On Sept. 30, the United States District Court for the Southern District of New York granted the U.S. Securities and Exchange Commission’s (SEC) motion for sum
mary judgment against Kik Interactive Inc. (Kik) and denied Kik’s cross-motion for summary judgment. As we previously reported, the SEC challenged Kik’s compliance with the federal securities laws in raising funds through simple agreements for future tokens, or SAFTs, and Kik’s 2017 public sale, valued at approximately $100 million, of Ethereum-based ERC20 tokens, known as Kin. The Court held that the undisputed facts show Kik offered and sold securities without a registration statement or exemption from registration, in violation of Section 5 of the Securities Act of 1933 (Securities Act).
Key Court Findings
The Court made numerous findings that are central to its opinion and provide additional precedent to the securities law analysis of digital assets and the offer and sale of those digital assets. Here, the Court held that the SAFT and public token offering were two offerings that were integrated. The integration doctrine prevents an issuer from improperly avoiding registration by artificially dividing a single offering into multiple offerings such that Securities Act exemptions would apply to multiple offerings that would not be available for the combined offering. Here, because the SAFT sales relied on Regulation D, the integrated public token offering would be part of the same Regulation D offering, and all sales must meet all the terms and conditions of Regulation D. In determining whether the two offerings are integrated, the court considers the following factors, not all of which need to be met:
- Whether the sales are part of a single plan of financing;
- Whether the sales involve issuance of the same class of securities;
- Whether the sales have been made at or about the same time;
- Whether the same type of consideration is being received; and
- Whether the sales are made for the same general purpose.
The Court found that all the factors were met except that different consideration was received for the SAFTs (U.S. dollars) than was received for the Kin (ether). This creates a different precedent than the holding in the Telegram case, in which that court held that the SAFT offering and token distribution were part of a single scheme where there were multiple stages in the same offering. Notably, neither court held that the SAFTs converted into the tokens. Instead, both courts analyzed the distribution of tokens to SAFT holders, and the public token offering, as separate transactions from the SAFT sales.
The Kik court stated that when the SEC issued the DAO Report on July 25, 2017, companies were on notice to apply the investment contract analysis, known as the Howey test, to determine whether specific digital assets are securities. As adopted by the U.S. Supreme Court in SEC v. W.J. Howey Co., a contract, scheme or transaction is deemed an investment contract, and thus a security, if it involves: (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) based on the entrepreneurial or managerial efforts of others. The Kik court applied the Howey test and found that Kik’s public token offering was a securities offering. The parties did not dispute that there was an investment of money, and so the Court’s analysis focused on the second through fourth factors of the test.
The Court held that the second factor—a common enterprise—was met. The Court explained that horizontal commonality is sufficient under Second Circuit precedent, so the Court did not need to reach any determination on whether vertical commonality (broad or strict) existed. Among the relevant factors listed by the Court that indicated a common enterprise was that the company deposited all the public token offering funds into the same bank account and used the funds for operations, including construction of the digital ecosystem. The Court stated that a finding of horizontal commonality did not require a pro rata distribution of profits to investors. Instead, it was sufficient that the investors reaped profits in the form of the increased value of the tokens.
The Court combined factors three and four and found that there was an expectation of profits based on the efforts of others. The Court cited statements by Kik’s management that it found would lead a reasonable investor to expect profits from the purchase and later sale of Kin. The Court also noted that Kik management had, and told investors that they had, significant ownership of Kin such that they had a personal stake in increasing the value. The Court viewed the ownership of Kik and the nonprofit foundation created by Kik as under common control and found that through the company and the foundation, Kik had a combined 90 percent ownership of issued and outstanding Kin. The Court cited as additional relevant facts that:
- Kik management told investors if investors could increase demand, then the value of the Kin tokens would increase;
- Kin would be tradeable in the secondary market through cryptocurrency exchanges; and
- After the first 24 hours of the public token offering, Kik removed the cap on purchase amounts ($4,393 worth of Kin) so purchasers could buy for speculation rather than consumption.
A significant factor identified by the Court in finding an expectation of profits based on the efforts of Kik was that “consumptive use” of the tokens was unavailable at the time of the public token offering or token distribution to SAFT holders. According to the Court, “efforts by Kik were crucial because without the promised digital ecosystem, Kin would be worthless.” In comparing the Kik facts to the facts in United Housing Foundation, Inc. v. Forman—a case that involved sales of real estate—the Court noted that “unlike real estate, Kin have no inherent value and will generate no profit absent an ecosystem that drives demand.” The Court concluded that the demand for Kin relied heavily on Kik’s entrepreneurial and managerial efforts and that it is undisputed that Kik had to be the primary driver of the ecosystem.
While both the Kik and Telegram courts ruled in favor of the SEC, it is noteworthy that the two courts did not agree on all aspects of their analyses. An important distinction between the Telegram and Kik decisions is that the Telegram court held that the SAFT offering and token distribution were part of a single offering, whereas the Kik court held that the SAFT offering and token offering were two offerings that were integrated. In the “single-scheme” view articulated by the Telegram court, the SAFT sales don’t qualify for the exemption from registration under either Section 4(a)(2) of the Securities Act or Rule 506(c) of Regulation D because there is no intent for the tokens to “come to rest” with the SAFT purchasers, which effectively meant that the SAFT purchasers were statutory underwriters. In contrast, under the “integrated offering” analysis adopted by the Kik court, because the public token offering does not qualify for the exemption from registration under either Section 4(a)(2) of the Securities Act or Rule 506(c) of Regulation D, if the SAFT sales are considered integrated with the public token offering, the SAFT sales cannot qualify for the exemption from registration. While the outcome of these two approaches was the same in both cases from a practical standpoint, given different sets of facts, the two approaches may not always yield the same result. Notably, neither court held that the SAFTs converted into the tokens, which holds important precedential value for developers of cryptographic assets that use SAFTs for capital raising.
Both the Kik and Telegram courts indicated that significant factors in determining whether or not a cryptographic asset is a security include whether the network at issue is fully operational at the time the asset is distributed, and whether at the time of network launch the ongoing efforts of a core management team are necessary for the network to function. These appear to have emerged as key factors for courts to consider as they apply the Howey test to blockchain-based assets. As more courts are called on to analyze these issues, more clarity will emerge—and given recent SEC enforcement actions and public statements, there is still more clarity needed. In the meantime, developers of blockchain-based networks should consider the Kik and Telegram decisions carefully when designing products and solutions that involve or rely on Ethereum ERC20 tokens or similar cryptographic assets.