Sunday, June 30, 2019

Are Undeveloped Lots Securities?

As we recently found out from the CA Court of Appeals decision in People v. Dunham, undeveloped lots of land may be "investment contracts" and therefore, "securities".

A brief summary of the facts of this case are as follows:  Ronald Duane Dunham convinced several elderly persons in 2004 through 2007 to invest over a million dollars into the purchase of undeveloped lots of land in Cherokee Village, Arkansas and/or support his real estate development efforts.  There was no fund created.  Purchases were made individually.  According to the court opinion, Dunham told the investors that "he would increase land values through the marketing and development of a retirement community."  There were many misstatements in Dunham's promises, which coupled with other misdeeds by Dunham, resulted in a criminal and civil lawsuits being filed against him.  In 2014, a jury convicted Dunham of 20 counts of grand theft, elder theft, and securities fraud.  Although the Court of Appeals reversed six out of 20 counts relating to grand theft (because it was a lesser included offense of elder theft), it affirmed the other convictions, including the securities fraud counts.

This case illustrates the ever more resilient nature of the Howey test that can put just about any investment scheme into the realm of securities laws.  As a way of background (just in case you haven't heard enough about it yet), the US Supreme Court ruled in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) that an investment contract can be a security if it represents investment of money (or other consideration) in a common enterprise with an expectation of profits to be derived solely from the efforts of the promoter or a third party.  Hundreds of pages of legal analysis have been written since then about the Howey Test.  The test has been applied to find receipts for Scotch whiskey barrels, pairs of mating chinchillas, and the sale of beavers raised at a ranch all to be investment contracts.  More recently, the Howey Test has been applied to the initial coin offerings to find that digital tokens that investors received in exchange for their money were securities. 

Similarly here, the court looked at the Howey Test to determine whether the undeveloped lots were securities.  As the court noted:

"Here, like in Howey, Dunham offered investors an opportunity to contribute money and to share in the profits of a Cherokee Village retirement community, which would be managed, sold, and partly owned by Dunham. The lots represented the victims' "shares in [the] enterprise." (Howey, supra,328 U.S. at p. 300.) None of the California victims had any ability to develop homes in Arkansas, and they expected "Dunham and company" to sell their lots for them.  The victims were relying on Dunham to bring professional management, homebuilding, and financing experience to the project."

They all expected a return on their investment.  Even though there was no investment fund or other syndication company created, and there was no management contract between Dunham and the victims, it was clear from the presentations, seminars, and marketing materials that the victims placed their trust in Dunham to develop the lots in order to increase their value. 

This case reminds us once again to disregard form for substance and focus on the economic reality when analyzing whether any investment is an "investment contract" and therefore is a "security".  Even undeveloped land can be such.  What else?

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Tuesday, June 25, 2019

Regulation Crowdfunding Study - June 2019

On June 18, 2019, the staff of the SEC issued a report on Regulation Crowdfunding (in short, Regulation CF).  The report presents a summary of the status of crowdfunding as of now, three years after the SEC final rules for Regulation CF became effective.  Although a great initiative, Regulation CF is too complex and costly to be the main securities law exemption behind capital raising in the U.S.

As a way of background, Title III of the JOBS Act added Section 4(a)(6) to the Securities Act, providing for a new exemption from registration for private placements conducted through an online platform.  Regulation CF provides the regulations that put Section 4(a)(6) into practice.  According to Section 4(a)(6) and Regulation CF, a domestic issuer may raise up to $1.07 million in a 12-month period from unaccredited investors provided the issuer prepares certain disclosures, the investors invest only up to a certain maximum based on the investor's income or net worth, and the offering is conducted through a broker-dealer or a registered funding portal.

In summary, Regulation CF did not prove to be as popular as once anticipated.  According to the report, only 1,351 offerings relying on Regulation CF were initiated in 2.5 years between May 16, 2016 and December 31, 2018, and only 519 offerings were reported as completed.  The average amount reported raised per offering was approximately $107,367 for a total of $108.2 million.  In comparison, in 2016 alone, companies in the United Kingdom and China raised $335 million and $460 million, respectively, under similar crowdfunding exemptions.

Most issuers were early in their lifecycle: an average issuer was formed within two years prior to the offering and employed about three people.  Just over half of the offerings were done by issuers with no revenues.  Only about 10% of the issuers became profitable in the most recent fiscal year prior to the offering.  About one-third of the issuers were from California, followed by New York (about 11%) and Texas (about 7%).

The average offering lasted about four months.  About one-half of the issuers offered equity, 27% - debt, and the remaining issuers offered SAFE or another type of investment structure.

Although the $1.07 million limit in Regulation CF offerings was initially much criticized, a typical offering amount was small: the average target amounts ranged between $25,000 and $500,000.   Only 29 offerings reported raising at least $1.07 million during the three-year study period.  Therefore, the low offering limit seems to be appropriate, although one can argue that many potential issuers avoid Regulation CF because of such low limits.   

The SEC staff noted in the report some issuers' lack of compliance with the ongoing filing obligations.  Issuers have to file an annual report on Form C-AR and the final progress update on Form C-U.  Many survey respondents cited the complexity of regulations and Form C as well as high costs associated with Form C and financial statement preparation as the reasons behind such a lack of compliance.

Overall, the report is full of data that should be analyzed with the view of amending Regulation CF.  Then, those issuers that stay away from conducting a Regulation CF campaign due to the low limits, complex and onerous disclosure requirements, necessary audited financials for larger offerings, and ongoing reporting obligations will rely on the Regulation CF in their capital raising efforts and will allow more unaccredited investors to participate in the startup ecosystem.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.    

Tuesday, June 11, 2019

SEC vs. Kik Interactive Inc. - Another Test for the Howey Test

On June 4, 2019, the SEC filed a complaint in SDNY against Kik Interactive Inc. ("Kik"), a Canadian company, for failing to register the offering and sale of its digital tokens called Kin pursuant to Section 5 of the Securities Act of 1933 (the "Securities Act").

The complaint reiterates the SEC's long-standing position since it first issued the DAO Report in July 2017 that digital tokens may be securities and that the U.S. federal securities laws would apply regardless of whether the consideration paid was virtual currency or whether the securities were issued through a distributed ledger technology instead of in the certificated form.  According to the complaint, the Kik executives knew of the risk that the Kin tokens could be securities under the Securities Act but failed to sell them to the U.S. investors in a legally compliant way.  This complaint did not come as a surprise to the company or the larger blockchain community.   

Although we cannot foretell how the case will turn out (and this may go on to become a full-blown jury trial), there are several interesting observations about the Kik story, including some lessons for future token issuers.  Please note that the observations are based on the facts as they were presented in the SEC complaint.  These facts may be disputed by Kik in the process of litigation.

1.  There were no allegations of fraud made against Kik.  This case is solely about the violation of the registration provisions of the Securities Act.   There have been prior SEC enforcement actions against ICO issuers that did not involve allegations of fraud but they all were settled with the SEC (In re Matter of Paragon Coin, Inc., where the issuer raised $12,066,000, settled with the SEC on November 16, 2018, paid a $250,000 penalty, offered rescission rights to investors, and agreed to register tokens with the SEC; In the Matter of Carrierreq, Inc., d/b/a Airfox, where the issuer raised approximately $15 million, and settled with the SEC on the same day and with the same consequences; and In re Matter of Munchee Inc., where the issuer raised about $60,000 in the one day ICO, refunded all money, and settled on December 11, 2017 without penalty).

2.  Kik raised approximately $100 million from more than 10,000 investors, about half of whom were U.S. investors.  This was a large offering that was bound to attract the attention of the regulators.

3.  Kik actually conducted two Kin offerings that became integrated.  The first offer and sale took place from early July to September 11, 2017, whereby Kik received approximately $49.5 million from about 50 investors, including 21 U.S. investors.  This was a private offering of SAFTs (Simple Agreements for Future Tokens) only to accredited investors.  The company provided a PPM to the investors and filed a Form D, treating SAFTs as securities.  The SAFT contracts obligated Kik to generate and distribute half of the tokens at the time of the public sale that had to take place before the September 30, 2017 deadline or return to the investors 70% of the funds.  Since the company was running out of money, it had no choice but to conduct the public sale of tokens that took place between September 12-26, 2017, including distributing Kin tokens to the early investors, prior to the deadline.  The offerings were integrated in part because of (i) the proximity in time between the SAFT offering and the public sale (the last SAFT was sold on September 11, 2017, one day before the launch of the public sale), (ii) the fact that the tokens issued in the public sale and the tokens underlying the SAFT had the same characteristics, and (iii) the fact that the company failed to distinguish between the funds received through SAFTs and the funds received from the general public.

4.  Kik did not offer the Kin tokens to the Canadian investors in its public sale made to the retail investors from September 12 to September 26, 2017.  Interestingly, based on the advice of its Canadian counsel and after engaging into discussions with the Ontario Securities Commission, Kik excluded Canadian investors from the public sale because, based on a Canadian test that is similar to the Howey test, the Kin tokens were determined to be securities under Canadian law.  However, Kik did not reach out to the SEC and did not restrict U.S. investors from purchasing the tokens.  In fact, only the residents of Canada, Cuba, China and North Korea (and residents of New York and Washington states) were excluded from the offering. 

5.  Kik failed to treat the underlying Kin tokens as securities when it offered and sold them through the SAFTs.  The company knew at the time of offering and selling the SAFTs that it would not be able to build the "Kin Ecosystem" before the token distribution date, which, according to the SAFT contracts, had to take place before the September 30th deadline.  This tight deadline allowed only for a window of several months (and in the case of the SAFT sold on September 11th, only a 20-day window) to do so, which was clearly insufficient time to build a fully functioning platform for the Kin tokens with all the features promised by Kik.  Therefore, it was not reasonably possible for the Kin tokens to exist as "utility tokens" on the "Kin Ecosystem" and they had to be treated as securities.  The fact that they did gain some utility later should be irrelevant to the analysis of the initial distribution of the Kin tokens back in September 2017.

6.  The public sale was conducted several months after the SEC issued its DAO Report, warning issuers that tokens could be securities.  However, Kik did not heed the SEC guidance.

7.  In its press release issued on June 4, 2019, Kik referred to its Kin tokens as a currency and alleged that the SEC stretched the Howey test "well beyond its definition".  It is a question of fact whether Kin is now more like a currency rather than a security.  It is a different question of fact whether Kin was more like a security than a currency at the time of its initial issuance in 2017.  It should be noted that at the time Kin tokens were issued, the company was still building its "Kin Ecosystem" where Kin tokens could be used for payments, and therefore, unlike Ether, was not decentralized and depended on the efforts of Kik's developers.  As the SEC noted in paragraph 126 of the complaint, "There was, simply, nothing to purchase with Kin at the times Kik sold the tokens through September 26, 2017...". 

It will be up to the courts to decide whether Kin tokens were securities at the time of their issuance.  Since the SEC's complaint is in line with its prior enforcement actions and interpretive releases on the subject, the outcome of the Kik case may either reaffirm once again the SEC's position or, if Kik were to prevail, return the Wild West of 2017 ICOs.

Perhaps, instead of applying and perhaps "stretching" the old Howey test one more time, it is time to adopt a new legal regime suitable for digital asset offerings (as it is being done in multiple jurisdictions across the globe)?  But then remember,  the courts are not legislative bodies and are bound to apply the law as currently written.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.