The specter of regulation has long been a source of uncertainty for “crypto” companies, especially with regard to the application of securities laws to the tokens at the center of decentralized systems. While Bitcoin, the first and leading cryptoasset by all measures, enjoys regulatory clarity in that it is considered a commodity under the purview of the Commodities Futures Trading Commission, so far, other cryptoassets do not—especially if the token was initially distributed through an ICO.
A ruling against the SEC’s opinion that Kik’s ICO qualifies as an unregistered securities offering could establish a much clearer precedent for what ICOs fall under federal securities laws—providing that much-needed regulatory clarity to the budding “crypto” industry.
Why the Kin Case Matters
The DAO report of July 2017 was the first indication of how the SEC plans to address the nearly 1000 enterprises that raised over $22 billion during the ICO boom of 2017 and 2018. The SEC ruled that the DAO tokens sold as part of the now-infamous decentralized investment experiment were indeed securities according to the Howey Test. As a reminder, per SEC v. Howey, a security is a contract involving (1) an investment of money; (2) in a common enterprise; (3) with the expectation of profits; (4) from the efforts of others.
During a speech at the Institute on Securities Regulation in November 2017, SEC Chairman Jay Clayton made an off-the-cuff remark that he had “yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.” (He repeated the same opinion during Congressional testimony in April 2018). A month later, in December 2017, the SEC issued an enforcement action against Munchee Inc. for its ICO. Its reason for labeling the Munchee tokens securities was that, although the tokens were supposed to be used as a part of a decentralized restaurant review application, Munchee’s marketing materials for its ICO were aimed at persons “interested in investing in Bitcoin and other digital assets.” The materials also explicitly highlighted the token’s potential for future appreciation and secondary trading. In short, the offering checked all the boxes of the Howey test outlined above.
With the November 2018 settlement with Paragon and Airfox, the SEC continued to lay out its stance on ICOs: that offerings of digital assets “sold as investment contracts (regardless of the terminology or technology used in the transaction) are securities.” Paragon and Airfox paid penalties and were ordered to register their tokens as securities. They also agreed to “compensate investors who purchased tokens in the illegal offerings if an investor elects to make a claim.”
Where does Kik’s Kin token fit into all of this? According to the company’s response to the SEC Wells notice, unlike Paragon and Airfox, Kik is prepared to fight the potential claim that the terms of the Kin sale were that of an investment contract. Kik insists that Kin is a currency, which are specifically exempt from the definition of a security in the 1934 Securities Exchange Act that created the SEC. Such currency-like tokens, often referred to as “utility tokens,” are used for a specific purpose within an application of some kind. In this case, the Kin token is designed to be used as a medium of exchange within the economy of Kin users.
Kik thus plans the following defense against the claim that its tokens meet the Howey Test:
- The distribution of Kin tokens was a sale of a product (in this case, a currency to be used by participants in the Kin ecosystem), rather than an investment of money, and marketed as such in their white paper and elsewhere.
- The company Kik, the Kin Foundation (a separate non-profit entity founded to spur development of the Kin ecosystem), and the participants in the Kin ICO that aim to use the token do not constitute a “common enterprise.”
- Although the value of the tokens may appreciate with increased usage (i.e. rising demand with a fixed supply), there was no “expectation of profits” based on the efforts of the promoter as understood by current jurisprudence.
Citing attorney David Silver, an informative Breaker piece by David Z. Morris on the subject breaks down many of the potential pitfalls of Kik’s defense. One of those is the claim that there is a meaningful distinction between Kik and the Kin Foundation, especially with regards to “work done by a promoter,” considering the fact that both entities hold large amounts of Kin that may rise in value. The Kin Foundation has developed such products as an application programming interface (API) that allows third-parties to use Kin in games they develop. Silver thinks a judge may rule that the two entities are indeed not separate (it’s important to note that, for such a judicial opinion to matter, the rest of the Howey Test will have to be satisfied as well.)
Litigating Decentralization
The issue of distinct, separate entities brings up an interesting discussion about a potential legal definition of decentralization across “crypto” ecosystems. In June 2018, SEC Director of the Division of Corporate Finance Bill Hinman’s famous speech at the Yahoo! All Markets Summit, although nonbinding, gave hope to many in the “crypto” space that there may be a threshold of decentralization that projects could pass to protect them from being deemed a security. Quoting Hinman:
When I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value. And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value. Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.
Importantly, Hinman hints that the definition of a digital asset can be fluid, considered a security at the time that it is “packaged and sold” but not considered one later: like, for example, Ether.
However, crucially, Ethereum is still dependent on the Ethereum Foundation for coordinating the activity of developers. The most recent example is the postponing of the Constantinople Hard Fork—a step on the path to Proof-of-Stake, which is a fundamental redesign of how Ethereum’s consensus mechanism would work. Moreover, there exists an Ethereum analogue to the relationship between the company Kik and the Kin Foundation. One of the founders of the Ethereum protocol, Joe Lubin, runs Consensys—a large company that aims, like Kik does with Kin, to be a “participant not a landlord” in the Ethereum ecosystem. Lubin, as well as the other founders of Ethereum like Vitalik Buterin and Gavin Wood (who hold large amounts of Ether), stand to profit from the success of the Ethereum ecosystem in similar ways to how Kik would benefit from the success of the Kin ecosystem.
If the activities of the Kin Foundation are to be a deciding factor for a judge about whether there is sufficient decentralization as to not be considered a “common enterprise,” then the reasoning behind such a decision could have serious ramifications for the broader “crypto” industry.
“Crypto” Disclosures
Apart from the thorny question of defining decentralization in the context of securities laws is the issue of disclosures for “crypto” projects.
In the aforementioned Breaker piece, Silver speculates that because Kik already had an existing product prior to the introduction of the Kin token—namely, a messaging app with millions of users—the SEC is unlikely to “dismantle the kin system, much less Kik itself. Instead regulators may aim for a result that compensates investors while devaluing the Kin Token, perhaps by distributing the share Kik and the Kin Foundation are holding.” Thus, there may be a resolution to this case that, after a settlement of some kind, results in the ecosystem revolving around the use of a non-security Kin token envisioned by Kik.
One can imagine other existing networks, then, using securities law-compliant air drops — and, depending on the terms of a settlement or judicial decision related to Kin, new networks using ICOs — to create similar ecosystems. In these scenarios, where non-security tokens can exist, what types of disclosures are important? Although he didn’t frame it in the same way as Silver, Matt Levine concludes his note on Kik’s potential legal battle by touching on this question:
One thing to consider is: What if they’re right? What if these sorts of ICO tokens are not securities and shouldn’t be regulated like securities, because the sorts of disclosures and investor protections that are useful in securities law don’t make sense here? Surely that doesn’t mean that no disclosures or investor protections would be useful here; after all, the proportion of shady ICOs to good ones seems to be at least as high as the proportion of shady stock offerings to good ones. Arguments against securities regulation of tokens might be easier to make if they came with practical proposals for non-securities regulation of tokens.
Many in the “crypto” world agree that “the sorts of disclosures and investor protections that are useful in securities law don’t make sense here.” As Chris Brummer of Georgetown Law, along with Trevor Kiviat and Jai Massari of Davis Polk, demonstrate in their excellent paper entitled “What Should Be Disclosed in an Initial Coin Offering?,” existing regulatory disclosure requirements are not well-suited for the needs of ICO participants. For that reason, Brummer et al. outline a series of reforms for the SEC’s disclosure guidelines that would better accommodate “crypto investors” and conclude that “a long-term process of regulatory upgrades will be needed to fine tune protections for the retail public.”
Since “crypto” is a young and still-developing industry, what those disclosures should be is not entirely clear. However, there might be hope for the type of “practical proposals for non-securities regulation of tokens” that Levine suggested. A promising self-regulatory effort spearheaded by a company called Messari is attempting to crowd-source an answer to the “crypto” disclosure question.
One of the policy goals for the United States securities regulation framework is to protect investors by requiring public securities to submit a variety of disclosure forms, including S‑1’s, which detail the business model, outside competition, and planned security offering; 10‑Q’s, which give comprehensive quarterly reports on a firm’s financial position; and many more. While costly, these disclosures create transparent records on which public investors can base their investment decisions. Anyone can log on to the SEC’s EDGAR database (which stands for Electronic Data Gathering, Analysis, and Retrieval), where such forms are posted, and view the records of all public companies filed in the United States.
Eventually, Messari hopes to leverage a token-curated registry (TCR) — a token-based system in which token holders (i.e. members of a list) are incentivized to vote new or existing members in or out based on their adherence to an agreed upon set of rules — to create a decentralized, voluntary EDGAR. In other words, the Messari TCR would create a market that would foster a minimal standard of disclosure and transparency. In November 2018, Messari announced the first group of startups that would appear on a regular registry (which might later become the TCR), each of which have agreed to disclose such things as token supply and design details, information on team members and communication channels, and treasury management plans.
Whether the proposal fits Levine’s definition of “practical” is up for debate, but it does signal that the industry is thinking about what types of disclosures are needed for this new technology to gain meaningful adoption, safe from regulator ire.
Protecting Innovation
Kik’s public willingness to “fight back” against the SEC has been celebrated by many in the “crypto” community, which has seen some of its members close shop as a result of regulatory uncertainty. Just last month, a prominent stablecoin project called Basis, which had raised $133 million in the traditional manner from venture capital firms like Andreeson Horowitz and Bain Capital Ventures, was forced to return the money to its investors, citing the regulatory climate. The Basis stablecoin was to be built on a three-token model: the Basis token would remain pegged to the US dollar through on-chain auctions of “bond” and “share” tokens. (For an in-depth explanation of this model, see Basis’ white paper). According to CEO Nader Al-Naji, “as regulatory guidance started to trickle out over time, our lawyers came to a consensus that there would be no way to avoid securities status for bond and share tokens.” Not only would such a status force the company to pay for costly filings and legal fees, it would also threaten the core of their business model. Due to accredited investor laws, few people would be able to participate in the auctions market that would keep Basis tokens pegged to the dollar and user adoption would suffer as a result.
Regulatory clarity is needed for the innovations based on “crypto” technology to continue in the United States. After all, these new business models might have benefits: the reason Kik opted for token-based model was to avoid monetizing by selling user data like other companies, such as Google and Facebook, do. Also, Kik seems to have conducted an ICO in good faith, with every intention of abiding by securities laws (by avoiding offering one). What more can regulators ask for?
To their credit, with the establishment of the SEC’s FinHub and the CFTC’s LabCFTC, both the agencies have been working to adapt existing regulatory frameworks to “crypto,” but they can only move so fast and do so much. So far, despite enthusiastic statements by SEC Commissioner Hester Peirce and CFTC Chairman J. Christopher Giancarlo, it hasn’t been enough to avoid stifling innovation.
One effort in Congress is worth keeping an eye on. The Token Taxonomy Act — introduced by Rep. Warren Davidson (R‑OH) and Rep. Darren Soto (D‑FL) on the last legislative day of the 115th Congress — would provide a clear definition of a non-security “digital token” that would thus be excluded from suffering the consequent regulatory burden. Time will tell whether the bill has a chance in the 116th Congress.
For now, fans and members of the industry must wait for regulatory clarity in whatever form it comes — whether from regulators, legislative action, a judicial decision in a potential Kik v. SEC case, or something else entirely. In the meantime, we can only hope the promise of new “crypto” technologies is not forced overseas or squelched altogether by rigid regulatory structures.
