Preston Byrne, a columnist for CoinDesk's Opinion section, is a partner in Anderson Kill's Technology, Media and Distributed Systems Group. He advises software, internet and fintech companies. His biweekly column, “Not Legal Advice,” is a roundup of pertinent legal topics in the crypto space. It is most definitely not legal advice.
At the tail end of last week, the U.S. Securities and Exchange Commission (SEC) filed a motion for summary judgment in its litigation against Kik.
By way of background, Kik was a (failing) instant messenger product backed by a number of VCs including Union Square Ventures’ Fred Wilson, who at one point sat on the company’s board. To revive its fortunes, in 2017 the company decided to launch an $100 million Initial Coin Offering, or ICO, whereby the company offered tokens called “kin” to be used as payment tokens within a to-be-built “Kin Ecosystem” led by none other than Kik itself.
As to the sale of tokens, Kik wrote in its white paper:
Recalling briefly that the common-law Howey Test for determining whether a scheme is a security for the purposes of U.S. law (and therefore subject to securities regulation) is “[a] an investment, contract, or scheme involving [b] the investment of money [c] into a common enterprise with [d] the expectation of profits [e] arising from the efforts of a promoter or third party,” what Kik described in its white paper sounds like it ticks rather a lot of those boxes.
Suffice it to say, Kik disagrees with that assessment, arguing purchasers of kin neither (a) were investing in a common enterprise nor (b) were they done with the expectation of profits nor (c) were they made to the investing public, being conducted under a private placement exemption under Rule 506(c) of Regulation D under a contract for the sale of tokens known as a Simple Agreement for Future Tokens, or a “SAFT” for short.
The SAFT, for those of you who have not seen one, is a contract that forms part of a two-step coin issuance structure pioneered by a number of white shoe law firms in New York back in the 2017-18 period.
The SAFT allowed token issuers to sell a promise of future token delivery to investors rather than selling the tokens themselves to investors. The logic behind this approach was selling tokens directly to investors ran the risk of turning those tokens into securities for the purposes of U.S. law, with attendant regulatory consequences. As the legal status of tokens sold directly for investment purposes was, at least among firms whose books of business swelled with token issuers, uncertain back in 2016-17, the SAFT promised certainty to investors by treating at least the initial transaction unambiguously as a securities offering.
On delivery of a functional network at a later date, when the note converted into tokens, the tokens would lose their character as securities and instead became “utility tokens.” At that point, they would function as, and be regulated as, any other licensed software product, save that these “utility tokens” would be run on decentralized networks rather than being used to purchase software from a central provider.
This approach should be contrasted to industry practices in the 2013-16 period, when coin issuers usually sold their tokens directly to the investing public. The SEC undertook little enforcement except in cases of egregious fraud such as, for example, the Josh Garza/Paycoin Ponzi scheme which collapsed in early 2014.
From mid-2017 onwards, following the SEC's “DAO Report of Investigation,” which was widely regarded as a warning shot towards coin issuers, industry best practice evolved so that virtually all tokens sold in the United States by reputable projects were issued by SAFT and not directly to the public.
Although there are some systems for which the “utility token” argument might make sense (systems which use on-chain tokens to regulate bandwidth or decentralized storage, for example), there are many others for which it does not. Personally, Telegram’s TON and Kik’s kin strike me as not serving any functionality other than being a money-substitute and investment vehicle, although whether this is legally the case will depend on the outcome of the litigation.
The SEC appears to be trying to look through the two-step SAFT issuance process that became so common in the 2017-19 period, arguing it was an intermediate step was an artificial attempt to skirt securities laws. In both Telegram and Kik the commission says distributing tokens to investors in a SAFT with a view to onward distribution in the U.S. by those investors is not, in fact, a private placement but a preparatory step for a public offering via cryptocurrency exchanges, with the SAFT holders being regulated not as investors, but as as statutory underwriters for onward distribution to the public. This conduct is, of course, prohibited under Section 5 of the Securities Act of 1933, unless a registration statement has been approved by the SEC and the tokens are regulated as securities.
In a ruling granting the SEC a permanent injunction against Telegram last month, the court referred to the two-step SAFT-then-distribute-in-America as “a disguised public distribution.” In Kik, the SEC asks the court to do so once again. The commission alleges Kik failed to comply with the exemption from registration under rule 506(c) of Regulation D because Kik sold kin to both retail mom & pop investors and sophisticated accredited investors at the same time. Furthermore, citing Telegram, it argues “the portion of Kik’s offering to SAFT participants… was a public distribution of securities with the SAFT participants serving as statutory underwriters.”
For its part, Kik disputes this, arguing it was a separate offering of a software product that was meant to be used, rather than speculated upon: “Kik never advertised Kin as a passive investment… [it] repeatedly emphasized that Kin would be a medium of exchange in this new economy of digital services.”
The messages the government is sending are somewhat mixed. For example, Coinbase Pro lists a number of pre-sold tokens that differ very little from kin or TON in their manner of sale, but against which no enforcement has, at least publicly, yet taken place.
Prudence dictates that until further guidance is available, token protocol developers exercise extreme caution. If the SEC succeeds in this motion for summary judgment, the SAFT structure, which was once regarded as compliance best practice in the cryptocurrency industry, will be greatly diminished in its usefulness in the U.S.