Reading Between the Lines: SEC, Telegram, and Rule 144
Many in the crypto community and beyond have been closely watching the SEC’s case against Telegram as another regulatory test for the fast-growing space. In a complaint filed in October 2019 in federal court, the SEC alleged that the company’s sale of approximately 2.9 billion digital tokens (“Grams”) was in violation of the Securities Act of 1933.
But hidden in the SEC’s official complaint is an interesting nuance — little more than a passing reference, really — with potential implications for the broader private equity markets because it may call into question nearly 50 years of settled law and practice relating to how private equity transactions are structured. And just this week, in the case’s first public hearing, there were indications that that reference could have broader implications for all kinds of “investors” and so-called “underwriters.” In fact, that distinction could be at the heart of the case.
From crypto to a broader question
The big question in the case has been whether something that is initially sold under a “security” contract — in this case, via a token purchase agreement (a promise to deliver future tokens) that Telegram sold to investors pre-network launch — can later NOT be a “security.” That is, when the network launches, the tokens underlying the initial investment contract become tradable on the network; or, more broadly, if the company no longer existed, could the network still persist (as is the case with full decentralization).
The case is particularly interesting given ongoing discussions of what is a “security” under the Howey test — not just the label, but the substance of what constitutes a security. The federal judge who first heard arguments in U.S. District Court for the Southern District of New York this week indicated he would rule by April 30; however, he also emphasized that the court will not be rendering an opinion on cryptocurrency at large or a particular subset of cryptocurrencies, and that whether a cryptocurrency is inherently a security is “not what this case is about.” It’s the sale of tokens and the launch conditions that are at issue.
But the broader concern is about whether a “capital raise” took place, and that has implications for other industries including and beyond crypto.
How can that be?
First, some basics. In the U.S., securities can be sold only if they are registered with the SEC or if they qualify for an exemption from registration. The classic example of a registered offering is an initial public offering (“IPO”) — the SEC reviews the disclosures made by the company to potential purchasers and imposes on the issuer a series of ongoing financial and operational disclosure requirements to protect investors in the public markets.
But private markets rely on a series of well-established exemptions to the registration process. Simply put, “accredited” investors (meaning rich people or institutions such as university endowments and foundations) can purchase unregistered securities from the issuer via a set of rules known as 506(b) or 506(c) under Regulation D. In effect, the securities laws enable such so-called “sophisticated” buyers and sellers to transact without the SEC’s formal intervention, presuming that each party can protect itself without the need for an extra set of SEC-prescribed disclosure statements.
The most obvious example of this is a venture capital firm investing in a Series A offering for Company X. The firm does its diligence, enters into a set of legal contracts with Company X that defines the firm’s rights and restrictions, wires money to Company X and thus is able to purchase a security known as a Series A preferred stock. That’s the typical process for the private sale of unregistered securities from a company to an investor.
What happens, however, if some time in the future the venture firm wants to sell its shares in Company X? Under the SEC’s well-established rules, the firm can sell unregistered securities under Rule 144, which allows public resale of restricted and controlled securities if a number of conditions are met. But it basically says that if an investor has held the securities for 6-12 months — the time period depends on whether the company is publicly reporting and whether one is an “affiliate” of the company (a fancy way of saying board member or substantial shareholder) — then that investor is generally free to sell the stock to another sophisticated investor or into the public market if the company’s shares are publicly traded.
So why does this matter?
This is a commonplace and well-settled law from the 1970s, and as a result, the rule has been a significant factor in the rise of the venture capital industry that has led to some of the most important companies, in turn resulting in jobs creation, economic growth, and more.
But the SEC case against Telegram appears to ignore this legal precedent.
Instead, the SEC said in their original complaint that the private, institutional investors who entered into the Telegram purchase agreement (which was sold privately as a security under the appropriate regulatory statutes) did so with the intention of distributing the tokens to unsuspecting investors (“unloading it on the unadvised public”) — rather than through the orderly sale of securities to accredited investors as outlined in the SEC’s own Reg. D rules for registering for an exemption before filing.
That is, even though many of the investors could hold the tokens for more than a year (or already did if they were able to “tack” their holding period back to the date of the purchase agreement, another common practice under securities laws), we should ignore that and assume that the original purchase was done under false pretenses because, in the SEC’s words, it was obvious that the only way that the investors would profit from their investment was to sell to those unsuspecting investors.
In legal terms, the SEC is implying that those investors were effectively “underwriters” — intermediaries who bought Grams with an eye toward selling it or an asset underlying it to some unsuspecting member of the public. This not only contradicts 50 years of settled regulation around Rule 144, it also calls into question the very nature of purchases of private securities and the potential resale of those securities in the private or public markets.
So why should we care? Because if the SEC’s interpretation stands, any purchaser of a security issued by a non-public company could be deemed to be an underwriter. That has two big implications:
- First, traditional underwriters (e.g., investment banks) can be subject to legal liability for any material misstatements or misrepresentations made by the issuer of a security. This makes sense in the traditional underwriting scenario because the underwriters are being paid a fee to market and sell a security offering — they have a duty to make sure they are doing so with full and appropriate disclosures to the buyer of a security. Under the SEC’s Telegram interpretation of 144, however, any buyer of a private security would now be deemed an underwriter and thus subject to potential liability for misdeeds of the issuer. This could mean a buyer of the security could in theory sue another buyer of the security for some bad behavior on the part of the issuer/seller of the security? That doesn’t make sense.
- Second, if a buyer is deemed to be an underwriter, they may also be unable to engage in an otherwise lawful common exempt resale of that security at a later date. This is because in the Telegram case, the SEC equates a desire to sell at a profit, despite complying with the holding period contained in Rule 144, with an intent to unload to an unsuspecting public and therefore impermissible. Again, a strange outcome: Why would anyone buy a security if they were unable to later sell that security, as long as they of course comply with existing security laws that govern the later sale?
Whether this proposition will survive the Telegram case per se remains to be seen, but it’s important to pause and examine it, given the important precedents under which buyers and sellers of private equity have operated. If left to stand, private companies may find themselves unable to raise capital from investors who may fear that they are taking on broader liability as an underwriter when they look to sell their investments at a later date. This is important because a key underlying principle of private markets is that early investors are willing to take on risk and can de-risk said investments for later investors.
If policymakers wish to make changes to the process by which private companies raise capital and in turn create companies that can create value in other ways, they should honor the normal rule-making and legislative process rather than seeking to change policy via enforcement actions.
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