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SEC “Kiks” Another Goal In Ongoing Fight Against Cryptocurrencies
October 1, 2020

SEC “Kiks” Another Goal In Ongoing Fight Against Cryptocurrencies

By: Ifrah Law

In the latest blow to businesses seeking to offer digital tokens or cryptocurrencies to consumers, the United States District Court for the Southern District of New York ruled on Wednesday that Kik Interactive Inc.’s offering of its Kin digital token violated Section 5 of the federal Securities Act, granting summary judgment to the Securities and Exchange Commission in its lawsuit against Kik.

Kik operates an application called Kik Messenger, and its Kin cryptocurrency was marketed as being designed to be used across a variety of digital applications, including applications not operated by Kik.  Among the examples provided for Kin was the ability to use it to purchase digital music, or to access premium features in a gaming application.  During the initial private and public sales in 2017, Kik sold approximately $100 million worth of Kin, and in the time since the initial sale, dozens of applications have introduced the ability to spend or earn Kin in their application.

Last year, the SEC filed a lawsuit against Kik alleging violations of the Securities Act, claiming that Kik sold securities without a registration statement or an exemption from registration.  The key issue in the Kik litigation—as is true of most cryptocurrency litigation—was whether Kik’s sale of Kin falls within the definition of an “investment contract” for purposes of the Securities Act, which would subject Kin to securities regulation requirements.

The SEC has not engaged in rulemaking to provide a clear set of standards outlining which digital tokens are subject to securities laws.  As a result, the SEC has attempted to apply the three-quarter-century-old “Howey test,” which was developed with respect to more traditional investment vehicles, to digital tokens.  Under Howey, a product is an “investment contract” subject to securities laws when there is (i) an investment of money (ii) in a common enterprise (iii) with a reasonable expectation profits to be derived solely from the efforts of others.  (Kik conceded that Kin involved an investment of money, so the court focused on the other two factors.)

Judge Alvin Hellerstein found that Kik created a common enterprise because it used the funds from the sale of Kin to finance its operations and to build the digital ecosystem in which Kin operated.  In other words, the court found that a common enterprise existed because the value of Kin was promoted to increase in lockstep with the value of the Kik enterprise, and that Kik emphasized this.

In finding that there was a reasonable expectation of profits based on the efforts of others, Judge Hellerstein looked to the fact that Kik’s CEO explained to early Kin purchasers that because there was only a limited supply of Kin, demand for Kin would increase its value, allowing early purchasers to profit.  The court found that the increase in value occurred due to Kik’s managerial efforts.  Judge Hellerstein rejected Kik’s argument that Kin was designed for consumptive use as opposed to being an investment, emphasizing that any consumptive uses only materialized after token distribution.  The court additionally rejected Kik’s argument that market forces (such as the increase in the price of all cryptocurrencies, such as Bitcoin, during the timeframe following Kin’s distribution), and not Kik’s efforts, were what would drive Kin’s value.

This week’s decision is the latest in a blow against companies attempting to integrate digital tokens into their business operations.  Earlier this year, the SEC obtained a preliminary injunction against Telegram Group related to its sale of over $1.7 billion worth of Gram tokens, in a case that Telegram and the SEC ultimately reached a settlement.

Without clear regulations governing the securities law approach to digital tokens and cryptocurrencies, businesses are correct to be concerned about the SEC’s aggressive approach toward digital token issuers.  In this environment, almost any business issuing a digital token could draw the SEC’s ire. If adopted broadly, the decision in the Kik case effectively will bar startup companies from offering any token other than through a regulated securities offering.   The Commission does seem most focused on businesses that do not yet have an established platform or ecosystem prior to issuing their tokens, along with business that promote the potential for their tokens to increase in value, and those that advertise the ability to buy and sell tokens via secondary markets.  Although avoiding those features with new digital tokens may represent some rough guidelines for businesses to consider, the threat of costly litigation against token issuers will be ever-present until the SEC provides clear guidance.

One proposal—championed by SEC Commissioner Hester Peirce—is to allow token issuers that meet a defined set of conditions to qualify for a three-year “safe harbor” during which they can develop their token networks without the fear of securities enforcement.  In a speech this past February, Commissioner Peirce recognized that “our securities laws stand in the way of innovation,” when it comes to cryptocurrencies.  Unfortunately, at this time, it does not appear that the SEC’s other Commissioners have adopted Commissioner Peirce’s viewpoint.

The examples of Kik, Telegram, and countless others have confirmed Commissioner Peirce’s assertion that securities laws represent a threat to innovation in the cryptocurrency arena, and unless there is a change to the legal landscape, potential token developers might choose to avoid altogether sailing into the choppy regulatory waters that challenge new token issuers.  The result will likely be lost opportunities for economic development in the U.S., with many developers choosing to avoid trying to utilize tokens altogether or, alternatively, offering their tokens outside of the U.S. in order to avoid the SEC’s scrutiny.

Although the SEC should certainly play a role when a token issuer engages in fraud, its current approach (which does not require allegations of fraud) already has harmed businesses and consumers alike—and is chilling token development in the United States.  And for now, Kik stands as the latest warning that until more clarity is obtained—whether through clear regulation, a safe harbor, or some combination of the two—businesses considering digital tokens should exercise extreme caution.