Securities Regulatory Framework For Cryptocurrencies Put To The Test
The Securities and Exchange Commission (SEC) will have to defend its evolving framework for regulating a cryptocurrency as a security in a recently-filed court case where settlement is unlikely. In early June, the SEC filed a complaint in the Southern District of New York (Case No. 19-cv-5244) against Kik Interactive Inc. (“Kik”), a private Canadian company formed in 2009 that owns and operates a mobile messaging application. The complaint alleges that Kik’s offering of one trillion digital tokens called “Kin” to more than 10,000 investors worldwide for approximately $100 million was an illegal sale of an unregistered security. Kik has announced it will fight the lawsuit, which means the SEC will face its first judicial test of its evolving regulatory framework for digital assets.
Section 5 of the 1933 Securities Act prohibits the unregistered offer or sale of a “security” absent an exemption from registration. There is no special exemption for cryptocurrency offerings; if they have not been registered, the argument is that they are not securities. The Securities Act defines a security to include a variety of instruments, such as stocks, bonds, and “investment contracts.” Over 70 years ago, in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the U.S. Supreme Court defined what constitutes an investment contract. Specifically, “an investment contract for purposes of the Securities Act means a contract, 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.” Id. at 298-99.
Howey does not apply cleanly to cryptocurrencies, which may have traits both of currencies (operating as a unit of value that can be exchanged for goods and services) and securities (operating as an investment that may increase in value due to the efforts of others). The SEC has struggled to apply this seventy-year-old case to the digital asset space. To date, although the SEC has brought Section 5 cases, many have been directed at companies running clearly fraudulent operations. In addition, because the vast majority of those cases have settled, they have not produced published opinions setting forth an analytical framework.
In June 2018, SEC Director of Corporate Finance William Hinman attempted to articulate a framework in his “When Howey Met Gary (Plastic)” speech, which analyzed when a digital asset would be considered a security. The speech repeated basic principles, such as the importance of the economic substance of a transaction over labels, analyzed the investment contract concept from Howey, and listed 13 “illustrative” factors relevant to the investment contract analysis for digital assets. The speech left many industry participants seeking more clarity.
Accordingly, in April 2019, the SEC staff provided a more formal framework for evaluating whether a cryptocurrency qualifies as an “investment contract” and therefore a security. The April 2019 statement, by Director Hinman and Valerie Szczepanik (the SEC’s “crypto Czar”) stated that because cryptocurrency offerings typically involve an investment of money in a common enterprise, the real question is whether a purchaser has a reasonable expectation of profits derived from the efforts of others. The April 2019 statement identified three categories of characteristics relevant to this factor. The first category is reliance on the efforts of others, including an analysis into whether important tasks will be performed by a few third parties, rather than an unaffiliated, dispersed community of network users. The second category is reasonable expectation of profits from the work of others rather than price appreciation resulting solely from external market forces. The third category is “other relevant considerations,” such as whether the digital asset is marketed in a way that emphasizes its potential for an increase in value rather than its functionality.
The SEC’s efforts to provide more clarity have come at a cost, requiring it to reach farther from guidance provided by case law. The Kik lawsuit will force the SEC to defend its framework before a court. Unlike prior digital asset firms targeted by the SEC, Kik has announced it has no intentions of settling the case. Kik took the extraordinary step of publicizing its response to the SEC’s Wells Notice by warning of a possible enforcement action before it was sued and has launched a crowdfunding campaign seeking to raise $5 million for its defense (the fund has raised about $1.75 million as of July 2019).
In the Kik lawsuit, the SEC alleges that Kik’s offering of Kin tokens was an unregistered securities offering in violation of Sections 5(a) and (c) of the 1933 Securities Act because the Kin tokens are investment contracts, and thus securities. The SEC alleges that the tokens are investment contracts because purchasers of Kin tokens invested money in a common enterprise with Kik and each other with the reasonable expectation of profits derived from the entrepreneurial and managerial efforts of Kik and its agents. Among other facts that the SEC considered important were that Kik repeatedly promised potential buyers that they stood to profit from investing in Kin allegedly as a result of Kik’s efforts, including the development of a Kin Ecosystem and the creation of a “rewards engine,” and that Kik allegedly assured potential buyers that they would be able to trade Kin on secondary trading platforms, often described as “exchanges,” to convert Kin to dollars or another digital currency (e.g., Bitcoin or Ether). Overall, the complaint repeatedly highlights the ways that Kik described Kin as an investment opportunity.
The Kik case almost certainly will generate case law interpreting when a digital asset qualifies as a security, and may provide the first in-depth judicial analysis of whether and how Howey applies to digital assets. Only time will tell if the case gives the market the certainty and clarity it has been clamoring for.