Ever because the creation of Bitcoin within the late 2000s, the SEC has warned that, relying on the circumstances, “preliminary coin choices” (ICOs) involving digital tokens or cash could also be topic to regulation beneath the federal securities legal guidelines.1 The SEC has supplied “information and circumstances” steerage relating to whether or not a selected cryptocurrency providing includes a safety. See, e.g., the SEC’s Framework for “Investment Contract Analysis of Digital Assets.” However officers have opined that cryptocurrencies offered solely for use to buy an excellent or service, reminiscent of Bitcoin or Ethereum, will not be securities.2
The current disposition of two SEC enforcement actions—Within the Matter of Unikrn, Inc., SEC Administrative Continuing No. 3-20003, and SEC v. Kik Interactive, No. 19-cv-5244 (S.D.N.Y., filed June 4, 2019)—characterize extra milestones within the debate over whether or not, and when, cryptocurrency choices implicate the securities legal guidelines. In each actions, the SEC alleged the defendant violated Sections 5(a) and (c) of the Securities Act of 1933 by providing and promoting securities—i.e. their respective cryptocurrencies—with no registration assertion in impact, and with no legitimate exemption from registration. And, in Kik, the U.S. District Court docket finally agreed with the SEC.
These actions function a reminder that the SEC v. Howey funding contract elements ought to be thought-about when figuring out whether or not an ICO constitutes an providing or sale of securities. Nevertheless, the bizarre expression of dissent by one of many SEC’s Commissioners relating to the Unikrn matter signifies this problem stays controversial and unsettled, significantly since there are comparatively few instances which have resulted in revealed opinions.
SEC v. Kik Interactive
In its Criticism in SEC v. Kik Interactive, the SEC alleged Kik performed a $100 million illegally unregistered ICO of digital tokens. Kik disputed the allegations. Based in 2009 as a messaging utility firm, in 2017 Kik “pivoted” to digital capital to lift funds. To this finish, Kik created and offered a digital forex referred to as “Kin,” which was to be saved, transferred, and recorded on blockchain digital ledger. Kik contemplated that it could create demand for Kin by constructing a Kin “ecosystem” and incorporating it into its already present messenger merchandise.
Kik offered Kin in two phases: first by way of a personal providing between June-September 11, 2017 (the “Pre-Sale”), and second by way of a public providing that befell starting on September 12, 2017 (the “Token Distribution Occasion,” or “TDE”). Within the pre-sale, Kik entered into agreements with accredited traders, who acknowledged that Kin was an unregistered safety. Kik obtained $50 million by the Pre-Sale and roughly $49.5 million although the TDE. On September 26, 2017, Kik distributed one trillion Kin to purchasers within the non-public and public gross sales, who had the appropriate to make additional gross sales within the secondary markets. On the identical day, Kik distributed six trillion Kin to a not-for-profit entity it created, and it retained a further three trillion Kin. As of September 26, 2017, when these distributions have been made, no items or companies have been accessible on the market to holders of Kin.
Court docket’s Holding
On September 30, 2020, the US District Court docket for the Southern District of New York granted abstract judgment for the SEC, holding that Kik’s complete providing constituted an illegally unregistered sale of securities in violation of Part 5 of the Securities Act of 1933.3 The Court docket first reasoned that Kik’s sale of Kin was an funding contract, and thus a safety, beneath SEC v. WJ Howey Co., 328 U.S. 293 (1946).4 As established by the U.S. Supreme Court docket in Howey: “[A]n funding contract for functions of the Securities Act means a contract, transaction or scheme whereby an individual invests his cash in a typical enterprise and is led to count on income solely from the efforts of the promoter or a 3rd occasion.” 328 U.S. at 298-99. The Kik Court docket discovered “horizontal commonality”—i.e. a circumstance by which every investor’s fortunes are tied to the fortunes of different traders, by the pooling of belongings—adequate to ascertain a typical enterprise, existed. It reasoned that Kik deposited all funds obtained from its providing right into a single checking account and used these funds for its operations, together with the event of the Kin ecosystem, which drove demand for and boosted the worth of Kin. Thus, the stronger the ecosystem Kik constructed, the larger the demand for Kin, and the larger the worth of every purchaser’s funding. This supported the courtroom’s conclusion that there was a typical enterprise.
Additional, the Court docket discovered that “an inexpensive expectation of income to be derived from the entrepreneurial or managerial efforts of others,” crucial for an funding to represent an funding contract, additionally existed.5 It reasoned that the demand for Kin, and the worth of the funding, was “closely depending on Kik’s entrepreneurial and managerial efforts.” Kik was to combine Kin into Kik messengers and create and foster the Kin ecosystem by making a collection of latest merchandise, companies, and techniques. Furthermore, Kik had an incentive to extend demand for Kin, as a result of it retained 30% of the tokens created. Kik’s efforts have been essential as a result of, with out the promised digital ecosystem for Kin, Kin could be nugatory. And, Kik needed to be the first driver of that ecosystem.
The Court docket additional discovered that the Pre-Sale and TDE have been an built-in providing. Subsequently, the Pre-Sale didn’t qualify for an exemption beneath Regulation D and constituted an unregistered sale of securities.6 It reasoned that the Pre-Sale and TDE have been a part of a single plan of financing made for a similar common function, purchasers in each gross sales obtained similar belongings, the gross sales befell at roughly the identical time, and each gross sales have been integral to a profitable launch of Kin. As such, it held that the whole lot of Kik’s $100 million providing constituted an unregistered supply and sale of securities, in violation of Part 5. The Court docket concluded by ordering the events to collectively submit a proposed judgment for injunctive and financial aid. On October 20, 2020, the events submitted Kik’s consent to the entry of a ultimate judgment that may require it to pay a $5 million civil penalty pursuant to Part 20(d) of the Securities Act.
Within the Matter of Unikrn, Inc.
On September 15, 2020, the SEC issued a settled cease-and-desist order in opposition to Unikrn, Inc., operator of an internet eSports gaming and playing platform, once more primarily based on violations of Part 5, beneath very related circumstances.7 In response to the SEC, Unikrn raised $31 million by the sale of Unikoin Gold (“UKG”), a digital token, by a pre-sale and an ICO. Within the pre-sale, which started June 11, 2017, Unikrn supplied UKG to Unikrn shareholders, rich people, and digital asset funding funds, who might buy UKG by a “easy settlement for future tokens,” or SAFT. Within the ICO, starting June 19, 2017, Unikrn supplied its UKG to members of the general public. UKGs have been supposed to facilitate customers’ entry to services and products on the Unikrn platform, and the vast majority of the proceeds could be used for platform growth. Unikrn retained 20% of the UKG tokens issued, whereas distributing one other 10% to its staff.
Based mostly on Howey, the SEC decided that the UKGs have been supplied and offered as funding contracts, and have been subsequently securities, as a result of a purchaser would have had an inexpensive expectation of acquiring a future revenue primarily based on Unikrn’s efforts. As such, the company discovered that Unikrn violated Sections 5(a) and 5(c) of the Securities Act by providing and promoting these securities with out having a registration assertion filed or in impact or qualifying for an exemption from registration. The SEC’s order directed Unikrn to disable UKG and pay a $6.1 million civil penalty, representing considerably all of its belongings. Though Unikrn was not litigated and never determined by a courtroom, it supplies extra context to the physique of securities legislation governing cryptocurrency choices.
Dissent by Commissioner Peirce
The numerous settlement in Unikrn gave rise to a uncommon dissent by Commissioner Hester M. Peirce, a Republican who has typically expressed assist for cryptocurrency and digital belongings and considerations about regulator overreach. Commissioner Pierce opined that such enforcement actions quell innovation and stifle financial progress.8 She famous that, by requiring Unikrn to completely disable the UKG, which it had built-in into its product choices, and pay a penalty representing considerably all of its belongings, the SEC “successfully forc[ed] the corporate to stop operations due to an allegedly improper providing of supposed securities.” The Commissioner famous that Unikrn concerned no allegations of fraud, and disagreed that Unikrn engaged in an providing of securities. She additional famous that, as a result of figuring out whether or not an providing is an funding contract requires a weighing of information and circumstances and is especially difficult within the context of latest companies and applied sciences, there aren’t any “clear guideposts for entrepreneurs and others to observe.” Consequently, entrepreneurs could also be pressured to expend restricted capital on authorized session and compliance, or face enforcement actions.
To unravel this dilemma, Commissioner Peirce thus proposed that corporations reminiscent of Unikrn ought to be allowed a 3-year regulatory window to develop and refine its platform, whereas nonetheless being subjected to the antifraud provisions of the federal securities legal guidelines. The Commissioner famous that, if such a protected harbor had been accessible to Unikrn, as a substitute of completely disabling its tokens because of the SEC’s settled enforcement motion, Unikrn, in live performance with its tokenholders, is likely to be devoting its time and sources to figuring out new makes use of and increasing its consumer base. And, although acknowledging not all may see the lack of advantages of innovation as massive within the case of Unikrn, Commissioner Peirce opined that “posterity will really feel the cumulative loss to society of innovation foregone” due to motion reminiscent of Unikrn. The Commissioner additional opined that society “won’t ever know the complete magnitude of such losses, as a result of some would-be entrepreneurs may, in gentle of enforcement actions like Unikrn, choose to shelve their most transformative concepts. Thus, Commissioner Peirce famous, by failing to experiment with new approaches to regulation, the SEC dangers “surrendering the fruits of innovation.”
The inclinations of Kik and Unikrn display that ICOs could also be considered by the SEC and courts as choices of securities; nevertheless, Commissioner Peirce’s dissent signifies the authorized points stay controversial and considerably unsettled. Accordingly, anybody providing cryptocurrencies ought to seek the advice of with certified securities legislation counsel.
1See, e.g., SEC’s Report of Investigation pursuant to Section 21 of the Exchange Act (the “DAO Report”), Launch No. 81207, issued July 25, 2017. An “Preliminary Coin Providing” or “ICO” is a fundraising occasion by which an entity presents individuals a singular digital asset – typically described as a “coin” or “token” – in change for consideration.
2 See Digital Asset Transactions: When Howey Met Gary (Plastic), Speech of William Hinman, Director, Division of Company Finance (June 14, 2018).
3See Opinion and Order on Motions for Abstract Judgment, Doc. No. 88, No. 19-cv-5244 (S.D.N.Y.), filed Sept. 30, 2020 (the “Abstract Judgement Order”).
4 Underneath Part 2(a)(1) of the Securities Act, a “safety” contains an “funding contract.” 15 U.S.C. § 77b(a)(1).
5See Abstract Judgement Order, supra, at notice 3 (quoting United Hous. Discovered., Inc. v. Forman, 421 U.S. 837, 852 (1975)).
6 The Court docket additional rejected Kik’s assertion that “funding contract” was unconstitutionally imprecise as utilized to Kik.
7See Within the Matter of Unikrn, Inc., SEC Administrative Continuing No. 3-20003, Launch No. 10841, Order Instituting Stop-and-Desist Proceedings Pursuant to Part 8A of the Securities Act of 1933, Making Findings and Imposing Penalties and a Stop-and-Desist Order, accessible at https://www.sec.gov/litigation/admin/2020/33-10841.pdf.
8See Commissioner Hester M. Peirce, Statement on SEC Settlement Charging Token Issuer with Violation of Registration Provisions of the Securities Act of 1933, issued Sept. 15, 2020.