The Ultranet

Filecoin Is a Security: The Surprising Conculsion From a Rigorous Analysis of the Telegram Injunction

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A picture of Sarah Connor from the Terminator series

sarah c0nn0r – creator of The Ultranet

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Last week, a bombshell was dropped that the SEC had won an injunction on Telegram, preventing it from being able to launch its new cryptocurrency, called “Grams,” due to the high likelihood that grams would be classified as a security. What’s even more surprising, however, is that the same arguments that take down Telegram also take down Filecoin, since their fundraises were very similar. With over 200,000,000 monthly active users on its messaging app, and having executed the largest token on record raising $1.7 billion, Telegram is not a small fish. As such, the fact that the SEC was able to succeed in halting the launch of its blockchain is stunning, and can teach us a lot about what to expect for other yet-to-launch cryptocurrency projects, specifically Filecoin. Moreover, while most coverage of the injunction has been superficial, in this article, we’ll be analyzing the actual text of the injunction order, granted by US judge Kevin Castel. Additionally, since the case of Telegram seems almost identical to that of Filecoin, another project that broke records with its $257 million token sale, I’ll be commenting on the implications for Filecoin specifically all throughout.

Notably, even though Filecoin is seen by many as a “blue-chip” project in the space, having been backed by Sequoia, Andreessen Horowitz, Union Square Ventures, and many others, it seems, based on the Telegram injunction, that Filecoin is a security as well, and will likely be barred from launching using almost identical arguments.

Context

If you’d like a primer on what a security is, what the role of the SEC is, what makes a cryptocurrency token a security, and why it’s a really bad thing to be a security, check out my previous post.

What Did Telegram Do?

To start, what did Telegram actually do? Well, it doesn’t get more precise than the text in the injunction itself:

In early 2018, Telegram received $1.7 billion from 175 sophisticated entities and high net-worth individuals in exchange for a promise to deliver 2.9 billion Grams.

The key here is that they didn’t sell tokens directly, but rather a “promise to deliver” tokens to the investors once the blockchain was fully developed. This is not uncommon in the blockchain space, and companies like Filecoin did exactly the same thing when they launched. The type of agreement used by both Telegram and Filecoin is called a “Simple Agreement for Future Tokens” or “SAFT,” and it basically says “you will get X tokens when the network launches because you invested $Y.”

Telegram’s Argument

Fundamentally, Telegram is trying to argue that the way in which it raised money does not make Grams a security, and therefore it should not be prevented from launching its blockchain and allowing Grams to trade on the open market. This is important because if Grams were to be a security, they basically wouldn’t be listed on any crypto exchanges, which would be very bad for Grams investors, as I explain in my previous article. To get around this, Telegram argues that the initial “promise to deliver” tokens (i.e. the SAFT) is a security, but that the underlying Grams are not because the subsequent sale of Grams by investors on the open market is independent of the SAFT transaction. What’s interesting is that this is the exact same argument Filecoin made when it sold SAFTs to its investors. From the injunction, we can see the exact text of Telegram’s argument, which is pretty clear:

Telegram contends that the agreements to sell the 2.9 billion Grams are lawful private placements of securities covered by an exemption from the registration requirement. In Telegram’s view, only the agreements with the individual purchasers are securities. Currently, the Grams will not be delivered to these purchasers until the launch of Telegram’s new blockchain, the Telegram Open Network (“TON”) Blockchain. Telegram views the anticipated releases of Grams by the 175 purchasers into a secondary public market via the TON Blockchain as wholly-unrelated transactions and argues they would not be the offering of securities.

Arguments From the SEC and the Court

According to the injunction, the SEC “sees things differently” than Telegram, and that is an understatement if anything. Throughout the remainder of the injunction order, the SEC and the court, together, lay out their thorough and detailed reasoning explaining why Grams tokens are actually securities in their view, and why the court has decided to grant the SEC its injunction.

To prove that Telegram is a security, the SEC must show that Grams constitutes “an investment of money into a common enterprise with the expectation of profit due to the efforts of a promoter or third party,” called the “Howey test.” As I explain in my previous article, really the only shot that Telegram, Filecoin, and most cryptocurrencies have at evading this definition is by arguing that the entity that launched the cryptocurrency is not a meaningful promoter when the cryptocurrency actually launches, perhaps because the currency is running on a decentralized network. Because of this, most of the arguments made by the SEC and supported by the court hinge on showing that Telegram as a company is an integral part of the value proposition compelling an investor to buy Grams, even after the network launches.

In what follows, I go through some of the key arguments made by the SEC and supported by the court that Grams tokens are securities, and how these arguments impact Filecoin.

You Can’t Separate SAFT Sale From Token Delivery

As mentioned before, the core of Telegram’s and Filecoin’s argument is that the “promise to deliver” tokens in the future (i.e. the sale of SAFTs) can be seen as a securities offering, but the eventual delivery and re-sale of tokens is a wholly-independent event. If you follow this logic, you can reasonably make the argument that Grams are not securities, even though SAFTs are. The problem is that the court shot this down explicitly, effectively saying that the entire “scheme” needs to be considered holistically (making a point to emphasize that “scheme” is a technical term not meant disparagingly of course…). If one takes this view, then it seems clear that the securities status of the SAFTs would extend to the Grams. This seems extremely bad for Telegram and Filecoin because SAFTs are widely considered to be securities and both Telegram and Filecoin sold them as such. Below is, in my opinion, the most damning statement from the court that impacts both Telegram and Filecoin equally (and indeed any other project that sold SAFTs that has not launched yet).

This case presents a “scheme” to be evaluated under Howey that consists of the full set of contracts, expectations, and understandings centered on the sale and distribution of the Gram. … the Court finds that the appropriate point at which to evaluate this scheme to sell and distribute Grams is at the point at which the scheme’s participants had a meeting of the minds, i.e. at the time of the 2018 Sales, rather than the date of delivery.

Honestly, there isn’t really much more to say about this– if court has decided that the securities status of the SAFTs extends to the Grams in the case of Telegram, then there isn’t really any way around this argument for Filecoin either. In other words, having sold SAFTs seems sufficient to make your token a security based on this injunction. Nevertheless, in the following sections, I highlight other parts of the injunction that may apply even to token projects that didn’t issue SAFTs.

Telegram’s Existence Impacts the Price at Launch

In the injunction, the court considers a thought experiment: Would the price of Grams at launch be impacted if Telegram were to completely disappear as an entity? They argue the answer is “yes,” since the Telegram company will likely play a key role in pushing Telegram to mass adoption. The same argument seems to apply to Filecoin and its entity “protocol labs” as well. From the injunction:

The Court finds that if, immediately after launch, Telegram and its team decamped to the British Virgin Islands, where Telegram is incorporated, and ceased all further efforts to support the TON blockchain, the TON Blockchain and Grams would exist in some form but would likely lack the mass adoption, vibrancy, and utility that would enable the Initial Purchasers to earn their expected huge profits.

“Initial Purchasers’ dependence on Telegram to develop, launch, and support the TON Blockchain is sufficient to find that the Initial Purchasers’ expectation of profits was reliant on the essential efforts of Telegram.”

You Don’t Need a Legal Obligation to Be a Promoter

Perhaps one potential out that Telegram or Filecoin would seek would be to argue that, even if the price of their token might be impacted by their existence, the fact that there’s no legal obligation for them to support the project should absolve them of promoter status. After all, the price of Ethereum would probably be lower if the Ethereum foundation didn’t exist, even now, but this doesn’t make them a promoter since Ethereum is not a security. The court quickly closes this line of argument, however, basically saying that you can be a promoter even if there’s nothing legally tying you to supporting the project.

Telegram, as a matter of fact rather than legal obligation, will be the guiding force behind the TON blockchain for the immediate post-launch period while 175 purchasers unload their Grams into the secondary market. As such, the initial 175 purchasers possess a reasonable expectation of profit based upon the efforts of Telegram because these purchasers expect to reap whopping gains from the resale of Grams in the immediate post-launch period. Under the Howey test, the series of contracts and understandings centered on Grams are a security within the meaning of the Securities Act of 1933 (the “Securities Act”).

Having Employees Incentivized By Locked-Up Tokens Is Bad

The court used the fact that Telegram pledged tokens to its employees after launch to argue that investors’ expectation of profit is dependent on the efforts of Telegram through said employees. This means that any company that has used locked-up tokens to incentivize employees, including Filecoin, would fall under this argument:

Telegram pledged to give Grams to its development team and the lockup provision governing those Grams fed reasonable expectations that this development team would continue to play an important role in the growth of the TON Blockchain.

A lockup period imposed on critical employees aligns their interests with the success of Grams and the TON Blockchain during the lockup period.

These lockups have their most plausible and logical economic justification if the employees subject to the lockup will play a critical role in the ongoing success of the entity.

Having a Mobile App Seems Bad

The court then argues that the fact that Telegram was planning to integrate Grams into a mobile app that it controls is further evidence that Telegram is a promoter under the Howey test. This is a very problematic argument because it means that virtually any cryptocurrency that has a mobile app would be subject to this line of reasoning, since mobile apps are inherently centralized due to app store restrictions. Notably, however the court seems to have a sufficient argument even without this line of reasoning, due to the previous sections. From the injunction:

Telegram’s advertised promotion of the TON Blockchain and Grams through integration with Messenger created a reasonable expectation in the minds of the Initial Pruchasers that their anticipated profits were dependent on Telegram’s essential post-launch efforts.

If the plans for a technically identical blockchain were floated, stripped of Telegram’s branding and support, it is unlikely that such an offering would have raised $1.7 billion in less than three months.

Telegram knew that Messenger was the critical element for the TON Blockchain to become something more than a new competitor to other cryptocurrencies.

Investors also knew that the Mesenger represented the key to Grams’ mass adoption and therefore expected Telegram to use Messenger to advance this goal. The Initial Purchasers reasonably expected that Telegram would continue to support the TON Blockchain in the post-launch period.

The cumulative effect of the advertised integration of the TON blockchain with Messenger and the lockups placed on the developer’s Grams created a reasonable expectation among the Initial Purchasers that Telegram would continue to provide essential support for the TON blockchain after launch.

Aside from the above, it seems like doing airdrops through a centralized app is also a bad idea:

Telegram structured post-launch financial incentives to ensure the link between Grams and Messenger was unmistakable to users.

What Does This Mean for Filecoin?

As mentioned in a previous section, the injunction seems to imply that any project that sold SAFTs that hasn’t launched yet, which includes Filecoin, is subject to regulation by the SEC. This is extremely bad, as I mention in the context article, because it means that the tokens associated with these projects cannot be listed on any crypto exchanges. What are Filecoin investors to do in this case? Unclear, but it would probably be helpful to have a statement from Filecoin on this issue at least.

What Does This Mean for Other Projects?

Aside from selling SAFTs, there are other things projects can do that could subject them to regulation by the SEC. In particular, if a company’s existence significantly impacts the price of a token, it could be sufficient grounds for the SEC to regulate them. If a company has a mobile app associated with their token it could be sufficient (Celo would fall in this category). If a company has employees motivated by tokens it could be sufficient.

A Glimmer of Hope?

Although not useful to Telegram or Filecoin, the court does state explicitly that it is indeed possible for some cryptocurrencies to avoid securities status. From the injunction:

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 S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946). The SEC, for example, does not contend that Bitcoins transferred on the Bitcoin blockchain are securities.

The problem is that in order to meet this criteria, based on everything else discussed in the injunction, it seems projects basically have to launch anonymously without raising any money, as I argue in my previous article. This worked for projects like Bitcoin and the Ultranet, but of course it is much more limiting.

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