Crypto Crisis: Why SAFT Investors Should Sue Immediatelybr>
The Simple Agreement for Future Tokens (“SAFT”) was developed in 2017 as a way for companies developing blockchain technologies to raise funds from venture capitalists and other professional investors under something akin to the typical private placement framework used by early-stage companies to fundraise. This would purportedly allow blockchain startups to sidestep regulatory issues that were (and continue) to raise concerns with fundraising directly through the sale of tokens.
But the recent decision in the Telegram case has potentially upended the legal framework behind the SAFT and, if the rationale is adopted more broadly, will have rendered many SAFTs worthless at best, and a significant liability at worst.
With plaintiffs’ attorneys salivating at the chance to file securities class actions against token issuers and anyone affiliated with them, SAFT investors – particularly those whose SAFT portfolio companies have not achieved a network launch – have a unique and time-limited head start to recoup some of their investment before the companies they have invested in are decimated by future lawsuits.
Brief background on SAFTs
A SAFT represents a future right to acquire tokens issued by the developer, usually at a discount, once a functional network upon which the tokens may be used is developed. Once the developer is able to launch a functional network, it issues tokens to the SAFT investors who, in turn, sell these tokens into the secondary market.
The theory behind SAFTS is that once a functional network has been established, the tokens are not securities but rather utility tokens that can be freely distributed as commodities or currency without registration under the federal securities laws.
Background on Telegram Case
Telegram, Inc. and TON Issuer, Inc. (together, “Telegram”) raised $1.7 billion from 175 SAFT investors in 2018. Per the terms of the SAFTS, Telegram was required to distribute 2.9 billion “Grams” tokens to the SAFT investors upon development and launch of the Telegram Open Network (“TON”) Blockchain.
Telegram planned to launch the TON Blockchain and distribute 2.9 billion Grams to the SAFT investors at the end of October 2019. The anticipated resale of Grams by SAFT investors to secondary market purchasers was not going to be registered on the ground that Grams were purportedly utility tokens.
On October 11, 2019, the SEC sued Telegram in the United States District Court for the Southern District of New York for the offer or sale of unregistered securities and obtained a Temporary Restraining Order temporarily halting the distribution of tokens.
In a development that sent shockwaves through the SAFT investor community, on March 24, 2020, Judge P. Kevin Castel, granted the SEC’s motion for a preliminary injunction. Judge Castel found that the SEC had shown a substantial likelihood of proving that Telegram’s sale of $1.7 billion in SAFTs in 2018, the planned distribution of Grams to SAFT investors in late-2019, and the anticipated resale by SAFT investors to the secondary public market, was part of one integrated scheme to sell unregistered securities. Among other things, the court rejected Telegram’s argument that the SAFT investors wanted Grams with “consumptive intent,” and concluded that SAFT Investors entered into SAFTs with the intent to make profit from their ability to resell the Grams into the secondary public market once Telegram launched the TON Blockchain. On May 13, 2020, Telegram announced that it would no longer be involved in the TON Blockchain.
Of particular concern to all SAFT investors, Judge Castel concluded that the VCs and other investors that entered into SAFT agreements with Telegram were statutory underwriters. Section 2(a)(11) of the Securities Act of 1933 (“Securities Act”) defines an “underwriter” as “any person who has purchased from an issuer with a view to . . . the distribution of any security.” Judge Castel found that at the time the SAFT investors purchased SAFTs, they intended to resell the tokens into the secondary market and therefore “acted as mere conduits to the general public . . . .”
Ramifications for SAFT Investors
Judge Castel’s holding exposes a serious source of liability for SAFT investors. Any institutions or individuals that have invested in cryptocurrency companies through SAFTs should carefully scrutinize their potential exposure and take measures to limit that exposure.
Specifically, Section 12(a)(1) of the Securities Act provides that:
Any person who … offers or sells a security in violation of [Section 5] … shall be liable … to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security.
Section 12(a)(1) is a strict liability offense and entitles the purchaser of an unregistered security to rescind their purchase and have their investment monies returned to them. Thus, when SAFT investors sell their tokens into the open market, they are strictly liable to return the purchase price with interest to any purchaser.
This raises the very real specter of SAFT investors facing lawsuits, including class action lawsuits, by token-holders seeking a return of their investments. It is only a matter of time.
Further, SAFT investors may well be the “deep pockets” in this scenario. The issuer may be insolvent or on its way to insolvency, leaving SAFT investors “holding the bag” for any Section 12(a)(1) claims brought.
SAFT investors may think that if they get sued under Section 12(a)(1), they can sue the issuing companies to pay some or all of the judgment – what is called a claim for “contribution.” But courts have been leery of implying rights of contribution under Section 12(a)(1), even if the issuer had assets.
What Should A SAFT Investor Do?
Given the Telegram decision, SAFT investors are in a precarious position. Not only has it become exponentially less likely SAFT investors will ever be able to monetize their investments, but they may also become subject to potential Section 12(a)(1) claims themselves. Worse still, the issuing companies are themselves under threat of huge liabilities. SAFT investors would be wise to work with counsel to assess a strategy without delay.
First, if the SAFT investor has been issued tokens, and has not yet resold them, it should stop all sales activities immediately. Being saddled with unsellable tokens is a very bad outcome, but a SAFT investor only aggravates its situation by creating Section 12(a)(1) liability for itself by reselling tokens.
Second, the SAFT investor should carefully and quickly explore all potential legal claims against the issuer to obtain a return of its investment, which has effectively become worthless. Speed is of importance here. Issuing companies may only have so much in the way of assets and the more time that goes by, the less likely those assets will be available to recover. So, if there are legal claims available – which, as discussed below, there very well may be – the SAFT investor should pursue them without delay and consider emergency injunctive relief, such as through writs of attachment, to ensure the company’s assets are preserved through any litigation.
In terms of legal remedies that SAFT investors may be able to pursue, there are options under federal and state law. Under federal law, the SAFT investor may attempt to bring its own Section 12(a)(1) claim against the issuer to seek rescission of the SAFT, but the investor will need to overcome a powerful common law in pari delicto or “at equal fault” defense. Further, many SAFT investors face an additional obstacle that the statute of limitations for Section 12(a)(1) claims is one year from the time they purchased the SAFT.
The SAFT investor may fare better by bringing contractual rescission claims under state law. Under the doctrine of Mutual Mistake of Law, a contract is voidable if, at formation, both parties held the same mistaken understanding of the law material to the contract. At the time that the issuer and the SAFT investor entered into the SAFT, there was plainly a mutual mistake of law. Both parties believed that the two-stage framework of the SAFT would allow the issuer to sell the SAFT under an exemption from registration and to later distribute tokens to the SAFT investors, and that the SAFT investors would be able to resell these tokens into the secondary market as utility tokens. This misunderstanding goes to the very heart of the SAFT vehicle. Given that both sides of the transaction were mistaken as to the viability of the SAFT device, SAFT investors should be able to bring claims for rescission under the doctrine of Mutual of Law to void these contracts and get their money back. Other grounds for rescission under state law, such as illegality or failure of consideration, may also be available.
The Telegram case presents a nightmare scenario for SAFT investors – a once promising investment that may become a liability. Thankfully, the law provides options that SAFT investors may able to pursue to minimize liability and recover at least some investment proceeds.
And for SAFT investors who have not been issued tokens, you have a head start. If you act quickly, before tokens are issued and resold and plaintiffs’ attorneys start competing for the issuer’s assets, there is the opportunity to come out at least somewhat unscathed.