Does Kik Stand a Chance Against the Goliath of the SEC in a US Court?

Cointelegraph.com News

Why Kik believes it has a case against the SEC in proving that “kin” isn’t a security.

It’s difficult to fight progress. Although, if you're the United States Securities and Exchange Commission (SEC), you can at least try, which could explain why the agency has so far refrained from producing clear and favorable cryptocurrency regulation. Since February 2018, the SEC has taken to consider all initial coin offerings (ICOs) as being securities. Meanwhile, in June 2018, SEC Chairman Jay Clayton proclaimed that the commission is "not going to do any violence to the traditional definition of a security that has worked for a long time."

And given that the SEC has closed down its fair share of ICOs, it would seem there's little hope that it's going to provide any special treatment for crypto and propose lenient guidelines or regulation for the industry. Still, there is at least one company operating within crypto that believes such a scenario is possible.

On May 28, it emerged that the creators of the kin cryptocurrency, the Kik platform, had launched what it calls the Defend Crypto fund. Establishing the new fund with an endowment of $5 million, Kik is calling on sympathetic members of the crypto community to donate cryptocurrencies, in case the initial $5 million isn't sufficient to negotiate with the SEC and possibly "take them on in court."

However, while there's little doubt that Kik is absolutely serious about the possibility of fighting it out against the SEC in a legal setting, history suggests that the SEC won’t be budged from its view that kin is a security. But even if the two parties do eventually go to court, the legal opinion Cointelegraph obtained suggests that Kik has a good case, and that the commission should think very carefully before proceeding with any legal action.

A brief history lesson

Back in September 2017, Kik was able to raise almost $100 million in a "token distribution event" (i.e., an ICO) for its kin cryptocurrency, placing it in the top-10 biggest token sales of that year. However, in January 2018, rumors emerged that the SEC had begun investigating the sale, with the commission apparently sending inquiries and one subpoena to the Canadian company (something that has now been confirmed by Kik’s CEO, Ted Livingston).

These inquiries gradually grew in number over the course of 2018, in parallel with the SEC's mounting interest toward ICOs in general. While everything was kept largely under wraps and there were no significant news reports at the time (beyond various pieces of speculation on Reddit), the SEC issued Kik with eight subpoenas between March and July 2018 — and between August and November of the same year, it demanded nine testimonies from members of the Kik team. This was all capped off on Nov. 16, when the SEC issued Kik with a Wells notice, indicating that it would begin enforcement action against the firm, pending approval by commissioners.

As the Wells notice sent by the SEC makes clear, Kik had potentially violated Sections 5(a) and 5(c) of the 1933 Securities Act, which prohibit the sale of securities that haven't been registered with the commission.

Of course, in its response to this letter, Kik strongly refuted any violations, affirming that "Kin is exempt from the federal securities laws" because it "possesses all the characteristics of a currency like Bitcoin and Ether." In other words, its line was that kin isn't a security but rather a currency or a utility token, while its token sale did not fall whatsoever under the description of an "investment contract."

In fact, Kik's 30-page response to the Wells notice was so confident (if not aggressive) that it closed on a defiant tone, with its hired counsel, Patrick E. Gibbs, concluding, “Should the Commission choose to file an enforcement action, Kik and the Kin Foundation are prepared to litigate and are confident that they will prevail in court." This exchange of letters was then followed by a variety of discussions and negotiations between the two parties at the beginning of 2019, with the SEC also requesting further information and documents from Kik.

Since then, the only thing that's happened is that, according to Defend Crypto's website, the SEC extended its Wells notice deadline to some time in May. This was done in order to give the commission additional time to decide and vote on whether to actually take enforcement action. This seems to have displeased Kik, as the messaging app company has responded by publicizing the Defend Crypto fund while explaining to the media on May 16 that it has so far spent $5 million on going back-and-forth with the SEC.

Why the Defend Crypto initiative?

Livingston revealed in a podcast on May 28 that the Defend Crypto fund has been launched not so much to cover the expenses Kik has run up so far, but to help it launch its own legal case against the SEC. The Kik CEO went on to say:

"The continued challenge for us has been the lack of clarity on the regulatory side, and so over the last year and a half, we've also been working with the SEC. [...] Then, when they started to ask us for some comments and some meetings [...] to understand crypto, to create that clear guidance we all need. And after spending 18 months and over $5 million trying to work with them, we just continue to be super frustrated by the lack of clarity [...] and so we've put together defendcrypto.org, and what that's saying is that the only way we're going to get clarity is if somebody goes to court, and so we are prepared to do that."

As Livingston went on to add, Kik and the industry in general need "a new Howey test," so that future cryptocurrency projects can hold token sales without having to worry about whether they should be registered with the SEC or not. More importantly, "that new Howey test is going to come from a ruling in a court case," which is why Kik and the Kin Foundation have launched Defend Crypto — and which is why Kik is prepared to take the SEC to court if the SEC doesn't take them to court first.

What are the chances of success?

It's worth pointing out at this juncture that the SEC has only ever issued one “no-action” letter in its short history of scrutinizing ICOs, a letter that arrived in April and was addressed to TurnKey Jet concerning its TKJ utility tokens. Casual observers would therefore be forgiven for assuming that Kik doesn't have much of a chance when it comes to either changing the SEC's mind, or winning a legal case.

However, while there isn't a clear conviction that Kik will prevail, certain figures within the crypto industry have welcomed its actions, indicating at least a willingness to believe it has a chance.

Jake Chervinsky, a lawyer who currently serves as general counsel for decentralized money market Compound, tweeted:

This is the most important storyline in the world of crypto securities law in 2019; far more significant than any SEC guidance or proposed legislation. The SEC keeps saying digital tokens are securities, but can they prove it in court? Respect to Kik for their aggressive stance. https://t.co/Csh8viwijj

— Jake Chervinsky (@jchervinsky) May 28, 2019

Likewise, Anthony "Pomp" Pompliano hosted Livingston on his “Off the Chain” podcast on May 30, and while he arguably spent much of the show playing devil's advocate to Livingston's arguments, he concluded by saying, "I think that there are a lot of people who are paying attention to what you guys are doing, and frankly cheering for you guys to help get some clarity."

Kik believes it has a chance, clarifying its position on whether Kik is a security in an extensively detailed response to the SEC's Wells notice and on the Defend Crypto website. In particular, it lists a number of reasons why it believes kin isn't a security, starting with the fact that kin is currently used by around 300,000 Kik users as a currency within the Kik ecosystem, making it one of the most-used cryptos in terms of transactions per 24 hours, as of writing. Because it's used in an ecosystem, this should qualify it first and foremost as a utility token, in Kik's opinion, and as it notes in its response to the Wells notice, "The industry understood the DAO Report to stand for the proposition that token sales with ‘specific utility […] to software or a platform’ likely do not require registration."

Related to this, Kik also argue that, like Ethereum (which isn’t a security), kin was always intended to become a decentralized cryptocurrency that wouldn't be managed or overseen by Kik, but rather by its distributed community of developers and users.

“Kik stressed that Kin would ‘serve as a foundation for a decentralized ecosystem of digital services.’ (SEC Ex. 88.) By providing an open and decentralized network of digital services, the Kin ecosystem would ‘foster direct economic relationships between developers, creators, and consumers, with value and governance shared among the participants,’” it wrote in the Wells letter, and what's interesting about this is that it echoes what the SEC's William Hinman had said at a summit in June 2018, when it was reported that the commission had decided Ethereum was not a security:

"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."

SEC Chairman Clayton seconded these views in March, in a letter to U.S. Rep. Ted Budd:

"A digital asset transaction may no longer represent an investment contract if, for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts. Under those circumstances, the digital asset may not represent an investment contract under the Howey framework."

As Clayton's reasoning implies, the "essential managerial or entrepreneurial efforts" on which the exchange and transmission of ETH is based is no longer carried out by a centralized party. As such, it could no longer be classed as a security, which would explain why Ethereum hasn't faced any kind of SEC enforcement action, despite benefitting from an $18.4 million ICO in 2014.

Lastly, there's also Kik's assertion that the kin token sale did not satisfy the criteria of an "investment contract" as defined in the Howey test, which states that such a contract is any "transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party." As Kik's counsel, Gibbs writes on its behalf, the kin token sale (or presale) doesn't qualify as an investment contract "because no common enterprise exists between Kik and/or the Kin Foundation, on the one hand, and Kin purchasers, on the other hand."

Put simply, kin holders don't have any stake or ownership interest in Kik as a company, and neither do they have any claims to Kik's future profits or assets. Kik also argues that, just because kin holders stand to benefit from any increase in the currency's value, this doesn't qualify as a common enterprise: "Simply owning a common asset whose value rises and falls depending on market forces does not give rise to a ‘common enterprise’ for purposes of Howey. See Woodward v. Terracor, 574 F.2d 1023, 1025 (10th Cir. 1978)."

Win or lose, will crypto be better off regardless?

While it’s hard to provide a decisive prediction of what exactly will now happen between Kik and the SEC, legal opinion would agree that Kik has a pretty solid case, at least in terms of obtaining a favorable judgment on kin’s status. Benjamin J. Sauter, a lawyer with Kobre & Kim, said:

“At the moment, it’s unclear whether Kik will be asserting an affirmative claim against the SEC. [...] In most cases, companies will wait to see if the SEC follows through on the threat to bring an enforcement action. Either way, Kik has put forward some credible arguments thus far, so the SEC will bear legitimate risk if it decides to follow through with an enforcement action.”

Nonetheless, even if Kik isn’t being overly ambitious in challenging the SEC, it's still highly uncertain as to whether any case would result in a new Howey test for crypto in general. David H. McGill, also of Kobre & Kim, told Cointelegraph:

“If the goal here is to overturn the Howey test or render it broadly inapplicable to tokens, I don’t think that is very realistic. But if the goal is to get a court to agree that, under the particular facts and circumstances at issue, KIN tokens don’t constitute securities, I think Kik has a reasonable chance of achieving that outcome, which can then serve as foothold for other token issuers to push back against the SEC.”

These encouraging judgments aside, it still needs to be remembered that, in the past, the SEC has taken enforcement actions on the basis of evidence that investors believed they would benefit from “an increase in value of the tokens.” Because this also likely applies (at least to an extent) in the case of Kik, it’s possible that the commission could behave similarly, even if Kin is already more decentralized than other cryptos.

Even so, because Kik has already spent so much care setting out its case and has now taken things a step further with Defend Crypto. But, Benjamin Sauter believes that the overall legal process may not take as long as some might fear. “Of course, even in a scenario where Kik waits for the SEC to file, Kik would have opportunities to seek an early exit ramp in the form of a motion to dismiss the case, which could help shorten an otherwise lengthy proceeding.”

Yet, win or lose, Kik has taken an important step in confronting the SEC so openly — by expressing grievance with how long it has taken the governing body to reach an enforcement decision and with how the commission's lack of clarity has been damaging the American crypto industry.

This could potentially goad the regulator into finally producing some clear, unequivocal ruling on how to classify cryptocurrencies that have been distributed via a token sale. And if the company does indeed follow through with the initiative and actually sues the SEC, then it's very likely that such a ruling would be produced by a United States court, regardless of the outcome.

June 01, 2019 at 08:02PM Posted by cointelegraph