In a much-anticipated decision with important implications for the cryptocurrency industry, a second New York federal judge has now ruled that an offeror's use of a two-stage "Simple Agreement for Future Tokens" or "SAFT" structure for issuing cryptocurrency tokens will not suffice to exempt the offering from the reach of US securities law. In this latest ruling, the court held that social-media company Kik Interactive Inc. violated US securities laws when it failed to register its 2017 sale of nearly US$100 million of its digital tokens, called "Kin," with the Securities and Exchange Commission. SEC v. Kik Interactive Inc., 2020 WL 5819770 (SDNY Sept. 30, 2020). This ruling comes on the heels of a similar decision earlier this year from the same court, SEC v. Telegram Grp., 2020 WL 1430035 (SDNY Mar. 24, 2020), where the court blocked cryptocurrency developer Telegram Group from selling its new cryptocurrency "Grams" to a group of private investors in the absence of a registration statement, by using a SAFT offering structure. See R. Schwinger, A 'Telegram' to SAFTs: 'Beware!' (NYLJ May 26, 2020).
SAFTs were conceived as a creative way for cryptocurrency issuers to bypass the registration requirements of US securities laws. The idea behind SAFTs was to use a two-part structure in which the initial issuance would fall under exemptions available for offerings made to accredited investors, but that investors would not receive cryptocurrency but only the right to receive digital tokens at a later stage, the theory being that because by that time the tokens would be fully functional and usable on the issuer's blockchain network, they would not be required to comply with registration requirements for securities offerings because they would longer be considered "securities" within the meaning of US securities laws.
In the earlier decision in Telegram, the Court rejected this theory, finding that Telegram's plan to distribute its "Grams" tokens using the SAFT structure was an offering of securities subject to US securities laws, including the registration requirements. Telegram prompted speculation about whether Kik's 2017 sale of Kin, which relied on a somewhat different SAFT structure, could survive judicial scrutiny. The court in Kik likewise ruled it could not. These two rulings send a strong message to cryptocurrency issuers that they are unlikely to be able to avoid the registration requirements of US securities laws by structuring public offerings of cryptocurrency tokens through SAFTs.
In 2017, Kik embarked on an ambitious campaign to raise US$100 million in capital through the private and public sale of its Kin. The transaction took place in two phases. First, Kik sold Kin to fifty accredited investors, through a series of SAFTs. Under the SAFTs, investors paid money for the right to purchase discounted Kin at a future date after the public offering of Kin. Kik raised US$50 million through these initial private sales. Immediately after completing the initial private sales, Kik conducted a public offering of Kin. Offering participants could purchase Kin by using another cryptocurrency called Ether. The public offering netted Kik an additional US$49 million, for a total of nearly US$100 million between the private sale and the public offering.
Kik's success proved short lived. In June 2019, the SEC filed a lawsuit against Kik, alleging that its distribution of Kin through the private sales and public offering was an illegal offer and sale of unregistered securities and did not qualify for any exemption from registration requirements.
Defining a "security": The Howey test
The main issue in the case was whether Kik's sale of Kin to the public in the second phase of the transaction was a sale of a "security" within the meaning of the US securities laws. Kik conceded that the initial private sales were sales of "securities." Because a "security" as defined in the Securities Act specifically includes an "investment contract," the Court considered whether the issuance of Kin through the public offering was an investment contract and, therefore, a security. To make this determination, the Court applied a three-part test established by the US Supreme Court in the 1946 case of SEC v. W. J. Howey Co, 328 US 293, 298-99 (1946).
Under the Howey test, a transaction is an "investment contract" within the meaning of the Securities Act if it involves (i) an investment of money, (ii) in a common enterprise, (iii) with profits to be derived solely from the efforts of others. The Court noted that it had little precedent to draw on in applying the Howey test, since "few courts" within the judicial circuit had applied the Howey test to cryptocurrency transactions, and the Second Circuit, the circuit's highest appellate court, had yet to address the issue. Kik conceded that the first part of the Howey test was satisfied because the issuance of Kin through the public offering involved an investment of money. Thus, the only issues in the case were whether the second and third prongs of the Howey test were met. The Court concluded that they were.
A "common enterprise"
The Court found that the public offering of Kin was a "common enterprise" under the second prong of the Howey test because it was part and parcel of Kik's efforts to increase the value and viability of Kin as a digital currency. Kik pooled together proceeds from the public offering of Kin with the goal of funding the construction of a so-called "digital ecosystem," where Kin would be the currency used to buy and sell a variety of digital products and services. This digital ecosystem was "crucial," the Court found, because the "success of the ecosystem drove demand for Kin and thus dictated investors' profits" by increasing the value of their Kin holdings. Further evidence of the common enterprise, the Court found, was the fact that any profits realized by Kik's investors in the public offering would be directly linked to the increase in the value of their Kin as a result of the digital ecosystem.
The Court rejected Kik's arguments that the "common enterprise" prong was not met because the terms of its agreement with participants in the Kin public offering expressly disclaimed any ongoing contractual obligations after the Kin were distributed, and because the participants in the public offering could sell their Kik whenever they wished. The Court concluded that these points did not negate the larger "economic reality" that the value of the purchasers' Kin in the public offering remained inextricably tied to the overall success of Kik's enterprise, including its digital ecosystem. This was sufficient to satisfy Howey's "common enterprise" prong.
"Profits derived solely from the efforts of others"
The Court also found that the public offering of Kin satisfied the final prong of the Howey test because investors in the public offering would have had a reasonable expectation of profits derived solely from the efforts of others, namely Kik. The Court noted that Kik repeatedly talked up and sought to expand Kin's "profit-making potential," including by initially limiting the amount of Kin that participants in the public offering could acquire, thereby allowing early purchasers to realize a profit as the demand and value of Kin increased. The Court also stressed that the value of Kin "would not grow on its own" but rather would "rely heavily on Kik's entrepreneurial and managerial efforts." To that end, Kik unveiled plans to make Kin tradeable on the secondary market through cryptocurrency exchanges and to integrate Kin into new and existing products and services, including Kik's own messaging application, Kik Messenger.
Kik argued that Kin could not be an investment contract and was properly characterized as a general purpose cryptocurrency intended for "consumptive use" in digital services like chat, social media, and payment. The Court rejected this argument, observing that "none of this 'consumptive use' was available" at the time of the public offering. Indeed, absent Kik's efforts to create a successful digital ecosystem that would drive demand for Kin, Kin not only would not be profitable to investors but "would be worthless."
No exemption from registration
Unlike the Kin public offering, Kik did not dispute that the initial sales of Kin to private investors involved the sale of "securities," and therefore were subject to US securities laws. Kik nevertheless argued that the initial private sales were exempt from registration requirements under Rule 506(c) of Regulation D, which exempts securities from registration requirements if the issuer takes measures to ensure that the investors are accredited and files certain forms to this effect with the SEC. The Court rejected this defense, viewing both the initial private sales and the public offering as part of a single and interdependent financing transaction for Kin. The Court noted that proceeds from both the initial sales and the public offering funded Kik's operations and the creation of the Kin digital ecosystem. Moreover, under the SAFTs, investors could not even receive their Kin until after their successful launch through a public offering. As further evidence of integration between the private sales and the public offering, the Court noted that Kik in its internal and public statements failed to differentiate between the two transactions, referencing only the US$100 million it had raised through both.
While the Court noted that Kik received different consideration in the private sales and the public offering—US dollars form the initial sales, and Ether from the public offering—the Court found that it was not sufficient to undercut the weight of the evidence that the transactions were integrated. Given the interdependence and shared purpose behind the two transactions, the Court concluded that they should be viewed as "part of a single plan" to launch Kin and its supporting digital ecosystem. The Court therefore concluded that both the initial sale and the public offering were part of a single unregistered offering and, as such, ineligible for an exemption from registration requirements under Rule 506(c).
Taken together, the Telegram and Kik rulings send a stark warning to cryptocurrency issuers that they are unlikely to be able to bypass securities regulations and requirements by relying on a two-stage SAFT structure. In both cases, the courts in deciding whether a cryptocurrency offering amounted to a sale of "securities" under US securities laws declined to view the stages in isolation but rather considered them together, focusing on the full economic reality of the transaction and not elevating form over substance.
In requiring these cryptocurrency token offerings to comply with the requirements of US securities laws, these cases simply reflect the current breadth of those laws rather than any conclusion of whether subjecting such offerings to those laws represents good public policy or is conducive to fostering innovation in the FinTech space. For this reason, new laws or regulations may be required if society concludes that a different approach is desirable to promote FinTech innovation. Indeed, Congress continues to consider a variety of new proposals that might change the current rules in this area for this reason. See, e.g., J. Brett, Two New Bills in Congress Offer Clarity for Blockchain Tokens and Crypto Exchanges (Forbes Sept. 24, 2020). In the meantime, cryptocurrency issuers who rely on SAFTs as a means to avoid having to comply with US securities laws most likely do so at their peril.