On September 30, 2020, SDNY Judge Alvin Hellerstein issued a decision of major significance for the digital token industry in Securities and Exchange Commission v. Kik Interactive, Inc. This is only the second federal court decision to address the question of whether funds raised to support a digital token through the Simple Agreement for Future Tokens (SAFT) model constitute a security that must be registered with the SEC. The court held that Kik’s pre-sale of its new digital asset, the Kin token, to private investors through SAFTs, coupled with the public distribution of this token following the private sale, qualified as a single public distribution and an unregistered security. This ruling, in combination with the Telegram decision issued in March 2020, provides important guidance to the token industry on the critical issue of how to raise funds.
This decision offers at least three key takeaways. Chief among them, as this case and the Telegram case demonstrate, courts will not stop at the four corners of a private sales contract in evaluating whether a series of transactions qualify as an investment contract, but rather will focus on the economic realities of the situation. Thus, adding disclaimers on paper that do not accord with the economic realities may ultimately provide precious little protection from regulatory oversight.
Second, this opinion signals that in order to be treated as a commodity, it is not enough for a digital token to have anticipated future consumptive use at the time of the sale. Rather, the token must have actual consumptive use and a digital ecosystem that supports those consumptive uses at the time of launch.
Finally, where private sales to accredited investors and a subsequent public sale are made in the same general time frame, are part of an integrated fundraising effort, and the proceeds from both are jointly used to invest in the digital token and build out the ecosystem supporting the token, courts are more likely to view these sales as part of a single public distribution.
So has the SAFT model been kicked to the curb? Not necessarily. To be sure, there are clear takeaways from this decision, as noted above. However, the Kik and Telegram cases make equally clear that the application of securities law to digital token fundraising efforts is highly fact specific, and each case must be assessed on its own set of facts. For further insight into the specific factors that drove the court’s decision here, read on.
The Court’s Decision
In 2010, Kik launched a messenger app, Kik Messenger, which now has 300 million users. In 2017, Kik decided to generate revenue by creating a token, Kin, that could be used for consumptive purposes within Kik Messenger. Kik sold future rights to Kin to accredited investors through a private sale from June through September 11, 2017. It used the SAFT model for these investors. Under Kik’s SAFT, the investors received the right to future Kin tokens at a 30 percent discount on the price offered to the public at launch. Kik required each investor to sign a legal disclaimer stating that it was entering into the agreement for its own account, and not for the purpose of resale. It also engaged in a public offering beginning on September 12, 2017, the day after the private sale ended. In total, Kik sold 1 trillion Kin and received $100 million from these sales. Fifty million dollars came from its sales to private accredited investors, and $49 million came from sales to the public. Kik and the Kin Foundation retained control of 90 percent of Kin distributed in its September 2017 sale to the public. Kik did not register the offering and sale with the SEC and did not publicly disclose its financial statements.
The Court’s Holding
The court held that these unregistered sales violated Section 5 of the Securities Act of 1933. Section 5 provides that it is unlawful for any person to sell a security in interstate commerce unless that security has been registered with the SEC. The dispute centered on whether the sales at issue qualified as the sale of a “security,” and the court held that they did.
The Howey Test
The court’s ruling turned on the application of S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946). Section 2(a)(1) of the Securities Act defines a “security” to include an “investment contract.” In what is known as Howey, the Supreme Court defined an “investment contract” as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” Thus, under the Howey test, an investment contract exists when there is:
an investment of money;
in a common enterprise;
with a reasonable expectation of profits derived from the entrepreneurial or managerial efforts of others.
Both parties agreed that the first element was present, but disagreed with respect to the latter two elements. The court found both present.
The Court’s Rationale
The court found a common enterprise because Kik deposited the funds from investors into a single bank account and used them to develop the digital ecosystem for the Kin token, which was crucial to the token’s value. The court stressed that Kik recognized and repeatedly emphasized that the success of the ecosystem would drive demand for the token and influence its value. The court was not dissuaded by the fact that the public investors checked a box agreeing to receive the tokens “as is.” It followed other courts in concluding that this provision must be viewed in light of the economic reality of the situation. It observed that the economic reality of the offering reflected that Kik pooled proceeds from the sales of Kin to create a digital ecosystem for the token to boost the value of the investment. It thus held that this arrangement amounted to a common enterprise.
The court likewise found that the investors reasonably expected profits to be derived from Kik’s entrepreneurial and managerial efforts. The court noted that in marketing Kin to investors, Kik touted the token’s profit-making potential. The court further observed that Kik’s CEO had emphasized to investors the limited supply of Kin as a reason why its value would increase as demand for the token increased, giving early investors an opportunity to profit.
The court rejected Kik’s argument that the sales of Kin did not qualify as an investment contract because of the token’s intended consumptive use, explaining that at the time of the sales, there were no goods or services available to purchase with Kin, such that it had no consumptive use at the time of distribution. It concluded that Kin would only become valuable by the promoter’s subsequent efforts to attract developers and invest in those opportunities for consumption. It found these efforts by Kik “crucial” to the potential value of Kin because absent development of the Kin digital ecosystem, “Kin would be worthless.”
Critically, the court held that Kik’s sales to private investors and to the public constituted a single public distribution that was part of an “integrated offering.” It considered five factors: (a) whether the two sales were part of a single plan of financing; (b) whether the sales involved issuance of the same class of securities; (c) whether the sales were made around the same time; (d) whether the same type of consideration was received in both sales; and (e) whether the sales were made for the same general purpose.
The court found four of these elements present. It concluded that the private investor sale and public sale were part of a single plan of financing and made for the same general purpose, as proceeds of both sales funded Kik’s operation and building the Kin ecosystem. It also relied upon the fact that in public and internal statements, Kik discussed its efforts to raise the $100 million collectively, treating both sales as part of a single fundraising effort. It further relied upon the fact that pre-sale participants could not receive their Kin tokens unless the token successfully launched through the public sale. The court thus found these sales were intertwined by design. In addition, it found that the sales were made around the same time and involved the same class of securities. Finally, while the consideration received in the two sales differed, the court held that, on balance, these factors constituted an integrated offering subject to Section 5’s registration requirements.
The court closed out its thoughtful analysis by recognizing that “every cryptocurrency, along with the issuance thereof, is different and requires a fact-specific analysis.”
This opinion thus provides welcomed guidance for the burgeoning token industry, while recognizing that there can be no one-size-fits-all answer to these nuanced regulatory questions.