The SEC Finally Kicks Kik To The Curb: Federal Court Grants Summary Judgment To The SEC, Holding That Kin Tokens Are Securities – Corporate/Commercial Law

Last week the U.S. Securities and Exchange Commission
(“SEC”) won a major victory in its ongoing war against
initial coin offerings (“ICOs”) of digital assets (called
coins or tokens).  A large number of ICOs were conducted in
2017 and 2018, raising billions of dollars for the promoters,
without complying with the registration requirements of the
Securities Act of 1933 (“Securities Act”) or ensuring
that there was an exemption from registration.  The SEC
brought high-profile enforcement actions against Kik Interactive
Inc. (“Kik”) and Telegram Group Inc.
(“Telegram”) in 2019.  The SEC alleged that the Kik
and Telegram tokens were in fact securities within the meaning of
the U.S. securities laws and that Kik and Telegram should have
registered the tokens under the Securities Act.  Telegram settled with the SEC in June 2020
(returning $1.2 billion to investors), as have a number of
smaller token issuers, including Unikm Inc. and Salt Blockchain Inc., f/k/a Salt Lending Holdings,
Inc., which entered into settlements with the SEC in 
September 2020.    

On September 30, 2020, Judge Hellerstein of the U.S. District
Court for the Southern District of New York granted summary
judgment in favor of the SEC in the Kik case, ruling that Kik’s
tokens, called “Kins,” were securities and that the sale
of $49.2 million in tokens in a “Token Distribution
Event” (the ICO) was integrated with an earlier, arguably
exempt, $50 million sale of “SAFTs” (Simple Agreements
for Future Tokens) to accredited investors.

To recap the federal securities law applied by the SEC to token
offerings, a token or other digital asset may be a
“security” within the meaning of the Securities Act
because of the 1946 Supreme Court Case SEC v. W.J. Howey
Co. (“Howey”).   An “investment
contract” is included in the Securities Act’s definition
of a security.  In Howey, the Supreme Court
defined an “investment contract” as an investment of
money in a common enterprise with an expectation of profits,
derived solely from the entrepreneurial and managerial efforts of
others.   

Judge Hellerstein did not have the benefit of direct precedent
applying the Howey test to
cryptocurrencies.  However, he had little difficulty
applying Howey to the Kin tokens, holding that
(i) the parties agreed that there was an investment of money, (ii)
there was a common enterprise by reason of Kik’s depositing the
ICO proceeds in a single bank account and using them for operations
(construction of the Kin ecosystem), and (iii) there was an
expectation of profit on the part of the investors deriving from
the efforts of others.  As to the expectation of profits
“prong” of the Howey test, Judge
Hellerstein noted that Howey’s requirement that profits derive
“solely” from the efforts of others has been modified by
subsequent Second Circuit precedent to delete “solely” as
a literal requirement.  He further noted that Kik promoted the
Kin token sale by telling prospective investors that the limited
supply and planned cryptocurrency exchange listings for Kin meant,
“you could make a lot of money.”  Judge Hellerstein
brushed aside Kik’s “consumptive use” argument
because the digital ecosystem for Kin did not exist at the time of
the ICO.  He also explained that the “efforts of
others” element clearly was present because the demand for Kin
and the value of the investment would depend on “Kik’s
entrepreneurial and managerial efforts,” principally the
development of the Kin ecosystem and integration of Kin into the
Kik Messenger app.  

Accordingly, Judge Hellerstein ruled that Kik’s offering of
Kin tokens in its ICO was an unregistered offering of securities
that violated the Securities Act.

Kik had argued that its $50 million pre-sale of SAFTs to a
limited number of accredited investors was exempt from Securities
Act registration by reason of Rule 506(c) of Regulation D, which
permits a general solicitation of investors if sales are made only
to “accredited investors” who meet income and net worth
requirements.  However, Judge Hellerstein held that the SAFT
sale was integrated with the unregistered sale of Kin tokens, which
commenced the day after the SAFT offering concluded.  As a
result, the SAFT offering was also held to be in violation of the
registration requirements of the Securities Act.  

In determining whether the two offerings should have been
integrated, Judge Hellerstein considered the factors set forth in
Rule 502(a) of Regulation D: (a) whether the sales are part of a
single plan of financing; (b) whether the sales involve issuance of
the same class of securities; (c) whether the sales have been made
at or about the same time; (d) whether the same type of
consideration is being received; and (e) whether the sales are made
for the same general purpose.  Giving (a) and (e) the most
weight, Judge Hellerstein reasoned that the funds from both
offerings were used to fund Kik’s operations and Kin ecosystem
development.  As he noted: “[o]ne would not have happened
without the other, and both were integral to the successful launch
of Kin.”  As a result, neither the pre-sale of SAFTs nor
the sale of Kin tokens in the ICO complied with the registration
provisions of the Securities Act.  The parties were ordered to
submit an order for injunctive and monetary relief by October
20.

Judge Hellerstein’s ruling provides rare case law guidance
as to the question of when a digital asset constitutes a
security.  By contrast, the SEC has failed to conduct a
rulemaking in this area that would give the digital asset industry
a clearer road map for compliance.   An SEC rulemaking on
when a digital asset constitutes a security would represent a step
in the direction of less “regulation by enforcement” and
would update Howey’s 1946 test for the
crypto age.  Offering a greater degree of regulatory certainty
for the crypto industry would lead to more innovation and benefits
to the U.S. economy.

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