On October 21, 2020, the United States District Court for the Southern District of New York entered a final judgment on consent against Kik Interactive Inc. to resolve the Securities and Exchange Commission’s charges that Kik’s unregistered public sale of digital tokens in 2017 violated the federal securities laws. The final judgment requires Kik to pay a $5 million penalty, obligates Kik for the next three years to provide notice to the SEC before engaging in certain offers or sales of digital assets and permanently enjoins Kik from violating the registration provisions of the Securities Act of 1933. Kik sold its digital tokens to the public prior to achieving functionality, which under prevailing legal standards meant that the tokens were deemed to be securities and their sale without registration or exemption violated the securities laws. But despite some unfortunate factors relied on by the court, the case leaves open the possibility for the unregistered public sale of fully functional digital tokens whose development is completely funded through an earlier exempt offering round.
Kik Interactive Inc. is a Canadian corporation formed in 2009 to develop a mobile messaging application called Kik Messenger. Despite the application’s initial success and Kik’s raise of over $100 million in venture funding, the company was losing Kik Messenger users by 2017 and was expected to run out of cash by the end of that year. After an unsuccessful effort through an investment bank to get acquired, Kik pivoted and adopted a plan to fund its operations through a two-stage initial coin offering of “Kin” digital tokens for in-app purchases on its blockchain network: initially through simple agreements for future tokens or “SAFT”s, followed by a public sale of Kin into which the SAFT rights would convert at a 30% discount.
From May to September 2017, Kik offered and sold SAFTs to accredited investors, raising approximately $49 million. Under the SAFTs, Kik was obligated to deliver half the Kin tokens into which the SAFT was convertible at the time that Kik delivered tokens to the general public and the other half on the one-year anniversary of the first delivery. Kik filed a Form D with the SEC after the conclusion of the SAFT offering, claiming an exemption under Rule 506(c).
The terms of the SAFT included an aggressive deadline of September 30 for the public token sale (which would trigger the issuance of the first half of the conversion Kin) with a draconian forfeiture feature: if the September 30 deadline was not met, Kik would be required to return 70% of the cash invested in the SAFT round ($35 million of the $49 million raised) to the SAFT investors.
Kik began offering Kin to the general public during the same period of May through September 2017 in which it was conducting the offer and sale of the SAFTs. With the September 30 deadline looming, Kik proceeded with closing the public token sale one day after the SAFT offering was completed. Kik raised an additional $50 million in the public sale, with proceeds paid in Ether currency.
Two months before bringing the lawsuit against Kik in June of 2019, the SEC published a framework for analyzing the circumstances under which a digital token would be deemed an investment contract and thus a security. It was intended to assist compliance with the U.S. federal securities laws by startups seeking to be funded by an initial coin offering by providing a toolkit for applying the Supreme Court’s Howey test to determine whether digital tokens are deemed to be “investment contracts” and therefor securities. Under Howey, a financial arrangement is an investment contract when there is an investment of money, in a common enterprise, with a reasonable expectation of earning a profit through the efforts of others.
Under the framework, the inquiry into whether a purchaser is relying on the efforts of others generally focuses on whether, at the time the digital tokens are sold, the sponsor of the tokens is responsible for the development, improvement, operation or promotion of the network, and whether there are essential tasks or responsibilities to be performed by a sponsor, rather than an unaffiliated, dispersed community of network users commonly referred to as a “decentralized” network. Other areas of focus are whether the sponsor creates or supports a market or price for the digital asset, and whether the sponsor has a continuing managerial role concerning the network or the characteristics or rights the digital asset represents.
Basically, where the network or the digital token is still in development and not fully functional at the time of the offer or sale, purchasers would reasonably expect a sponsor to further develop the functionality of the network or digital asset. Under such circumstances, purchasers would be determined to have a reasonable expectation of earning a profit through the efforts of others and the digital token would be deemed to be an investment contract and thus a security (assuming the other prongs of the Howey test are also satisfied).
The SEC’s Lawsuit Against Kik
The SEC sued Kik in June of 2019, alleging that Kik’s offering of Kin digital tokens violated Section 5 of the Securities Act.
The SEC devoted most of its complaint to asserting facts to establish that Kik failed the last two prongs of Howey, namely that purchasers of Kin had a reasonable expectation of earning a profit from Kin and that such profit would necessarily flow from the efforts of others, namely the managers of Kik. The focus of the SEC’s complaint was on three overarching factors: the manner in which Kik marketed Kin to investors, the lack of functionality of the Kin token and ecosystem and Kik’s motivation for selling Kin to the public prior to achieving functionality.
Kik was shown to have marketed Kin in a manner that emphasized Kik’s primary role in developing it and the potential for Kin to increase in value, rather than the underlying ecosystem and functionality of the token. Kik promised prospective investors that it would create demand for Kin by building new products, services and systems for the Kin ecosystem, by modifying Kik Messenger, by implementing new technology to allow for scalable, fast and cost-effective transactions, and by building a “rewards engine”. Kik also emphasized its experience and ability, and maintained that Kik itself intended to profit from Kin’s appreciation in value.
The complaint next asserted that Kik pursued the public sale without first achieving a decentralized economy for Kin, and without even ensuring that investors would be able to buy goods and services with the tokens upon their receipt. Instead, Kik pursued a “superficial Minimum Viable Product” in the form of digital cartoon “stickers”, intended as an added benefit to Kik Messenger users who purchased Kin. The stickers would appear inside Kik Messenger and would be available only to Kin buyers who also had a Kik Messenger account. The more Kin owned by a Kik Messenger user, the higher the user’s “status” level and the more stickers the user could access. According to the SEC, Kik developed the stickers in an effort to create a hypothetical “use” for the tokens, which Kik believed was relevant to whether its public sales of Kin were securities transactions under the securities laws.
So why didn’t Kik just defer the public sale until the Kin token and ecosystem were functional? Apparently, the $49 million of proceeds would not give Kik enough runway to complete the development of the Kin ecosystem and it needed to raise additional funds in the public sale. Moreover, Kik was racing against the SAFT’s aggressive deadline for completing the public sale and effecting the issuance of the first tranche of Kin to the SAFT investors; failure to meet the deadline would mean forfeiture of $35 million of the $49 million raised.
On the third anniversary of that deadline, Judge Alvin Hellerstein ruled that Kik had offered and sold securities without registration or exemption in violation of Section 5 of the Securities Act, granting the SEC’s motion for summary judgment and instructing the parties to submit a joint proposed judgment for injunctive and monetary relief.
Judge Hellerstein’s opinion consists of two basic findings: First, that the sale of Kin to the public was a sale of a security requiring either registration or exemption; and second, that although the pre-sale of SAFTs, if viewed in a vacuum, appeared to have qualified for an exemption under Rule 506(b), it was actually part of an integrated offering with the public sale, thus blowing the exemption.
As to whether Kin was a security, Judge Hellerstein applied the Howey test and focused largely on the last two prongs: whether there was (i) an expectation of profit, (ii) through the efforts of others. In its marketing campaign, Kik stressed the profit making potential of Kin, saying it would be tradable on secondary markets. Although Kik also characterized Kin as a medium for consumptive use for digital services such as chat, social media and payments, any such consumptive use was unavailable at the time of Kin’s public distribution and would only materialize if the enterprise became successful. Kik conveyed the notion that growth in value would rely heavily on Kik’s managerial and entrepreneurial efforts, saying that it would “provide startup resources, technology and a covenant to integrate with the Kin cryptocurrency and brand”. The judge also stressed that Kik’s insistence that market forces would drive the value of Kin “ignored the essential role of Kik in establishing the market”.
Even assuming Kik had met the requirements for an exemption under Rule 506(c) (primarily, use of reasonable methods to verify that all purchasers were accredited investors), the exemption would be blown if the SAFT presale would be found to be integrated with the public sale. That’s because the reasonable verification requirement was clearly not be met as to all the purchasers in the public sale. In determining whether two ostensibly separate offerings should be integrated, a court considers whether the offerings (i) are part of a single plan of financing, (ii) involve issuance of the same class of securities, (iii) have been made at or about the same time, (iv) involve the same type of consideration, and (v) are made for the same general purpose. Not all factors have to exist, and courts generally give the most weight to the first and fifth factor.
As to the first and fifth factor, the court found that the SAFT round and the public sale were part of a single plan of financing, effected for the same general purpose. Proceeds from both sales went toward funding Kik’s operations and building the Kin ecosystem. The two offerings were intertwined in ways that went beyond the use of funds, and the court used as an example that under the SAFTs, investors could not receive their Kin unless there was a successful launch through the public sale. The court also found that Kik offered and sold the same class of securities in the two offerings, namely fungible Kin that were equal in value. Although investors in the two offerings received the tokens via different instruments with different rights, the court determined the ultimate result was distribution of identical assets. Finally, the sales took place at about the same time. The only factor weighing against a finding of integration is that Kik received different forms of consideration from the two sales (dollars in the SAFTs, Ether in the public sale).
On October 21, the court entered final judgment on consent requiring Kik to pay a $5 million penalty, obligating Kik for the next three years to provide notice to the SEC before engaging in certain offers or sales of digital assets and permanently enjoining Kik from violating the registration provisions of the Securities Act.
There are a few valuable takeaways from this case.
First, the facts and circumstances were such that made it extremely easy for the court to conclude that the Kin digital tokens were securities. Because of the draconian forfeiture feature in the SAFT, Kik chose to speed up the public release of the tokens before reaching anything close to full functionality in order to avoid forfeiting $35 million. Kik’s marketing materials overwhelmingly emphasized the investment potential of the Kin tokens, rather than their utility. Not all future blockchain startups seeking to fund development through ICOs, however, will be under the kind of financial stress experienced by Kik, and should be able to resist the type of forfeiture feature the SAFT investors imposed on Kik. More importantly, given the SEC’s and the courts’ emphasis on token functionality, it should be evident that the amount raised in a SAFT should ideally provide sufficient runway to complete the development of the digital token and the underlying network to achieve full functionality.
Second, the court’s integration analysis suggests a very high bar to avoid integration and a blown exemption. Here again, the facts easily pointed to a conclusion that the presale and public sale should be integrated. The Kin public sale closed the day after the SAFT round, and both had the same general purpose. But the court also relied on two factors that could create unfair integration challenges to issuers in the future. One of those factors was that SAFT investors could not receive their Kin tokens unless there was a successful launch through the public sale. But that would be true of every SAFT, and the reliance on this point as a factor could throw into question the viability of SAFT based ICOs. The court also maintained that both the SAFT and the public Kin sale involved the issuance of the same security despite the fact that, as the court acknowledged, the respective investors received their securities through different instruments with different rights. This too is a universal feature in SAFTs and thus presents additional uncertainty to ICOs involving them. Hopefully, the courts will have an opportunity soon to clear up this uncertainty.