Categories: Ethereum

New SEC lawsuit could decide the fate of dozens of blockchain projects

Click here to view original web page at arstechnica.com
Enlarge / Kik CEO Ted Livingston. Alex Flynn/Bloomberg via Getty Images

The Securities and Exchange Commission has filed a lawsuit against social media company Kik over its creation and sale of a cryptocurrency called Kin back in 2017. Kik is vowing to fight the lawsuit, setting the stage for a landmark ruling on how securities laws apply to the sale of digital tokens online.

The case is important because the Kin sale was one of thousands of so-called initial coin offerings held in the last three years. The Kin sale generated almost $100 million in revenue, and coin offerings have collectively raised billions of dollars. Most organizers did not file the kind of disclosure forms that the law requires for conventional stock sales.

The big question is whether the law required them to do so. We don't yet have a clear answer, largely because the SEC has been slow to address the issue.

In the months during and after the 2017 ICO boom, the SEC focused on cases where ICO promoters allegedly committed outright fraud. But those enforcement actions did little to clarify the legal status of mainstream projects like Kin.

As a result, dozens of high-profile cryptocurrency projects are still operating in a legal grey area. It's not clear if they've broken the law, or what penalties they might face as a result. But the penalties could be serious. And more importantly, the strict legal requirements for issuing securities to the public could make initial coin offerings effectively illegal.

Most companies go out of their way to avoid confrontation with federal regulators, but not Kik. Instead, the company has used the case to rally the cryptocurrency community behind it. Last week, Kik announced a crowdfunding campaign to raise millions of dollars to cover its legal costs. The case could determine the fate of dozens of other cryptocurrency projects that have raised money through coin offerings.

“The whole point is to make our legal department happy”

People buy all sorts of things—from gold to real estate to baseball cards—in hopes of making a profit. But only certain types of investments are legally considered securities, a category that triggers a range of legal obligations.

A security exists when someone invests in a common enterprise expecting to profit from the management efforts of a third party. Apple stock, for example, is a security because shareholders invested in Apple (the common enterprise) and are counting on Tim Cook and his employees to generate profits that will get paid back to Apple shareholders.

In a letter to the SEC last fall, Kik argued that Kin is nothing like this. Kik argued that Kin's primary value comes not from its investment value but from its potential use as a currency. People can use Kin to buy goods and services in the growing Kin economy. The fact that Kin's value might go up over time doesn't make it a security any more than baseball cards or gold are securities.

But in its Tuesday lawsuit against Kik, the SEC argues that Kik's own marketing efforts focused on opportunities to subsequently sell Kin at a profit—not on its potential use as a medium of exchange.

"Kik allegedly told investors that rising demand would drive up the value of Kin, and that Kik would undertake crucial work to spur that demand, including by incorporating the tokens into its messaging app," the SEC said in a press release.

The SEC points out that by the end of the Kin crowdsale in September 2017, Kin had only been implemented as an ERC-20 token on the Ethereum blockchain. The Ethereum network is not known for its scalability, and widespread use of Kin on the Ethereum blockchain would likely bring the network to its knees. Kik planned to deal with this by migrating the cryptocurrency to a new, native blockchain—but that would only happen long after the crowdsale was complete.

The SEC also notes that there was hardly anything users could do with Kin tokens when they first came out. Kin payments had not yet been integrated into the Kik app, and no one was yet offering goods or services in exchange for Kin.

In short, the SEC argues, it's hard to believe that most users bought Kin for its value as a medium of exchange. Instead, the SEC says, most users bought the cryptocurrency as an investment, hoping that it would go up in value.

The SEC's complaint includes a hilarious illustration of this point. Kik knew it would be on firmer legal ground if it could point to some practical use for Kin tokens. So the company developed what it called a "minimum viable product"—a Kik feature that gave users access to digital sticker packs based on how many Kin they owned. Theoretically, this allowed the company to say it was selling a token for a currently functional network rather than asking people to make a speculative bet on a not-yet-developed technology.

If you bought enough Kin in September 2017, you could have gained access to this digital "sticker" in the Kik app.

But even Kik's own employees didn't seem to take this claim very seriously. One executive wrote in June 2017 that the company's sticker-pack minimum viable product was designed "with one purpose only: COMPLIANCE. This is NOT an MVP for product purposes, nor to satisfy any good user experience for crypto participants. We discussed that once we integrate Kin into Kik we will rebuild the entire product bottom up and the MVP will not be used in any way."

That same month, an employee wrote that the quality of the sticker product "doesn’t really matter. The whole point is to make our legal department happy, not the users (who are actually investors and probably could care less that they got a sticker pack for their $10K investment into KIN)."

The SEC’s “common enterprise” problem

While the SEC provides compelling evidence that Kik primarily sold Kin as an investment vehicle, the agency didn't do as much to rebut another key part of Kik's argument.

As mentioned above, a security must be an investment in a "common enterprise." In a typical investment scenario, an investor buys a share of a company expecting to receive a share of the profits.

A "common enterprise" doesn't have to involve traditional stock shares. In a famous 1946 case, the Supreme Court ruled that strips of land in an orange grove could be considered securities. Florida developer William Howey would create orange groves, sell parts of them to mostly out-of-state investors, and then lease the land back from them. Howey's company would then operate the grove as a single operation and split the profits among the landowners. While Howey was nominally selling land, the Supreme Court ruled that the land titles effectively operated as shares in Howey's orange-growing business, and as a result the land sales were effectively sales of securities.

The SEC argues that Kin fits the definition of a security articulated by the Supreme Court in the 1946 Howey case. Kin purchasers don't expect to get dividends directly from Kik, but they did expect to profit indirectly from Kik's subsequent efforts to grow the Kin economy. In the SEC's view, the Kin platform is a "common enterprise" analogous to Howey's orange grove.

But other precedents cast doubt on that conclusion. Kik points to a 1978 ruling by the 10th Circuit Appeals Court in which plaintiffs had purchased plots of land in a planned community. The developer, Terracorr, had ambitious plans for the community, including "shopping centers, health and cultural facilities, transportation facilities, and abundant recreational opportunity, including a golf course and lake." While some people bought plots to live on, others did so for investment purposes.

When the larger community didn't grow as rapidly as the plaintiffs hoped, some of the purchasers sued the developer. In their view, the developer's stated plans to develop nearby amenities made the land sales unregistered sales of securities. But the appeals court disagreed.

"We fail to see any common venture or common enterprise between the plaintiffs and Terracor," the court wrote. "The mere fact that the plaintiffs bought lots from Terracor does not mean that by such acquisition they were thereafter engaged in a common venture or enterprise with Terracor."

Kik draws a parallel between Terracorr's land sales and its own sale of Kin tokens. Many customers bought Kin hoping that Kik's efforts would increase the tokens' value, just as some landowners bought lots expecting Terracor's development efforts to make the land more valuable. But as in the Terracorr case, it's hard to see a "common enterprise" between Kik and people who bought Kin. While Kik had promised to take steps to build the Kin platform and ecosystem, it hadn't signed contracts with Kin owners promising to do so.

If the courts accept the SEC's loose interpretation of the common enterprise requirement, it could have broad-ranging consequences. For example, back in April Elon Musk predicted that rapid improvements in Tesla's self-driving technology would make Tesla vehicles an "appreciating asset."

Does that mean that Tesla is marketing its cars as securities? The SEC's arguments in the Kin case seem to point in that direction. Musk is urging customers to invest money in an asset (a car) in the expectation that its value will rise over time thanks to Tesla's software development efforts. The "common enterprise" here would be Tesla's efforts to increase the value of Tesla cars on behalf of customers.

Similar logic could apply in other cases. For example, if a company acquires a new top-level domain and urges people to invest in sub-domains, the domain names could be securities. If a company creates a multiplayer online games with limited-edition in-game items and encourages people to invest in them, the items could be securities.

The Kik case will have implications for a number of other cryptocurrency projects, too. For example, the startup behind the Brave browser sold a cryptocurrency called the Basic Attention Token in 2017 that is intended to be used in a new online advertising market. If the courts decide that Kin's tokens are securities, that could also make Brave's tokens securities, creating legal headaches for the startup.

cinerama

Illuminati, Mason, Anonymous I'll never tell. I can tell you this, global power is shifting and those who have the new intelligence are working to acquire this new force. You matter naught except to yourself, therefore prepare for the least expected and make your place in the new world order.

Disqus Comments Loading...
Share
Published by
cinerama

Recent Posts

CME Group Reveals Plan for Bitcoin Options in Q1 2020

Leading derivatives exchange operator, CME Group announced in a press release today that it will launch options on its bitcoin… Read More

6 hours ago

Analyst: Bakkt Launch to Improve Trustworthiness of Crypto Markets

For the past year many participants within the crypto markets have been looking towards the official launch of Bakkt as… Read More

6 hours ago

IBM Stock Gets a Blockchain Pop

IBM (NYSE: IBM ) investors haven’t had all that much to complain about in 2019. After a precipitous drop over… Read More

6 hours ago

I-Team: Bitcoin scams rob Triangle investors of $54K

RALEIGH, N.C. (WTVD) -- A series of online heists is robbing even the most tech-savvy people in the Triangle.According to… Read More

6 hours ago

Colombia is slowly moving toward Bitcoin-friendly regulations

To say Colombia doesn’t have the best cryptocurrency regulations in the world would be an understatement. As it stands, crypto,… Read More

6 hours ago

Ethereum price analysis: Bulls take full control of ETH/USD

ETH/USD went up from $218.55 to $220.60. The Relative Strength Index (RSI) indicator is trending in the overbought zone. ETH/USD… Read More

6 hours ago

This website uses cookies. We use these cookies to collect data about your interaction with our website for the purpose of continuously improving your experience with our site. For more information we encourage you to read our privacy policy.

Read More