A legal battle is brewing between Ontario-based social media startup Kik Interactive and the U.S. Securities and Exchange Commission (SEC), and it’s one that could potentially determine the scope of the regulator’s authority over initial coin offerings (ICOs).
Four commissioners with the SEC are on the verge of taking Kik Interactive to task over the “securities infraction” of its 2017 token sale of Kin, described as, “currency for the digital world” for use in chat, social media and payments within the Kik ecosystem.
Kin raised some $98 million in 2017; this is despite the lack of participation in Canada—where the startup is based—after Kik declared it would ban Canadian investors from buying its crypto token due to “weak guidance” from the Ontario Securities Commission (OSC). In response, the securities regulator clarified that after reviewing the Kin token, they concluded it is a security—but the OSC was willing to grant Kik with “relief from certain securities regulation requirements” if it provided protections to retail investors, among other conditions. No deal, says Kik.
Surprise, surprise
Now the company has run into potentially more severe trouble, this time with the U.S. SEC, which has deemed ICOs as securities. In an interview with the Wall Street Journal, Kik CEO Ted Livingston said the U.S. regulator isn’t accusing the company of fraud, but because Kik failed to register the ICO with the SEC, they didn’t give investors the proper information. Also, the Kin token is considered a security under the 1934 Securities Exchange Act.
Livingston, however, asserted that the regulator’s interpretation of the law is entirely wrong, stating: “On page 11 of the 1934 Securities Exchange Act, the very act that created the SEC, it explicitly states that the definition of a security ‘shall not include currency.’” Kin, according to its website, “has monetary value, which means it can be bought and sold for real money.”
According to the Kik CEO, “Already, hundreds of thousands of people have exchanged Kin for goods and services. Kin is one cryptocurrency that truly is a currency.”
Can Kik kick back at SEC?
It’s unclear whether the commissioners have already taken a vote, but when the SEC enforcement action does come out, Kik is ready to fight back in court if necessary—for all the good it will do them.
“Canada follows similar legal tests for determining whether something is a security as the Howey test from the U.S. Supreme Court. Past cases have shown that if an asset qualifies as a security under U.S. law, it will likely qualify as a securitized asset under Canadian law as well,” Jimmy Nguyen, who has a 21-year legal career in the United States, explains to CoinGeek.
He adds, “In general, if a start-up cryptocurrency venture is issuing tokens (especially through an initial coin offering) to raise funds which are used as operating capital for the company, it is highly likely that token will be considered a covered security under the United States and Canadian laws (as well as laws of many other jurisdictions). That does not require governments to enact new securities laws that apply to cryptocurrencies and tokens; it simply is an application of existing securities laws (such as the Howey U.S. Supreme Court test) to the realm of cryptocurrency.”
In its Wells Response, Kik pointed out: “…we believe the staff’s proposed enforcement action against Kik and the Kin Foundation would fail any similarly rigorous application of the definition of ‘investment contract’ as interpreted by the Supreme Court in Howey.”
Conrad Druzeta, a partner at Bennett Jones LLP, explained how the four-part Howey Test works. Canada has an identical test, but with a secondary “basket clause” that allows regulators to classify an investment contract or a crypto token in this case, as a security “in the public interest.”
Under the Howey Test, a token is an investment contract if it involves the investment of money. In the case of ICOs, initially projects tried to limit the purchase currency to Bitcoin Core (BTC), but when regulators made clear that BTC sufficed, they turned to airdrops—an ingenious solution, Druzeta said, until regulators took the view that if an airdrop was part of a larger scheme, particularly where the issuer held back coins ostensibly to sell into a market that would develop later, it was deemed value enough.
Was there an expectation of profit? This inquiry focuses on the objective standard meaning the judge looks at whether a “reasonable person” would expect a profit, according to Druzeta. Here, promotion of the ICO comes into play. But according to Kik, “Kin purchasers were led to expect consumptive use, not profits” and that “to the extent purchasers expected profits, they did not expect such profits based on the entrepreneurial or managerial efforts, of Kik or the Kin Foundation, as defined under Howey.”
Another test is if the investment of money is in a common enterprise. This involves an assessment of whether the success of the project is dependent on others, apart from the investor. Druzeta said it’s also why Bitcoin and other commodity type cryptos are not considered securities but why there is a danger they could be classified as such if a small group of miners have too much control—such as in the case of BCHABC. Recently, an SEC official declared that cryptos like BTC and ETH are sufficiently decentralized not to be classified as a security.
Lastly, does the profit come from the efforts of a promoter or a third party? This is obvious in most cases. Hockey tickets, for instance, are not considered securities if the arena is already built. However, it could be deemed a security if the arena is yet to be built because investors are relying on the project managers and building crews to make the tickets worth something, according to Druzeta, who delved deeper into crypto assets and securities laws in this blog post.
But is it sufficiently decentralized?
Kin has described itself as “currency” that can be earned and spent on goods and services inside of Kik ecosystem. The question, however, remains whether it is “sufficiently decentralized” not to be classified as a security.
“The way to place this is there is no decentralization. Miners in Bitcoin are a clearing house and settlement function, coins are just the top layer,” Dr. Craig Wright notes. “There is nothing at all close to being centralized in this [Kin].”
The bottom line here is that ICOs like Kin are nothing new, according to Wright, who is also a researcher in the Leicester University’s legal facility and a member of the Society of Legal Scholars, among other credentials.
“There is an expectation of profit,” Wright said. “Even if it was a mere utility token, it will be a securitized asset. So they are just doing old scams in new bottles. ICOs are not new. Not even close.”
Although there’s no enforcement action yet, Kik’s situation will prove to be one of the most important cases to follow, and whatever the outcome is, the industry will surely benefit from the increased clarity of the rules and regulations. As Anthony Pompliano, co-founder and partner at Morgan Creek Capital, pointed out in a blog post: “No one knows what the outcome of Kik’s situation will be. Either way, this will be one of the most important legal cases to watch in crypto.”
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