleventh hour to file an ex parte application to enjoin Telegram’s launch.”
The company’s complaints are not limited to timing or etiquette alone. Telegram also stated that the SEC’s classification of Grams as a security is incorrect and that the tokens are merely a currency or commodity such as gold or silver:
“The SEC’s action hinges on a fundamentally flawed theory that Grams constitute a ‘security’ subject to the U.S. securities laws — a theory that runs counter to longstanding Supreme Court precedent, the SEC’s own views.”
While arguing that the SEC’s claims are baseless, along with the commission’s readiness to fight any legal challenge in court, Telegram elected to delay the launch of TON and the token distribution date until all legal issues are resolved. Telegram also argued in the filing that there is no need for the court to enter a preliminary injunction.
SEC claims Telegram breached Form D restrictions
Although the public token distribution was eagerly awaited by the crypto community in October, the event that drew the ire of the SEC is embedded in the fine print of the company’s February 2018 private sales round.
In February 2018, Telegram filed what is known as a “Form D,” a type of application that relieves companies of the obligation to register their securities with the SEC. While this might sound like a staggering oversight in an otherwise robust framework of regulatory law, the Form D does not give applicants full freedom to act at will. Mark Boiron, partner at U.S. law firm FisherBroyles, explained the premise of a Form D to Cointelegraph:
“A Form D is filed only when an offering is completed under an exemption from registration under the Securities Act of 1933, known as Regulation D.” This exemption is most commonly used by crypto projects that make use of Simple Agreements for Future Tokens (SAFTs) to sell the rights to receive tokens, and in doing so, are selling a security. Boiron went on:
“As a result, the projects that use SAFTs need to file a Form D. If you search Form D on the SEC’s website for the term ‘simple agreement for future tokens,’ then you will see many results pop up. The other time a Form D is filed would be when crypto itself is sold as a security, but that is rare.”
Companies looking to stave off the all-seeing eye of the SEC need to choose from two possible exemptions, both with their own respective restrictions. The first, 506(b), bears the most constraints for prospective applicants. Under this exemption, applicants may sell the security to accredited investors, along with a maximum of 35 nonaccredited investors. The caveat: The security cannot be advertised. The SEC also gave a description of which nonaccredited investors are eligible for sales:
“Each purchaser who is not an accredited investor either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.”
Telegram chose the second, a decision that would play a central role in the SEC’s decision to stop TON dead in its tracks — 506(c). This exemption allows the security to avoid SEC registration if sold to accredited investors alone, while permitting the applying company to advertise.
This fateful decision is the epicentre of the SEC’s restraining order. Although the initial coin offering (ICO) may well have sold to accredited investors, those very same investors could resell their newly acquired assets. For the SEC, this constituted a violation of the exemption. Consequently, the SEC alleged that Telegram and TON did not register their sale of the Gram tokens, which it considers securities.
In its Oct. 16 legal challenge to the SEC, Telegram sought to dispute the claims that Grams were offered through an ICO, stating that the company has never engaged in such an activity. The firm maintains that the tokens were sold in private purchase agreements according to the necessary regulatory framework:
“Unlike other digital assets that were offered to the general public through so-called Initial Coin Offerings (‘ICOs’), Telegram did not — and will never — offer any securities to the public through an ICO.”
In a statement to Cointelegraph, attorney for German legal firm Winheller, Benjamin Kirschbaum, explained that attempting to prevent regulation by the SEC is fairly common:
“It is quite common to try to prevent regulation by the SEC and similar authorities by only targeting qualified investors. While the definition of what a ‘qualified investor’ is differs from jurisdiction to jurisdiction, at least in the Western Hemisphere such an offering usually does not need to submit a prospectus.”
Gary E. Murphy, counsel at New York-based legal practice Debevoise & Plimpton, told Cointelegraph that although the Form D application route is available, it is difficult to launch a cryptocurrency in a compliant way in any other form than a security, as determined by the Howey Test:
“For the SEC to not view TON as a security, one prong of the Howey test would have needed to not exist. The most likely way to achieve that in a new network is to build the network with the funds from the SAFT sale under Regulation D and publicly disclose that the issuer (in this case Telegram) will no longer provide any development or other efforts to grow the network as a technical matter or to bring users to the network.”
Murphy added that this route might not be the most appealing to Telegram from a business standpoint, as it would deny a swift launch of the service, “As a result, there are very few, if any, real options to launch TON compliantly.”
TON seeks delay
According to an investor message shared with Cointelegraph on Oct. 16, Telegram announced to investors that it will seek to delay the launch deadline to April 30, 2020. In the letter, published on Wednesday, Telegram outlined that moving the deadline will require the permission of a majority of purchase amounts received by Telegram in relation to the Stage A purchase agreements. The same requirements for an extension of the presale round also apply.
Such an arrangement, however, means that one group of investors could vote to extend the deadline, while the other may not. The firm has encouraged investors to make a decision about the extension before Oct. 23, ahead of the Oct. 24 court date with regulators in New York.
Majeure trouble ahead: Legal experts speak out
As if the ban and impending court date wasn’t enough drama for both investors and Telegram, another legal technicality with the potential to have a major impact reared its head on Oct. 14. Should the delay to the network launch go ahead, investors that participated in the gargantuan Gram sale event may not see their spent funds in the near future.
As previously reported by Cointelegraph, Telegram’s pledge to return money to investors could be superseded by a so-called “force majeure” clause in its purchase agreement. Contrary to the company’s claims, the force majeure clause of the contract outlined that the company is absolved of responsibility for any delay caused by acts of God, natural disasters, war, and most importantly, governmental action or regulatory changes. Debevoise & Plimpton’s Murphy outlined to Cointelegraph that the presence of the force majeure clause does not necessarily equate to a total loss of investment funds:
“The Force Majeure clause, on its face, does not explicitly reference the termination provision in Clause 7.1 or the obligation thereunder to pay the Termination Amount if Network Launch has not occurred as of October 31, 2019. Thus investors may have a technical argument that the Force Majeure provision simply doesn’t apply with respect to the obligation to either launch the TON Network by October 31, 2019 or pay the Termination Amount.”
According to Murphy, investors could argue that Telegram is more than able to return funds from the Gram token sales rounds by virtue of the firm’s size and revenue, thereby cancelling out the need for the force majeure:
“They might point out that the Telegram Messenger app is functional and has a very large user base, which can provide an alternative source of funds for covering the payment of the Termination Amount. Telegram also has traditionally had access to funding from its founder.”
Kirschbaum postulated that the validity of the force majeure could depend on the type of investor involved in the purchase of the Gram tokens:
“Since the prospectus requirements and other rules regarding securities are in place to protect the average investor, the rules regarding qualified investors shall enable issuers to only deal with experienced clients (such as banks, security brokers, insurance companies, experienced wealthy individuals) where the lawmaker presumes that they can do their own due diligence before investing in any vehicle.”
If Kirschbaum’s hypothesis is correct, judges could side against accredited investors if the scenario, based on questioning the investor experience and assuming due diligence was conducted, does indeed occur. Regarding noninstitutional and inexperienced investors that do not fit the SEC description, Kirschbaum added that the clause may not be applicable:
“Since those investors are presumably experienced, a section in the T&C like Telegram, where a return of investment is excluded due to regulatory issues, seems valid. In such cases, experienced investors can make up their own mind on how high the risk of regulatory action is.”
Gary Murphy told Cointelegraph that investors could press on Telegram for knowingly keeping them in the dark regarding the securities classifications of the token, saying: “Given that Telegram did not treat TON as securities, there could very well be a claim investors could bring. However, without seeing all of the offering documents, it is difficult to judge.”