SEC v. Kik doesn’t have to be game-over for Kik or SAFTs. In fact, the
decision is perhaps more favorable than the SEC v. Telegram order.
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.
Related: Does Kik stand a chance against the goliath of the SEC in a US court?
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.
source link: https://cointelegraph.com/news/sec-versus-kik-safts-are-far-from-safe
