Telegram has put in its response to the US Securities and Exchange Commission’s October complaint, which blocked the release of the Telegram Open Network’s Gram tokens until at least February 2020.

The SEC alleges that Telegram and their investors ran a scheme where the investors would get tokens cheap, then dump them on crypto exchanges to bilk the eventual retail end buyers — and that the tokens are securities under the Howey test at every step of the way, so you can’t do that without the whole registration rigmarole required to offer securities to the general public.

Long summary: The Howey test is so vague, and cryptos are so new! Who could know anything, really? Also, the SEC messed us around. All this is so fundamentally unknowable that it violates constitutional due process, and you should throw it out.

Short summary: f— you SEC, and see you in court.

This is all about SAFTs

Telegram did their Initial Coin Offering on the Simple Agreement for Future Tokens (SAFT) model — where you sell contracts to supply a token that doesn’t exist yet. The buyers get their tokens only when the network the tokens will live on is up and running.

The idea is that the SAFT contracts are securities, and can only be sold to accredited (i.e., rich) investors — but the eventual tokens are not. They’ll be “utility tokens” — like car-wash tokens, or game tokens, or perhaps a private currency substitute called Grams. But not securities — so you can sell them to ordinary people.

This theory has never been tested in court — though Kik’s Kin token was done as a SAFT, and the SEC are currently suing over that offering.

The term “SAFT” isn’t mentioned in the SEC complaint or Telegram’s response — but it’s the important question here: can you sell something as a security, and transmute it into a non-security?

With Telegram’s robust response to a solid complaint, this is suddenly the most interesting and important court case in ICOs.

The facts aren’t so great for Telegram — and the law isn’t really good for them either. So they pound on the table. Telegram’s response isn’t a slam-dunk refutation of the complaint — there’s more than a few holes in their arguments.

But it does mean we’ll get a proper courtroom discussion — with some precedential answers to the most important question: can a SAFT turn a security into not-a-security?

Defendants’ answer to the complaint

Telegram start with a paragraph-by-paragraph reply to the original SEC complaint.

Most of this just repeats “Defendants deny the allegations in Paragraph x,” with occasional admissions of basic facts. This is completely standard — make the plaintiff work to prove every dot of their case against you.

The key point is the precise matter that will be at the heart of the case — the SEC’s allegation that Grams are and will be securities:

3. Defendants deny the allegations in Paragraph 3. Grams do not exist yet but if and when they do, they will constitute a currency and/or commodity — not securities under the federal securities laws. 4. Defendants deny the allegations in Paragraph 4, except admit that Telegram has not filed any registration statement with the SEC because none was, is or will be required under the federal securities laws. … 50. … Telegram believes that Grams are not a security and will not be a security at the time of the launch of the TON Blockchain …

There’s a bit of definitional wrangling in paragraphs 29 to 32. These paragraphs are just basic explanations of terms — but Telegram isn’t letting anything pass:

29. Defendants deny the allegations in Paragraph 29 on the ground that the terms used therein, including “digital asset,” “digital token,” “blockchain technology,” “ICOs,” and others, involve circumstances, facts and details which vary significantly.

When the SEC literally quotes Telegram’s own words to back up the complaint, there’s a lot of:

83. Defendants deny the allegations in Paragraph 83, except admit that Plaintiff purports to quote from certain documents, and respectfully refer the Court to the referenced documents for their true and complete contents

If only we had, uh, regulatory clarity!

Telegram claim the law has been applied in an unclear manner — and, in the favourite refrain of the dodgy ICO promoter desperate for a loophole, they maintain there’s insufficient regulatory clarity on digital assets.

You’ll be amazed to hear that the Howey test doesn’t apply to digital assets! For reasons that Telegram don’t specify:

5. Here, Telegram has not been provided legally and constitutionally sufficient notice that its actions do and would violate the Securities Act of 1933. The term “investment contract,” in this context, is open-ended: while the Supreme Court interpreted it in Howey, the application of Howey to digital assets raises unique issues that require more specific guidance to avoid trapping the unwary. But to date, the SEC has failed to provide consistent and meaningful guidance on whether and how it will regulate cryptocurrencies like Grams.

You and I might think the SEC has provided considerable guidance, all of it consistent, over the past couple of years — that almost all of this stuff is a security under Howey. After the DAO Report in July 2017, there’s been a parade of SEC administrative orders with legal reasoning, and judges’ rulings that Howey applies just fine to digital assets.

But Telegram are hoping to find a loophole — or make one.

Telegram says the investors in the original private placements of SAFTs for Grams were highly sophisticated buyers, and knew what they were getting into. They filed Regulation D 506(c) exemptions from registering as a security accordingly.

This is completely true — and I admired how Telegram had taken money for magic beans from precisely those people who were definitely rich enough to know better. But the SEC didn’t object to those token sales — only when the tokens were about to get dumped on retail buyers.

But who could know anything? Really

The next section claims that “The SEC Has Failed to Provide Necessary Clarity And Notice Regarding the Securities Law Violations Alleged, Which Has Led to Arbitrary Enforcement.”

Telegram back this up by quoting … not regulatory statements, not administrative orders with legal reasoning, not precedent-setting rulings from court cases — but speculative public comments from SEC staff.

Telegram also add a page of comments from SEC Commissioner Hester Peirce — who has spoken up lots in favour of crypto, but who’s been notably unable to convince her fellow commissioners to let crypto promoters have their way.

I am not entirely convinced that building a $1.7 billion venture on one commissioner’s dissenting opinions is the wisest business move.

Most of the quoted comments came well after the Grams sales were concluded in March 2018.

Also, what about those other guys who aren’t the subject of this case, huh:

34. As particularly relevant here, the SEC has not initiated any actions with respect to cryptocurrencies Bitcoin and Ether, which share similar characteristics with Grams.

It turns out that— even if Bitcoin and ether were within the SEC’s purview, which neither the SEC nor the CFTC (the commodities regulator, who do handle Bitcoin futures) think they are — the SEC isn’t required to pursue everyone liable under a given rule simultaneously, and has been dealing with misbehaving ICO promoters slowly, and in order.

This is not a good section.

We wuz railroaded!

After that previous terrible section, Telegram list all their meetings and discussions with the SEC concerning Grams — “The SEC Failed to Provide Guidance While Telegram Was Expending Funds to Build the TON Blockchain.” Telegram feel the SEC has messed them around badly, despite their hard work to comply.

This section at least does its homework, and sets a plausible scenario that Telegram might have been messed around by the SEC.

The problem is that a challenge of legal vagueness has to apply to the regulations themselves — not to the regulator’s conduct. Telegram don’t mention the rules themselves at all.

Nor do Telegram even mention the SEC’s detailed allegations of how the investment contract works — the whole offering was designed to eventually result in tokens that were distributed to the public, above the price charged to the investors — thus, an investment contract.

Telegram act like this never came up — as if the SEC’s claims of a scheme aren’t going to be a huge part of the eventual proceedings.

Specific defenses

Given all the above as background, these are Telegram’s specific reasons to throw this complaint out:

FIRST DEFENSE: CONSTITUTIONAL VIOLATION – VOID FOR VAGUENESS/LACK OF NOTICE — who knows what any of this “Howey test” stuff means, really? You should throw it all out.

SECOND DEFENSE: EXEMPT PRIVATE PLACEMENT — the Regulation D 506(c) forms were sufficient, because the SAFTs were sold to accredited investors, and the eventual Grams won’t be securities.

THIRD DEFENSE: LACK OF EXTRATERRITORIAL AUTHORITY — Telegram want their sales to non-US investors (mostly Russians) to stand. This argument has something to it, at least.

FOURTH DEFENSE: JURISDICTION — “The SEC’s claims are barred because Defendants are not subject to general or specific jurisdiction in this Court.” And so there.

FIFTH DEFENSE: RESERVATION OF RIGHTS — anything we think of later.

Yes, but what’s going to happen next?

Skadden, Arps are a serious business law firm, and Telegram have $1.7 billion on hand. This response is not such a great showing for a firm of that quality.

But then, the lawyers can only work with what they’ve got. “Our facts aren’t great, but we admit nothing, and by the way we have $1.7 billion here. Do you feel lucky, SEC?”

Well, obviously, the SEC do feel lucky — they don’t bring cases where they don’t feel lucky.

So this will be a live test in court — with both sides well-resourced — of the SAFT model: can this One Weird Trick transmute a security into not-a-security?

I’m not so sure Telegram are onto a winner here. There are pretty much Zero Weird Tricks. The SEC has seen everything — there is no clever wrinkle that hasn’t been tried in the past century. There are no new frauds under the sun.

Of course, these are all general statements. This is a specific case — so let’s see what happens! The hearing is in February 2020.

Cheers to actual lawyers Grant Gulovsen (who spotted the document on the docket), Tamara Rogers and Gabriel Shapiro for observations and cribs.