On June 4, 2019, the Securities and Exchange Commission filed a complaint against Kik Interactive Inc. (“Kik”), alleging that Kik had engaged in the unregistered sale of securities in violation of applicable U.S. securities laws when it sold its Kin token in private and public offerings in 2017, raising approximately $100 million worldwide in fiat and cryptocurrencies in an “initial coin offering” or “ICO.”¹ The Kik complaint has been referred to as “the first shoe finally dropping”² as it is the SEC’s first litigation based solely on tokens being sold in an unregistered offering of securities since the DAO Report was released by the SEC in 2017. All other previous actions had included some other violation of U.S. securities laws such as fraud or were settled before they reached this stage.

The Kik action is noteworthy, not just because of the size of the offering, but also because the defendant has vowed to fight the SEC³ and through one of its affiliates is trying to raise a war chest for the upcoming court battle.⁴ According to news reports, Kik’s management is hoping that a court will come up with a “new Howey test” for token offerings.⁵ That goal is probably best described as ambitious, and even if the effort were to succeed, it would likely take years. In the meantime, below is a summary of issues an issuer of tokens should consider when determining whether an offer of tokens in the United States or to U.S. investors.

First, determine whether the token is a security, commodity, or something else.

A token could be a security, a commodity or, in certain circumstances, neither.

• Any token that has aspects traditionally associated with stock, debt or another traditional type of security is likely as security. For instance, if a token has equity-like rights such as voting, dividend or liquidation rights, debt-like rights such as payment of principal and interest, or is convertible into stock or debt, there is a strong possibility that the token itself is a security. Likewise, if the token represents a fractionalized interest in an underlying asset, it is possible that the token is a security. If the token is a security, it is not necessary to conduct a Howey test analysis as described below
• The CFTC takes the position that any “virtual currency,” defined as “a digital representation that functions as a medium of exchange, a unit of account, and/or a store of value” is a commodity. This definition is quite broad and includes not only “traditional” cryptocurrencies such as bitcoin and stablecoins but can also sweep up tokens that may not be deemed to be currency-like. If a token is a commodity, any offering of such tokens must comply with the laws applicable to offerings of commodities.
• Some tokens are neither securities nor commodities; “utility tokens,” that is tokens that are designed to be used to unlock the utility of a system may fall into this category.

Second, determine whether the way the token is offered creates a separate security referred to as an “investment contract.

This analysis utilizes the famous⁶ Howey test, which is a court-developed test that determines whether an offering involves the creation of a separate security called an “investment contract.” One of the key elements of the Howey test is that the purchaser of the item or token in question has an expectation of profits based on the efforts of others. Many token offerings can trip this element (even if the token sold is not otherwise a security) if the offering is structured badly; problems can arise if the token is marketed as an investment, if at the time of the offering there is no working platform on which the token can be used (and the company intends to use the funds raised to create such a platform), if the token purchasers are assured that the issuer will create a secondary market by listing the tokens on a token exchange, or if purchasers buy tokens in amounts that significantly exceed the amount of tokens that one would generally purchase to use them on the platform. This analysis is fact based and requires an in-depth understanding not only of the letter of the law but also the way courts and regulators interpret it, so issuers should not undertake it without input from counsel knowledgeable in this area of the law.

Third, determine the scope and type of offering.

• If the offering is an offering of a security, the first determination is whether the offering will be a public offering or a private placement (the term currently used for offerings of tokens that are securities is “STO”, short for “securities token offering”).
  • A public offering is the most expansive type of offering, but requires registration of the tokens to be offered with the SEC. In the best of circumstances, this is a three to six month process that involves the drafting of a registration statement that is reviewed by the SEC; however, currently registrations of tokens with the SEC have been facing a much longer process, regardless of whether the issuer has chosen to pursue registration under Regulation A (often referred to as a Reg A+ offering) or the standard registration process.
  • A private placement is generally an easier and faster process to navigate, and is the way most offerings of tokens that involve a security are currently done in the U.S. These offerings are usually done pursuant to Regulation D under Rule 506(b) (which does not permit advertising the offering in what is called “general solicitation”) and Rule 506(c) (which does permit general solicitation but involves a few additional considerations).
• If the offering is an offering of a commodity, the offering is subject to the rules of the CFTC. There often are no registration-type requirements, but general anti-fraud rules will apply and some participants may need to be registered to participate in the offering as described below.
• If the offering is an offering of a utility token, there are no registration requirements; but care must be taken that the tokens are not offered or sold in a way that creates a separate investment contract (e.g., tokens should be purchased in amounts that commensurate to the amounts of tokens one would need to utilize the platform for which the tokens are designed).

Fourth, determine what the requirements of the type of offering are.

Different types of offerings have different requirements. For instance, a public offering requires an expansive disclosure document drafted for retail investors with low financial sophistication that includes audited financials. Private placements have less stringent requirements, but ideally will also use written offering documents that adequately describe the token, the token issuer, all material risks that an investment in the token entails, and include financial disclosure if the issuer has operations that merit such disclosure.

In addition, if an issuer has assets exceeding $10 million, has sold an “equity security” and has in excess of 500 non-accredited holders of record or more than 2,000 holders of record, the issuer may become a reporting company under the Securities Exchange Act of 1934, as amended.

Fifth, identify the offering participants and the requirements for such participants.

Buying and selling securities or commodities may require registration with the SEC as broker or dealer or the CFTC as commodities trader; there are available narrow exceptions for the issuer and its employees, but financial advisors and others that get compensated to assist with such sales may need to be registered.

Sixth, determine what if any secondary market will exist and how the tokens can be traded on such a secondary market.

Many tokens are listed and traded on cryptocurrency exchanges, but an issuer should carefully consider the potential consequences before taking active steps to have its tokens listed on such an exchange. For example, if the tokens are securities and have been offered in a private placement as described above, they cannot be traded freely in the United States or with U.S. persons for a certain period of time, so should not be listed on an “open” exchange that permits anyone to trade. In addition, if the issuer guarantees to make a secondary market or to list the tokens on an exchange, that could result in the creation of a separate security.

Although significant guidance exists with respect to offerings of tokens, the analysis remains highly complex and involves review on a case-by-case basis. Additionally, the laws and regulations surrounding digital assets are subject to constant change. Seward & Kissel has decades of experience applying Howey and other relevant cases to complex financial products and providing advice on structures that avoid creating investment contracts. If you have any questions regarding issues that may arise in connection an offering of digital assets or any other blockchain-related questions, please speak with your Seward & Kissel contact attorney.

¹ U.S. Securities and Exchange Commission v. Kik Interactive Inc., Case No. 19-cv-5244, S.D.N.Y, June 4, 2019. A copy of the complaint can be found at https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf.

² Kik Case to Illuminate SEC’s Relationship With ICOs, Law360, June 5, 2019, available at https://www.law360.com/newyork/articles/1166212/kik-case-to-illuminate-sec-s-relationship-with-icos.\

³ Are ICO Tokens Securities? Startup Wants a Judge to Decide, The Wall Street Journal, Jan. 27, 2019, available at https://www.wsj.com/articles/are-ico-tokens-securities-startup-wants-a-judge-to-decide-11548604800.

⁴ Kin Launches $5 Million DefendCrypto Fund to Take on the SEC, Forbes online, available at https://www.forbes.com/sites/laurashin/2019/05/28/kin-launches-5-million-defendcrypto-fund-to-take-on-the-sec/#407e79a5733b.

⁵ Does Kik Stand A Chance Against the Goliath of the SEC in a U.S. Court? Cointelegraph, June 1, 2019, available at https://cointelegraph.com/news/does-kik-stand-a-chance-against-the-goliath-of-the-sec-in-a-us-court.

⁶ Or infamous, depending on one’s point of view. The Howey test was first formulated in SEC v. Howey Co., 328 U.S. 293 (1946) and has been further developed in cases such as Gary Plastics Packaging v. Merrill Lynch, Pierce, Fenner, & Smith Inc., 756 F.2d 230 (2d Cir. 1985) (“Gary Plastics”) and Marine Bank v. Weaver, 455 U.S. 551 (1982).