Type of Case: Securities Exchange Commission enforcement action pertaining to Kik Interative’s unregistered token offering.
Jurisdiction: United States District Court for the Southern District of New York – September 30, 2020
Procedural History: The SEC filed this action against Kik Interactive, Inc. and both parties moved for Summary Judgement, which was heard on September 30,2020.
Facts: Kik Interactive is a messaging service, which began in2009. Kik was more of a digital community than a messenger service. Kik did not share user’s third party data, therefore it had profitability issues. In an effort to reach profitability and also deepen their digital community Kik created “Kin”, a digital currency which they intended to use to broaden their digital community. Kik created a white paper and offered trillions of tokens in multiple different manners, including Pre-Sales and SAFTs. Kik’s offering of Kin was linked to the Ethereum blockchain.
The SEC seeks relief in the form of an injunction barring Kik from violating Section 5(a) and 5(c) Securities Act, disgorgement of ill-gotten gains, and monetary penalties under Section 20(d) of the Securities Act, 15 U.S.C. § 77t(d). Kik denied the allegations by asserting as a defense that the definition of “investment contract” is void for vagueness as applied to Kin. In other words, Kik posited that an investment contract as it relates to cryptocurrency is ambiguous.
The SEC’s MSJ claims that Kik’s Kin offering was an unregistered offering of digital tokens, which violated Section 5 of the Securities Act.
Kik’s MSJ claims that Kin was exempt from registration under Rule506(c) of Regulation D and that the term investment contract is vague in relation to cryptocurrency.
To put this in perspective, the SEC’s MSJ is more of a classic legal argument, whereas, Kik’s MSJ is rife with issues that are factual in nature and require balancing.
To prove a violation of Section 5the SEC was required to establish three elements: (1) That the defendant directly or indirectly sold or offered to sell securities; (2) that no registration statement was in effect for the subject securities; and (3) that interstate means were used in connection with the offer or sale.”
An investment contract for purposes of the Securities Act means 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.
The Court evaluated whether Kik’s offering was an investment contract through the lens of SEC v. W. J. Howey Co., 328 U.S. 293,which creates “three elements of the Howeytest” are “(i) an investment of money (ii) in a common enterprise(iii) with profits to be derived solely from the efforts of others”
INVESTMENT OF MONEY
Kik freely admits that it’s offering of Kin constituted an investment of money, which established the first element of Howey.
IN A COMMON ENTERPRISE
The Court determined that Kik’s offering constituted a common enterprise. A common enterprise within the meaning of Howey can be established by a showing of ‘horizontal commonality’. Horizontal commonality is the binding of each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets, usually combined with the pro-rata distribution of profits.”
The Court contemplated that the nature of a common enterprise is to pool invested proceeds to increase the range of goods and services from which income and profits could be earned. In the case of Kik, Kin was used to increase the range of goods and services that would enrich the digital community.
The court determined that Kik established a common enterprise. Kik deposited the funds into a single bank account, used the funds for its operations and promoted the offering through its digital ecosystem.
WITH THE EXPECTATIONS OF PROFITS DERIVED FROM THE EFFORTS OF OTHERS
The court views the expectation of profit through the wise eyes of 80 years of Howey precedent. Howey contemplates that an investor is “led to expect profits solely from the efforts of the promoter or a third party.” The Second Circuit “ha[s] held that the word ‘solely’ should not be construed as a literal limitation; rather, we `consider whether, under all the circumstances, the scheme was being promoted primarily as an investment or as a means whereby participants could pool their own activities, their money and the promoter’s contribution in a meaningful way.'”
The Court understood that it’s not about investors reaping profits, it was more about investors profits being tied to the success of the enterprise. In public statements and at public events promoting Kin, Kik highlighted investors’ profit making potential. In Kik’s white paper, they promised to “provide startup resources, technology, and a covenant to integrate with the Kin cryptocurrency and brand.” Kik’s CEO explained, Kik had a unique incentive to increase demand for Kin because it retained for itself 30% of the tokens created.
Kik argues that this consumptive use shows that its sale of Kin does not constitute an investment contract. However, none of this “consumptive use” was available at the time of the distribution. Kik’s two Pre-Sales were intertwined to such an extent that they went beyond use of funds. Through the use of SAFTs, Kik’s Pre-Sale behavior suggests that the offering is a single effort to raise capital to deploy Kin and financially benefit Kik as a company.
The only factor weighing against a finding of integration is that Kik received different forms of consideration from the two sales. For the Pre-Sale, Kik received consideration in the form of U.S. dollars. For the TDE, Kik received consideration in the form of Ether.
The Court struch an understanding tone and applied “a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”
Ultimately, the Court rules for the SEC, which is hostile towards the industry as a whole, but there are multiple silver linings. There was an undeniable element of compromise within the holding which is important and conciliatory. The SEC did not force Kik to register Kin as a security. The SEC didn’t impose trading restrictions on Kin. The SEC didnt attempt to unwind the Kin Foundation. Lastly, the SEC only imposed a 5 million fine on Kin, which was meager in comparison to overall market value.
The SEC “established that Kik’s sales of ‘Kin’ tokens were sales of investment contracts, and therefore of securities, and that Kik violated the federal securities laws when it conducted an unregistered offering of securities that did not qualify for any exemption from registration requirements.”
The SEC specifically states: “Nothing in this paragraph requires, or should be construed to require, Defendant to seek the Commission’s approval or consent prior to issuing, offering, selling, or transferring [KIN tokens], nor should this paragraph be construed to require Defendant to provide the Commission with any information beyond the notice contemplated herein.”
The effect of this case on the overall industry is mixed. To date, unless you are Bitcoin or Ether, it’s unclear whether you are a security. The chilling effect will always be there. In comparison to what the SEC has done to Ripple, Kik likely got off easily.
In actuality, the SEC’s position creates itself a perfect middle ground where crypto entrepreneurs still fear the long arm of the law but are unafraid to innovate. The SEC’s ruling is definitive, but leaves open whether Kin would be a security today. The SEC’s ruling is carefully tailored to allow for the evolution and intersection of crypto and securities.