Alerts

SEC and Kik Present Competing Arguments on Application of Securities Laws to Blockchain Tokens

Alerts / May 21, 2020

On May 8, 2020, the U.S. Securities and Exchange Commission (SEC) and Kik Interactive Inc. (Kik) finished briefing their cross motions for summary judgment, which were previously filed on March 20, with opposition briefs filed on April 24. The briefing totals more than 400 pages of arguments by the parties in the SEC’s court challenge to Kik’s actions in raising funds through Simple Agreements for Future Tokens (SAFTs) and Kik’s 2017 public sale, valued at approximately $100 million, of Ethereum-based ERC20 tokens, known as Kin tokens.

How the court responds to the parties’ competing arguments could have significant implications for the legal status of blockchain tokens in the United States. On one side, Kik warns that the SEC is seeking “an unprecedented and dramatic expansion” of its regulatory authority by “stretch[ing] the definition of a ‘security’ ... far beyond [its] plain language” and in a way that “would be confusing and potentially inconsistent with the actions of other agencies.” On the other side, the SEC asks the court to apply an analysis similar to the reasoning in the recent decision in the Telegram case (which we previously covered in this article) and argues that the court should look at the economic reality of the transactions. On May 12, Telegram announced that as a result of the court’s decision in the Telegram case, it has canceled its TON blockchain project. This raises the stakes in the Kik case, with the Kik court’s decision now set to either affirm, reject or alter the Telegram court’s analysis.

Single-Scheme Theory

The SEC contends that the SAFTs and public Kin sales were a single transaction with multiple stages. According to the SEC’s “single scheme” theory, because Kik did not limit all Kin sales to accredited investors, the SAFT sales did not constitute a private exempt offering but rather were part of a public offering for which registration was required. Among other things, the SEC emphasizes that the following factors indicate Kik engaged in one “single noncompliant offering”:

  • Kik publicized it was conducting “one sale” to raise one “total” amount of money.
  • Kik conducted the same marketing to both groups.
  • Kik “expressly conditioned” the SAFT price on the public sale.
  • Kik distributed the Kin tokens to the SAFT investors at the same time as the public sale.

According to the SEC, Kik “took no steps to ensure that the SAFT participants were not underwriters of Kin” and that, as in Telegram, “Kin were never intended to come to rest in the hands of the SAFT participants, but to be dispersed to the broader public.”

Kik differentiates the public sale of Kin from the SAFTs, which it entered into with accredited investors pursuant to Rule 506(c) of Regulation D and for which it filed a Form D with the SEC. According to Kik, the two sales should not be lumped together because they “involved sales of different assets to different groups of purchasers over different time periods.” Kik argues the registration of a security is transaction-specific, and therefore the SAFTs and public sale must be evaluated independently.

Integrated Offering

The SEC alternatively argues that even if the SAFTs and the public sale are treated as two offerings, they should be integrated and considered one offering under the SEC rules. The SEC emphasizes that the SAFTs and Kin sales “were part of a single plan of financing, involved issuance of the same class of securities (i.e., identical and fungible Kin), were made at or about the same time, involved functionally similar consideration, and were for the same general purpose.”

In contrast, Kik contends there are two separate transactions: (1) a private sale governed by SAFTs to accredited investors of the contractual rights to purchase then-nonexistent Kin tokens at a point in the future, if and when Kik successfully launched Kin, and (2) a sale of goods to the public governed by Terms of Use conducted after the infrastructure for Kin already existed. According to Kik, the Kin sales did not involve the “issuance of the same class of securities” and were conducted at a different time than the SAFTs. Kik also argues that the SAFTs and Kin sales required different consideration (U.S. dollars for the SAFTs and ether for Kin) and were not made for the “same general purpose.”

Two Independent Offerings

The SEC offers a second alternative argument that if the SAFTs and the public Kin sale are considered two independent offerings, both required registration and independently violated Section 5 of the Securities Act. The SEC argues that Kik offered and sold Kin via the SAFTs, and therefore Regulation D required Kik to comply with Rule 502(d) to exercise reasonable care to ensure that the SAFT purchasers were not underwriters under Securities Act Section 2(a)(11). According to the SEC, the SAFT purchasers effectively acted as underwriters, and Kik’s failure to prevent this renders the Rule 506(c) registration exemption unavailable, rendering the SAFTs an unregistered public securities offering. Separately, the SEC avers that Kin are investment contracts and the public Kin sale was an unregistered public offering of securities in violation of Section 5.

Kik argues that the SAFTs were exempt under Rule 506(c) of Regulation D, and if the Regulation D exemption is not available, the SAFTs were nonetheless exempt pursuant to Section 4(a)(2) of the Securities Act as “transactions by an issuer not involving any public offering” in which the investors are able to fend for themselves. As to the token distribution, Kik contends that the SEC fails to establish an investment contract under the Howey test, as discussed below.

Howey Analysis

The central issue of the case is whether the Kin sales are investment contracts based on the Howey test, which requires (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 parties do not dispute that there was an investment of money and focus instead on prongs (2)-(4) of the Howey analysis.

Common Enterprise

The SEC argues that there was a common enterprise under two alternative tests:

  • Horizontal commonality exists because the fortunes of SAFT purchasers and Kin purchasers were tied together by Kik’s pooling of the funds that the investors collectively paid Kik to increase Kin’s value, fund Kik operations, deploy the Kin Foundation and execute development for Kin integration into Kik.
  • Strict vertical commonality exists due to Kik’s large stake in Kin (30 percent of Kin tokens), and Kin investors understood that their fortunes would rise and fall with those of Kik.

Kik presents the following arguments in contending that there was no common enterprise:

  • Kik did not contractually owe Kin purchasers anything beyond delivering Kin tokens.
  • Purchasers did not hold an interest in the sale proceeds or in pro rata distribution of profits.
  • Owning a common, fungible asset, where each individual may sell the asset at any time and price of their choosing, does not create commonality.
  • Kik marketed Kin as a currency for consumptive use, not an investment opportunity.
  • The Kin Foundation was “intended as an independent, nonprofit, and democratic governance body for members of [the Kin economy]” to support and foster the growth of the economy – but not to manage or control the economy or to create demand for Kin.
Expectation of Profits

In arguing that there was an expectation of profits, the SEC makes the following arguments:

  • Kik marketed Kin to traditional investors such as venture capital funds.
  • Kik promoted the limited supply and liquidity of Kin and Kin’s potential to increase in value, including on secondary markets, but did not identify any specific use for Kin as a proposed medium of exchange.
  • The minimum viable product (MVP) could not be bought or sold with Kin.
  • Investors bought Kin in such large quantities that their purchases can only be logically explained by an expectation of profits and not by a desire to use or consume.
  • The SAFT participants had a profit incentive because they bought Kin at a 30 percent discount from the public sale price of Kin.

In arguing that an expectation of profits did not exist, Kik argues the following:

  • The SEC established no statements in which Kik assured purchasers that it would provide or guarantee liquidity.
  • Kin has been functional as a medium of exchange from the day of its launch.
  • Large purchases of Kin do not equate to “investment” intent. For example, a purchaser who wanted to integrate Kin into a digital application would need a sizable supply of Kin to begin distributing it to users.
  • The MVP enabled purchasers to link their digital wallets, view their balances, and access and send premium content, and such functionality was used.
  • Within the many applications that integrate Kin, there are 4.3 million users spending Kin each month, with more than 11 million different users having spent Kin tokens and more than 26 million different users having earned Kin from these applications.
  • Facts regarding the SAFTs are irrelevant to whether Kik led purchasers to expect profits in the public Kin sale.
Efforts of Others

In arguing that Kin purchasers relied on the entrepreneurial or managerial efforts of others, the SEC contends that:

  • Kin had no inherent value or even historical existence.
  • Kin only existed and could gain value only through efforts to develop the ecosystem and drive up demand for the token.
  • Kik promised to take numerous value-enhancing actions for Kin after it distributed the token, including to (i) integrate Kin into Kik Messenger, build new products and develop the Kik “ecosystem” that would increase the value of Kin; (ii) supplement and improve the current Kin blockchain network; and (iii) create and “influence” the Kin Foundation to promote demand for Kin.
  • “[T]he record overwhelmingly demonstrate[d] that public investors reasonably expected ‘profits from the entrepreneurial or managerial efforts of others’” when they purchased Kin (e.g., averring that based on Kik’s statements during its marketing campaign, Kin purchasers would expect that Kik’s continued efforts had the potential to “make a lot of money” for both Kik and the purchasers).

In arguing that Kin purchasers did not rely on the efforts of others, Kik argues the following:

  • Purchasers who expect profits from market forces as opposed to the promoter’s efforts do not satisfy the efforts of others prong of Howey.
  • The SEC does not identify any promises by Kik that create an expectation of profits from the efforts of others.
  • The Kin Rewards Engine was designed and launched by the Kin Foundation, which should be viewed as separate and distinct from Kik.
  • Kik’s efforts are infrastructural, not managerial.
  • When Kin were distributed to the public on Sept. 26, 2017, the Kin Network was already fully functional as a medium of exchange for digital services and could also be used inside Kik Messenger.
  • Kin’s consumptive use was demonstrated by consumptive use after launch.
Takeaways and Conclusion

Similar to the Telegram case, the arguments in the Kik case are very fact-specific. As in Telegram, the SEC seems to particularly highlight the extent to which a company represented to SAFT purchasers that the company would engage in post-launch efforts to support the network and encourage adoption and the extent to which the company would retain the power after launch to support the market price of the token. The outcome of the Kik case is likely to further define the status of blockchain token models in the U.S. market, particularly whether the Telegram court’s application of the Howey test to SAFT sales and blockchain token sales will be supported or distinguished in whole or in part, and the corresponding implications for future actions by the SEC and market participants.

No matter the outcome, the court’s decision is expected to provide greater clarity on the legal boundaries that developers of blockchain-based networks should consider when designing products and solutions that involve or rely on Ethereum ERC20 tokens or similar cryptographic assets. While some questions are certain to remain open – or be further challenged on appeal – any measure of clarity the decision provides will be a welcome development for an industry that continues to advance while navigating a gray legal environment.

Authorship Credit: Teresa Goody Guillén, Jonathan A. Forman and Robert A. Musiala Jr.

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