(Reuters) - There is scant precedent on whether cryptocurrency developers can sell tokens to the public without triggering U.S. securities laws. So a decision Wednesday by U.S. District Judge Alvin Hellerstein in Manhattan, concluding that Kik Interactive violated U.S. securities laws when it sold a new digital currency called Kin in 2017, could loom large.
Judge Hellerstein granted summary judgment to the Securities and Exchange Commission, which alleged in a 2019 complaint that when the messaging platform Kik sold its newly-created digital currency Kin - in a $50 million private offering to qualified investors and a subsequent $50 million distribution of tokens to the public - it engaged in an unregistered sale of securities. To reach that conclusion, the judge had to answer a question that’s crucial to the future of the blockchain and digital currency industries: Are newly-issued digital tokens “securities” under the test set out by the U.S. Supreme Court in 1946’s SEC v. Howey (66 S.Ct. 1100)?
Judge Hellerstein said he is the first judge in New York specifically to answer that question on a summary judgment record. U.S. District Judge Kevin Castel of Manhattan sided with the SEC earlier this year in SEC v. Telegram (2020 WL 1430035), granting a preliminary injunction to block the launch of the Telegram Open Network blockchain, which was funded by private offerings of prospective digital tokens that would have traded on the network. But Judge Castel did not directly say whether digital tokens are themselves securities. In 2019, U.S. District Judge Vernon Broderick of Manhattan ruled in Balestra v. ATBCoin (380 F.Supp.3d 340) that the digital currency ABT Coin met the Howey test, but his decision addressed a dismissal motion in a shareholder class action. The SEC, which has been under fire from the blockchain industry for failing to provide clear standards on whether new digital tokens are securities, wasn’t a party in the case before Judge Broderick.
Kik, which was represented by Cooley and Kirkland & Ellis, said in a press release about Wednesday’s ruling that it is considering an appeal. “We continue to believe that the public sale of Kin was that of a functional currency and not a sale of securities,” the statement said. Kik’s general counsel, Eileen Lyon, said in the company’s press release that Judge Hellerstein’s decision “may raise more questions than it answers” for the industry, faulting the SEC for failing to engage in public rulemaking on the intersection of digital currency and securities laws.
An SEC spokeswoman declined via email to comment on the Kik ruling.
Kik clearly tried to structure its Kin offerings to avoid triggering obligations under U.S. securities laws. It first entered into agreements to provide future tokens to 50 accredited investors in a private offering. Kik acknowledged that its contracts with those investors, who agreed to pay U.S. dollars for a right to receive Kin at a discounted price when the tokens launched on the Ethereum platform, were securities, but it maintained that the private offering was exempt from registration because it involved only qualified investors. The day after the private offering closed, Kik sold Kin to members of the public. Those purchasers, who bought the tokens with the digital currency Ether, agreed to purchase terms that said Kin tokens were provided with no warranties or conditions, just for use as currency within a new, Kik-created “ecosystem” of products and services. According to Kik’s motion for summary judgment, those terms established that Kin was not an investment but merely a medium of exchange, like Bitcoin and Ether, which the SEC has deemed not to be securities.
The SEC’s filings contended that the two Kik offerings should be considered a single campaign to market Kin to the public with assurances that the tokens would appreciate in value with help from Kik. “Kik relentlessly pitched Kin and the prospect that Kik’s future efforts to develop the Kin Ecosystem would drive an increase in Kin’s value,” the SEC said in its complaint. “Kik promised that it would spur such demand by dedicating company expertise and resources.”
Judge Hellerstein’s analysis focused on two prongs of the Howey test: Was the sale of Kin a “common enterprise”? And would investors derive profits “solely from the efforts of others”? (Kudos to the judge for digesting hundreds of pages of briefing on competing summary judgment motions into just 19 pages!)
Kik, he said, created a common enterprise by emphasizing the importance of the Kin ecosystem. It told investors in the private offering, the judge said, that their money would be used to develop a platform for Kin owners to spend their tokens, whether on tangible stuff like sunglasses or services like pay-to-participate chat groups.
“The success of the ecosystem drove demand for Kin and thus dictated investors’ profits,” Hellerstein said. “This is the nature of a common enterprise, to pool invested proceeds to increase the range of goods and services from which income and profits could be earned.”
And Kik satisfied the third Howey prong, Judge Hellerstein said, by telling investors that the value of their Kin would rise as a result of Kik’s “entrepreneurial and managerial efforts.” As a digital currency, the judge said, Kin tokens have no inherent value. Their only worth comes from serving as a means of exchange for goods and services on the Kin ecosystem – which depended on Kik for development. (The supply of Kin, the judge noted, also depended on Kik, which controlled a huge chunk of the currency.)
Hellerstein was not persuaded by Kik’s arguments that its terms of purchase in the public offering expressly made no promises that Kin would be profitable, citing instead public statements in which “Kik extolled Kin’s profit-making potential.” He also rejected Kik’s contention that the public and private offerings were discrete events. The offerings, he said, “were part of a single plan of financing … for the same general purpose.”
The Blockchain Association, a group of 27 crypto companies, filed an amicus brief in the Kik case, asking Judge Hellerstein to issue a narrow ruling based only on the facts of the Kin offering. The judge did that, rooting his decision in specifics rather than broad conclusions about the nature of digital currency offerings. He even emphasized that “every cryptocurrency, along with the issuance thereof, is different and requires a fact-specific analysis.” That could limit the impact of the decision across the industry.
But the judge also rejected one of the industry’s favorite arguments. The amicus brief echoed Kik’s assertion that the SEC has left blockchain developers and digital currency creators at sea because it has not articulated a clear set of rules and regulations about when digital tokens are securities and when they aren’t. The commission, according to this argument, is constitutionally prohibited from suing developers under its vague standards. But Judge Hellerstein ruled that Howey and case law interpreting the Supreme Court’s test for a security provides “sufficiently clear standards to eliminate the risk of arbitrary enforcement.”
Wednesday’s decision did not specify what relief the SEC is entitled to. The commission wants Kik to disgorge “ill-gotten gains” and pay a civil penalty.
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