With the 2019 rebound in the price of Bitcoin and the hearings surrounding Facebook’s Libra cryptocurrency project, there’s a lot of renewed buzz around digital assets. This level of enthusiasm also means that regulators are circling the waters, looking for projects that could be operating outside the traditional boundaries of securities regulation. With the relative lack of guidance available, it is fairly easy for digital asset promoters to run afoul of regulations. When that happens, regulators will be all too happy to act. This is exactly what happened this June when the Securities and Exchange Commission (“SEC”) filed a suit against Kik Interactive Inc. (“Kik”), a Canadian corporation, for allegedly conducting an unregistered securities offering for its Kin token in violation of section 5 of the Securities Act of 1933 (the “Complaint”). In this Complaint, the SEC is seeking a permanent injunction against Kik, disgorgement plus interest of the amount raised, and civil penalties. Now, and most interestingly, Kik filed an “Answer to complaint” (the “Answer”) on August 7, 2019, which provides a detailed response to the SEC’s allegations. The Answer provides a rebuttal to the SEC’s allegations and argues that the SEC has mischaracterized facts and took information out of context. Regardless of the specific outcome for Kik, this proceeding should help provide guidance on the SECs view of ICOs and the factors they look at in analyzing such offerings.
Kik’s operations are based on its Kik Messenger application, which provides similar functionality to other popular messaging apps such as Snapchat. With a user base of about 300 million users and having US$120 million in venture capital backing, Kik needed additional funding in order to continue its operations. Looking to monetize its user base and tapping into the initial coin offering (“ICO”) craze of 2017, they launched their ICO in May 2017. According to their whitepaper, Kin would be given to users as a reward for certain actions such as creating content or viewing advertisements. In turn, users could use Kin to reward other content creators or enter into private chat groups. The ICO ran until September 2017 and ultimately sold 1 trillion Kin tokens, raising over $100 million from investors in the process. Throughout their campaign, Kik’s promotional material suggested that Kik itself did not view their Kin token to be a security.
While Kik believed their cyptocurrency, Kin, was not a security and as such, securities regulations were not applicable to the offering, the manner in which the Kin tokens were presented to the market is what ultimately triggered the SEC to take action. To make things interesting, the Kin token was partially offered through a “Simple Agreement for Future Tokens” (“SAFT”). Through the SAFT, which itself is a security, Kik offered and sold tokens to accredited investors and investment funds, using the private placement memorandum exemption, at a discount compared to what the public would pay during the ICO. Kik raised about US$49 million through this offering, representing close to half of its total raise. It was believed that by entering into the SAFT agreement pursuant to a prospectus exemption, the tokens issued pursuant to the SAFT could be issued to SAFT holders without being subject to securities regulation.
In the Complaint, the SEC indicates, among other things, that while a SAFT might be exempt from regulation, the digital asset issued pursuant to the SAFT must be analyzed separately. In effect, this means analyzing KIN through a traditional “investment contract” analysis under US securities laws through the SEC v. Howey lens. Under Howey, a digital asset is an investment contract when there is an investment of money in a common enterprise, with the expectation of profits to be derived solely from the efforts of others. This analysis must look not only at the characteristics of the token itself, but also look at how the ICO was marketed to potential investors, including all promotional material available, such as the whitepaper, social media content and public statements.
Canada has its own version of the Howey test, developed by the Supreme Court of Canada in the seminal case Pacific Coast Coin Exchange v. Ontario Securities Commission. Under Pacific Coast, there will be an investment contract when there is: (i) an investment of money; (ii) in a common enterprise; (iii) with the expectation of profit; and (iv) that comes significantly from the efforts of others. Guidance issued by the Canadian Securities Administrators (the “CSA”) in the form of Staff Notice 46-307 Cryptocurrency Offerings and Staff Notice 46-308 Securities Law Implications for Offerings of Tokens, issued on August 24, 2017, and June 11, 2018, respectively, discuss in great detail the Canadian securities law implications related to cryptocurrencies and digital assets, and we encourage readers to go over these as a refresher.
At the same time as Kik was building and promoting its ICO, two other start-ups were in discussions with the CSA Sandbox. Of note is the fact that two decisions regarding ICOs were issued during KIK’s campaign by provincial securities regulators, namely the Autorité des marchés financiers in Québec (“AMF”) and the British Columbia Securities Commission. In these decisions, which covered the Impak Finance and TokenFunder ICOs, the regulators clearly give a blueprint for companies wishing to conduct ICOs. These decisions also came after the PlexCorps enforcement action pursued by the AMF. Given Kik’s Canadian headquarters, this should have been a fair indication that substantial risks were involved if they went ahead with their ICO as planned.
In the Complaint, the SEC goes on at great length to portray Kik’s marketing campaign as an investment campaign, using promotional materials and various quotes from Kik executives. This frames the ICO as a capital raising activity and, more importantly, sets the table for the application of the Howey test.
While the investment of money is not really at issue for most if not all ICOs (we will spare the reader the discussion as to the legal qualification of cryptoassets and the application or exclusion of currency laws), the other elements are highlighted by the SEC in a fairly damning fashion. The SEC alleges that numerous statements were made by Kik regarding the fact that the value of Kik would increase, that several meetings in various cities were organized to drum up interest in the ICO and promote its investment quality, and that Kik expected its coin to be freely tradable on various exchanges on Day 1. Coupled with statements made that Kik would be developing the platform and building the ecosystem, based on its experience and know-how, this makes for a compelling argument that Kik’s ICO could be considered to be an investment contract.
The SEC also threw in a bit of shade in a “you knew better” allegation, mentioning that Kik had discussions with the Ontario Securities Commission (the “OSC”), where the OSC warned Kik that it would consider it to be in violation of Ontario securities laws should it conduct an ICO where Canadian investors would be allowed to invest. Given the similarities between the applicable tests in Canada and the US, this should have given them pause, especially since the discussions with the OSC took place at the same time as the Impak Finance and TokenFunder decisions were rendered. Instead, Kik simply decided to block Canadians, among others, from participating in the ICO.
In its Answer, Kik and their counsel reply to each and every allegation from the Complaint. They attack the allegations by clarifying many of the statements made by some of its executives – in particular its CEO Ken Livingston – that were used by the SEC. According to Kik, the SEC cherry-picked the statements to fit their narrative, not giving the full picture. The Answer is a scathing text that tries to show that the SEC overreached in its enforcement of securities regulation in the US. Kik also argues that its ICO is not an investment contract and that there was no sufficient guidance to allow Kik to ensure its project was fully compliant in the US. This sets the table for a bitter fight, with supporters on both sides. Throughout this process, Kik even set up a legal fight fund to help it go the distance and be the flag bearer for the industry.
This back and forth between Kik and the SEC, which began in earnest last January when the SEC served Kik with a “Wells Notice”, highlights the importance of both clear guidance from regulators and the fact that companies operating in the crypto space need to be careful in executing their vision. This case will give much clearer guidance for any promoter thinking of conducting an ICO or similar capital raise in the US. Although we do not believe that the Kik Complaint will resolve the debate regarding security tokens and utility tokens, it will, nonetheless, provide some interesting pointers on how American courts will look at the space.
We strongly encourage anyone venturing into this space to consult their counsel and their local securities regulator for guidance. Miller Thomson’s cryptoasset experts can help you navigate the intricacies of ICOs and obtain guidance from your local securities regulator.