When Cryptocurrencies and Insurance Policies collide – The D&O Securities Exclusion in the Blockchain Age

When Cryptocurrencies and Insurance Policies collide – The D&O Securities Exclusion in the Blockchain Age

During the fall of 2020, when Ontarians were hunkering down for the second COVID-19 pandemic wave, the Ontario Superior Court of Justice released its decision in Kik Interactive Inc. v. AIG Insurance Company of Canada[1]. The Court was tasked with interpreting whether the respondent insurer’s securities exclusion worked to preclude coverage for cryptocurrency sales to the public.

Background

Kik Interactive Inc. (“Kik”) is a Kitchener-Waterloo, Ontario based information technology company famous for developing the instant messaging app named “Kik Messenger”. During the late 2010s, as with many other information technology companies, Kik took steps to enter the world of cryptocurrency. Cryptocurrencies are digital currencies designed to function as a medium of exchange independent of government or central bank authority.

Kik developed the blockchain-based cryptocurrency called ‘Kin’, and in 2017, sold the currency to accredited investors using a common investment contract offered by cryptocurrency developers called Simple Agreement for Future Tokens (“SAFT”). SAFT requires investors to pay money to the developer for the right to cryptocurrency tokens upon the completion of the product. Following the initial phase where Kin was sold using SAFT to accredited investors, Kik moved to a second phase where they intended to offer Kin for sale to the public.

Kik met with the Ontario Securities Commission which advised that it would consider the sale of Kin to the public to be a public offering of securities. As a result, Kik decided to prohibit Canadian residents from purchasing Kin, but otherwise proceeded with the public sale. Kik’s position was that Kin was not an investment contract or security, and therefore did not register the sale with the Securities and Exchange Commission (the “SEC”), the American regulator.

SEC Complaint

On June 4, 2019, the SEC commenced an enforcement action in the United States Court for the Southern District of New York, alleging that Kik failed to register Kin with the SEC, and as a result, investors did not receive the disclosure required by American federal securities laws.[2] The SEC alleged that Kin was a security and therefore Kik engaged in a public offering of a security without compliance with applicable laws and regulations. Kik retained counsel in the United States to defend the SEC Complaint on the basis that Kin was not a security but rather an asset. Kik sought coverage from its D&O insurer, AIG, for its costs in defending the SEC enforcement action which was denied on the basis that exclusion 4(j) of the insurer’s policy had been triggered.

The Securities Exclusion

Many D&O policies contain what is known as a securities exclusion, including the AIG policy issued to Kik. The policy contained the following language:

The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against an Insured:…

(j) alleging, arising out of, based upon or attributable to any public offering of securities by a Company, an Outside Entity or an Affiliate or alleging a purchase or sale of such securities to such public offering…

Application for Coverage before the SCJ

Justice Chalmers found that the securities exclusion in the AIG policy was unambiguous based on the ordinary and literal meaning of the words used in the provision (following the test outlined in Progressive Homes Ltd. v. Lombard General Insurance Co. of Canada[3]). The Court rejected Kik’s argument that the provision only meant to exclude claims arising from the issuance of shares in an initial public offering or in taking a company public, and instead endorsed the view that “public offering of securities” in the AIG policy includes the sale of cryptocurrency to the public.

The Court also rejected Kik’s argument that an exception to the exclusion applied in the circumstances. The exception under the exclusion provision applied where the following conditions were met:

1. the insured gave written notice of a public offering with full particulars and underwriting information to the insurer;

2. the notice was given at least 30 days prior to the effective time of the public offering;

3. the insurer offered a quote for coverage; and

4. the insured accepted the conditions for coverage and paid the additional premium for such coverage.

Justice Chalmers found that, while Kik communicated some information to AIG about the public sale of Kin, such communication did not constitute notice under the first condition. While not explicitly outlined in the Court’s decision, it appears that Kik’s characterization that the public sale of Kin was not a public offering of a security made it difficult for Kik to later argue that it provided notice of a public offering of a security to AIG. The Court also found that AIG never provided a quote for additional coverage, no additional premium was charged or paid, and that Kik did not satisfy any of the conditions of the exception.

Key Takeaway

In this case, it appears that both securities regulators and the courts in multiple jurisdictions have recognized the cryptocurrency known as Kin to be a security, and an offering of same to the public as a public offering. This case is likely the first of many cryptocurrency-related insurance cases ahead as blockchain-backed technologies and financial products become more common.

[1] 2020 ONSC 8194.

[2] See “Complaint” – U.S. Securities and Exchange Commission v Kik Interactive Inc., 19-cv-5244.

[3] 2010 SCC 33.

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