On the last day of September 2020, Judge Alvin K. Hellerstein dashed the hopes of Kik Interactive, crypto entrepreneurs and Simple Agreement for Future Tokens, or SAFT, proponents in general by ruling in favor of the U.S. Securities Exchange Commission’s motion for summary judgment in SEC v. Kik Interactive.
The case was instigated by the SEC in June 2019 when the SEC filed an enforcement action against Kik Interactive Inc., (referred to in the complaint and here as Kik), a social media company that had used SAFT to launch its “Kin” crypto token in September 2017.
The SAFT and Kik’s SAFT process
As many folks in the crypto space know, the SAFT was originally modeled on the highly successful SAFT process in which entrepreneurs raised funds by selling contractual rights to acquire equity interests in an ongoing venture if and when the company issued those interests in a specifically defined broader distribution.
A SAFT similarly involves a two-stage process in which a crypto developer seeks to raise funds by selling contractual rights to acquire a crypto asset when it is launched. Upon the launch, if the crypto asset is a fully functional utility token, the hope has been that the token itself would not be a security. This would mean that while the original sale of the SAFTs would need to be registered or exempt under the securities laws, the sales of the functional crypto asset would not need to comply with the securities laws at all.
In the Kik complaint, the SEC claimed that Kik’s 2017 offering of SAFTs relating to Kin tokens was an unregistered, nonexempt sale of securities, involving a single planned distribution that needed to be viewed as part of the eventual token sale. Despite Kik’s arguments that it had engaged in two separate transactions (first, the “pre-sale” of contractual rights, and second, the sale of Kin tokens in its token distribution event, or TDE), Judge Hellerstein of the Southern District of New York ruled on Sept. 30, 2020, that these “two phases” were intertwined so that the sale of contractual rights and the eventual public offering of Kin tokens were part of a single plan of financing with a single purpose. As a result, the pre-sale and TDE “constituted an unregistered offering of securities that did not qualify for exemption.”
The ruling is indeed a significant setback for the crypto community, which had taken hope from Judge Hellerstein’s earlier comments distinguishing the preliminary injunction ordered by Judge Castel in SEC v. Telegram from the Kik case. However, despite recognizing the lack of direct precedent in relation to cryptocurrencies, the judge found that the Kin tokens were securities and that the entire plan of distribution violated federal law.
A more detailed consideration of the Kik ruling
In his decision, Judge Hellerstein applied the Howey investment contract test in determining that the Kin tokens were securities. He seemed particularly influenced by Kik’s promotional efforts extolling the profit-potential of Kin, the lack of consumptive uses available as of the launch, and references to the range of activities that Kik anticipated, which would support the growth of the Kin ecosystem and token value. He was not convinced by the minimum functionality — the existence of the wallet and the ability to send and receive premium stickers, and achieve and view Kin status — that existed at the time of the launch, or the prominent disclaimers of any contractual obligation for Kik to support the development of Kin or its ecosystem. Nor did he consider the extent to which the 57 Kin applications that currently exist and support value in the ecosystem were developed by persons other than Kik.
With regard to his conclusion that the pre-sale was part of an integrated offering, the judge looked to conventional integration doctrine. This requires a consideration of five factors:
- Is there a single plan of financing?
- Do the sales involve the issuance of the same class of securities?
- Were the sales made at or about the same time?
- Was the same type of consideration received?
- Were the sales made for the same general purpose?
Judge Hellerstein found that there was a single plan of financing for the same general purpose, based on the facts that the TDE started one day after the pre-sale, and all proceeds went to support Kik’s business or the Kin ecosystem.
While the lack of any temporal separation is hard to deny, there were a number of factors that could have weighed against the conclusion that was reached. For example, although everything that a business spends can be lumped together as business operations, there were doubtless different projects supported by the funds raised in the two stages. Certainly, the minimum functionality could not have been supported by funds raised in the second stage.
The two stages actually did not receive the same class of securities; the first class was the contractual right, and the second class was the crypto asset. The judge concluded that, ultimately, the results of the two stages were ownership of the same security, but this result is not compelled by the facts. And even the judge acknowledged that different consideration was received in the two stages of the offering, although he decided this was insufficient to change his conclusion.
One of the most problematic aspects of the decision is the reality that Kik’s distribution was planned and announced before the SEC had issued any guidance as to how the federal securities laws should apply to crypto asset sales. Kik had announced its plans on May 25, 2017, and began its pre-sale in June of that year. It was not until July 25, 2017, that the SEC released its “Report of Investigation Pursuant to Section 21 (a) of the Securities Exchange Act of 1934: The DAO,” or the “DAO Report.” This marked the first indication that the SEC intended to apply the Howey investment contract test — first developed by the U.S. Supreme Court in 1946 — to the novel crypto asset class. In addition, DAO tokens were specifically designed to work like a venture capital development fund for crypto-based enterprises. The decision to treat that kind of offering as a security seemed far removed from Kik’s proposed offering. As a result, Kik continued with its plans, initiating the TDE for Kin tokens on Sept. 12, 2017. It took almost two years for the SEC to initiate legal action against Kik for these sales.
The other troubling aspect is just how successful Kin has been. This is not a case that involves massive fraud and deception. Kik has followed through on everything it said it would do. It created the Kin ecosystem and has set up a structure that allows other developers to create applications in which the tokens can be used. If it were not for the SEC, Kik would be thriving, the developers would be happy and thriving, purchasers and users would be satisfied, and an innovative ecosystem would be experimenting with a unique technology that has uses and benefits yet to be fully realized. As it is, the future of this ecosystem is uncertain.
Where to go from here?
This is not the end of Kin. First, we do not know what consequences there will be for Kin. The Sept. 30 order does not include either an injunction or monetary penalty, although the court has asked the parties to subject proposed judgments for such relief by Oct. 20. Depending on the scope of that order, Kik and Kin might well continue to operate as they have been, or might be relegated to operating primarily outside the confines of the United States.
In addition, there are now 57 active Kin applications that offer opportunities to earn and/or spend Kin. Judge Hellerstein also noted:
“Based on blockchain activity excluding secondary market transactions, Kin currently ranks third among all cryptocurrencies.”
Thus, when Kik says that it is contemplating an appeal, it actually has more to lose and more, potentially, to gain than did Telegram. An appeal would give the Second Circuit an opportunity to weigh in on the issue of how the securities laws should apply to this transaction.
Lessons to be learned
As for other crypto entrepreneurs interested in the SAFT process, there are some lessons to be learned. For example, there are steps that might be taken in order to reduce the risk that the assets will be treated as securities. Entrepreneurs should be careful to avoid over-emphasizing the potential for profit from the efforts of the developer during distribution. In addition, having a robust range of functionality prior to issuance would be very helpful.
There are also steps that should decrease the chance that the two stages of the SAFT process will be integrated and treated as a single scheme. A gap in time between the contractual-rights sale and the token distribution phase is highly desirable. A period of months would be ideal.
Another way to discourage integration would be to give different names to the tokens issued to investors who originally purchased the contractual rights and the tokens issued to other purchasers upon launch. While in the wallets of the original purchasers, the tokens might have limitations on how quickly they could be resold or even limitations on the IP addresses of purchasers. Steps like this could bolster the notion that there are different classes of interest being sold.
In addition, the developer should strive to segregate funds received in each stage of the offering, earmarking proceeds from each part of the offering process for distinct functions. Having the two phases receive different types of consideration — such as fiat versus Ether (ETH) — is also a good idea, as noted in the Kik decision.
However, given that Judge Hellerstein’s opinion negatively impacts a very popular crypto asset, a company that did everything it said it would do, and an investor/user base that has been very happy with the opportunities that have been created, it is unfortunate that this is the way the SEC has chosen to proceed. If the SEC wants to come charging to the rescue, it would be nice if they first made sure that a rescue is warranted.
The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Carol Goforth is a university professor and the Clayton N. Little Professor of Law at the University of Arkansas (Fayetteville) School of Law.
The opinions expressed are the author’s alone and do not necessarily reflect the views of the University or its affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.