On October 8, Judge Alvin Hellerstein in the Southern District of New York granted summary judgment in the Securities and Exchange Commission (SEC) finding that the Kin token issued by Kik Interactive, Inc. was a security. After the Telegram decision, this conclusion is not surprising, but emphasizes that many of the proposed arguments that digital tokens are not securities will be unsuccessful.
Kik had developed Kik Messenger, a real-time communication system for mobile devices, using traditional venture financing, but the business was not profitable. Kik hoped to develop a "digital ecosystem" using digital tokens (dubbed Kin) which would serve as a digital currency, intending it to become a cryptocurrency stored, transferred and recorded on Ethereum.
On May 25, 2017, Kik publicly announced its intention to raise $100 million through private and public sales of Kin. It embarked on a multi-city roadshow to promote its cryptocurrency and completed its offering in two phases:
- Pre-sale private offering: Kik entered into Simple Agreements for Future Tokens (SAFTs) with 50 sophisticated participants, verified by Kik’s independent consultant to be accredited investors.The SAFTs provided for the payment by the participants of US dollars in exchange for the right to receive Kin at a discount.In those agreements, SAFT participants acknowledged that their right to acquire Kin was an unregistered security being acquired for investment for their own account (not for the account of others) and not with a view to resell or distribute such securities. After raising $50 million through a pre-sale period of almost four months, Kik filed a Form D with the SEC on September 11, 2017, claiming an exemption under Rule 506(c).
As a result of both private and public offerings, Kik was in receipt of approximately $100 million (including Ether converted to dollars) which it deposited in a single bank account. Kik remained in direct control of 90 percent of all issued and outstanding tokens (10 percent of the total number of Kin were distributed to purchasers, 30 percent were retained by Kik, with the remaining 60 percent being held by the Kin Foundation, a nonprofit created by Kik).
Prior to Kik’s distribution of Kin, the SEC had not promulgated rules to regulate issuances of cryptocurrencies. It was only in July 2017, after Kik had announced its plans, that the SEC issued the DAO Report, in which it determined that tokens were securities, without however initiating enforcement proceedings. In the DAO Report, the SEC advised caution in raising capital through blockchain-enabled means without taking the appropriated steps to ensure compliance with US federal securities laws.
In June 2019, the SEC filed suit against Kik alleging violations of Sections 5(a) and 5(c) of the Securities Act based on Kik’s alleged offering and sale of securities without a registration statement or an exemption. The SEC sought relief in the form of an injunction barring the violation of the Securities Act, disgorgement of ill-gotten gains, and monetary penalties. Kik denied the allegations and asserted that the definition of "investment contract" in the Howey test is void for vagueness as applied to Kik and that if the Howey test was not void for vagueness, the test did not apply to the Kik offering. The court concluded that the Kin offering was a security under the Howey test:
- "Investment contract" is not unconstitutionally vague as applied to Kik: the court held that the definition of "investment contract" is not unconstitutionally vague as applied to Kik and that the statute at issue here neither authorized nor encouraged arbitrary and discriminatory enforcement. The court noted that the government is not required to reach out and warn all potential violators on an individual or industry level.The court found In its determination that (i) the definition gives a reasonable opportunity to understand what conduct and devices it covers and (ii) the law provides sufficiently clear standards to eliminate the risk of arbitrary enforcement. In other words, it concluded that the Howey test is constitutionally sufficient and objective enough to provide the necessary flexibility for the assessment of a wide range of investment vehicles.
- The sale of Kin to the public was a sale of a security and required a registration statement: the parties agreed that there was no registration statement in effect and that interstate means were used in connection with the offer or sale of Kin.The Howey test is generally characterized as having four primary components: (i) an investment of money (ii) in a common enterprise (iii) with an expectation of profit (iv) solely from the effort of others. The court, however, characterized the test as having three factors, combining the last two factors. Kik challenged the application of two factors to its Kin offering:(i) in a common enterprise and (iii) with an expectation of profit solely from the effort of others.The court found that the Kin ecosystem constituted a common enterprise and its success depended on efforts of Kik.Similar to Telegram, the Kin infrastructure did not exist at the time of the offering but was dependent on management by Kik to create the infrastructure.
- The pre-sale was part of an integral offering: the court held that the pre-sale and public sale should be considered integrated for purposes of Regulation D and, as such, constituted an unregistered offering of securities that did not qualify for exemption under Rule 506(c). In determining whether the transactions should be integrated, the court looked at whether the sales (i) are part of a single plan; (ii) involve the issuance of the same class of securities; (iii) have been made at or about the same time; (iv) were for the same type of consideration; and (v) made for the same general purpose.Four of the five factors were met in favor of a finding of integration, with prongs (i) and (v) being the most important. The only factor that weighed against such finding was that Kik received different forms of consideration for the two sales.
This decision strongly suggests that many of the arguments raised about the application of the Howey tests to ICOs structured in 2017 and 2018 are not likely to be successful. And, like Telegram, the decision reflects the risks of "fighting" the SEC.