Last week was a busy one for the SEC, and other crypto related litigation. That’s probably all we’re going to get while the battle between regulators and token issuers rages on, as Congress is not in session and many in the finance and tech industries are capping off their summers with vacations.
Kik Interactive (“Kik”) is continuing its high profile attempt to fight the SEC’s enforcement action it. On June 4, 2019, the SEC launched an enforcement action against Kik Interactive claiming the company offered and sold one trillion digital tokens known as Kin in violation of the Securities Act of 1933 (the “Securities Act”). The Securities Act requires an issuer of securities to either register the offering with the SEC or to conduct the offering pursuant to an exemption from registration. The SEC claims the Kin tokens are securities as defined in the Securities Act and that Kik failed to sell the securities pursuant to a registration or an exemption from registration under the Securities Act.
Kik is a messaging app that raised over $100 million in 2017 through an initial coin offering (“ICO”) involving the use of simple agreements for future tokens (“SAFT”) that promised purchasers a digital token.
With much publicity, the SEC sued Kik, alleging that Kik had offered unregistered securities through its SAFT. The SEC believes the Kin offering, and SAFT in particular, were not exempt from registration under Regulation D. While many ICOs have drawn regulatory scrutiny, the sheer size of Kik’s SAFT and ICO, combined with their compulsion to challenge the SEC is getting particular attention and scrutiny in the industry.
Perhaps recognizing that the standard for a motion to dismiss gives a plaintiff the benefit of all the allegations it pleads, and the factual nature of SEC enforcement actions, Kik did not move to dismiss the SEC’s complaint, but that did not stop Kik from arguing against the SEC’s allegations. Kik filed its answer to the SEC’s complaint on August 6, 2019 denying that Kik engaged in any unlawful activity. In particular, Kik’s 131-page, filing argues that Kik’s ICO was actually a two-part offering, a private SAFT which it claims was done in compliance with federal securities laws. Kik claims the SAFT was effected under an exemption from registration under the Securities Act of 1933, and second a public sale for Kin tokens which Kik argues were not investment contracts under U.S. securities law. Kik also appears to argue that the SEC lawsuit is a violation of Kik’s right to due process since the legal standard defining what is or is not a “security” is vague and many companies have sold similar “tokens” without SEC intervention.
Kik’s answer is fairly combative in insinuating that the SEC made intentional misstatements in its complaint. This follows Kik’s pattern of taking an unorthodox, controversial, and combative stance in its dealings with the SEC. Kik’s aggressive moves previously included publishing its Wells Notice from the SEC and publicly raising funds for its legal defense on the grounds that it was “Defending Crypto.” Long, drawn out discovery and a high-stakes trial should be expected and it may be years before this lawsuit is resolved. For those who believe that the facts in the case are unfavorable to Kik and that bad facts make bad law, the slow pace could be beneficial.
While Kik is vigorously defending the use of a SAFT whitepaper in the Kin ICO, leading members of the FinTech Bar have questioned the soundness of the SAFT model. The Kik enforcement action has the potential to bring an end to the use of risk-filled financial products.
A copy of Kik’s answer to the SEC can be found here.
SEC Sues ICO Issuer for Illegal Sale of Securities and Manipulative Trades
On August 12, filed another enforcement action related to an ICO in the U.S. District Court for the Eastern District of New York against Reginald Middleton and two companies controlled by Middleton, Veritaseum Inc. and Veritaseum LLC. The SEC asserts that when Middleton and his companies conducted an ICO in April-May 2017 they sold unregistered securities without a valid exemption from registration, despite Middleton’s claim that these tokens were not securities, but digital assets known as VERI Tokens, VERI, or Veritas. The SEC further alleges that Middleton made misleading statements about the nature of his businesses, e.g., that it had market-ready products when none existed, and about the nature of the VERI.
In an addition to the standard allegations brought against an ICO issuer, the SEC alleges that Middleton placed a number of secret, manipulative trades in VERI after the ICO took place. In one instance, his trading managed to pump the price of VERI up by 315% in a single day. Middleton is a New York-based, self-styled financial guru. He formerly wrote a financial blog called the Boom Bust Blog and he claims to have foreseen the 2008 financial crisis and the collapse of Bear Sterns and Lehman Brothers. The complaint also seeks to freeze the assets of Middleton and his companies, obtain expedited discovery, place all of the defendants’ digital assets in escrow, and obtain a final judgment for money damages.
Will this go the way nearly all other ICO enforcement actions have gone thus far—by granting a preliminary injunction freezing all assets? It is hard to believe it won’t, but the defendants have yet to respond to the lawsuit, so anything is possible. A copy of the complaint can be found here.
SAFT Issuer Gets Credit for Cooperating With The SEC
On August 12, the SEC announced that it entered into a settlement with SimplyVital Health, Inc. (“SimplyVital”), which, claimed to have created a blockchain based healthcare ecosystem through which healthcare providers could share patient data. In 2017, SimplyVital offered private investors entrance into a variety of the SAFTs with the public for the sale of SimplyVital’s own token, known as HLTH tokens. SimplyVital did not register the SAFTs or its tokens and did little to confirm the purchasers of the SAFTs were accredited investors. The SEC alleged that SimplyVital engaged in the sale of unregistered securities in violation of Section 5(c) of the Securities Act. To avoid litigation with the SEC, SimplyVital agreed to forgo generation of its HLTH tokens and return funds to the SAFT purchasers.
SimplyVital’s response to the SEC is opposite from Kik’s response in terms of rhetoric and publicity, and the credit SimplyVital received for its cooperation with the SEC is evidenced by the minimal sanctions sought by the SEC.
A copy of the SEC’s order can be found here.
Coinbase Obtains Dismissal of Fraud Claims Related to BitCoin Cash
Coinbase, Inc. (“Coinbase”) one of the largest crypto exchanges operating in the U.S., succeeded in obtaining dismissal of some federal claims relating Coinbase’s trading launch of the digital currency, bitcoin cash (“BCH”). In 2017, a number of bitcoin operators decided to fork the bitcoin database into a new digital currency called Bitcoin Cash or BCH. The Plaintiffs in Berk v. Coinbase, allege that Coinbase acted improperly by freezing trading of BCH almost immediately after launching the asset on its exchange in December 2017. Berk alleges that Coinbase halted trading of BCH less than two minutes after opening the market when it determined that the market lacked liquidity and found evidence of possible insider trading. Berk asserts that this was not only a sign of dysfunction and foul play but was even fraud and unfair competition. The U.S. District Court for the Northern District of California dismissed the plaintiffs’ fraud and unfair competition claims, but the court did not dismiss the negligence claims or have the entire lawsuit moved to an arbitration proceeding. Coinbase must thus face claims for negligence based on plaintiffs’ allegations that, “Coinbase breached its duty to maintain a functional market.” While the case is still in its early stages and could settle out of court, the suit does have the possibility of establishing legal precedent and offering some clarity on the standards for cryptocurrency exchanges in the United States.
A copy of the opinion can be found here.
Any company planning to conduct an offering of digital assets or to develop a digital asset for use in an ecosystem should proceed with caution. Any company planning to use a SAFT, should not do so. Similarly, anyone looking to resell digital assets that are acquired in an ecosystem should make sure the digital assets are not securities because the resale of digital assets that are securities by a party that is not a broker-dealer could result in that party being deemed a resale of securities by an unregistered underwriter in violation of Section 2(a)(11) of the Securities Act.
 Time To Kik SAFTS To The Curb, Richard Levin, Block Tribune (June 25, 2019), available at: https://blocktribune.com/time-to-kik-safts-to-the-curb/.