June 5, 2019 – The U.S. Securities and Exchange Commission (SEC) has filed a lawsuit against Kik Interactive Inc. (Kik) for the offer and sale of unregistered securities.[1] In its complaint, the SEC alleges that Kik, over a five-month period in 2017, offered and sold one trillion digital tokens called “Kin.” This initial coin offering (ICO),[2] the SEC alleges, violated Section 5(a) and (c) of the Securities Act of 1933.[3] The SEC is seeking a permanent restraining order from violating the Securities Act; disgorgement of “all ill-gotten gains” derived from the sale; and a civil penalty.

The SEC’s lawsuit against Kik is the agency’s first official enforcement action involving an ICO. It is being closely watched by the entire cryptocurrency world, including investors, platforms, those that have already sold digital assets, and every company that is considering launching an ICO. The outcome of the lawsuit will have a wide impact on a nascent area of law. If the SEC is successful, the case could reset the regulatory playing field for cryptocurrency and ICOs. If the SEC is unsuccessful, then new legislation will probably be needed to regulate the digital coin market. Though, this still may be needed even if the SEC wins. Of course, the case could settle. Either way, this is must watch litigation.

Below is a summary of what triggered the action, some background on the SEC’s interest in the cryptocurrency world, the SEC’s initial investigation, and a few main points from the SEC complaint.

The Securities Act Of 1933

The Securities Act of 1933 regulates the offer and sale of securities. A security is broadly defined to include many types of investment “vehicles”, such as any note, stock, bond, debenture, evidence of indebtedness, or investment contract.[4] Every offer and sale of a security in the U.S. must either be: (1) registered with the SEC; or (2) subject to an exemption from registration under the Securities Act.

Who Or What Is Kik & What Did It Do? – May – September 2017

Kik is a Canadian company that owns and operates a mobile messaging application called Kik messenger. After facing financial trouble in 2016 and 2017, Kik attempted to sell itself to a larger tech company, but was unsuccessful. In early 2017, “Kik began to devise a plan to offer and sell digital tokens,” as a way to solve its financial problems and keep the company afloat.[5] Kik publicly announced its plan using many forums beginning in May 2017. Kik also announced a plan to create a “Kin Ecosystem” which “could be used to buy goods and services,” and said it would redesign the Kik app to incorporate Kin. Further, Kik explained that there would be secondary trading platforms – also known as online exchanges – where Kin could be converted to other digital assets, such as Bitcoin or Ether, or to U.S. dollars. An example of such an exchange is Coinbase, where numerous types of cryptocurrency can be converted, sold, or purchased. Like other cryptocurrencies, the amount of Kin would be finite. Kik told potential buyers that, by allotting 30 percent of the outstanding supply of Kin to itself, the company would align its financial interests with those of other Kin investors.[6]

From roughly May through September 2017, Kik offered and sold Kin tokens to professional investment funds and other select, wealthy investors at a discount to the price that the general public would pay, using Select Agreements for Future Tokens (SAFTs). Kik raised approximately $49 million this way.[7] Kik’s sale of Kin to the general public was denominated in Ether, a well-known cryptocurrency. Kik received approximately $50 million in Ether for the public sale of Kin.[8] According to the complaint, U.S.-based investors accounted for over $55 million in cash and Ether received by Kik for the Kin ICO.

The SEC’s DAO Report – July 2017

On July 25, 2017, the SEC released a report on its investigation of whether “The DAO” and its agents may have violated federal securities laws.[9] As explained by the SEC, “The DAO is one example of a Decentralized Autonomous Organization, which is a term used to describe a ‘virtual’ organization embodied in computer code and executed on a distributed ledger or blockchain.” The DAO was created to raise funds from the public, and then use those funds to “support charitable projects.” The gist of the DAO Report is summed up in the opening paragraph of the SEC’s press release:

The Securities and Exchange Commission issued an investigative report today cautioning market participants that offers and sales of digital assets by "virtual" organizations are subject to the requirements of the federal securities laws. Such offers and sales, conducted by organizations using distributed ledger or blockchain technology, have been referred to, among other things, as "Initial Coin Offerings" or "Token Sales." Whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.

The SEC’s Investigation Of The Cryptocurrency Industry – 2018

In 2018, the SEC reportedly sent a subpoena to cryptocurrency firms, sellers, investors, and platforms, as part of a broad investigation into the world of cryptocurrency and ICOs. The SEC subpoenas requested information about the sale of new digital coins and how ICOs are structured. It’s important to note that the U.S. is not the only country where cryptocurrency is being created and sold. In terms of regulation, cryptocurrency and ICOs are subject to various requirements and restrictions based on the country where they are launched.

The SEC Enforcement Decision Preliminary Investigation Of Kik – November 2018

In November 2018, the SEC’s Enforcement Division notified Kik that it had made a preliminary determination to recommend that the SEC file an enforcement action against Kik. Pursuant to established SEC procedural process, Kik responded with a Wells Submission, setting out its position and legal arguments opposing an enforcement action.

Kik’s legal argument boils down to whether Kin is a security. Kik claims an enforcement action would exceed the SEC’s statutory authority because Kin, a currency, is exempt from securities laws. That’s the gist of it without going into details. One other important point is that Kik made its response to the SEC notice publicly available on the kin.org website. Most often, the notice and response process is kept private between the Enforcement Division and the target company. By doing this, Kik may be signaling that it will fight any action in court, and may be trying to rally the broader cryptocurrency industry to the fight against SEC regulation.

The SEC’s Complaint – June 2019

The SEC alleges Kik’s sale of Kin digital tokens is the offer and sale of unregistered securities in violation of the Securities Act. Here are some of the main allegations in the SEC’s complaint:

The SEC alleges Kik offered and sold securities from May 2017 through September 2017 without filing a registration statement. Neither the offering nor component sales were registered with the SEC, and no registration exemption applied to the offering or to any of these sales.

By failing to prepare and file a registration statement, Kik did not provide important information to investors regarding the investment opportunity promoted by Kik, such as information about Kik’s current financial condition (including that the company’s expenses far exceeded its revenue), future plans of operation and budget, the proposed use of investor proceeds, and detailed disclosure of material trends and the most significant factors that made the offering speculative and risky.

In the initial announcements of the Kin project and throughout the Kin offering, Kik told potential purchasers that they would be able to easily liquidate their Kin holdings and that Kin would trade on online trading platforms, which Kik referred to as “exchanges,” soon after issuance.

Kik filed a Form D with the SEC with respect to the Kin offered and sold via the

SAFTs; however, those offers and sales were not exempt from registration under Regulation D, which was promulgated under the Securities Act. The exemption does not apply because the offer and sale of Kin via Kik’s SAFTs was part of a single offering of Kin to the general public that raised $100 million, or, in the alternative, was integrated with the offering of Kin whose sales began on September 12, 2017, and neither the totality of the offering nor the non-SAFT portion of it was limited to accredited investors.

In addition, Kik did not exercise reasonable care to assure that the purchasers of Kin via the SAFTs were not statutory underwriters of Kin within the meaning of Section 2(a)(11) of the Securities Act.

Kin is currently trading on unregulated trading platforms at about half of the value that public buyers paid in the offering, and, during the intervening period, it has often traded much lower.

By engaging in the conduct set forth in this Complaint without a registration statement being in effect or filed, Kik has engaged in the unlawful offer and sale of securities in violation of Sections 5(a) and 5(c) of the Securities Act.

The SEC is seeking a judgement (1) permanently restraining and enjoining Kik from violating the Securities Act; (2) ordering Kik to disgorge “all ill-gotten gains or unjust enrichment” derived from the unregistered offering and sale of securities, with prejudgment interest; and (3) ordering Kik to pay a civil penalty.

**************

[1] Securities and Exchange Commission v. Kik Interactive Inc., Case No. 19-cv-5244, Complaint, U.S. District Court for the Southern District of New York (filed June 4, 2019) (Complaint).

[2] An “Initial Coin Offering” or “ICO” is a fundraising event in which an entity offers participants a unique digital asset – often described as a “coin” or “token” – in exchange for consideration (most commonly Bitcoin, Ether, U.S. dollars, or other fiat currency). The tokens are issued and distributed on a “blockchain” or cryptographically secured ledger. Complaint at 29.

[3] Section 5(a) of the Securities Act provides that, unless a registration statement is in effect as to a security or an exemption from registration applies, it is unlawful for any person, directly or indirectly, to sell securities in interstate commerce. 15 U.S.C. § 77e(a). Section 5(c) of the Securities Act provides a similar prohibition against offers to sell or offers to buy, unless a registration statement has been filed or an exemption from registration applies. 15 U.S.C. § 77e(c). Thus, Sections 5(a) and 5(c) of the Securities Act prohibit the unregistered offer or sale of securities in interstate commerce absent an exemption.

[4] 15 U.S.C. § 77b(a)(1). To determine whether an asset or investment vehicle is a security, the “Howey Test” is usually applied. It comes from a 1946 Supreme Court case: “The test of whether there is an ‘investment contract’ under the Securities Act is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others; and, if that test be satisfied, it is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value. SEC v. Howey Co., 328 U.S. 293, 301 (1946).

[5] Complaint at 8.

[6] Complaint at 10.

[7] Complaint at 12.

[8] Complaint at 13.

[9] Securities and Exchange Commission, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Release No. 81207 (July 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf.