Judge Hellerstein in the Southern District of New York ruled in favor of the SEC against Kik for violating US securities laws for raising $100 million in a token sale in 2017. The Kik CEO Ted Livingston is considering options including an appeal. This is one of the first cases that a court has ruled on a token sale based on the Howey test. We’ll break down the judge’s ruling and see if there is potential that the judge erred and discuss how the Kin token sale could have been designed differently.
Evaluating the Ruling and Howey Test
The judge’s ruling last Wednesday is composed of facts and a legal discussion. The Howey test is described in the ruling as having the following three elements: “(i) an investment of money (ii) in a common enterprise (iii) with profits to be derived solely from the efforts of others.” Judge Hellerstein noted that so far there have only been two other cases where the Howey test was applied to cryptocurrencies: SEC v. Telegram Group Inc. , No. 448 F. Supp. 3d 352 (S.D.N.Y. 2020) and Balestra v. ATBCOIN LLC, 380 F. Supp. 3d 340 (S.D.N.Y. 2019). Both Kik and the SEC agreed about the first element that the Kin sale was an investment of money so the judge only considered the second and third elements.
Judge Hellerstein ruled that the investors and Kik were involved in a ‘common enterprise’ based on a ‘horizontal commonality’ that ties “each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets, usually combined with the pro-rata distribution of profits.” Revak, 18 F .3d at 87. 5.
Judge Hellerstein contends Kik used the pooled investment funds to build out the digital ecosystem and that the Kik corporation was critical to the success of the ecosystem. He also asserted that he did not believe that profit-sharing was a necessary component to determine horizontal commonality.
Commonality is a gray area and the term ‘token sale’ instead of ‘initial coin offering (ICO)’ has the explicit purpose to create this separation between the corporation and blockchain platform. The key is that the token needs to be structured as a pure sale of a token product rather than a vehicle for both investor and company to be working together in ‘common.’ Kik argued there was no ongoing contractual obligation to perform as a common enterprise and issued disclaimers, but the judge emphasized that the courts look at ‘economic reality.’
Judge Hellerstein also brings up one interesting point about another case where the court rejected the ‘horizontal commonality’ issue because the investment was not pooled, but segregated and the profit of each account was independent of each other. Savino v. E. F. Hutton & Co., Inc., 507 F. Supp. 1225, 2136-37 (S.D.N.Y. 1981)
Judge Hellerstein took a straightforward approach and asserted that the ‘economic reality’ was that Kik pooled investor funds to build the Kin ecosystem and Kik the company would be critical to the success of the investment via the Kin token. Judge Hellerstein asserts: “The stronger the ecosystem that Kik built, the greater the demand for Kin, and thus the greater the value of each purchaser’s investment.”
Judge Hellerstein‘s ruling is reasonable, but there are some nuanced points that may be important to discuss. If Kik structured the Kin token primarily as a sale rather than indicate that the proceeds would be used to build out the platform and ecosystem that could have made a big difference. A pre-purchase of a good or token would be considered a sale rather than an investment. The ‘economic reality’ of Kickstarter campaigns is that many are a pre-sale of goods rather than donations. However, a sale of a product would not be considered an investment contract. Therefore, in situations where the team does not have a product built, does not describe tokens as a pre-purchase of a good or conveys a ‘use of proceeds’, they may be considered in a ‘common enterprise’ with investors. Kin did seem to describe how they would use these proceeds to help the ecosystem much like someone would expect to see in an investment prospectus. This fact may suggest ‘commonality’. Therefore, startup teams who build the product first and sell tokens without future obligations might find themselves in a better position.
Another problem is that many token project companies have reserved a portion of the token allocation to themselves. This structure may suggest ‘commonality’. Both the investors and the company would own the same tokens and share in the token’s success. Instead, if a startup company is a seller of a good and service and ‘investors’ are just buyers, there would likely be no ‘horizontal commonality.’
Expectation of Profits Based on the Efforts of Others
Judge Hellerstein asserts that profits do not need to be based on an income distribution, but can be based on capital or token appreciation. He includes the following statement in United Haus. Found. , Inc. v. Forman, 421 U.S. 837, 852 (1975). “Howey contemplates that an investor is “led to expect profits solely from the efforts of the promoter or a third party (emphasis added).” Judge Hellerstein continues: “However, the Second Circuit “ha[s] held that the word ‘solely’ should not be construed as a literal limitation; rather, we ‘consider whether, under all the circumstances, the scheme was being promoted primarily as an investment or as a means whereby participants could pool their own activities, their money and the promoter’s contribution in a meaningful way.”‘ United States v. Leonard, 529 F.3d 83, 88 (2d Cir. 2008) (quoting SEC v. Aqua-Sonic Prods. Corp., 687 F.2d 577, 582 (2d Cir.1982))“. Judge Hellerstein did not feel that participants could ‘pool their own activities’ in a ‘meaningful way.’ The reason that the courts consider this situation is that if everyone contributes to a platform’s success instead of solely relying on Kik, the structure would be considered a ‘partnership’ and would be exempt from security laws as I discussed in The Secret to Conducting an ICO or Token Sale Legally. However, Kik seemed to have focused too much on promoting its own activities for the success of the platform rather than describing what investors on the platform would be able to do to bring success. The success of most decentralized blockchain platforms do depend on investor and community activity for their success so investors often can be considered activist investors or partners in the project. Kik can still argue this point although the facts of its situation might be weaker than others. Setting up a decentralized governance or organization like a decentralized-autonomous-organization (DAO) or decentralized autonomous company (DAC) where each investor can vote on the operational activity of the platform should enable a more effective partnership structure and ensure that investors are not ‘solely’ relying on the efforts of a company like Kik. [Note: It is important not to conflate shareholder voting and DAO/DAC voting. Shareholders do vote in corporations, but they delegate operations to a board and executive management. Hence there is a distinction between shareholder voting and DAO/DAC voting in that the latter directly influences operational activity.]
Judge Hellerstein then responded to the argument that Kin has a consumptive use or what many in the cryptocurrency industry call ‘utility.’ He quotes: “See Forman, 421 U.S. at 852-53 (“[W]hen a purchaser is motivated by a desire to use or consume the item purchased[,] … the securities laws do not apply.”).” Judge Hellerstein argues the consumptive use was not available at the time of distribution. Furtheremore Judge Hellerstein asserts: “By contrast, in Forman, cited by Kik, “there [ could] be no doubt that investors were attracted solely by the prospect of acquiring a place to live, and not by financial returns on their investments.” 320 U.S. at 344. This point could be contested since real estate is also naturally considered an investment and the Kin tokens really do have consumptive use. Judges should not presume the intent of investors as long as a utility or consumptive use exists. Judge Hellerstein also says “Growth would rely heavily on Kik’s entrepreneurial and managerial efforts,” but that is different than ‘solely on the efforts‘ of others used for the Howey test. Judge Hellerstein continues: “Unlike real estate, Kin have no inherent value and will generate no profit absent an ecosystem that drives demand.” Kik could challenge this statement by asserting that the ecosystem would be able to thrive even without Kik and that decentralized platforms enable open participation.
Lastly, Judge Hellerstein considers Kik’s pre-sale and public sale an integrated offering and addresses Kik’s argument that the ‘investment contract’ is unconstitutionally vague.
The Kik court case is a good example of how US courts will apply the Howey test to cryptocurrency token sales and should give startups an indication of what elements they should focus on and improve when designing a token sale. Although Judge Hellerstein’s ruling seems reasonable, the law is nuanced so Kik can still challenge the ruling on 1) Kin’s token utility and 2) the fact that the contribution, collaboration and activity of ‘investors’ on the open platform will contribute to an ecosystem’s success. However it seems Kik’s arguments could still fall short based on the specific facts of the case so it’s probably preferable for another cryptocurrency company that has more favorable facts to be the representative case in an appeal. In the meantime bootstrapping startup founders might consider a partnership token sale or otherwise take precautions and avoid US investors in general.