The cold war between digital currency companies and the S.E.C. has lasted a long time (by crypto standards), but it appears to be turning hot. On June 6, 2019, the tension between Kik and the US Securities and Exchange Commission (“SEC”) came to a head when the SEC issued a formal complaint against Kik over the sale of their own digital currency, Kin. Kik, a private Canadian company founded in 2009, operates a mobile messaging app similar to WhatsApp and Viber. Kik raised close to $100 million selling Kin tokens during their Initial Coin Offering (“ICO”).[1]The Kin token began as an ERC-20 utility token and is built on top of the Ethereum platform.[2]The SEC is using Kik’s ICO as an opportunity to take a stand against what it considers to be the unregistered sale of securities.
From May to September of 2017, Kik sold tokens to accredited investors by way of a Simple Agreement for Future Tokens (“SAFT”).[3]A SAFT is an investment contract used by cryptocurrency creators to sell their coins/tokens to accredited investors.[4]Most regulators consider SAFT contracts to be investment contracts (in other words securities), none more so than the SEC, accordingly most issuers relying on SAFTs contain provisions that prohibit US investors from participating in token sales. Kik’s SAFTs were a promise of a future delivery of the Kin purchased through the SAFT. Most of the future token purchasers invested in these tokens using U.S. dollars. On September 12, 2017, Kik made the Kin tokens available to anyone who wanted to buy them through a crowd-sale (the “Crowd Sale”), thereby ignoring US securities law in the eyes of the SEC.[5]Unlike the Kin purchased through the SAFTs, which was paid for in USD, the Kin sold in the Crowd Sale was mostly paid for in ether worth approximately $50 million.[6]While Kik is a company based in Canada, many of the individuals purchasing Kin were U.S. residents. By September 15, 2017, the SEC sent its first inquiry to Kik regarding their sale of Kin.[7]By June 6, 2019, the SEC followed this with a formal complaint. In this complaint, the SEC stated that Kin was a security and therefore its ICO should have been registered with the SEC.
Kik vehemently disputed the SEC’s charges and claims to have attempted to comply with U.S. securities laws. Kik cited several examples of its attempts to comply. Its first argument is basically that by using SAFTs to sell Kin, only accredited investors would be exposed to the initial risk of buying a token like Kin.[8]Kik sold tokens using SAFTs under the Rule 506(c) exemption of Regulation D (“Reg D”) to in an attempt to comply with the Securities Act of 1933 (the “33 Act”).[9] This exemption allows issuers to sell securities to accredited investors without registering said securities. This exemption to the 33 Act exists because the SEC assumes that accredited investors have the knowledge to safely invest their money and avoid fraudulent schemes.[10] Kik has stated that the money raised in the Reg D offering would be used to build a bigger community (i.e. the “Kin Ecosystem”) where the tokens could be used.[11]
Surprising absolutely nobody, the SEC remained un-swayed by the SAFT argument and claims that Kik violated US securities laws by not registering their ICO with the SEC or properly qualifying for any exemptions to the registration requirements.[12] SAFT agreements are not codified in statute or recognized by most regulators, so Kik knew or should have known that it was running a risk relying on SAFTs as an exemption. On November 16, 2018, the SEC told Kik that it would be recommending that the Commission file an enforcement action against Kik for conducting an unregistered sale of securities. Kik was allowed to respond through a Wells Submission (the “Submission”).[13] In its Submission, Kik presented three main reasons why the SEC should not pursue enforcement.[14]
Kik first argued that the Kin tokens constitute a currency, and as such, they are exempt from US securities laws as such laws do not apply to currencies (the Exchange act of 1934 expressly excludes “currency” from its definition of a “security”).[15] Next, Kik argued that theKin token is not an investment contract as defined in the seminal Supreme Court case SEC v. W. J. Howey Co., in which the Supreme Court established the eponymous Howey Test as the gold standard for determining what is and isn’t a security,[16]and therefore the sale of Kin could not be an unlicensed sale of securities. Kik’s final argument was that the company practiced good faith in its attempts to comply with the law as Kik understood it at the time.[17]
Kik’s first argument, that Kin is a currency, has proved to be one of its most contentious. The 33 Act does not contain currency in its list of securities, and the Exchange Act of 1934 (the “34 Act”) explicitly excluded currency from its definition of a security.[18] The digital currencies bitcoin and ether have both been deemed to be currencies by the SEC.[19]Kik has attempted to show that Kin is functionally similar to bitcoin and ether. Kik insists that Kin can be used to pay for physical and digital goods and services. However, the chairman of the SEC released a statement emphasizing the fact that calling something a “currency,” doesn’t mean it isn’t a security.[20]Additionally Chairman Clayton stated, “Before launching a cryptocurrency or a product with its value tied to one or more cryptocurrencies, its promoters must either (1) be able to demonstrate that the currency or product is not a security or (2) comply with applicable registration and other requirements under our securities laws.”[21]It’s safe to say that the SEC isn’t buying the argument that Kin is a currency. Kik also cited the fact that itattempted to comply with currency regulations, such as requiring everyKin token purchaser to submit to AML[22], KYC[23]and OFAC[24] screening, as proof that it operated under the belief that it was creating a currency. Lastly, Kik listed Kin as inventory on its taxes and therefore paid tax on the sales of Kin, which is something it wouldn’t have had to do if Kin was a security.[25] The SEC’s response to this aspect of Kik’s argument has largely been to detail that Kin is not functionally the same as bitcoin and should be treated as a security.[26]
Kik’s second argument is that the Kin tokens do not the meet the definition of “investment contract” under the Howey Test.[27] As mentioned briefly supra, the Howey Test is result of the Supreme Court decision, SEC v. Howey, and is the main legal analysis used to determine whether or not an investment is a security in situations where the classification of such an investment as a security is disputed or unclear. Traditionally, the Howey Test is interpreted to have four (4)[28]main criteria or “prongs,” which are: 1) there be an investment of money; 2) in a common enterprise; 3) that the purchaser/investor reasonably expects to receive profits from the enterprise; and 4) that the expected profits come from the managerial or entrepreneurial efforts of “others” (i.e. not the investor/purchaser). When applying the Howey Test to cryptocurrencies, the main issue is “whether or not cryptocurrency investors are participating in a speculative enterprise, and if so, if the profits those investors are hoping for are entirely dependent upon the work of a third party.”[29]
There is no dispute that the Kin sale satisfies the first prong of the test. People paid/invested money in order to get Kin tokens (the first prong of the Howey test is rarely disputed when questions about the classification of an investment/purchase/transaction as a security arise).
As to the second prong of the Howey test, Kik has argued that there is no common enterprise between Kik and the holders of Kin tokens. Its position is that the only agreement between Kik and the purchasers of Kin tokens is the delivery of said tokens. Kik noted that in Howey, there was a contractual obligation by the seller to develop the land after it was purchased,[30]but that in the case of the Kin tokens there was no similar obligation. In Kik’s view, purchasers paid Kik for the token and in exchange Kik gave them Kin tokens, full stop. Basically, Kik claimed that the Kin ICO was a simple sale of a good not the sale of security that would be expected to appreciate in value. The SEC’s complaint dismisses this interpretation of events and cites the fact that Kik actively solicited Kin purchasers by telling them that Kik would be creating a “Kin Ecosystem” the result of which would be the increase in value of the Kin tokens.[31]Additionally, the complaint alleges that Kik explicitly stated that it would share a common interest with Kin purchasers by investing heavily in Kin. Given these facts, it is highly likely that a court would find that Kin satisfies the second prong of the Howey Test.
The third prong of the Howey Test looks at whether or not purchasers/investors expect to receive profits from the purchase/investment. Accordingly, establishing whether or not Kin token purchasers expected profits from their purchase of Kin is essential.[32]Kik likened their situation to the Supreme Court case, United States v. Forman, where the Court held that having shares of a co-op cannot be classified as securities since the shares were purchased as part of a contract rather than because the purchasers expected them to increase in value.[33]In this case, a low income housing project required incoming tenants to purchase stock as part of their agreement for living in the project.[34]Once the tenants left, the value of the stocks were returned to them.[35]The Supreme Court concluded that this failed the “for profit” part of the Howey test.[36]Kik claimed that the exchange Kin tokens are consumable items that are just part of a contract like in Forman. The SEC’s complaint flatly contradicts this view. According to the SEC, “Kik described Kin as an opportunity for both Kik and early Kin investors to ‘make a ton of money.’”[37]The compliant detailed that Kik told investors that the number of Kin tokens would be finite so as to create demand and that the tokens would be tradeable on secondary platforms.[38]It appears that there was a clear promise of profits to the potential Kin purchasers when Kik was pitching these Kin tokens. If proven, any court would find that Kin satisfies the third prong of the Howey Test.
The last part of the Howey Test involves an analysis of whether the profits generated for investors/purchasers in a common enterprise are derived from the efforts of “others.” In this case, the question is whether the purchasers ofKin tokens expected to realize profits because of Kik’s efforts.[39] Kik argued that only market forces will affect whether or not people profit from purchasing Kin tokens.[40]However, the SEC’s complaint alleges that Kik pitched Kin as a product it would work to make more profitable for investors. “Kik promised that it would spur such demand by dedicating company expertise and resources-including proceeds from Kin sales, to specific Ecosystem-enhancing projects.”[41]In its promotional campaign, Kik also promised to align their interest with those of the Kin investors by owning roughly one third of the Kin tokens themselves.[42]If the SEC’s claim is true, the only way to interpret these actions is that Kik knowingly and intentionally gave Kin purchasers the reasonable expectation that Kin’s value would increase, at least in part, due to the efforts of Kik. Accordingly, Kin would satisfy the fourth prong of the Howey Test.
The analysis of any purchase/investment/transaction using the Howey Test is entirely fact dependent. If the SEC’s allegations are found to be true, Kik’s argument that Kin fails the Howey Test is untenable.
Kik’s final argument in its response to the SEC’s complaint was that it acted in good faith.[43]Kik hired lawyers and an independent auditor, all of whom concluded that the Kin ICO did not constitute the sale of unregistered securities.[44]Kik stressed that Kin was being marketed as a currency that could be spent like bitcoin.[45]Kik used these reasons to show why it had a reasonable, good faith, belief that Kin would be a classified as a currency, not a security.[46]The SEC addressed Kik’s good faith argument by suggesting that Kik acted in bad faith. The SEC claims Kik was told by one of its consultants that the Kin offering was potentially an offering of securities that needed to be registered with the SEC, and that an unregistered public securities offering was not legal in the U.S.[47]Additionally, at the beginning of the complaint, the SEC detailed how Kik decided to sell Kin tokens largely as a last ditch effort to save the company. These claims together all support a finding of a lack of good faith.
The SEC and Kik’s statements are so contradictory in this case it is difficult to see exactly how the court will rule as the result will be entirely based on what is provable in court under the rules of evidence. The fact finder, the judge or jury, will have to look at all the relevant facts presented and decide for themselves. The evidence released so far suggests that Kin would be classified as a security, but no one will know for sure until the case is decided. This case has the potential to be titled “landmark” or “seminal” because cryptocurrencies like bitcoin, ether, Kin etc. have long lived in a regulatory twilight zone. A new activist group called “Defend Crypto” has been created to help support Kik in their legal battle with the SEC.[48] The group hopes this case will transform how the regulatory system in the US categorizes cryptocurrency, opting to create a new asset class with new rules and regulations instead of relying on precedent set down before the fax machine was invented… something that may in fact make sense given the novelty of cryptocurrency and its power to democratize capital. The result here could very well be that cryptocurrency necessitates the creation of an entirely new asset class, that said, the Howey Test was laid down broadly for a reason, and despite its age it has proven able to keep up with an ever-growing number of financial products. Whether Kik and Defend Crypto’s hopes are fulfilled or dashed, this case will set an important precedent to guide the future of cryptocurrency.
[1]https://cryptobriefing.com/what-is-the-kin-ecosystem-introduction-to-kiks-kin-token/
[2]https://cryptobriefing.com/what-is-the-kin-ecosystem-introduction-to-kiks-kin-token/
[3]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[4]https://www.investopedia.com/terms/s/simple-agreement-future-tokens-saft.asp
[5]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[6]https://www.scribd.com/document/412379084/Kik-Sec-Filing#fullscreen&from_embed
[7]https://www.defendcrypto.org
[8]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[9]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[10]https://thismatter.com/money/stocks/exempt-securities.htm
[11]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[12]https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
[13]https://www.kin.org/wells_response.pdf
[14]https://www.kin.org/wells_response.pdf
[15]https://www.kin.org/wells_response.pdf
[16]https://www.kin.org/wells_response.pdf
[17]https://www.kin.org/wells_response.pdf
[18]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[19]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[20]https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11
[21]https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11
[22]AML refers to compliance with Anti Money Laundering regulations
[23]KYC means Know Your Customer and generally denotes government regulations designed to prevent money laundering.
[24]OFAC is the Office of Foreign Assets Control.
[25]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[26]https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
[27]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[28]In some cases the Howey Test is described as having three prongs.
[29]https://www.investopedia.com/terms/h/howey-test.asp
[30]https://www.investopedia.com/terms/h/howey-test.asp
[31]https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
[32]https://www.investopedia.com/terms/h/howey-test.asp
[33]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[34]https://supreme.justia.com/cases/federal/us/421/837/
[35]https://supreme.justia.com/cases/federal/us/421/837/
[36]https://supreme.justia.com/cases/federal/us/421/837/
[37]https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
[38]https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
[39]https://www.investopedia.com/terms/h/howey-test.asp
[40]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[41]https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
[42]https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
[43]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[44]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[45]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[46]https://www.crowdfundinsider.com/2019/02/143914-breaking-down-kiks-fight-against-the-sec-and-their-100-million-ico/
[47]https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
[48]https://www.defendcrypto.org
