How the SEC Wants you to Conduct an ICO – 3 Lessons From Kik and Telegram

After nearly 2 years of battle, the project that bravely stood up to the SEC in defense of crypto has been defeated. 

After much deliberation, US District Court Judge Alvin Hellerstein granted the SEC its summary judgement against Kik. With this, Hellerstein asserted that it was indisputable that Kik had conducted an unregistered securities offering. 

For the SEC, winning summary judgement was a slam dunk in its case against Kik and meant that the regulators could seek the maximum penalty. 

But they didn’t…

Instead, the SEC offered a settlement of just $5 million

This settlement surprised most industry pundits because it was just a small fraction of what the SEC could have demanded. 

Even more notably, the SEC did not require Kik to offer rescission rights, like it mandated from Airfox and Paragon in earlier cases. This would have given Kik investors the ability to rescind their investments and receive a refund at the original token price, a move that would have undoubtedly bankrupted the company.

This light settlement comes as a surprise. It signals that perhaps the SEC is trying to work with the crypto space to create regulatory certainty and is not just on a witch hunt to take down as many projects as it can.

Regardless of the SEC’s intentions, the fact is that from this case, we now have significantly greater regulatory clarity on how to proceed with token sales in the future if projects wish to do so in compliance with SEC regulations. 

From these rulings, it is now clear that there are three distinct phases that crypto projects must consider in order to conduct an ICO in compliance with US securities laws. Read on to learn what these phases are.

Table of Contents

1. Register a Standalone Token That Represents a Security

The number one takeaway from these cases is that when a project wants to raise capital for the development of its platform or network, it should register its offering with the SEC as a straight-forward securities offering.

The token offered should represent an equity or debt interest in the project and not have a relationship to the platform’s utility functionality.

Both Kik and Telegram demonstrate that this is the SEC’s preferred approach.

In both cases, the projects held an initial ICO that was strictly limited to a small pool of accredited investors. The projects acknowledged that these were securities offerings and filed for registration exemptions with the SEC. 

Up to this point, everything was by the book and in compliance with SEC guidelines. 

However, Kik and Telegram offered these investors pre-sale access to the utility token that would be used on the platform once it was built.

Pre-sale access to a platform’s utility token, by default made that utility token part of the initial investment contract and thus the basis of the ‘expectation of profit’ in the arrangement. 

In Kik’s case, it directly acknowledged that Kin was a security when it offered the token to investors in a pre-sale, but it believed that Kin transformed into a utility token when selling the token to the general public. The court didn’t accept this argument.

The judge pointed to statements from Kik CEO, Ted Livingston, to potential investors saying that as demand for Kin would grow in the future, the value of the token would go up. 

By referring to the Kin token as an investment vehicle, the token could no longer be considered just a utility token. Selling Kin to the general public suddenly became an investment offering.

In Telegram’s case, the project opted to create two separate tokens. The first token offering was registered with the SEC, however these tokens gave investors the ability to purchase the platform’s future utility token at a pre-sale price. 

Conjoining these two token offerings made the utility token part of the expectation of profit in the initial investment offering. As a result, the court prohibited the utility token from being sold to the general public without being registered as a public offering.

The lesson here is that the SEC wants projects to clearly differentiate between tokens that represent securities and tokens that represent utility. According to the SEC, the two are treated very differently. 

2. Build the Network Before Selling Your Utility Token

Once a project has raised its capital, the next step is to use those funds to build its platform. Until that’s done, the project should not consider issuing a utility token.

This was one of the primary factors used against Kik by the SEC.

One day after conducting its private pre-sale, Kik proceeded to conduct a public sale of Kin tokens to the general public. 

This was not enough time, according to the SEC, for the token to be used as a utility token since the platform wasn’t built and there was nothing of value to purchase on the network. Until users can buy something of value with their utility tokens, regulators will treat them as nothing more than a speculative investment instrument.

Regardless of how Kin could be used in the future, at the time of the token offering Kin was being purchased only for its potential future value. A future value that depended on Kik’s ability to deliver the network as promised.

SEC Director William Hinneman put this well in a 2018 speech on the topic,

“In the ICOs I have seen, overwhelmingly, promoters tout their ability to create an innovative application of blockchain technology. Like in Howey, the investors are passive. Marketing efforts are rarely narrowly targeted to token users. And typically at the outset, the business model and very viability of the application is still uncertain. The purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success. At that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.” 

3. Release the Platform’s Utility Token

The final phase for a project is, of course, to release the platform’s utility token. 

Again, this should only happen once the project is sufficiently developed. But on top of that, it is also important to note that the SEC does not want the token to be offered with overt promises of future development of the platform that would materially increase the value of the token. 

While development understandably will always be needed on a platform or network, it’s key that the value of the tokens is not entirely based on this future work. There must be strong market demand for the token in the present to prevent it from being considered an investment. 

This emphasizes the importance of releasing the token only after the network is functional and not during a beginning or intermediate phase. 

The final lesson here is to genuinely create and encourage a market for utility tokens within the platform and to not over promise future features around the sale of these tokens.

What does this mean for Crypto Law Insiders?

Following Kik and Telegram, we have a better understanding of how to legally conduct an ICO and what is required to differentiate a security token from a utility token in the eyes of the SEC.

The key here is to keep things as clear as possible, register or apply for an exemption with any capital raising activity, and to make sure that there is a functioning network before releasing any utility tokens. 

The most incredible part of Kik is that at the end of it all, it looks like the project will survive even after going head-to-head with the SEC. In fact, Kin, its token, has rallied over 140% after this news. After seeing one project after another go bankrupt after being accused of violating securities laws, this is a very welcome surprise. 

Hopefully this means a positive change in the SEC’s attitude toward crypto and greater collaboration between regulators and industry participants going forward.

Dean Steinbeck

Dean Steinbeck

Dean Steinbeck, Managing Director of Crypto Law Insider, is the leading authority on legal issues related to cryptocurrency and blockchain technologies.
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