Last week the SEC hit Kik Interactive with a federal complaint alleging violations of the Securities Act in connection with Kik’s ICO of its digital “Kin” token. I tweeted my gut check of the allegations while the story was fresh, promising to provide a more nuanced impression once I’ve had a chance to digest.
A few asides:
- I strongly believe that only a very small minority of blockchain projects would stand to benefit from the introduction of their own, proprietary token (I spent the last year helping run a NY-based blockchain accelerator and our first challenge to any such applicant has been to defend their use of a token — so far all but one have failed).
- I think the tiny minority of projects that can make a compelling reason for a proprietary token typically have awful tokenomics in massive need of a rethink.
That being said, I do recognize the need for proprietary tokens in certain limited circumstances, which I won’t go into here. More importantly, I think that the sale of a digital license, in the form of a token or otherwise, should not necessarily constitute the sale of an unregistered security.
So… I’ve had a chance to zero in on what’s important and not so important about this lawsuit, the allegations in the complaint, and Kik’s informal response. Here goes:
- Assuming the case doesn’t settle prior to some sort of court and/or jury judgment, we’ll finally get an update on what “the efforts of others” (from the Third Howey Factor) means in the context of digital token sales.
- Kik seems to have done too much wrong for this case to provide much clarity on whether there is a right way to legally issue a digital token.
HOWEY IS A 70 YEAR OLD TEST IN DIRE NEED OF AN UPDATE
The US Securities Act makes it illegal to sell unregistered securities except under certain specific exceptions. Registering securities to participate in what is called an Initial Public Offering is an incredibly time consuming and expensive process, requiring lawyers, several years worth of financial audits, and a bank to underwrite the sale — thus disqualifying most startups.
Long before cryptocurrency and the advent of ICOs, companies have sought to raise money by selling consumers all sorts of financial products that bordered on the Securities Act’s definition of “security”. The problem is that the Securities Act doesn’t actually have a very clear definition, it includes a jumble of stuff:
any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
At the end of the day, it was left to US courts to interpret the above-jumbled-mess. Enter SEC v. Howey, the 70 year old case that ultimately defined an “investment contract” (a.k.a. security) as something that incorporated all three of the following Howey Factors:
- An investment of money;
- in a common enterprise; and
- with an expectation of profits predominantly from the efforts of others.
MOST ICOS WOULD CONSTITUTE SECURITIES UNDER HOWEY
“Every ICO I’ve seen is a security.”
— Jay Clayton, SEC Chairman
The problem with most ICOs is that they sought to sell “access licenses” (e.g., tokens that could be used to access or use their touted software products) long before those products ever existed. In other words, ICO token purchasers typically:
- Invested money;
- which was pooled by the company for the purposes of developing a product; and
- the token purchasers expected the value of their tokens to appreciate so that they could flip them for a profit.
This perfectly aligns with Howey’s definition of a security or investment contract.
IF THE SEC’S ALLEGATIONS ARE TRUE, KIK PROBABLY SOLD UNREGISTERED SECURITIES
The crux of the SEC’s complaint boils down to this allegation:
There was, simply, nothing to purchase with Kin at the times Kik sold the tokens through September 26, 2017.
In other words, if Kik’s ICO and sale of $Kin was meant to raise money to build an ecosystem on which users could use $Kin to purchase products, then by purchasing $Kin users (1) invested money, (2) which Kik pooled into the common enterprise of software/business development, (3) users expected $Kin to appreciate in value when the ecosystem was launched and $Kin would actually become useful.
Another damning point raised by the SEC:
“Kik also assured prospective buyers that, following distribution of the tokens, buyers would be able to trade Kin on secondary trading platforms.”
A token can’t be speculative if there’s no market on which to speculate. By promising to list the token on exchanges, Kik essentially promised such a market.
THE KIK CASE IS UNLIKELY TO PROVIDE STRONG CLARITY ON HOWEY FACTOR 3
My Twitter gut check of the complaint quotes all sorts of other allegations made by the SEC that were meant to buttress all three of the Howey Factors, so I won’t go into that here. What I will point out is that if the SEC’s factual allegations are true, then this is not a very good test case because Kik will probably lose without all that much being clarified about how the Howey Factors ought to apply to digital tokens.
For example, it would add a lot of clarity to the industry to have a court rule that digital access tokens (blockchain-based or otherwise), even if able to be traded on exchanges, would not constitute securities so long as X, Y, and Z usability factors were in place before those tokens were originally issued to investors.
People can trade certain popular trading cards, and can even speculate on their values, without those cards being considered securities. Why shouldn’t the same be possible with digital tokens?
ENTER HOWEY FACTOR 3: AN EXPECTATION OF PROFITS PREDOMINANTLY FROM THE EFFORTS OF OTHERS
The problem here is that trading card companies typically have something that, according to the SEC, Kik did not: A fully complete, living ecosystem from which the cards derived their value by the time they were first purchased by consumers.
To the extent that trading cards have speculative value, it’s because the invisible hand of the market has driven certain card values up.
Traditionally, courts following Howey have ruled that if you can’t put a specific face on the reason an asset appreciates in value, then the appreciation is not “predominantly from the efforts of others.” In other words, you need to be able to identify the “others” which has typically meant the management team and other related promoters of the company issuing the asset.
Sure, you can say that company management is responsible for marketing the ecosystem, thereby driving card sales, thereby driving scarcity and value appreciation. But courts have not traditionally viewed these sorts of general market forces as a predominant factor in asset speculation. All businesses will strive to make their products desirable, that alone is not enough to make the product a speculative asset.
Of course not all courts have gone this way — and it has varied by industry — so one nice thing about this case will be if/when the court says that the “management and promoters” definition of “others” applies to digital tokens as well. Unfortunately, if the SEC’s allegations are all true, then this is all that the court is likely to say before ruling that Kik issued a digital investment contract. The end.
THE IDEAL TEST CASE
The ideal test case would be one where digital tokens were sold as actual access licenses to an existing technology. A technology platform that wasn’t a mere proof of concept, as alleged in the Kik case, but one that a large network of users actually, well, used.
Even more ideal would be a blockchain ecosystem where other companies built dApps and businesses on the ecosystem thus contributing, in a decentralized manner, to the value of the underlying access token. This would give a court some substance to digest and expound on how decentralized or removed “others” needed to be from an organization before their contribution to the value of the organization’s token would fail to align with Howey Factor 3.
Unfortunately, we do not have these facts in SEC v. Kik, and I don’t think it’s likely that the SEC will pursue what could ultimately end up a losing case for the agency.
Original article printed here.