Yuwei Liu

On March 24, 2020, Judge Castel of the U.S. District Court for the Southern District of New York sided with the SEC and granted a preliminary injunction to halt Telegram Group’s initial coin offering (“ICO”).[1] Notably, the court held that the Gram token offered by Telegram in the ICO is a “security” (“investment contract”) within the meaning of § 2(a)(1) of the Securities Act of 1933, thus subjecting the offering to the Act’s registration provisions.[2] In reaching the decision, the court adopted an overly broad test –the Bahamas Test – advocated by Professors M. Todd Henderson and Max Raskin,[3] under which no ICOs will escape the fate of being deemed as a security offering. This decision is disappointing because it will inevitably stifle the development of the blockchain industry and blockchain-based technology in the US. The court’s analysis will effectively make almost all ICOs securities offerings, which in turn will prohibit many tech startups from turning to ICOs as a less regulated but more cost-efficient way to raise the funds necessary to develop their blockchain projects.[4]

Factual Background and Legal Framework

The Durov Brothers are owners and operators of Telegram Messenger, an encrypted instant messaging application with hundreds of millions of active users.[5] Seeing the potential in this massive user base, they proposed to create a new blockchain network called TON to facilitate payments and host decentralized applications at high scalability levels to be integrated into Telegram Messenger.[6] In 2018, Telegram raised $1.7 billion through sales of the right to receive digital tokens called “Grams.” These Initial Purchasers bought Grams pursuant to Gram Purchase Agreements, under which Telegram was obligated to create a working blockchain and deliver Grams by Oct 31, 2019.[7]

Although the SEC has not yet engaged in any formal or informal rulemaking, it has provided some guidance in determining whether a digital asset is a security.[8] Whether a digital asset is a security depends on the Howey test—a fact-intensive analysis focusing on the substantive economic reality of the instrument rather than its form.[9]Under Howey, an investment contract exists when there is (1) the investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the efforts of others.[10] Whether the Gram is a security depends on the application of the Howey test.

The Parties’ Arguments and Judge Castel’s Analysis

 In Telegram, the SEC’s argued that Telegram’s offer and sale of Grams to Initial Purchasers under the Purchase Agreements, and any upcoming distributions of Grams were a single transaction that constituted a security offering under Howey.[11] On the contrary, Telegram’s main argument was that while the Purchase Agreements were a security offering, the underlying Gram itself was not a security, but a currency or a commodity, like gold or silver.[12]

In deciding the case, Judge Castel agreed with the SEC and stressed that the analysis should focus on the economic reality of the transaction.[13] Walking through each prong of Howey, Judge Castel found the first prong was established when the Initial Purchasers invested money in exchange for the future delivery of Grams.[14] As for the second prong, Judge Castel pointed out that both horizontal commonality and vertical commonality were satisfied.[15] With regard to the “expectation of profit” prong, the Court did not reject the possibility that some purchasers bought Grams for consumptive use, but concluded that the SEC had shown a substantial likelihood in proving that the Initial Purchasers purchased with expectation of profit in the resale of the Grams.[16] Finally, in adopting a novel test, the Bahamas Test, the court found that the purchasers “were entirely reliant on Telegram’s efforts to develop, launch, and provide ongoing support for the TON Blockchain and Grams,” which was sufficient to find that their “expectation of profits was reliant on the essential efforts of Telegram.”[17] In addition, the possibility of high returns from reselling Grams depended on Telegram integrating TON into Telegram Messenger and successfully encouraging the mass adoption of Grams.[18] Therefore, the Court concluded that all four elements were met and as a result, the whole transaction was a security offering under the Howey test, and Telegram had made an unauthorized offering in violation of the ’33 Act.

The Court Should Reconsider its Adoption of the Bahamas Test in Analyzing the Fourth Prong

In analyzing the fourth prong, the court adopted the Bahamas Test as advocated by Professors M. Todd Henderson and Max Raskin.[19] Under this test, an instrument is deemed decentralized enough to not satisfy the fourth prong only if the proposed project can still be capable of existing even after “the sellers fled to the Bahamas or ceased to show up to work—like Satoshi Nakamoto.”[20] The Court should reconsider its decision in adopting this test, since under the Bahamas Test, no companies would be able to raise funds to develop blockchain projects without registering the offering with the SEC.

In a 2018 statement, SEC Director William Hinman said that the SEC did not, in its 2018 state, consider Ether to be a security.[21] But, as Henderson and Raskin noted in their article, even Ether would have failed the Bahamas Test at the point of its 2014 ICO when Vitalik Buterin raised funds to build the Ethereum blockchain because the proposed project would have collapsed had Buterin and the team absconded to the Bahamas.[22] Therefore, in order to pass the Bahamas Test, at the time of its ICO, the blockchain and blockchain-based applications, which the startup is raising money to develop and launch, must be fully functioning and decentralized. This means that the startup needs to raise money from other sources before it can engage in an ICO. However, most startups do not have access to enough resources to fully develop their blockchain application using traditional fundraising methods like IPO or borrowing from banks. If they have other financing methods, they would not consider an ICO. Therefore, under the Bahamas Test, most startups will have no means to develop their projects and they would probably not put the effort into developing the blockchain technology necessary to consider an ICO in the first place.

Under the Traditional Analysis, the Gram Might not Satisfy the Fourth Prong

Had the court followed the traditional analysis of the fourth prong, focusing on whether the expectation of profits stem from essential managerial efforts of others,[23] Gram might not have been considered an investment contract. In the SEC’s words, to satisfy “reliance on efforts of others” prong, the efforts need to be “the undeniably significantones, those essential managerial efforts which affect the failure or success of the enterprise.”[24] Telegram made managerial efforts to develop, launch, and support the TON blockchain and purchasers relied on these managerial efforts, but the court failed to show that the efforts were undeniably significant to the success of the enterprise. In this case, the existing ecosystem of Telegram already had a massive user base, making it hard to determine whether the profits made in the appreciation of TON were driven mainly by the Durovs’ efforts or by demand from users. In addition, since the source code for the TON blockchain was released in September 2019 and is now available on Github, theoretically, anyone, including the purchasers of the Gram, could launch the TON blockchain.[25] In other words, even without the efforts of Telegram, the collective efforts of the community could run the TON blockchain.[26] Given these factors, it is hard to say that the predominance test could be satisfied in this case.


The Bahamas Test, as adopted by the court, makes it extremely easy  for the SEC to meet its burden in satisfying the fourth prong of the Howey test. This will unfortunately close the door to startups considering an unregistered ICO as an alternative fundraising tool. Although this decision could further the SEC’s goal of investor protection, it will inevitably stifle the development blockchain industry in the U.S. As Henderson and Raskin noted, the framework they offered should serve as a start of the debate. Following the ruling, Telegram filed an interlocutory appeal to the Second Circuit. The Second Circuit should examine the Bahamas Test, remand and order the court to follow the traditional fourth prong test. Companies in the blockchain industry should keep a close eye on the development of the case.



[1] SEC v. Telegram Group Inc. and TON Issuer Inc., No. 19-cv-9439, at 3 (S.D.N.Y. Mar. 24, 2020).
[2] Id.
[3] M. Todd Henderson & Max Raskin, A Regulatory Classification Of Digital Assets: Toward An Operational Howey Test For Cryptocurrencies, ICOs, And Other Digital Assets, 2019 Colum. Bus. L. Rev. 444, 461 (2019).
[4] See, e.g., Laurin Arnold et al., Blockchain and Initial Coin Offerings: Blockchain’s Implications for Crowdfunding, in 1 Business Transformation Through Blockchain 233, 235–36 (2019) (noting that compared to traditional fundraising methods, ICOs have little regulatory oversight, do not need involvement of financial institutions and enable all actors to participate and thus are more cost-efficient to raise fund).
[5] Complaint at 10, SEC v. Telegram Group Inc. and TON Issuer Inc., No. 19-cv-9439 (S.D.N.Y. Oct 11, 2019).
[6] See Stephen O’Neal, Telegram is Losing to the US SEC, TON Community Can Launch Network Regardless, CoinTelegraph (Mar. 26, 2020), https://cointelegraph.com/news/telegram-is-losing-to-the-us-sec-ton-community-can-launch-network-regardless [https://perma.cc/E2GJ-JABK].
[7] Complaint, supra note 5, at 11–12.
[8] See Framework for “Investment Contract” Analysis of Digital Assets, SEC (Apr. 3, 2019), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets [https://perma.cc/VV4J-65ZW] [hereinafter Framework]. In addition, the SEC has started several enforcement actions and issued multiple orders and no-action letters to illustrate its analysis.
[9] See SEC v. W.J. Howey Co., 328 U.S. 293, 298 (1946).
[10] See Framework, supra note 8.
[11] Telegram Group, No. 19-cv-9439, at 29.
[12] Defendant’s Memorandum of Law in Opposition to Plaintiff’s Motion for Summary Judgment at 1–2, SEC v. Telegram Group Inc. and TON Issuer Inc., No. 19-cv-9439 (Jan. 21, 2020).
[13] Opinion and Order, supra note 1 at 17.
[14] Id. at 20.
[15] Id. at 21–22.
[16] Id. at 24.
[17] Id. at 32.
[18] Id. at 33–35.
[19]  Henderson & Raskin, supra note 3, at 461.
[20] Id.
[21] William Hinman, Dir., Div. Corp. Fin., SEC, Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018), https://www.sec.gov/news/speech/speech-hinman-061418 [https://perma.cc/89V8-ZWZB].
[22] Henderson & Raskin, supra note 3, at 471–72.
[23] United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852 (1975). While the original Howey test requires that the expectation of profits does not need to stem “solely” from the efforts of the promoter or a third party (Howey, 328 U.S. at 299), Forman conspicuously left out “solely.” In addition, Forman stated that the efforts must be entrepreneurial or managerial. See, e.g., Henderson & Raskin, supra note 18.
[24] Framework, supra note 8 (citing SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir. 1973)) (emphasis added).
[25] Anna Baydakova, Devs Plot Launch of Telegram’s Blockchain Without Company’s Involvement, CoinDesk (Mar. 25, 2020), https://www.coindesk.com/devs-plot-launch-of-telegrams-blockchain-without-companys-involvement [https://perma.cc/9DQK-ZQ8D].
[26] Jeff Fawkes, Telegram Open Network May Launch Without Durov Brothers, TON Developer Says, Coinspeaker (Mar. 26, 2020), https://www.coinspeaker.com/telegram-ton-without-durov-brothers/ [https://perma.cc/4S4W-Z8BW].