On June 4, 2019, the US Securities and Exchange Commission (SEC) sued Kik Interactive Inc. (Kik), a privately-held Canadian corporation based in Waterloo, Ontario, for conducting an unregistered securities offering of its digital token "Kin" in violation of section 5 of the Securities Act of 1933. The SEC is seeking a permanent injunction, disgorgement of ill-gotten gains, and civil penalties against Kik.
Kik's offering was structured as an initial coin offering (ICO), a novel style of digital fundraising that was enormously successful in 2017, but which also generated controversy due to its similarities to traditional securities offerings. The Kik offering took place from May to September 2017 and raised proceeds of $100 million, half of which came from US-based investors.
The United States District Court must now determine whether Kik's ICO was an offering of securities, thus requiring registration. Since 2017, securities regulators in the US and Canada have approached this question by applying decades-old case law to this novel structure and have faced few challenges. This case means that regulators' reliance on historical case law, and their interpretation of it, is now open to judicial scrutiny.
Background
Founded in 2009, Kik has developed and operates a mobile messaging application called "Kik Messenger" with about 300 million users, and has raised US$120 million in venture capital along the way. Despite the application's initial success, according to the SEC by early 2017 Kik had begun experiencing financial difficulty and at one point had only eight months of financial "runway" before running out of money.
In May 2017, Kik launched the Kin ICO. An ICO is a fundraising event in which digital assets such as "coins" or "tokens" are offered by a company, rather than shares or debt, in exchange for consideration in the form of cryptocurrency or fiat money. Pursuant to its ICO, Kik proposed to sell up to one trillion Kin to a combination of institutional and retail purchasers.
The rights attaching to these coins vary from ICO to ICO, but are generally some combination of the ability to "spend" the coin (which often presents no securities laws issues) and market value appreciation (which often does present such issues).
In the Kin Whitepaper Kik described Kin as "an enable currency" that can "transform attention, curation, and creation into real-world value". Users were to earn Kin as a form of reward after completing certain tasks, creating content or giving attention to an advertisement. Kin was to be spent within the application through multiple use cases like accessing a private chat group or tipping a writer. The Whitepaper further notes that "like other cryptocurrencies, units of Kin are fungible and transferable."
These rights and promotional materials suggest that Kik viewed Kin as a non-security. However, the SEC alleges that the ICO represented a dramatic shift to Kik's business strategy and that Kik's founder repeatedly made public references to Kin's potential for appreciation.
Applying the Howey Test
Both the US and Canada have adopted a broad definition of "security", which generally includes any transactions where an investor (a) invests money, (b) in a common enterprise, (c) with the reasonable expectation of profits, (d) to be derived from the entrepreneurial or managerial efforts of others (the "Howey Test" in the US and the "Pacific Coast Coin Exchange Test" in Canada).
Both the SEC and the Canadian Securities Administrators (CSA) published guidance in 2017 explaining that they intended to apply the existing case law tests in determining whether a particular coin is a security. Nevertheless, the novel nature of ICOs and coins make application of those tests difficult, and accordingly, ICO issuers have been forced to operate without much certainty as to how they would be regulated.
The SEC's Arguments
As noted above, Kik described Kin as having been designed to be used as a "currency" to buy goods and services or as a form of rewards within the "Kin Ecosystem" which was to be developed by Kik.
According to the SEC, however, Kin was marketed as an investment opportunity. In applying the Howey test, the SEC first contended that any purchase of Kin from Kik in its ICO would satisfy the first two prongs of the test, namely an investment of money in a common enterprise.
With respect to the expectation of profits portion of the Howey Test, the SEC alleges that (a) Kik made numerous public statements that the value of Kin would increase1, (b) Kik engaged in activities that resembled a traditional road show for an initial public offering of securities2, and (c) Kik indicated that Kin would be listed on an exchange, which would allow purchasers to easily liquidate their Kin3. The SEC argues that all of the foregoing are evidence that investors would expect appreciation of value, or profit, from their investment.
With respect to the efforts of others portion of the Howey Test, the SEC alleges that the efforts of the Kik team will play a central role in building the ecosystem and increasing the future value of Kin. The SEC alleges that Kik has "repeatedly promised" to spur the demand of Kin and increase the token's future value through the management team's expertise and experience4.
The SEC further alleges that Kik was fully aware that Kin would likely be considered a security. The DAO report, in which the SEC first warned ICO issuers about securities law compliance, was published prior to Kik's token offering. In addition, the Ontario Securities Commission ("OSC") has informed Kik that its sale of Kin to the public constituted an offering of securities and after learning the OSC's position, Kik barred Canadians from purchasing Kin in the public sale.
Implications and Impact
This lawsuit is a continuation of SEC's enforcement action against unregistered ICOs. However, unlike prior actions, Kik has vowed to fight back by initiating a crowdfunding campaign to help pay for its defence named "Defend Crypto", which has raised over $5 million. Ted Livingston, CEO of Kik stands by the company's earlier statements that Kin was designed and used as a currency within the network of applications and that it was not created, as the SEC alleges, to save Kik from financial troubles. The blockchain and cryptocurrency community has contributed to the "Defend Crypto" fundraising with hopes that the case will provide clarity on how securities laws will be applied to characterize digital tokens.
The case may also offer guidance to businesses who are developing their own virtual currencies that enable users to trade goods and purchase services, such as Facebook's recently announced Libra coin.
As the regulatory framework is expecting some clarification and changes, we will continue to monitor the development of this case and encourage issuers and stakeholders to consult advisors and securities commissions for further guidance.
Footnotes
1 See paragraph 62 – 68, SEC's Complaint, filed June 4, 2019,https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
2 See paragraph 69-78, SEC's Complaint, filed June 4, 2019, https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
3 See paragraph 79-84, SEC's Complaint, filed June 4, 2019, https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
4 See paragraph 112 – 114 and 118-122, SEC's Complaint, filed June 4, 2019, https://www.sec.gov/litigation/complaints/2019/comp-pr2019-87.pdf
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