A new reality streaming television series called Unicorn Hunters debuts May 10 in which startups will pitch to a panel that includes Apple co-founder Steve Wozniak, and the panelists after grilling the entrepreneurs will make decisions on whether or not to invest, similar to Shark Tank.  But unlike the couch potato viewers of Shark Tank, viewers of Unicorn Hunters will also be given the opportunity to invest in the presenting companies, which raises some pretty interesting securities law issues.

The securities offered on Unicorn Hunters will not be registered with the Securities and Exchange Commission, which means the companies, show sponsors and intermediaries will need to make sure the offerings satisfy the requirements of an exemption from registration and refrain from engaging in any activities prohibited thereby.  In fact, Unicorn HuntersFact Sheet states that all presenting companies will be engaging in side-by-side offerings under two different equity crowdfunding exemptions: Regulation Crowdfunding, which limits issuers to an aggregate offering amount of $5 million, and Rule 506(c) under Regulation D, in which only accredited investors may participate.

Regulation Crowdfunding

As for Regulation CF, the companies on Unicorn Hunters will benefit from recently promulgated significant reforms, which include an increase in the aggregate offering amount from $1.07 million to $5 million, change in the calculation of the investor cap from the lesser of to the greater of income and net worth, permission to test-the waters and self-certification for previously verified accredited investors.

But Reg CF also has strict rules governing how issuers may “advertise” the offering.  A Reg CF offering must be conducted through one (and only one) online intermediary, either a registered broker-dealer or a platform satisfying the requirements of a “funding portal”.  An issuer may communicate with investors and potential investors about the terms of the offering only through communication channels provided by the intermediary on the intermediary’s platform, provided that an issuer identifies itself as the issuer in all communications.

But what about communications outside the funding portal, such as what will take place on Unicorn Hunters? Under Reg CF, issuers are prohibited from advertising any of the terms of the offering outside the intermediary’s portal.  Rather, communications outside the portal may only include a brief description of the business of the issuer, as well as the name of and link to the platform.  This strict limitation on advertising outside the funding portal could be a significant regulatory risk for Unicorn Hunters’ presenting companies.  If companies on Unicorn Hunters mention the terms of the offering on the show, they may be blowing their exemption under Reg CF.  This probably explains why, unlike Shark Tank, there will be no negotiation of terms between the Unicorn Hunters panelists and the presenting companies.  It remains to be seen whether the companies will say anything on air about the terms of their offering.

There is another potential trap in the Reg CF side of the Unicorn Hunter investment program, but this additional trap is one that will impact NetCapital, the registered funding portal through which all Reg CF Unicorn Hunters investments will be made.  The potential trap is the individual investor cap.  Each investor is limited as to how much he or she may invest in all Reg CF deals in any rolling 12-month period based on a formula that depends on an individual’s annual income and net worth.  If either annual income or net worth are below $107,000, the investor’s aggregate investment in all Reg CF deals in any rolling 12-month period may not exceed the greater of $2,000 or five percent of the greater of annual income and net worth.  If both annual income and net worth exceed $107,000, the cap is the greater of 10% or the greater of annual income and net worth with a hard cap of $100,000.  The risk here is how to monitor individual investment caps on potentially thousands of investors, and that burden will fall on NetCapital because under Reg CF, it is the intermediary that is responsible for monitoring individual cap compliance.  Thankfully, intermediaries are judged by a reasonableness standard: the intermediary must have a reasonable basis for believing that the investor satisfies the investment limitations, and in this regard an intermediary may rely on an investor’s representations concerning the investor’s annual income, net worth and the amount of the investor’s other investments made pursuant to Reg CF, unless the intermediary has reason to question the reliability of the representation.  For example, the intermediary may be expected to be able to track all other Reg CF investments made by an individual on that intermediary’s platform, and if an investor has exceeded the cap just on that platform, it presumably would not be reasonable for the intermediary to rely on the individual’s representation that his aggregate Reg CF investments fall below the cap.

One last point here on Reg CF is that, ironically, among the recent crowdfunding reforms was that accredited investors are no longer subject to the Reg CF individual cap, yet Unicorn Hunters will steer accredited investors into the Rule 506(c) side of the offering and to the extent that occurs, companies won’t be able to benefit from that reform.

Rule 506(c)

Recognizing that companies are capped at $5 million under Regulation CF, Unicorn Hunters is set up so that all companies are also conducting a simultaneous or side-by-side Rule 506(c) offering.  Rule 506(c) allows issuers to use general solicitation to raise an unlimited amount, provided sales are made only to accredited investors and issuers use reasonable verification methods to determine accredited investor status.  Unlike Reg CF, Rule 506(c) has no limitation on how investors are solicited or the content of any advertising.  To maximize proceeds, companies appearing on Unicorn Hunters will try to include all investments from accredited investors in the Rule 506(c) side of the offering, which has no cap on the dollar amount raised.  Furthermore, once a presenting company on the show reaches the $5 million limit from Reg CF investors, the company will only accept further investment from accredited investors and only under Rule 506(c).  Nevertheless, not all accredited investors will be willing to provide the additional information or third-party certifications needed for verification as required under Rule 506(c).  The Unicorn Hunters Fact Sheet states that its broker/dealer partners will be responsible for determining if proper validation of accredited investor status has been completed.  Interestingly, Unicorn Hunters’ designated broker dealer for investments under Rule 506(c) is Livingston Securities, controlled by Scott Livingston, a Uniform Hunters panelist.

Key Takeaway

Self-styled as a new genre of “enrichtainment”, Unicorn Hunters will aim to combine entertainment with the drama of millions of viewing investors being given the opportunity to invest in growth companies with the chance, however remote, that one or more of these companies will become a unicorn.  This is equity crowdfunding, and reality television is its newest frontier.  But lurking beneath the entertainment aspect of the show are the complex rules that govern how unregistered securities may be offered to the public.  Presenting companies will need to be mindful of the prohibition under Reg CF on discussing the terms of the offering on air (i.e., outside the permissible confines of the funding portal), and the intermediary will have a tall task monitoring individual investment limitations.  I’m excited to see how this goes, and what exactly companies will be saying on air about their offering terms.  All I can say at this point is: stay tuned!



Perhaps the most vexing threshold issue faced by any company considering a capital raise is which securities exemption to pursue.  The chosen exemption largely depends on the targeted amount of the raise, as well as the manner in which potential investors will be solicited and the type of disclosure to be provided.  But this presents a capital-raising Catch 22 for issuers:  you can’t know for sure how much can be raised and from whom without first soliciting interest, but until recently soliciting interest would generally constitute a general solicitation which could blow the ultimate exemption used.  The SEC has attempted to rectify this Catch 22 by adopting new Rule 241 which allows issuers to “test the waters” by making a generic solicitation of interest in an offering prior to deciding on which exemption to pursue.

New Rule 241, adopted as part of the SEC’s significant exempt offering reforms which became effective March 15, provides that, prior to selecting an exemption for a particular offering, an issuer may solicit investors to determine the extent of investor interest.  Communications under the Rule would be deemed securities offers for fraud liability purposes, and Rule 241 will not preempt applicable blue sky registration or qualification.  No solicitation or acceptance of money is allowed, nor is any investor commitment permitted until the issuer commences an offering meeting the requirements of a particular exemption.

To protect prospective investors, Rule 241 communications must state that (i) the issuer is considering an exempt offering but has not determined the specific exemption, (ii) no money or other consideration is being solicited, and none will be accepted, (iii) no offer to buy the securities can be accepted and no part of the purchase price can be received until the issuer determines what the exemption will be and any applicable filing, disclosure and qualification requirements are met, and (iv) a prospective investor’s indication of interest involves no obligation or commitment of any kind.  Such communications may include the means by which a person may indicate his interest, and may require the person’s name, address, telephone number and/or email address in any response form.

The new test-the-waters exemption under rule 241 is similar to the one available in connection with registered public offerings.  Rule 241 is broader in scope, however, in that it allows generic solicitations of interest to anyone, whereas those for registered offerings may only target qualified institutional buyers and institutional accredited investors.

One trap for the unwary here is that a Rule 241 test-the-waters communication may be deemed to be a general solicitation, depending on facts and circumstances.  An issuer would not be able to engage in a solicitation of interest constituting general solicitation and then pursue an offering exemption that prohibits general solicitation, such as under Rule 506(b) or Section 4(a)(2).  The SEC provided in its final rules release that an issuer may reasonably conclude, depending on the facts and circumstances, that a test-the-waters communication targeted only to qualified institutional buyers and/or institutional accredited investors would not constitute general solicitation. Accordingly, issuers contemplating an exemption that prohibits general solicitation may decide to solicit interest only from qualified institutional buyers and/or institutional accredited investors.

If an offering is launched under Regulation Crowdfunding or Regulation A within 30 days following a Rule 241 communication, the issuer must file the written communication or broadcast script (as applicable) as an exhibit to the Form C or Form 1-A, as applicable, which is filed with the SEC. If a Rule 241 communication is followed within 30 days by a Rule 506(b) offering in which any securities are sold to a non-accredited investor, the written communication or broadcast script must be provided to such non-accredited investor a reasonable period of time before the sale.

For Regulation Crowdfunding issuers, Rule 241 will serve to complement new Rule 206 and Rule 204.  Rule 206 allows test-the-waters communications after an issuer decides to rely on Regulation CF but before it files a Form C.  Rule 204 was amended in connection with these new rules explicitly in order to permit oral communications after filing Form C, clarify that an issuer may include a description of the planned use of proceeds and progress information and permit issuers to provide information about the offering in a concurrent offering (e.g., under Regulation A). The combination of these test-the-water rules should be enormously helpful to companies contemplating Regulation CF campaigns as it will allow them to gauge investor interest before committing significant resources.

On December 2, the Securities and Exchange Commission filed a lawsuit against Ripple Labs, Inc. and two of its executives alleging they offered and sold over $1.38 billion of digital asset XRP without registration or exemption in violation of Section 5 of the Securities Act of 1933, seeking disgorgement of ill-gotten gains.  Ripple filed an answer on January 29 denying that XRP is a security or that it violated the securities laws.  At the heart of this case is the issue that’s been central to just about every other enforcement action brought by the SEC in the digital asset space: whether XRP is an “investment contract” and thus a security.  The court in Ripple may have a unique opportunity to fill a regulatory vacuum and provide needed guidance to cryptocurrency network developers about how to launch digital currencies without triggering the securities laws.  The decision in the Ripple case may indeed make waves throughout digital asset markets.

Ripple and XRP

Ripple operates a network that allows cross-border payments using the cryptocurrency XRP to facilitate currency transfers over the XRP network.  XRP differs from Bitcoin or Ether, two cryptocurrencies acknowledged by the SEC to be non-securities, in that Bitcoin and Ether are minted through the mining process, whereas XRP’s supply was capped at 100 billion XRP when it was created in 2012, 20 billion of which was transferred to Ripple’s three co-founders and the remaining 80 billion was left in reserve for future issuances.

Regulatory Landscape

SEC enforcement actions in the digital asset space tend to focus on the last two prongs of Howey, namely whether purchasers had a reasonable expectation of profit, and if so whether the profit expectation was dependent on the efforts of others.  Key factors relevant to the profit expectation prong include whether the promoter marketed the digital assets to prospective users for their functionality or alternatively to investors for the tokens’ speculative value.  Important elements in determining the efforts of others prong have included whether the network was decentralized or fully functional.

For the past several years, crypto network developers have faced a regulatory Catch-22.  Distributing tokens to people may violate the securities laws if the network isn’t functional or decentralized.  But it can’t mature into a functional, decentralized network that isn’t dependent on the managerial and entrepreneurial efforts of a single group unless the tokens are distributed to and freely transferable among potential users and developers on the network.

This is where the Ripple case can provide much needed clarity.  Prior cases have focused on whether the developer suggested the tokens will increase in value and whether it tried to support a secondary market.  But a meaningful facts and circumstances analysis should really dig deeper.  A developer’s touting of a token’s potential to increase in value certainly makes the token look like an investment contract, but it could also be explained more innocently as an expression of a desire that the network succeed and be used by lots of people.  Some crypto network developers have proceeded with digital token offerings in the hope of being able to convince the SEC that its token is sufficiently functional and avoid being branded an investment contract, but this approach is risky because it’s difficult to prove that a token is functional before distributing it to lots of people for use on the network.

One alternative for a crypto network developer would be to bite the bullet, concede the securities issue and sell the tokens to investors under an exemption from registration.  Several blockchain network developers have done so under Rule 506 of Regulation D, but that approach has severe limitations inasmuch as the issuer is limited to selling only to accredited investors.  Further, if the offering is under Rule 506(c), which is expected because the offering would likely involve general solicitation efforts, the seller would need to use enhanced methods of verification of accredited investor status, which isn’t practical.  Another exemption pathway would be a mini-public offering under Regulation A+.  But that is a more expensive process that involves intermediaries, which would undercut one of the primary advantages of a blockchain network, namely that it is decentralized with people transacting directly with each other without the need for intermediaries.

Another alternative would be to distribute the tokens only outside the U.S. in jurisdictions that would allow it.  The risk here is that the tokens could easily find their way back to the U.S.  And from a public policy perspective, a regulatory regime that incentivizes entrepreneurs to operate outside the U.S. denies Americans and U.S. markets the opportunity to participate in an innovative opportunity.

Last year, SEC Commissioner Hester Peirce proposed a safe harbor for blockchain network developers that would entail a three-year grace period during which they could develop a functional or decentralized network exempt from registration, so long as certain disclosure, intended functionality, liquidity and notice conditions are met.  I blogged about the proposal here.  It represents a sensible, practical solution to the blockchain developers’ regulatory Catch 22, although it hasn’t been formally proposed by the SEC.

The SEC’s Claims

The SEC alleges that from at least 2013 through the present, Ripple, its Chairman and its CEO sold over 14.6 billion XRP in return for nearly $1.4 billion in cash or other consideration to fund Ripple’s operations and enrich themselves.  They did so despite two memos from Ripple’s lawyers telling the company in 2012 that XRP may be considered an investment contract, that XRP differed from Bitcoin because Ripple had identified itself as responsible for the distribution, promotion and marketing of the network XRP traded on and that it should seek guidance from the SEC on how to distribute XRP without triggering the securities laws.  Further, Ripple promised during the offering that it would engage in efforts to increase the value of XRP, and then engaged in extensive entrepreneurial and managerial efforts with proceeds from the offering.  It also touted the potential future use of XRP by certain specialized institutions while simultaneously selling XRP widely into the market.

The SEC asserts that XRP is an investment contract and thus a security under the Howey Test, which is met when there’s an investment of money in a common enterprise with a reasonable expectation of earning profit through the efforts of others.  Ripple promised to undertake significant efforts to develop, monitor and maintain a secondary market for XRP with a goal of increasing trading volume and resale opportunities. It made repeated public statements highlighting its business development effort that will drive demand, adoption and liquidity of XRP, and held itself out as the primary source of information regarding XRP. The SEC alleges these factors led investors reasonably to expect that Ripple’s entrepreneurial and managerial efforts would drive the success or failure of Ripple’s XRP network.

Ripple’s Response

Ripple’s response to the SEC’s lawsuit is multifaceted.  In its answer to the complaint, it notes the SEC’s action comes five years after the DOJ and FinCen determined in a separate proceeding that XRP is a virtual currency.  It states that inasmuch as the SEC has previously deemed Bitcoin and Ether not to be securities, this action would amount to the SEC picking virtual currency winners and losers.  It asserts the mere filing of the lawsuit has caused immense harm to XRP holders, with an estimated $15 billion in damage to those the SEC purports to protect.

Ripple asserts it never conducted an initial coin offering, never offered or contracted to sell future tokens as a way to raise money to build an ecosystem, has no explicit or implicit obligation to any counterparty to expend efforts on their behalf and never explicitly or implicitly promised profits to any XRP holder.  For these reasons, Ripple concludes XRP holders cannot objectively rely on Ripple’s efforts.  Further, Ripple has its own equity shareholders who purchased shares in traditional venture capital funding rounds and who, unlike purchasers of XRP, did contribute capital to fund Ripple’s operations, do have a claim on its future profits and obtained their shares through a lawful (and unchallenged) exempt private offering.

Ripple seems to be signaling it knows it’s in trouble as it appears to be going above and beyond in asserting it is being treated differently than other cryptocurrency initiatives which have not been targeted with an SEC enforcement action.  Ripple filed a Freedom of Information Act request seeking all SEC communications regarding other cryptocurrencies, and its legal team includes such heavyweights as former SEC Chairwoman Mary Jo White and the former Director of Enforcement at the SEC, Andrew Ceresney, both now of Debevoise & Plimpton.

Why Ripple is Potentially Significant

Whether or not cryptocurrencies are investment contracts and thus securities remains an unresolved issue vexing crypto network entrepreneurs, and there could be some meaningful case law to emerge from Ripple on this. Although Commissioner Peirce’s safe harbor recommendation seems like a good way to promote innovation in this space without hammering entrepreneurs right off the bat with onerous securities regulatory requirements, there’s no reason to believe it will be formally proposed by the SEC given the new administration’s paternalistic emphasis on investor protection.  Cryptocurrencies cannot be launched in a decentralized manner.  Like network effects in economics, cryptocurrency networks need to hit a critical mass of participants for the network to be economically viable.  Most cryptocurrencies are considered decentralized with no central authority governing the blockchain.  Whether or not Ripple has that kind of central authority is what this case seems to be hinging on.

Right now we’re in a regulatory vacuum in which the SEC has not provided enough formal guidance to cryptocurrency developers and their lawyers about how to launch digital currencies without triggering the securities laws.  If it doesn’t settle, Ripple could be a seminal case in the cryptocurrency arena and an opportunity to set forth clear, objective standards which could hopefully be followed by well-intentioned crypto network developers.  If that happens, Ripple could make waves in the digital asset space.

For the second time in nine days, I recently drove ten hours round-trip to drop my son off at school for spring semester.  The first time around, he ended up returning home with me the next day for unexpected oral surgery to remove his wisdom teeth after completing his mandatory one-day COVID quarantine at school.  But on his second return to school several days later, he was required by the university to undergo another round of COVID testing and isolation protocols all over again.

It’s pretty common for issuers in follow-on offerings to solicit investors from previous rounds first.  Indeed, doing so is often mandatory when early investors have preemptive rights.  If the particular offering exemption relied upon by the issuer includes an investor qualification requirement, the investor may need to endure the hassle of re-establishing his qualifications all over again in each subsequent round, sort of like my son’s repeat COVID testing and quarantining.  And if the verification method required by a particular offering exemption is time consuming, expensive and invasive, the issuer may decide it’s not worth the trouble and instead opt for another exemption, or the investor may choose to invest in another company.

Such has been the case with the offering exemption under Rule 506(c) of Regulation D.  As part of the Jumpstart Our Business Startups Act of 2012, Congress and the Securities and Exchange Commission created a new variation on the old private offering exemption to allow issuers to solicit investors by means of general solicitation (e.g., the internet), provided they sold only to accredited investors and used “reasonable methods” to verify qualification.  Rule 506(c) is principles-based (requiring an objective determination as to whether a proposed verification method is reasonable in light of the particular facts and circumstances of each investor and transaction) with a few non-exclusive safe harbor methods, such as reviewing tax returns, brokerage statements, appraisal reports and credit reports, and obtaining written confirmation from the investor’s broker-dealer, investment advisor, lawyer or certified public accountant that the investor is accredited. But despite the great promise of the new rule to allow issuers to use the internet to find investors, the vast majority of private offerings are not being conducted under Rule 506(c) but rather old Rule 506(b), notwithstanding the restrictive prohibition on general solicitation.  The overall consensus is that Rule 506(c) is significantly underutilized because the verification requirement is still perceived by many individual investors and issuers (deservedly or not) as an invasion of privacy, needlessly expensive and time consuming, despite the emergence of third party verification firms.

Recognizing that the burden of Rule 506(c)’s investor verification rule is exacerbated by the current requirement to repeat the intense scrutiny with each follow-on offering, the SEC, as part of the new exempt offering rules it adopted last November, relaxed the requirement as it would apply to previously verified investors.  Specifically, an issuer may establish that a previously verified investor remains an accredited investor at the time of a subsequent sale under Rule 506(c) merely by having the investor provide a written representation that he continues to qualify, so long as the issuer is not aware of information to the contrary and the previous verification occurred within five years prior to the subsequent sale.

The five year window was added to the final rule to address concerns that permitting reliance on a prior verification over an unlimited period of time may not appropriately account for changes in financial circumstances and could result in issuers raising money from non-accredited investors.  The SEC believes the five-year period is not so remote that the initial verification is no longer meaningful, and together with the preexisting relationship between the issuer and such investor, will appropriately balance cost and burden reduction with risk mitigation.

The relaxation of the verification rule for previously verified investors should make it easier for issuers to conduct, and encourage investors to be more willing to participate in, multiple offering rounds utilizing the internet or other general solicitation techniques under Rule 506(c).

The new exempt offering reform rules were published in the Federal Register on January 14, meaning that they would ordinarily become effective March 15 (60 days after publication).  But as per my last blog post, there exists some uncertainty regarding whether any of the reforms will become effective, or at least when.  That’s because President Biden ordered a “Regulatory Freeze Pending Review”, which provides, as to regulations that have already been published in the Federal Register but have not taken effect, that the heads of executive departments and agencies are instructed to consider postponing the rules’ effective dates for 60 days for the purpose of reviewing any questions of fact, law and policy the rules may raise.  Consequently, issuers should sit tight until further confirmation from the SEC or the new administration as to the effectiveness of the accredited investor verification rule or any other aspect of the exempt offering reforms adopted by the SEC in November.

A freeze on government regulation is generally perceived by most people as being a positive development for private enterprise.  Not necessarily so, however, when the regulation being frozen is itself a reform of preexisting regulatory burdens.

Among the many Presidential Actions taken by President Biden on his first day in office was one entitled Regulatory Freeze Pending Review, in which he ordered that all final regulations that have not yet become effective (because they haven’t completed the standard process of publication in the Federal Register followed by a waiting period) be frozen pending further review.  Specifically, regulations that have been sent to the Office of the Federal Register but not yet published in the Federal Register are to be immediately withdrawn for review and approval.  As to regulations that have already been published in the Federal Register but have not taken effect, the heads of executive departments and agencies are instructed to consider postponing the rules’ effective dates for 60 days for the purpose of reviewing any questions of fact, law and policy (emphasis added) the rules may raise.

Among the regulatory developments potentially impacted by the regulatory freeze are the November 2020 reforms on the exempt offering framework, which include rules specifically relating to crowdfunding under Regulation CF and Regulation A.  I previously blogged on these important reforms here, here, here and here, and indicated that the new rules would not be effective until 60 days after publication in the Federal Register.

As of my last blog post dated January 10, the exempt offering rules had not yet been published in the Federal Register.  The rules finally did get published on January 14.  Although the delay from November 2 to January 14 seemed strange inasmuch as final rules typically make their way over to the Federal Register within days following SEC adoption, to paraphrase Samuel Jackson in Pulp Fiction: “I didn’t give a lot of thought to what it meant”.  Until now.

The new exempt offering rules passed by the SEC in November were intended to be common sense reforms to facilitate capital formation, increase opportunities for investors and simplify and harmonize certain aspects of the exempt offering framework while preserving or enhancing important investor protections.  Seems pretty non-controversial, something everyone should be able to agree on.  But not everyone agrees that the new exempt offering rules preserve investor protections.

On December 4, 2020, the Chairwoman of the House Financial Services Committee Maxine Waters, on behalf of the Democratic members of the Committee, sent a letter to then President-elect Biden highlighting several areas where his administration “should immediately reverse the actions of [his] predecessors”.  Among the predecessors’ actions targeted by Cong. Waters are several taken by the SEC “that have … stripped away fundamental investor protections, including safeguards around private markets, where investors have few protections”.

Cong. Waters is not alone in her hostility to capital markets reform efforts by the SEC because of investor protection concerns.  In her dissent to the SEC’s exempt offering framework amendments, Commissioner (now Acting Chair) Allison Herren Lee did not mince words, asserting that the new rules on integration, test the waters and demo days, among others, exacerbate concerns over investor protections by encouraging a surge in general solicitation and offers to non-accredited investors in the private markets without a reliable method for regulators to determine if an exemption is available.  Commissioner Lee argued the best opportunities for retail investors are in the public markets where we should be encouraging investment, not in the private markets which have fewer investor safeguards.

Also at risk in the regulatory freeze are the proposed reforms of the rules that require private capital markets finders to be registered with the SEC as broker dealers.  On October 7, the SEC issued proposed rules for a limited, conditional exemption from broker-dealer registration for individual finders who engage in limited activities on behalf of issuers.  I blogged about that here.  Investor protection hawks have argued against the finder reform proposals, including Cong. Waters in her December 4 letter to the SEC and Commissioner Lee in her dissent to the proposed finder rules which she entitled “Regulating in the Dark: What We Don’t Know About Finders Can Hurt Us”.

Technically, the Presidential Action calling for a regulatory freeze may just mean an inconvenient delay in recently promulgated capital markets reforms becoming effective.  But that assumes no philosophical difference in policy. President Biden’s nominee for SEC Chair, Gary Gensler, has not yet been confirmed by the Senate and it’s anyone’s guess as to where he stands in the debate on private capital markets reform.  But there’s no guessing required as to where Acting SEC Chair Allison Herren Lee stands, and accordingly the risk of reform rollback is real, which if realized will impede crowdfunding markets from achieving their full potential.

You just raised $1 million in your crowdfunding offering under Title III/Regulation CF.  That’s the good news.  The bad news?  You now have over a thousand shareholders on your cap table, making it unwieldy, an administrative nightmare and likely to impede future funding.  It means a huge challenge seeking consents for such things as director elections, strategic decisions and later funding rounds.  And later rounds in turn will become more difficult to achieve as the company is perceived to be less attractive.

One way to avoid the messy cap table problem would be to conduct the raise through a special purpose vehicle whose sole purpose is to recruit investors and invest the proceeds in an identified operating company.  The investors receive interests in the SPV, and the operating company adds only one new shareholder to its cap table.  Unfortunately, SPVs have not been eligible under Regulation Crowdfunding.

Until now.  As part of the reform package adopted by the SEC last November to facilitate capital formation (see my previous posts here, here and here), the SEC lifted the prohibition on the use of special purpose vehicles in Regulation Crowdfunding offerings.  The crowdfunding ecosystem has been clamoring for this change for years, primarily because it would alleviate the messy cap table problem.  But the SPVs that will be allowed to recruit investors into Regulation CF deals must meet several stringent requirements not present in typical venture SPVs many of us are familiar with.  This is not your father’s SPV.


Technically, the reason SPVs were ineligible to offer securities under Title III of the JOBS Act is because of Regulation CF’s exclusion of “investment companies” and even companies excluded from the investment company definition because of having fewer than 100 investors or only “qualified purchasers”.  Since an “investment company” is defined generally as a company in the business of holding the securities of other companies, issuers were not allowed to conduct Regulation CF offerings through SPVs.

In addition to contributing to the messy cap table problem, the ineligibility of SPVs also increased the likelihood of prematurely triggering Securities Exchange Act registration due to the number of overall shareholders or the number of non-accredited investors.  Section 12(g) of the Exchange Act requires an issuer with total assets of more than $10 million and a class of securities held of record by either 2,000 persons, or 500 persons who are not accredited investors, to register that class of securities with the SEC.  Most companies seek to avoid Exchange Act registration until a time of their choosing.  Regulation Crowdfunding, however, does conditionally exempt securities issued under Regulation Crowdfunding from the shareholder number registration trigger under Section 12(g) if certain conditions are met, including having total assets of $25 million or less.  The $25 million asset threshold, combined with the 2,000/500 shareholder cap, could be a real trap for crowdfunding issuers.

New Conditional Crowdfunding Vehicles

The new SPV rules exclude from the definition of “investment company” crowdfunding vehicles that meet specific conditions designed to require that they function purely as conduits for investors to invest in a company seeking to raise capital through a crowdfunding vehicle.  To be excluded from the definition of “investment company” and thus be eligible to participate in an offering under Regulation Crowdfunding, a crowdfunding vehicle must:

  • be organized and operated for the sole purpose of acquiring, holding, and disposing of securities issued by a single crowdfunding issuer and raising capital under Regulation Crowdfunding;
  • not be permitted to borrow money;
  • be required to use the proceeds solely to purchase a single class of securities of a single crowdfunding issuer;
  • be permitted to issue only one class of securities in which the crowdfunding vehicle and the crowdfunding issuer are deemed to be co-issuers under the Securities Act;
  • maintain the same fiscal year-end as the crowdfunding issuer;
  • maintain a one-to-one relationship between the number, denomination, type and rights of crowdfunding issuer securities it owns and the number, denomination, type and rights of its securities outstanding;
  • vote the crowdfunding issuer securities, and participate in tender or exchange offers or similar transactions, only in accordance with instructions from the investors in the crowdfunding vehicle;
  • provide to each investor the right to direct the crowdfunding vehicle to assert such rights under state and federal law that the investor would have if he or she had invested directly in the crowdfunding issuer; and
  • promptly provide each investor any information that it receives from the crowdfunding issuer as a shareholder of record of the crowdfunding issuer.

The requirement that the crowdfunding vehicle issue only one class of securities in which the crowdfunding vehicle and the crowdfunding issuer are deemed to be co-issuers means that each of the issuer and the vehicle  would be deemed to be the maker of any statements by the crowdfunding vehicle and any material misstatements or omissions with respect to the offering.  The two entities (issuer and vehicle) would also be required to file jointly a Form C providing all of the required Form C disclosures with respect to (i) the offer and sale of the crowdfunding issuer’s securities to the crowdfunding vehicle and (ii) the offer and sale of the crowdfunding vehicle’s securities to the investors.

The crowdfunding issuer, for its part, must file its own Form C if it is separately offering securities both through a crowdfunding vehicle and directly to investors, and fund or reimburse the expenses associated with the crowdfunding vehicle’s formation, operation, or winding up.

The SEC also provided some Section 12(g) registration relief in the new crowdfunding vehicle rules.  A crowdfunding vehicle will constitute a single record holder in the crowdfunding issuer for purposes of Section 12(g) of the Exchange Act, but only to the extent that all investors in the crowdfunding vehicle are natural persons.  An issuer must include in the Section 12(g) calculation securities issued by a crowdfunding vehicle that are held by investors that are not natural persons.

Interesting to note that the SEC considered, but ultimately did not require, that a registered investment adviser manage the crowdfunding vehicle. The SEC explained that doing so would have made the SPV more than just a conduit, let alone that the RIA requirement would not be economically feasible for startups.

Key Takeaways

The restrictions on the use of crowdfunding vehicles in Regulation Crowdfunding offerings are intended to provide investors in the crowdfunding vehicle the same economic exposure, voting power and disclosures as if the investors had invested directly in the crowdfunding issuer.  The crowdfunding vehicle must act merely as a conduit for the crowdfunding issuer and not an independent investment entity like a fund or other similar investment vehicle.

For those crowdfunding issuers that choose to use crowdfunding vehicles, the new rules will ease cap table burdens and remove a potential deal breaker for future investors.  It will provide smaller investors with more leverage to negotiate better terms and protections, making crowdfunding safer and more profitable for them, and attract more capital and higher profile investors.

Also, a crowdfunding offering resulting in only one new shareholder for Exchange Act registration purposes under Section 12(g) (assuming all crowdfunding vehicle investors are natural persons) will be enormously helpful for issuers with assets of $25 million or above.

Nevertheless, because of the onerous conditions, each issuer will need to make its own cost-benefit analysis prior to implementing a crowdfunding vehicle strategy, which should take into consideration the issuer’s offering experience, potential for raising follow-on financing from a large investor, costs associated with the creation and administration of the crowdfunding vehicle and the number of small investors likely to participate in the crowdfunding offering.

The new crowdfunding vehicle rules won’t be effective until 60 days after publication in the Federal Register.  I anticipate the new rules will be published in the Federal Register soon and be effective sometime in March of this year.

At the 1932 Democratic National Convention, the live band at one point burst into “Happy Days are Here Again”, FDR’s favorite, drawing raucous cheers from convention delegates.  It went on to become the Democratic Party’s unofficial theme song for years to come.  The song is also associated with the repeal of Prohibition shortly after FDR’s election, sporting signs saying “Happy Days are Beer Again”.  And after the new rules passed last month by the Securities and Exchange Commission on how “demo-days” may be promoted without violating the securities laws, many of us could be forgiven if we break out into “Demo Days are Here Again”!

Welcome to Part Two of my deeper dive series into the SEC’s recently promulgated exempt offering amendments.  The final rules release could be found here, my initial post on the release here and Part One of the series on the new higher exempt offering caps here.

Like many others in the innovation ecosystem, I get lots of invitations to attend so-called demo-days or pitch days at which startups are invited to present to an audience that ostensibly includes potential investors, with the aim of securing investment.  Promoters of demo-days broadly advertise these events over the internet and through email blasts.  Yet since the most commonly used offering exemption prohibits the use of general solicitation, I’m often left scratching my head, hopefully not over a bad case of pityriasis capitis, thinking how this is not a blatant securities law violation.

That’s because a general solicitation is defined in Rule 502(c) to include “any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.”  Under previous SEC guidance, a demo day presenter would not be deemed to have engaged in general solicitation if the promoter limits attendance to individuals either with whom the startup or the promoter has a pre-existing substantive relationship or that have been contacted through an informal, personal network of experienced, financially sophisticated individuals, such as angel investors.  But for most demo day events, that doesn’t get enough people in the room.

New Rule 148

Under new Rule 148, a demo day communication will not be deemed to constitute general solicitation or general advertising if certain conditions are met with respect to the issuer, advertising content, the promoter and communications concerning an offering.  There are additional limitations on virtual events.

First, more than one issuer must participate in the event.  This is intended to prevent a promoter from holding an event that is essentially a sales pitch for one issuer’s offering while calling it a “demo day.”

Second, no sponsorship by brokers, dealers or investment advisers.  The idea here is to limit the exemption to events sponsored by organizations less likely to have a profit motive for their involvement in the event or whose sole or primary purpose is to attract investors to private issuers.

Third, if the demo day is organized by an angel group, the group must have “defined processes and procedures” (although not required to be in writing) for investment decisions.

Fourth, no referencing any specific offering of securities by an issuer in any event advertising.

Fifth, sponsors may not provide investment advice to attendees, help negotiate an investment, charge fees other than reasonable administrative fees, receive compensation for making introductions between attendees and issuers, or receive any event compensation that would trigger registration as a broker or dealer under the Securities Exchange Act or as an investment adviser under the Investment Advisers Act.  The rationale here is to limit the potential for a sponsor to profit from its involvement or to have a potential conflict of interest due to its relationship with either the issuer or investors attending the event.

Sixth, information that may be communicated regarding an offering of securities is limited to notification that the issuer is in the process of offering or planning to offer securities, type and amount of securities being offered, intended use of the proceeds and unsubscribed amount.

And lastly, online participation in the event is limited to individuals associated with the sponsor organization (e.g., members of an angel group or students, faculty and alumni of a university), individuals the sponsor reasonably believes are accredited investors and individuals invited to the event by the sponsor based on industry or investment-related experience reasonably selected by the sponsor in good faith and disclosed in the public communications about the event.  These participation restrictions address concerns about events otherwise making broad offering-related communications to non-accredited investors, particularly in light of the increasing prevalence of virtual “demo days” which are more accessible and widely attended by the general public.

Overall, new Rule 148 will allow startups greater flexibility at demo and pitch day events to say a few high-level things about their offerings without the uncertainty as to whether they’re blowing their offering exemption in the process. Demo days are here again!

Last month, the Securities and Exchange Commission passed sweeping reforms of the rules governing exempt offerings (the “2020 Reforms”) to make it easier for issuers to move from one exemption to another, to bring clarity and consistency to the rules governing offering communications, to increase offering and investment limits and to harmonize certain disclosure requirements and bad actor disqualification provisions.  I blogged about the SEC’s rules release here.  I also said at the time I would blog separately about some of the particular reforms contained in the new rules.  Here, then, is the first installment of a multi-part series on the new reforms, this one on the new offering and investment caps for Regulation A, Regulation Crowdfunding and Rule 504.

The SEC has estimated that approximately $2.7 trillion of new capital was raised through exempt offerings in 2019, of which only 0.05% was raised under Regulation A, Regulation Crowdfunding and Rule 504 combined.  These three exemptions contain a variety of requirements and investor protections, including limits on the amount of securities that may be offered and sold under the exemptions. Regulation A and Regulation Crowdfunding also include limits on how much an individual may invest.   One of the primary reasons cited for the underutilization of these exemptions is that the dollar limits have been set too low to make them useful.

Higher Caps for Tier 2 of Regulation A

SEC rules promulgated in 2015 under the JOBS Act of 2012 established two tiers of offerings under Regulation A: Tier 1 for offerings up to $20 million in a 12-month period, and Tier 2 for offerings that do not exceed $50 million in a 12-month period.

The 2020 Reforms increase the maximum offering amount under Tier 2 of Regulation A from $50 million to $75 million, and the maximum offering amount for secondary sales by existing affiliate stockholders from $15 million to $22.5 million.

Despite the increase in the offering cap to $50 million in 2015, Regulation A financing levels remained modest relative to traditional IPOs and Regulation D.  A 2020 report by the SEC’s Division of Corporation Finance found that from June 2015 to December 2019, $2.4 billion was raised by 183 issuers in Regulation A offerings, $230 million in Tier 1 and $2.2 billion in Tier 2.  The 2020 report noted that the weak Regulation A deal levels are likely related to a combination of factors, including the pool of issuers and investors drawn to the market under existing conditions, availability to issuers of attractive private placement alternatives without an offering limit, availability to investors of attractive investment alternatives outside of Regulation A with a more diversified pool of issuers, limited intermediary participation and a lack of traditional underwriting and a lack of secondary market liquidity.

The new $75 million cap will likely attract a more seasoned pool of investors as well as institutional investors, and improve the economics for issuers and broker dealers to participate in the Regulation A market.

Not everyone was in favor of raising the Tier 2 cap.  Some opponents believe that issuers raising such large amounts of capital should be subject to the full disclosure regime of a Securities Act registration. Others worry about the negative effects of increasing the use of Regulation A for unsophisticated non-accredited retail investors given the increased risks of investor losses.  The counter view, however, is that the enhanced issuer eligibility, content and filing requirements for issuers in Tier 2 offerings continue to provide appropriate protections for investors at the higher offering limit.

Higher Caps for Regulation Crowdfunding

The JOBS Act provided that the aggregate amount raised in Regulation Crowdfunding offerings during any 12-month period may not exceed $1 million, but also required the SEC to adjust the aggregate cap not less frequently than once every five years to reflect changes in the Consumer Price Index for All Urban Consumers.  In 2017, the SEC raised the maximum offering limit to $1.07 million.

Regulation Crowdfunding also limits the amount individual investors are allowed to invest across all Regulation Crowdfunding offerings over the course of a 12-month period. The amount of the individual limit depends on his or her net worth and annual income, with an overall cap currently set at $107,000.  The current (pre-amendment) individual investor limitations are set at:

  • The greater of $2,200 or 5% of the lesser of his or her annual income or net worth, if either annual income or net worth is less than $107,000; or
  • 10% of the lesser of his or her annual income or net worth, if both annual income and net worth are equal to or greater than $107,000.

The 2020 Reforms raise the Regulation Crowdfunding aggregate offering limit from $1.07 million to $5 million.  The 2020 Reforms also amend the investor limit in two important ways.  First, by not applying any investment limits to accredited investors; and second, by allowing non-accredited investors to rely on the greater of their annual income or net worth when calculating the limit on how much they may invest.

A 2019 SEC study found that the number of offerings and the total dollar amount of funding raised under Regulation Crowdfunding were relatively modest, with issuers raising only $108 million from May 16, 2016 through December 31, 2018. The study also found that the typical offering during the reviewed period raised less than the 12-month offering limit.

Approximately 2,000 offerings were initiated under Regulation Crowdfunding in the three and a half years from the time the exemption first became available through the end of 2019, but market participants had expressed concern that the vitality of the market and the number of offerings was being constrained by the $1.07 million offering limit.

Currently, companies seeking to raise more than $1.07 million need to spend time and expense pursuing other exempt offerings to supplement amounts raised under Regulation Crowdfunding and meet their funding needs, as the existing offering limits in Regulation Crowdfunding are insufficient to meet those needs. Permitting larger offerings under Regulation Crowdfunding should encourage more issuers to use the exemption and will lower the offering costs per dollar raised, which will make the exemption a more efficient capital raising option for smaller issuers.

The higher cap should also make Regulation Crowdfunding a more viable option for issuers looking to raise more than $1.07 million, but for which Regulation A may be cost prohibitive and for which Regulation D is too limiting in terms of the investor pool. Crowdfunding offerings permit greater participation of retail investors, in contrast to Rule 506(b) offerings under which technically up to 35 non-accredited investors may participate but as a practical matter hardly any offerings include them because of the built-in disclosure bias in favor of Rule 506(b) offerings made only to accredited investors.

As for accredited investors, the elimination of investment limits will make the treatment of accredited investors consistent across offering exemptions.  Accredited investors are not subject to investment limits in Regulation D offerings. Allowing accredited investors to invest without limit in a Regulation Crowdfunding offering will obviously help issuers to meet their capital raising goals.

Higher Caps for Rule 504

In 2016, the SEC amended Rule 504 to raise the aggregate dollar amount of securities an issuer may offer and sell in any 12-month period from $1 million to $5 million.  Nevertheless, Rule 504 continues to be a neglected capital raising pathway. From 2009 through 2019, only only two percent of the capital raised in sub-$5 million Regulation D offerings by issuers other than pooled investment funds was offered under Rule 504 (and under Rule 505, prior to its repeal), while 98 percent of the capital raised was offered under Rule 506.

The 2020 Reforms raise the maximum offering amount under Rule 504 of Regulation D from $5 million to $10 million.

The Rule 504 exemption has largely remained unused by issuers for several reasons, including the low $5 million offering cap. Increasing the offering amount will enable more issuers to gain access to this alternative pathway and provide more investment opportunities to investors.

But another reason for the underutilization of Rule 504 is the lack of state preemption. Securities issued in a Rule 504 offering are not deemed “covered securities”, as is the case under Rule 506(b) and (c), and as a consequence issuers in Rule 504 offerings must go through merit reviews under state blue sky laws in each state in which the offering is made.  Categorizing Rule 504 securities as “covered securities” would greatly simplify the compliance requirements for issuers relying on Regulation D, and further promote access to Rule 504 for issuers that previously ignored this exemption because of the onerous requirement to comply with state blue sky laws.  For the time being, the SEC has chosen not to take that step.

The foregoing offering cap changes will generally become effective 60 days after publication in the Federal Register, likely to occur sometime in February 2021.

On November 2, 2020, the SEC adopted significant rule amendments to simplify, harmonize and improve the exempt offering framework to facilitate capital formation and investment opportunities in startups and emerging companies. The rule amendments were initially proposed in March 2020, and first conceived in a concept release in June 2019.  The reforms simplify the integration doctrine, revise the offering and individual investment limits for certain exemptions, clarify communication rules regarding “testing-the-waters” and demo days and harmonizes disclosure and eligibility requirements and bad actor disqualification provisions. The amendments will generally become effective 60 days after publication in the Federal Register, likely to occur sometime in February 2021.

Each of the foregoing reforms is significant, and deserves its own blog post, so over the next several weeks I’ll aim to write more extensively about each one.  In the meantime, this post provides a brief summary of the amended rules, and for those who would like to go to the 388-page source, here’s a link to the SEC release containing the final rule amendments.


The amount of capital raised in exempt offerings in the United States is at least twice the amount raised in SEC-registered offerings. Emerging companies rely on multiple rounds of exempt offerings as to enable them to scale, and the trend has been for such companies to defer initial public offerings in favor of late stage private funding or other liquidity events.  The exempt offering framework has developed over time through legislative changes and SEC rules, including Regulation D and SEC rulemaking under the JOBS Act of 2012.  The current exempt offering framework is widely regarded as extremely complex and made up of differing, exemption-specific requirements and conditions.

On June 18, 2019, the SEC issued a concept release that solicited public comment on possible ways to simplify, harmonize and improve the exempt offering framework to promote capital formation and expand investment opportunities while maintaining appropriate investor protections.  After processing the comments received in response to the concept release, the SEC proposed a set of amendments in March 2020 that would generally retain the current exempt offering structure but reduce potential friction points, address gaps and complexities and help provide viable alternatives to dominant capital raising tools.

On November 2, 2020, the SEC issued a final rule release adopted the amendments substantially as proposed.

Integration Framework Reforms

The integration doctrine seeks to prevent an issuer from improperly separating a single offering into two or more separate offerings in an effort to fit the “separate” offerings within registration exemptions that would not be available for the combined offering. The Securities Act integration framework consists of a mixture of rules and SEC guidance for determining whether ostensibly separate securities transactions should be considered part of the same offering.

The amendments establish a new integration framework with a general principle that looks to the particular facts and circumstances of two or more offerings, and focuses the analysis on whether the issuer can establish that each offering either complies with the registration requirements of the Securities Act, or that an exemption from registration is available for the particular offering.

The new integration framework appears in the form of an amendment to Rule 152 under the Securities Act.  New Rule 152 will provide that offers and sales will not be integrated if, based on the particular facts and circumstances of the offerings, the issuer can establish that each offering either complies with the registration requirements of the Securities Act, or is eligible for an exemption from registration.

The amendments also provide the following four non-exclusive safe harbors from integration:

  • Any offering made more than 30 days before the commencement of any other offering, or more than 30 days after the termination or completion of any other offering, provided certain conditions are met.
  • Offers and sales made in compliance with Rule 701, pursuant to an employee benefit plan or in compliance with Regulation S will not be integrated with other offerings
  • an offering for which a registration statement has been filed will not be integrated if it is made subsequent to (i) a terminated or completed offering for which general solicitation is not permitted, (ii) a terminated or completed offering for which general solicitation is permitted that was made only to qualified institutional buyers and institutional accredited investors, or (iii) an offering for which general solicitation is permitted that terminated or was completed more than 30 calendar days prior to the commencement of the registered offering; and
  • offers and sales made in reliance on an exemption for which general solicitation is permitted if made subsequent to any terminated or completed offering.

Offering and Investment Limit Reforms

The new reforms will increase the offering and individual investment limits for certain exempt offerings, as follows:

Regulation AThe maximum offering amount under Tier 2 of Regulation A will increase from $50 million to $75 million, and for secondary sales from $15 million to $22.5 million.

Regulation CrowdfundingFor Regulation Crowdfunding, the amendments (i) raise the offering limit from $1.07 million to $5 million, and amend investment limits for investors by not applying any investment limits to accredited investors and allowing non-accredited investors to rely on the greater of their annual income or net worth when calculating the limit on how much they can invest.

Rule 504 of Regulation DThe maximum offering amount under Rule 504 of Regulation D will increase from $5 million to $10 million.

“Test-the-Waters” and “Demo Day” Communications

The rule amendments include several changes relating to offering communications, including:

  • permitting an issuer to use generic solicitation of interest materials to “test-the-waters” for an exempt offering of securities prior to determining which exemption it will use for the sale of the securities;
  • permitting Regulation Crowdfunding issuers to “test-the-waters” prior to filing an offering document with the SEC in a manner similar to current Regulation A; and
  • providing that certain “demo day” communications will not be deemed general solicitation or general advertising.

Special Purpose Vehicles for Regulation Crowdfunding

The amendments will allow sponsors to use Regulation Crowdfunding to raise capital into a special purpose vehicle whose purpose is to invest in an operating company.  Previously, special purpose vehicles were excluded from Regulation Crowdfunding.

Other Reforms to Specific Exemptions

The amendments also:

  • change the financial information that must be provided to non-accredited investors in Rule 506(b) private placements to align with the financial information that issuers must provide to investors in Regulation A offerings;
  • add a new item to the non-exclusive list of verification methods in Rule 506(c);
  • simplify certain requirements for Regulation A offerings and establish greater consistency between Regulation A and registered offerings; and
  • harmonize the bad actor disqualification provisions in Regulation D, Regulation A and Regulation Crowdfunding.

Stay tuned to my next blog post on the new integration rules, my first deeper dive installment on the new reforms.


On October 21, 2020, the United States District Court for the Southern District of New York entered a final judgment on consent against Kik Interactive Inc. to resolve the Securities and Exchange Commission’s charges that Kik’s unregistered public sale of digital tokens in 2017 violated the federal securities laws.  The final judgment requires Kik to pay a $5 million penalty, obligates Kik for the next three years to provide notice to the SEC before engaging in certain offers or sales of digital assets and permanently enjoins Kik from violating the registration provisions of the Securities Act of 1933.  Kik sold its digital tokens to the public prior to achieving functionality, which under prevailing legal standards meant that the tokens were deemed to be securities and their sale without registration or exemption violated the securities laws. But despite some unfortunate factors relied on by the court, the case leaves open the possibility for the unregistered public sale of fully functional digital tokens whose development is completely funded through an earlier exempt offering round.

Factual Background

Kik Interactive Inc. is a Canadian corporation formed in 2009 to develop a mobile messaging application called Kik Messenger. Despite the application’s initial success and Kik’s raise of over $100 million in venture funding, the company was losing Kik Messenger users by 2017 and was expected to run out of cash by the end of that year.  After an unsuccessful effort through an investment bank to get acquired, Kik pivoted and adopted a plan to fund its operations through a two-stage initial coin offering of “Kin” digital tokens for in-app purchases on its blockchain network: initially through simple agreements for future tokens or “SAFT”s, followed by a public sale of Kin into which the SAFT rights would convert at a 30% discount.

From May to September 2017, Kik offered and sold SAFTs to accredited investors, raising approximately $49 million. Under the SAFTs, Kik was obligated to deliver half the Kin tokens into which the SAFT was convertible at the time that Kik delivered tokens to the general public and the other half on the one-year anniversary of the first delivery.  Kik filed a Form D with the SEC after the conclusion of the SAFT offering, claiming an exemption under Rule 506(c).

The terms of the SAFT included an aggressive deadline of September 30 for the public token sale (which would trigger the issuance of the first half of the conversion Kin) with a draconian forfeiture feature: if the September 30 deadline was not met, Kik would be required to return 70% of the cash invested in the SAFT round ($35 million of the $49 million raised) to the SAFT investors.

Kik began offering Kin to the general public during the same period of May through September 2017 in which it was conducting the offer and sale of the SAFTs. With the September 30 deadline looming, Kik proceeded with closing the public token sale one day after the SAFT offering was completed.  Kik raised an additional $50 million in the public sale, with proceeds paid in Ether currency.

Legal Background

Two months before bringing the lawsuit against Kik in June of 2019, the SEC published a framework for analyzing the circumstances under which a digital token would be deemed an investment contract and thus a security.  It was intended to assist compliance with the U.S. federal securities laws by startups seeking to be funded by an initial coin offering by providing a toolkit for applying the Supreme Court’s Howey test to determine whether digital tokens are deemed to be “investment contracts” and therefor securities.  Under Howey, a financial arrangement is an investment contract when there is an investment of money, in a common enterprise, with a reasonable expectation of earning a profit through the efforts of others.

Under the framework, the inquiry into whether a purchaser is relying on the efforts of others generally focuses on whether, at the time the digital tokens are sold, the sponsor of the tokens is responsible for the development, improvement, operation or promotion of the network, and whether there are essential tasks or responsibilities to be performed by a sponsor, rather than an unaffiliated, dispersed community of network users commonly referred to as a “decentralized” network.  Other areas of focus are whether the sponsor creates or supports a market or price for the digital asset, and whether the sponsor has a continuing managerial role concerning the network or the characteristics or rights the digital asset represents.

Basically, where the network or the digital token is still in development and not fully functional at the time of the offer or sale, purchasers would reasonably expect a sponsor to further develop the functionality of the network or digital asset.  Under such circumstances, purchasers would be determined to have a reasonable expectation of earning a profit through the efforts of others and the digital token would be deemed to be an investment contract and thus a security (assuming the other prongs of the Howey test are also satisfied).

The SEC’s Lawsuit Against Kik

The SEC sued Kik in June of 2019, alleging that Kik’s offering of Kin digital tokens violated Section 5 of the Securities Act.

The SEC devoted most of its complaint to asserting facts to establish that Kik failed the last two prongs of Howey, namely that purchasers of Kin had a reasonable expectation of earning a profit from Kin and that such profit would necessarily flow from the efforts of others, namely the managers of Kik. The focus of the SEC’s complaint was on three overarching factors: the manner in which Kik marketed Kin to investors, the lack of functionality of the Kin token and ecosystem and Kik’s motivation for selling Kin to the public prior to achieving functionality.

Kik was shown to have marketed Kin in a manner that emphasized Kik’s primary role in developing it and the potential for Kin to increase in value, rather than the underlying ecosystem and functionality of the token.  Kik promised prospective investors that it would create demand for Kin by building new products, services and systems for the Kin ecosystem, by modifying Kik Messenger, by implementing new technology to allow for scalable, fast and cost-effective transactions, and by building a “rewards engine”.  Kik also emphasized its experience and ability, and maintained that Kik itself intended to profit from Kin’s appreciation in value.

The complaint next asserted that Kik pursued the public sale without first achieving a decentralized economy for Kin, and without even ensuring that investors would be able to buy goods and services with the tokens upon their receipt. Instead, Kik pursued a “superficial Minimum Viable Product” in the form of digital cartoon “stickers”, intended as an added benefit to Kik Messenger users who purchased Kin. The stickers would appear inside Kik Messenger and would be available only to Kin buyers who also had a Kik Messenger account. The more Kin owned by a Kik Messenger user, the higher the user’s “status” level and the more stickers the user could access.  According to the SEC, Kik developed the stickers in an effort to create a hypothetical “use” for the tokens, which Kik believed was relevant to whether its public sales of Kin were securities transactions under the securities laws.

So why didn’t Kik just defer the public sale until the Kin token and ecosystem were functional? Apparently, the $49 million of proceeds would not give Kik enough runway to complete the development of the Kin ecosystem and it needed to raise additional funds in the public sale.  Moreover, Kik was racing against the SAFT’s aggressive deadline for completing the public sale and effecting the issuance of the first tranche of Kin to the SAFT investors; failure to meet the deadline would mean forfeiture of $35 million of the $49 million raised.

On the third anniversary of that deadline, Judge Alvin Hellerstein ruled that Kik had offered and sold securities without registration or exemption in violation of Section 5 of the Securities Act, granting the SEC’s motion for summary judgment and instructing the parties to submit a joint proposed judgment for injunctive and monetary relief.

Judge Hellerstein’s opinion consists of two basic findings: First, that the sale of Kin to the public was a sale of a security requiring either registration or exemption; and second, that although the pre-sale of SAFTs, if viewed in a vacuum, appeared to have qualified for an exemption under Rule 506(b), it was actually part of an integrated offering with the public sale, thus blowing the exemption.

As to whether Kin was a security, Judge Hellerstein applied the Howey test and focused largely on the last two prongs: whether there was (i) an expectation of profit, (ii) through the efforts of others.  In its marketing campaign, Kik stressed the profit making potential of Kin, saying it would be tradable on secondary markets.  Although Kik also characterized Kin as a medium for consumptive use for digital services such as chat, social media and payments, any such consumptive use was unavailable at the time of Kin’s public distribution and would only materialize if the enterprise became successful.  Kik conveyed the notion that growth in value would rely heavily on Kik’s managerial and entrepreneurial efforts, saying that it would “provide startup resources, technology and a covenant to integrate with the Kin cryptocurrency and brand”. The judge also stressed that Kik’s insistence that market forces would drive the value of Kin “ignored the essential role of Kik in establishing the market”.

Even assuming Kik had met the requirements for an exemption under Rule 506(c) (primarily, use of reasonable methods to verify that all purchasers were accredited investors), the exemption would be blown if the SAFT presale would be found to be integrated with the public sale.  That’s because the reasonable verification requirement was clearly not be met as to all the purchasers in the public sale.  In determining whether two ostensibly separate offerings should be integrated, a court considers whether the offerings (i) are part of a single plan of financing, (ii) involve issuance of the same class of securities, (iii) have been made at or about the same time, (iv) involve the same type of consideration, and (v) are made for the same general purpose.  Not all factors have to exist, and courts generally give the most weight to the first and fifth factor.

As to the first and fifth factor, the court found that the SAFT round and the public sale were part of a single plan of financing, effected for the same general purpose. Proceeds from both sales went toward funding Kik’s operations and building the Kin ecosystem.  The two offerings were intertwined in ways that went beyond the use of funds, and the court used as an example that under the SAFTs, investors could not receive their Kin unless there was a successful launch through the public sale.  The court also found that Kik offered and sold the same class of securities in the two offerings, namely fungible Kin that were equal in value.  Although investors in the two offerings received the tokens via different instruments with different rights, the court determined the ultimate result was distribution of identical assets.  Finally, the sales took place at about the same time.  The only factor weighing against a finding of integration is that Kik received different forms of consideration from the two sales (dollars in the SAFTs, Ether in the public sale).

On October 21, the court entered final judgment on consent requiring Kik to pay a $5 million penalty, obligating Kik for the next three years to provide notice to the SEC before engaging in certain offers or sales of digital assets and permanently enjoining Kik from violating the registration provisions of the Securities Act.


There are a few valuable takeaways from this case.

First, the facts and circumstances were such that made it extremely easy for the court to conclude that the Kin digital tokens were securities.  Because of the draconian forfeiture feature in the SAFT, Kik chose to speed up the public release of the tokens before reaching anything close to full functionality in order to avoid forfeiting $35 million.  Kik’s marketing materials overwhelmingly emphasized the investment potential of the Kin tokens, rather than their utility.  Not all future blockchain startups seeking to fund development through ICOs, however, will be under the kind of financial stress experienced by Kik, and should be able to resist the type of forfeiture feature the SAFT investors imposed on Kik.  More importantly, given the SEC’s and the courts’ emphasis on token functionality, it should be evident that the amount raised in a SAFT should ideally provide sufficient runway to complete the development of the digital token and the underlying network to achieve full functionality.

Second, the court’s integration analysis suggests a very high bar to avoid integration and a blown exemption.  Here again, the facts easily pointed to a conclusion that the presale and public sale should be integrated.  The Kin public sale closed the day after the SAFT round, and both had the same general purpose.  But the court also relied on two factors that could create unfair integration challenges to issuers in the future.  One of those factors was that SAFT investors could not receive their Kin tokens unless there was a successful launch through the public sale.  But that would be true of every SAFT, and the reliance on this point as a factor could throw into question the viability of SAFT based ICOs.  The court also maintained that both the SAFT and the public Kin sale involved the issuance of the same security despite the fact that, as the court acknowledged, the respective investors received their securities through different instruments with different rights.  This too is a universal feature in SAFTs and thus presents additional uncertainty to ICOs involving them.  Hopefully, the courts will have an opportunity soon to clear up this uncertainty.