The Securities and Exchange Commission filed a lawsuit against Kik Interactive Inc., claiming that, from May through September 2017, the firm conducted an initial coin offering of one trillion Kin digital tokens without registering the cryptoassets with the SEC as required by law. According to the SEC, investors who purchased Kin tokens made an investment of money in a common enterprise with Kik and with other investors, and reasonably expected profits through the business and management activities of Kik and its agents.
Kik is an Ontario, Canada-based company that developed and promotes a popular internet chat messaging service.
In its complaint filed in a federal court in New York City, the SEC alleged that Kik determined in late 2016 through early 2017 to raise funds through an ICO when it recognized that the popularity of its chat service was declining, and it would run out of cash to fund its operations by late 2017. The firm decided to embark on a new business strategy, involving the development of the “Kin ecosystem” wherein persons could use Kin tokens to purchase goods and services. One director of Kik, termed this “pivot” to a new business model a “hail Mary pass,” claimed the SEC.
However, said the Commission, at the time of the ICO, the Kin ecosystem, as contemplated, did not exist, and proceeds from the ICO were intended to fund its development. According to the SEC, Kik extensively promoted the ICO as an investment opportunity.
Just prior to the launch of the ICO, the SEC published its so-called “DAO report” on July 25, 2017, in which it said that digital tokens might be securities under US law. (Click here for background in the article,” SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issued in Accordance with US Securities Laws” in the July 26, 2017 edition of Between Bridges.) In response, Kik contacted the Ontario Securities Commission to determine the legality of its offering in Canada. After being advised by OSC that its proposed offer of Kin would constitute the offering of securities, Kik determined to bar Canadians from purchasing Kin in its public sale. The firm did not similarly reach out to the SEC, said the Commission.
The Commission calculated that, through its ICO, as well as a pre-offering (known as a simple agreement for future tokens or “SAFT”) to certain professional investment funds and wealthy investors, Kik raised almost US $100 million, including US $55 million from US investors.
The SEC seeks to prohibit Kik from violating US securities law registration requirements, to disgorge funds raised through its ICO and to pay a fine. The agency requested a jury trial for this matter.
Previously, Kik publicized the possibility that it might be sued by the SEC in connection with its Kin ICO. In a so-called “Wells Submission” to the SEC, Kik claimed that Kin was a virtual currency and not subject to US securities laws, and in any case, there was no common enterprise between Kik on the one hand and purchasers of Kin on the other, and no expectation by any Kin purchaser of profits because of the managerial or entrepreneurial efforts of Kik. (Click here for details in the Legal Weeds section of the article, “California Federal Court Reverses Itself and Grants SEC Preliminary Injunction in Purported Cryptoasset Scam” in the February 17, 2019 edition of Bridging the Week.)
In response to the SEC’s complaint, Kik released a statement in which it said, “We have been expecting this for quite some time, and we welcome the opportunity to fight for the future of crypto in the United States. We hope this case will make it clear that the securities laws should not be applied to a currency used by millions of people in dozens of apps." (Click here to access the full Kik statement.) Recently, Kik launched an initiative called “Defend Crypto” to raise US $5 million to help defend itself in the SEC action through voluntary contributions; through June 7, the firm claimed it had received US $4.4 million. (click here for details).
In other legal and regulatory developments regarding cryptoassets:
- IOSCO Solicits Feedback on Proposed Key Considerations for Regulators’ Evaluation of Cryptoasset Trading Platforms: The International Organization of Securities Commissions issued a consultation report to help regulatory authorities evaluate cryptoasset trading platforms ("CTPs") under their oversight. Although CTPs often perform functions similar to trading venues, IOSCO noted that the platforms also “perform functions that are more typically performed by intermediaries, custodians, transfer agents and clearing houses.” As a result, key matters IOSCO recommends regulatory authorities consider when contemplating CTPs include: (1) how is access provided, and if non-intermediated, who is responsible for on-boarding and how is it performed; (2) how are customer assets held and protected; (3) where customer assets are held, what financial resources exist to protect against bankruptcy or insolvency; (4) what conflicts of interest exist and how are they managed; (5) what information exists regarding a CTP’s operations; (6) what rules and protections exist against market abuse; (7) how efficient is price discovery; (8) how resilient and reliable are critical systems; (9) and how is cybersecurity assured. IOSCO will accept comments to its consultation through July 29, 2019.
- European Central Bank Says Risks of Cryptoassets Minimal on Monetary Policy, Payments and Market Infrastructures: The European Central Bank published findings of a cryptoasset task force it established in March 2018 to consider the impact of digital assets on monetary policy and the risks they may pose to “the smooth functioning of market infrastructures and payments, as well as for the stability of the financial system.” Currently, said the ECB, while cryptoassets do not impose an “immediate threat” to financial stability, they pose risks regarding money laundering/terrorist financing and consumer protection. Digital assets are unusual, noted the ECB, because they have no underlying fundamental value – they do not “represent either a financial claim on, or a financial liability of, any natural or legal person, and [do] not embody a proprietary right against an entity.” The task force recommended that the ECB continue to monitor “the cryptoasset phenomenon” and be prepared for any “adverse scenarios.”
- Final Decision on Bitcoin ETF Again Delayed by SEC: The SEC delayed its evaluation of a proposed rule change by the Cboe BZX Exchange to permit listing and trading of shares of SolidX Bitcoin Shares issued by the VanEck SolidX Bitcoin Trust in order to undertake further analysis. Cboe initially filed its proposed rule change on January 30, 2019 and the SEC designated May 21, 2019 as the day by which it would approve, disapprove or begin proceedings to determine how to go forward. The SEC extended this period on March 29. The SEC has now initiated proceedings to make a final determination. The Commission will accept comments regarding Cboe’s proposal through 21 days after its publication in the Federal Register, and rebuttal comments for 35 days after such publication.
- ASIC Issues Advisory on ICOs and Cryptoasset Trading Platforms: The Australian Securities & Investment Commission published an overview of regulatory considerations related to ICOs and cryptoassets. Among other things, ASIC noted that, under Australian law, significant regulatory requirements may apply to the issuance of cryptoassets that fall within the definition of a financial product (e.g., securities, derivatives, general and life insurance, superannuation, margin lending, carbon units, deposit accounts and means of payment facilities). Among other things, licensing or authorization requirements may apply to cryptoasset intermediaries, exchanges and trading platforms, as well as wallet and custody service providers. Under Australia law, there are prohibitions against misleading or deceptive conduct for both ICOs and cryptoassets that involve and do not involve financial products.
My View:Two months ago, the SEC’s Strategic Hub for Innovation and Financial Technology issued guidance on what characteristics a cryptoasset might have that could make it more likely to be deemed an investment contract, and thus a security, under US securities laws. FinHub noted that these characteristics pertain not solely to the “form and terms” of the digital asset itself, but also “the means in which it is offered, sold or resold (which includes secondary market sales).”
In providing its analysis, FinHub utilized the three prongs of the Howey test to determine if an instrument was an investment contract (i.e., an (1) investment of money (2) in a common enterprise with the (3) reasonable expectation of profits through efforts of others), and keyed in on the last prong. (Click here to access the Supreme Court’s 1946 decision in SEC v. W.J. Howey.)
(Click here for background on the FinHub’s guidance in the article “SEC Staff Outlines Characteristics of Cryptoassets That Could Cause Them to Be Regarded as Securities” in the April 7, 2019 edition of Bridging the Week.)
In its complaint against Kik, the SEC tracked many of the themes in its April 2019 guidance in explaining why the Kin ICO constituted an offer of securities. The Commission meticulously laid out the basis for its view that investors who participated in the Kin ICO were investing money in a common enterprise and did so because they believed they would profit through the appreciation in the price of Kin as a result of the efforts of Kik and its agents in developing the Kin ecosystem and promoting Kin.
Internally at Kik, said the SEC, employees were told how the Kin ICO would be a “new way” to raise capital. Externally, noted the SEC, Kik and its agents emphasized to prospective Kin purchasers the opportunity to profit alongside other Kin investors as well as Kik itself as the Kin ecosystem was developed and matured. Critically, at the time of the ICO, said the SEC, the sole feature of the Kin ecosystem was a minimum value product in the form of cartoon stickers that was intended to enhance the Kik Messenger experience. Proceeds from the ICO were intended to fund the Kin ecosystem development.
Although Kik has not yet formally answered the SEC’s complaint, it previewed its response in a Wells Submission filed with the SEC last December as well as in a formal statement issued after the Commission’s filing. Generally, Kik believes the SEC has stretched Howey too broadly, but in any case, Kin is not a security; purchasers did not invest funds in a common enterprise; and purchasers did not have a reasonable expectation of profits through the efforts of Kik and its agents. Profits per Kik were to be obtained through ordinary market forces.
Notwithstanding Kik’s apparent arguments, if the SEC can prove the facts it pleaded, Kik will have an uphill battle. Howey – like it or not – is a long established Supreme Court precedent and it will be very challenging for Kik to convince a jury that what looks like a security offering, walks like a security offering and sounds like a security offering was anything else but a security offering.
That being said, it is not beyond possibility that a court could hold that a financial instrument that conveys no rights, directly or indirectly, to income from a corporation and where a holder has no claims of any kind if the corporation files for bankruptcy is not a security. Kik’s argument that any profits achieved through ordinary secondary market trading would not have been attributable to Kik or its agents has some technical, intellectual appeal; however, it likely ignores the impact of the firm’s purposeful publicity on market sentiment.