The SEC Takes Aim at Another Initial Coin Offering

Overview


A recent complaint concerning KIK Interactive Inc. filed in the US District Court of the Southern District of New York reveals some SEC priorities for cryptocurrency enforcement actions. The complaint indicates that the SEC believes that even if a “simple agreement for future tokens” (SAFT) is itself exempt from securities registration, an analysis of any digital asset offered or sold using the SAFT must be assessed separately under US Securities laws.

In Depth


The SEC is pursuing another company for its initial coin offering (ICO), alleging in a complaint filed in the United States District Court for the Southern District of New York (SDNY) on June 4, 2019 (the Complaint), that KIK Interactive Inc. (Kik)’s ICO constituted an unregistered sale of securities. Interestingly, the SEC has taken aim at a company that utilized the once popular “Simple Agreements for Future Tokens” (more commonly referred to as a “SAFT”) to sell its virtual currency. The Complaint indicates that the SEC believes that even if a SAFT is itself exempt from securities registration, an analysis of any digital asset offered or sold using the SAFT must be assessed separately under the US Securities laws. When considering whether a sale of virtual currency is a security, the question is whether the sale constitutes an “investment contract” under the Securities Exchange Act of 1934 and SEC v. Howey, 328 U.S. 293 (1946) and its progeny. Whether an investment constitutes an “investment contract” is referred to as the “Howey test.” Under Howey, an offering is an investment contract, and therefore a security, where there is an (1) investment of money; (2) in a common enterprise; (3) with the expectation of profits to be derived solely from the efforts of others. Further analysis on this topic is available in the following articles: Blockchain Tokens: the SEC Staff Issues Its Framework for Determining Whether an ICO Is an Issuance of Securities, Digital Token Offerings and Sales Under Regulation S, SEC Director Makes Groundbreaking Speech About Blockchain Token Sales, and Compliant Structures for Securities Offerings of Blockchain Tokens.

As in the SEC’s actions against Paragon and Airfox, the SEC referenced, and took into account, Kik’s white paper, marketing materials and statements on social media in the making of its determination, and decided that the ICO constituted an unregistered offering of securities.

The Complaint serves as another reminder that the SEC is focused on sales and distributions of digital assets, including ICOs, and how ICOs are marketed. The SEC continues to examine ICOs that took place years ago, before certain of the more recent SEC guidance on digital assets was issued. Companies in the industry must exercise extreme caution in structuring, marketing and offering digital assets, whether structured as an ICO or otherwise.

Summary

Kik, a messaging application company through the sale of Kin tokens, raised more than (the equivalent of) $100 million USD, and $55 million USD of that total came from US investors. At the time the Complaint was filed, Kin tokens were trading at about half the price investors had paid for Kin tokens in connection with the ICO. The price of Kin tokens has been dropping precipitously ever since the filing of the Complaint. According to the SEC, “Kik told investors they could expect profits from its effort to create a digital ecosystem . . . future profits based on the efforts of others is a hallmark of a securities offering that must comply with the federal securities laws.” Ultimately, the SEC alleged that, notwithstanding the SAFT structure, the Kik ICO constituted an unregistered sale of securities.

Kik’s Marketing

Like many companies engaging in ICOs, Kik issued a “white paper” prior to the ICO, which came back to haunt Kik. The SEC cited repeatedly to the white paper throughout the Complaint. The SEC also pointed to press releases, speeches by Kik’s chief executive officer, presentations to potential investors, YouTube postings, various social media postings and television appearances. The SEC’s main focus was the fact that Kik had promised investors that Kik’s efforts would result in profits for the investors. The SEC referenced the fact that Kik “promised” investors that Kik would spur demand for Kin tokens by 1) redesigning the “Kik Messenger” (Kik’s messaging application) to incorporate Kin tokens; 2) by creating a “rewards engine” to compensate companies that fostered Kin token transactions; and 3) by implementing new “transaction services” that would address flaws in existing blockchain technology. According to the SEC, these promises and statements indicated that Kin tokens satisfied the third prong of the Howey test because they indicate an “expectation of profits to be derived from the efforts of others.”

The SEC also cited to the fact that Kik highlighted in its marketing materials that contain members of Kik management that would profit alongside other investors because they would also be holding Kin tokens. According to the SEC, Kik assured buyers that after the ICO, Kin tokens would be sold on secondary virtual currency exchanges. According to the SEC, these allegations further indicate that investors in Kin tokens were expecting profits to be derived from the efforts of others under Howey.

The Kik Complaint is another reminder that companies that have launched ICOs need to be particularly careful with their marketing materials and statements on social media. For example, Kik apparently wrote in a tweet the following, seemingly equivocal statement about Kin tokens being adopted by virtual currency exchanges: “We have been given indication from multiple exchanges that they plan to list the token, no specifics available yet though. :)” At first glance, this tweet might appear to be mere puffery or standard marketing, but the SEC cited it and provided a screenshot in the Complaint as a reason why the Kik ICO constituted the unregistered sale of securities. When considering the Howey test, and whether an ICO satisfies the “expectation of profits derived from the efforts of others” prong, the SEC appears to be acutely focused on statements made in marketing materials and social media.

Kik’s SAFTs

Kik offered pre-sales of Kin tokens by using “Simple Agreements for Future Tokens” or “SAFTS.” While the Kik SAFT asserted that the SAFT itself was exempt from registration under Section 4(a)(2) of the Securities Act and Regulation D, Kik did not claim a separate exemption for the offer and sale of the Kin tokens themselves. The SEC claims that Kik’s failure to have a separate exemption for the underlying Kin tokens rendered the ICO an unregistered sale of securities. More specifically, the SEC alleges the following:

Although Kik’s SAFT specifically stated that the SAFT was itself a security, it failed to state that the Kin to be delivered under the SAFT were securities sold pursuant to the SAFTs. And although Kik’s PPM claimed that the offer and sale of the SAFTs were subject to an exemption from registration under Section 4(a)(2) of the Securities Act and Regulation D promulgated thereunder, among other United States laws, Kik did not claim any exemption for the offer and sale of Kin through the SAFT. As such, Kik’s offer and sale of the SAFTs and Kik’s offer and sale of the Kin purchased under the SAFTs were not registered.

While SAFTS have been popular mechanisms to pre-sell tokens in anticipation of an ICO, the SEC appears to have taken a dim view as to their legality if it is determined that the underlying virtual currency is a security.

Kik also raised money from venture capital investments and the general public. But it pooled all the proceeds from the sales of Kin into two Kik bank accounts and an Ethereum wallet.

Information Available to Kik at the Time of the ICO

The SEC noted that the DAO Report was issued seven weeks before the ICO, and alleged that the report should have provided sufficient warning to Kik that its planned ICO would violate federal securities laws. See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Release No. 81207 (July 25, 2017). The SEC also cited communications between Kik and its “New York-based consultant” to support the SEC’s allegation that Kik was advised that its ICO would constitute a securities offering.

In addition, the SEC pointed out that Kik has spoken with the Ontario Securities Commission, which indicated that the contemplated ICO constituted an offering of securities. Kik subsequently barred Canadians from the ICO, but launched the offering in the United States without first contacting the SEC.

It is important to note that Kik’s sales concluded in September of 2017. Since September of 2017, the SEC and other regulators have issued significant relevant guidance, including the most recent Framework for ‘Investment Contract’ Analysis of Digital Assets. See also Blockchain Tokens: the SEC Staff Issues Its Framework for Determining Whether an ICO Is an Issuance of Securities.

Emails Undermining the “Utility” Aspect of the Kik Offering

Apparently Kik gave investors “crypto stickers,” which were images that users can send to one another on the Kik messaging application. This, according to the SEC, was a ruse to “create a hypothetical ‘use’ for the tokens, which Kik believed was relevant to whether Kik’s sales of Kin were securities transactions under the securities laws.” Presumably, this was Kik’s effort to provide a “utility” aspect to its offering in the hope that Kin tokens would be considered “utility tokens” in then-current parlance, and, therefore, not securities. But emails sent by Kik executives undermined this argument. For example, one Kik executive sent an email stating the following: “Basically it doesn’t really matter. The whole point is to make our legal department happy, not the users (who are actually investors and probably could care less that they got a sticker pack for their $10K investment into KIN).”

Background of the Kik Investigation and Significance to the Industry

Kik received its first inquiry from the SEC on September 15, 2017. The SEC issued a series of subpoenas and took testimony from at least 10 witnesses in 2018.

When companies are under investigation by the SEC, they are given a “Wells” notice when the SEC staff comes to a preliminary conclusion that an enforcement action is necessary. The company is then given an opportunity to submit a memorandum spelling out why the SEC should not proceed with an enforcement action. These are called “Wells” submissions. Wells submissions are routinely filed with the SEC and are usually not released to the general public.

Kik received a Wells notice from the SEC on November 16, 2018. Kik responded with a detailed memorandum on December 10, 2018. However, Kik took the highly unusual step of publishing its Wells submission publicly on its website. The public filing of Kik’s Wells submission received substantial attention and garnered support from significant members of the virtual currency industry. Kik maintained its offensive with press releases, describing, in Kik’s view, “what has been going on behind the scenes with the SEC.” Prominent players in the virtual currency industry then marshalled their resources to hire law firms to help defend the investigation into Kik. Indeed, Kik launched a legal defense fund called “Defend Crypto” which, at the time of the writing of this article, had received the equivalent of $4,405,133 USD in various virtual currency (primarily Bitcoin and Ethereum). The Defend Crypto website calls for donations stating “if you too are fed up with this innovation tax, we encourage you to contribute also as we take on the SEC on behalf of the future of crypto in the US.” Following the filing of the SEC Complaint, Kik CEO Ted Livingston stated, “We have been expecting this for quite some time, and we welcome the opportunity to fight for the future of crypto in the United States.”

There is no question that Kik has taken an aggressive approach with the SEC. Both Kik and the SEC have become emboldened during the course of this investigation, and we anticipate a    hard-fought legal battle that could significantly alter virtual currency law. We anticipate that Kik will be filing a motion to dismiss. If the Court were to dismiss the Complaint, it would be a significant blow to the SEC’s ability to enforce upon virtual currency companies. If the Court rejects that motion to dismiss, the SEC will likely continue to aggressively pursue similar causes of action against other virtual currency companies that previously launched ICOs. This is perhaps most significant to the many virtual currency companies that launched ICOs in 2017 using the same or similar structures as Kik.

Conclusion

This is another aggressive action by the SEC indicating that the SEC will continue to actively investigate virtual currency companies. In particular, the SEC remains focused on ICOs and other sales and distributions of digital assets launched in 2017, long before additional clarifying guidance was issued. Companies that have launched ICOs need to be very careful with their external and internal communications and marketing materials. A tweet, reddit post or email that appears funny, innocuous or like mere puffery at the time could wind up in an SEC complaint. This action also impacts, perhaps even more significantly, companies that have already launched ICOs with the same or similar structures as Kik. The SEC is aggressively policing ICOs, and companies that have launched ICOs in the past would be well served to analyze their past ICOs and determine what can be done to limit potential exposure to SEC enforcement actions. While the SEC has taken aim at a company that used SAFTs to pre-sell its ICO, this enforcement action is not necessarily the death-knell for SAFTs. Kik will have the opportunity to fight these allegations, and the industry will be watching with great interest, since the case will likely lead to court decisions that could significantly shape how ICOs are launched—and regulated—in the future.