On September 30, 2020, Judge Alvin K. Hellerstein of the U.S. District Court for the Southern District of New York granted the Securities and Exchange Commission’s (“SEC”) motion for summary judgment against Kik Interactive Inc. (“Kik”), holding that Kik offered and sold securities in violation of §§ 5(a) and 5(c) of the Securities Act of 1933, specifically, investment contracts, under the test set forth in SEC. v. W.J. Howey Co., 328 U.S. 293 (1946) and its progeny, and that no exemption from registration applied.
Kik developed a cryptocurrency called Kin, which could be stored, transferred, and recorded on a blockchain. Kin was to serve as a means of buying and selling digital products and services across different applications, including applications not run by Kik. The launch of Kin took place in two phases: a private offering between June 2017 and September 11, 2017 (the “Pre-Sale”) and a public offering beginning on September 12, 2017, the day after the Pre-Sale.
Key Points of the Decision
The Kin Token Is an Investment Contract
The Court found that the sale of Kin was a security under the Howey test because the sale established a common enterprise and purchasers had the expectation of profits based on the efforts of others. Accordingly, the sale required a registration statement, which Kik did not provide.
First, Kik’s sale was deemed a security because it established a common enterprise whereby funds were deposited into a single bank account and used to develop Kik’s operations, including the construction of an ecosystem for Kin. The success of the ecosystem drove demand for Kin and dictated investors’ profits. Although Kik had contractual language in its Terms of Use Agreement that disclaimed any ongoing obligation to purchasers and purchasers enjoyed complete control over their Kin, the Court found that neither of these factors was dispositive where investors’ profits at any given time are tied to the success of the enterprise, and specifically to the success of the ecosystem built by Kik.
Second, Kik’s sale was deemed a security because purchasers had an expectation of profits based on the efforts of others. The decision relied on statements made by Kik in connection with marketing, stating that there was a limited supply of Kin and that a possibility for profit was available because as demand increased, the value of Kin would increase. Success depended on Kik’s entrepreneurial and managerial efforts because Kin had no inherent value and would be worthless without the promised digital ecosystem. The Court rejected arguments relating to the consumptive use of Kin, reasoning that such use was not available at the time of distribution, but would materialize only if the enterprise advertised by Kik turned out to be successful. While this begs the question of what functional use might entail, the decision provides no guidance on that issue.
The Pre-Sale and the Public Offering Should be “Integrated” as a Single Offering
Importantly, the Court also found that the Pre-Sale was a part of an integrated offering. This means that issuers who sell SAFTs in private placements followed by public sales of tokens should make sure they take all necessary steps to avoid integration of the two offerings. The Court’s integration holding is based on the conclusion that both sales were made for the same general purpose (proceeds from both sales went toward funding Kik’s operations and building the ecosystem for Kin); the sales took place at approximately the same time, only one day apart; and the Kin were distributed to both sets of purchasers at the same time. Although the Court acknowledged that the receipt of different forms of consideration (U.S. dollars for the Pre-Sale, Ether for the public sale) weighed in favor of Kik, this was ultimately not sufficient to overcome the remaining considerations.
The Term “Investment Contract” Is Not Unconstitutionally Vague
Finally, the Court rejected Kik’s argument that the term “investment contract” was unconstitutionally vague, finding that the law provided a reasonable opportunity for Kik to understand what conduct was prohibited, and that sufficiently clear standards were in place to eliminate the risk of arbitrary enforcement.
S&K Observations
The strength of the language of the decision finding for the SEC indicates that courts are currently poised to support the policing of the cryptocurrency and blockchain space. The ruling against Kik, together with the earlier decision in SEC v. Telegram Group Inc. et al., in March 2020, should put to rest the question of whether a different set of rules applies to the offer and sale of an investment contract simply because the issuer used a new technology in connection with the offering. Taken together, these two decisions also indicate the courts’ willingness to integrate pre-sale offerings or simple agreements for future tokens (SAFTs) with public ICOs.
The analysis of digital token offerings remains highly complex and involves a case-by-case review. Moreover, due to the mutable nature of digital assets, the analysis of the same asset can change over time. If you have any questions regarding issues that may arise in connection with an offering of digital assets or any other blockchain-related questions, please speak with your S&K contact attorney or any member of our Blockchain and Cryptocurrency Group.
