Kik Challenges the SEC on its Classification of Security Tokens

The case could prove groundbreaking for companies looking to launch ICOs

By Rakesh Sharma

Of the many problems plaguing ICOs, regulatory uncertainty is perhaps the most daunting. Radio silence from the SEC on the legal requirements for ICOs, and the prospect of prosecution, have left entrepreneurs in limbo over the status of their tokens.

Fortunately, clarity may be close at hand.

The messaging app Kik plans to take the SEC to court over the agency’s classification of its tokens as “an unregistered security offering” during the company’s 2017 ICO. The SEC says it reached this conclusion following extensive discussions with Kik’s management team and an investigation into the token sale.

Kik maintains that its Kin token is a utility token and not an investment vehicle. According to the company, Kin tokens will be used for transactions within its digital ecosystem — and not as shiny objects for speculators. (Security offerings generally require entrepreneurs to jump through more regulatory hoops, and often include significantly more disclosures and listing fees than utility tokens).

The Ontario, Canada-based company claims that the SEC has overreached its authority and failed to understand the role of tokens as a medium of exchange in the new digital ecosystem.

“This is the thing that everyone in the [ICO] industry is dealing with, but nobody wants to talk about,” wrote Kik CEO Ted Livingston in a Medium post earlier this week. “For all of us to be able to continue hiring, innovating, and competing, we need to change that.”

What Happened During Kik’s ICO?  

The status of Kik’s token hinges on the particulars of its August 2017 ICO. The company raised $100 million in the sale. Approximately $47.5 million came from retail investors and $50 million was raised through a pre-sale of Kin tokens to institutional investors. A slew of crypto-focused hedge funds and investment firms, including Pantera Capital, Polychain and Blockchain Capital, participated in the private placement round.

In its white paper discussing the offering, Kik classified Kin as a transaction currency for a digital economy. Kik users could earn Kin through an assortment of activities on its platform, including content creation. They could also spend Kin tokens on product purchases within Kik and through other digital services that join the Kin ecosystem.

“Kin will sit at the center of a new digital economy driving demand and fundamental value to cryptocurrencies,” the white paper stated. On the basis of its utility as a medium of transaction between different parties in a continuously evolving ecosystem — ie, a currency — Kik claims that Kin is a utility token.

But the SEC took a different view. Using the Howey Test to determine a token’s status as a security, the organization considers four criteria: the existence of an investment contract, an expectation of profits by investors, the establishment of a common enterprise for the venture and the use of a third party to promote the offering.

In September 2017, the agency sent a Wells Notice to Kik stating that the pre-sale and subsequent token distribution to retail investors violated Section 5 of the Securities Act, which requires registration of offers and sales with the federal body. That process involves disclosure of information relating to the company as well as its offerings. Sales of utility tokens do not require similar disclosures.

Soon after, Kik banned Canadian investors from participating in its offering, citing “weak guidance” from the Ontario Securities Commission (OSC). OSC told reporters that it considered Kin to be a security, but would provide exemption from certain regulatory requirements if Kik agreed to protect retail investors.

Kik contends that the application of the Howey Test exceeds the agency’s “statutory authority.” To reinforce its stance, Kik has offered several reasons.

First, as mentioned above, Kik alleges that Kin is a currency and not a security. The company contends that Kin’s characteristics are similar to those of Bitcoin and Ether, both of which have been cleared of their security status by the SEC because they are used as currencies.

The messaging app’s lawyers also parsed the definitions of “investment contract” and “common enterprise” to make the case for Kin as a utility token. Responding to the Wells Notice, they wrote, “The term ‘investment contract’ is supposed to encompass scenarios where a passive investor entrusts his or her money to managers of a big venture to exert entrepreneurial efforts to make the investors, more money…That framework does not fit the circumstances here.”

Finally, the Kik legal team also claims the SEC failed to identify or describe any specific “common enterprise” between holders of Kin tokens, Kik’s management and the non-profit foundation set up to manage disbursal and rewards from Kin.   

What’s at Stake?

The SEC’s response in cases involving infractions of securities laws by ICOs is a mixed bag. Last year, the agency cleared Bitcoin and Ether, the world’s top two cryptocurrencies. In the case of Bitcoin, there was no initial coin offering. SEC Chairman Jay Clayton also likened Bitcoin to a currency which is used for transactions. William Hinman, another SEC Commissioner, said that Ethereum’s blockchain is now “sufficiently decentralized” that “current offers and sales of Ether are not securities transactions.”

But the agency has also sounded a warning gong against startups that seek to take advantage of the regulatory ambiguity to slip their tokens past the agency. For example, it halted the Munchee ICO in December 2017, citing an array of reasons, including evidence that the founder was promoting the offering as a chance to profit from the token’s price movement.

The SEC’s rulings on ICO tokens had gone unchallenged until very recently. A Southern California District Court judge ruled against the agency’s motion to stop an ICO in December of 2018. The SEC had claimed that Blockvest’s offerings were security tokens, but the judge issued a preliminary ruling stating that it was too difficult to determine whether the startup’s test investors purchased the tokens solely on the basis of promotional material and marketing.

Considering its large amount of ICO funding and the app’s relatively high profile, Kik’s case is bound to receive media attention. This could help it become a blueprint for similar cases in the future.

 

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