Digital Assets—Investment Contracts or Howey Test Unicorns? (Part 3 of 6)
In the third segment of his six-part series, Professor Ari Gabinet discusses the application of the Howey test in the case of digital currency utilized by instant messaging service Kik to build out its blockchain. Professor Gabinet draws on his expertise in securities law, accrued through experience as a private practice litigator, a private sector in-house counsel, and as a district administrator of the SEC.
Two SEC enforcement cases involving unregistered offerings of securities in the form of digital assets have seized the attention of entrepreneurs in the cryptocurrency world. SEC v. Kik Interactive, Inc., 2020 U.S. Dist Lexis 181087 (S.D.N.Y. September 30, 2020), and SEC v. Ripple Labs, Inc., et al, 20 Civ. 10832 (filed December 22, 2020), demonstrate the SEC’s enforcement posture on the central issue of when the public offering of a digital asset is a security offering that must comply with the registration and exemption requirements of the ‘33 Act.
SEC v. Kik Interactive: Application of Howey in a Contested Section 5 Case
Kik Interactive began as an instant messaging service that offered users digital tokens that could be used to purchase emojis for use in their messages. Kik wanted to be a messaging service that did NOT rely on advertising revenue and therefore did NOT sell its users’ information to third parties. Management realized that its ad-free model would not be financially sustainable on its own. The solution they came up with was to develop a blockchain-based environment with a digital currency that could be used to buy and sell goods and services through applications that operated on its blockchain.
Kik needed capital to build out the blockchain and related infrastructure, and they decided to do so through an offering of a digital asset called “Kin.” Kin was to be a digital currency that could be used in various digital applications that would operate on the Kik blockchain, offered in a fixed amount that would gain value through scarcity. Kik conducted a “pre-sale” of Kin—selling to a select group of institutional investors the right to purchase Kin at a discount if and when the blockchain was built and initiated. Recognizing that this sale was likely to be viewed as a security, Kik conducted the pre-sale through a private offering under an exemption from SEC registration. The $49 million raised in the private offering were used to build out the blockchain platform (including the ultimate creation of Kin virtual tokens).
Kik then conducted a “Token Distribution Event” (the “TDE”) in which it sold $50 million of Kin to the public without registering the offering with the SEC, and without attempting to use an exemption from registration. According to Kik, at the time of the TDE the Kik blockchain was complete and had been initiated. Kik intended to use the funds from the TDE for its ongoing operations unrelated to the Kin blockchain. The tokens were sold pursuant to agreements in which Kik made no representation regarding development of the Kin economy and undertook no obligation to make further development efforts. Kik’s public statements about Kin included suggestions that buyers could potentially reap substantial profits from potential appreciation of Kin. Kin asserted, however, that its value would be completely dependent on the extent to which it was useful as a currency and on perceptions of its scarcity. Kik did acknowledge that the TDE was intended to put Kin in the hands of users to “jumpstart” the Kin economy.
The SEC brought an enforcement action against Kik contending that Kin was a security —specifically an “investment contract”—and that Kik’s TDE—and the earlier exempt offering—were unregistered offerings that violated section 5 of the ’33 Act. Kik contended that Kin was NOT a security, and that the definition of investment contract was unconstitutionally vague as applied to Kin. The case turned on whether Kin was a security for purposes of the securities laws. The SEC’s position was that the TDE involved an investment contract under Howey. Kik argued strenuously that the TDE did not involve a common enterprise, and that the Kin blockchain was completed using the proceeds of the private offering, so that the TDE buyers were not dependent on any further work by Kik; the value of Kin would depend on independent developers building apps on the Kik blockchain.
Kik and the SEC submitted hundreds of pages of briefing. The first prong of Howey— investment of money or other value—was not disputed. But the other two issues were fiercely contested.
The Court found a common enterprise under the Second Circuit’s horizontal commonality test because the proceeds of the TDE were pooled in Kik's bank account—evidencing a “commonality” among the thousands of Kin holders. In addition, the court stated that commonality existed because the proceeds of the sales of Kin were used to build the Kin ecosystem. On the third prong of Howey, the court looked to Kik’s public statements that Kin holders could become wealthy to conclude that Kin’s value depended on Kik’s entrepreneurial and managerial efforts. Finally, the court held that the private offering and the TDE should be integrated and considered all a single, unlawful unregistered offering.
The court’s analysis is superficially sensible. However, it makes less sense in closer reading. For example, in the context of analyzing commonality, the court relied primarily on the use of the proceeds of the sale of Kin to build the Kin ecosystem. But the use of proceeds has no bearing on whether horizontal commonality exists—it bears, rather, on the expectation of profits from Kik’s efforts. Whether the proceeds were used to build the ecosystem from which Kin would derive value is irrelevant to whether there was a common enterprise. Horizontal commonality is predicated not on how the value is created, but on whether all the putative investors derive their value from a common venture.
The court’s references to the use of the proceeds makes little sense in considering whether horizontal commonality existed. Either the Kin purchasers’ returns were all dependent on the same enterprise—the Kin blockchain economy—or they weren’t. Although the private offering purchasers took more risk—their returns required building the blockchain that would both produce Kin and provide the infrastructure for the Kin economy and the TDE purchasers bought into a ready made blockchain—they were all clearly dependent on the development of the Kin economy for their hoped for returns.
But the question before the court was not whether the private offering involved the sale of a security; by using an exemption from registration, Kik implicitly acknowledged that it did. The question before the court was whether the TDE involved the sale of a security. Clearly all the TDE purchasers were buying tokens whose value depended on the same Kin economy. Horizontal commonality comes from the interconnection of the buyers’ returns—they all expect returns from the same venture. That was arguably true of the TDE purchasers, regardless of how their proceeds were used.
The court’s focus on the use of the proceeds to build the Kin ecosystem seems more relevant to the question of whether Kin’s value depended on Kik’s “managerial and entrepreneurial efforts.” But the court’s analysis of this issue focused not on Kik’s efforts, but on the potential for profits that Kik touted. Here it seems that careful delineation between the private offering and the TDE is essential. Kik offered evidence that the Kin ecosystem was completed with the proceeds of the private offering, and the proceeds of the TDE were NOT used to develop it. In the TDE, Kik disclaimed any obligation or intent to do anything further to increase the value of Kin. The court brushed these assertions aside, commenting that the court could look beyond the terms of the contract itself at the statements Kik had made about fortunes to be made from Kin. Yet for all that those statements touted the potential for profit, they said nothing about the connection of those potential profits to any further work that Kik would be doing. Kik asserted—and the opinion did not appear to cite any contrary proof—that all of its entrepreneurial efforts were completed when the blockchain was built using the proceeds of the private sale. Everything that happened after that (the creation of the Kin economy) depended on the decisions of third parties to build applications on the Kik blockchain, decisions over which Kik had no control.
An explanation of the court’s logic could lie in the wording of its analysis of the commonality question. The court simply said the proceeds of the sale of Kin were used to build the Kin ecosystem—without separating the private offering from the TDE. If the two offerings are conflated, then it become easier to understand how the court could have concluded that the proceeds of the sale of Kin—from both sales combined—were indeed used to fund Kikk’s entrepreneurial efforts.
This argument, however, makes the sale of Kin in the TDE a security by combining it with the terms and conditions of the private offering, which took place on different terms under different conditions and for different purposes. The court’s conflation of the proceeds of the private offering with the proceeds of the TDE may have been based on its conclusion that the TDE and the exempt private offering should be “integrated” into a single offering for purposes of analysis. Under this view, the totality of Kik’s fundraising was designed to build and seed the business that would make Kin useful and valuable. But this reasoning is simply circular. Before the two offerings can be “integrated” into a single securities offering the SEC had to prove that the TDE was an offering of a security in the first place. It is illogical to argue that the TDE involved the offering of a security because it is integrated with the private offering which admittedly involved a security—and therefore the two offerings can be integrated because they are both offerings of the same “security.” The court needed to determine that the TDE involved a security without conflating the two offerings into a single unregistered security offering.
Ari Gabinet is a Senior Fellow at the Watson Institute for International and Public Affairs and the Legal Expert in Residence at Brown University. The Brown Undergraduate Law Review is grateful for his support as our Faculty Advisor.