Table of contents
- First, what does the SEC do and how do cases begin?
- The Wells Process, Kik, and the arguments
- Are cryptocurrencies really securities?
- Where does the
- What comes next?
Kik, the Tencent-backed messaging app, raised $150 million in August 2017 in an initial coin offering (ICO). Weeks before that, the SEC issued guidance that ICOs may constitute illegal securities offerings, so it was no surprise to learn Kik was among the wave of subpoenas the SEC sent to crypto projects last year. But last November, the SEC upped the stakes when it notified Kik it was thinking of pursuing an enforcement action for violating U.S. securities laws. Why does this matter, and what might it tell us about how far regulators are willing to stretch existing law to reach crypto projects?
Given how little accessible and accurate information is out there about how regulatory agencies actuallywork, I share some thoughts — based on my background in both government and the tech industry — on how SEC investigations happen (across all industries, not just crypto); how network usage may impact whether Kik’s cryptocurrency is deemed a security; and what the industry might expect next.
Kik submitted what is essentially a legal brief last December as part of a process where, typically, the SEC gives people a chance to make their case before it recommends an enforcement action. But the 180-day clock for the SEC to decide on whether to pursue an enforcement action against Kik is almost up. We’re not investors in Kik, but the arguments Kik made in this process are interesting, because they are representative of how the entire industry is dealing with an emerging technology where it’s still unclear which regulations will apply and how.
An independent agency within the federal government, the SEC’s primary functions are to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. To achieve its goals, the SEC has a host of regulations that its Enforcement Division ensures are followed, with jurisdiction over people and companies in both the U.S. and overseas — at least where overseas conduct has a substantial effect in the U.S. or significant steps are taken here.
Most SEC investigations start as informal matters under inquiry or “MUIs”, which the SEC can open without much cause at all. They begin in a number of ways: Sometimes they’re externally initiated, such as from a tipster or an investor complaint. But they can also come internally from the initiative of the enforcement staff, often because of a media report or some internal data analysis project. Or they can come from referrals from other agencies or SEC divisions, such as the Office of Compliance Inspections and Examinations, FINRA, state securities regulators, Congress, or the Justice or Treasury Departments.
One of the first steps in a MUI is to issue requests for documents, but compliance with these requests is optional, unlike a subpoena. In fact, at the MUI stage, the SEC staff doesn’t yet have subpoena authority. The only people who are required to hand over info are SEC-registered entities like broker-dealers and registered investment advisers.
Within a few months of opening a MUI, SEC staff determines whether to proceed further, and if they do, SEC management must approve a formal order of investigation (rarely denied). The real significance of this stage is this is when SEC staff gains subpoena power — and can compel documents and sworn testimony from the subject of the investigation, or from anyone else who may have information.
While a SEC subpoena isn’t something anyone welcomes, it’s wrong to equate one with an ultimate enforcement action. A subpoena is merely the way the SEC gathers information, including from third parties, so it can decide whether to pursue further action or not. Subpoena recipients can always request a copy of the formal order of investigation, but few take advantage of or know they are entitled to this. The orders don’t supply much detail, but will shed some light on what the investigation is about. And the SEC staff will usually provide some indication of their focus in subsequent discussions.
If the SEC staff decides an investigation should proceed, they’ll want to make their case as strong as possible in case it ultimately ends up in court. So they may issue additional subpoenas or interview even more witnesses. One former SEC Director of Enforcement used to call this “investigate to litigate”.
If after reviewing the evidence the SEC staff decides further action is merited, they typically provide a Wells notice. This is essentially a letter or call letting the subject know the SEC has made a preliminary determination to recommend an enforcement action. The idea here is for the subject to participate in a back and forth — whether that’s by filing a written statement spelling out why they are not a particularly good target, setting forth arguments for why the SEC could lose the case, requesting a meeting with higher ups, and so on.
A compelling Wells submission can actually make the staff reconsider a planned enforcement action, and it’s been estimated that this happens about 20% of the time. But participating in the process cuts both ways: A Wells submission may also help the SEC identify weaknesses in their own case that they can try to address before bringing an action. The statements in a Wells submission can also be used against the subject of an investigation down the road.
Kik participated in this Wells process, but they made their response public and through it let the SEC know they will take this to court. This was unusual because the Wells process is usually private, and parties generally don’t say that to the SEC — rather, parties usually say the case shouldn’t be brought. This ups the ante and puts more pressure on the SEC to decide if it wants to make this a bellwether ICO case, that is, a test case to try a widely contested issue.
The arguments made in this process are interesting, because they are representative of how the entire industry is dealing with an emerging technology where it’s still unclear which regulations will apply and how
I found Kik’s submission pretty compelling, especially from the perspective of someone who’s been observing and working with entrepreneurs for some time. But one thing I’ve learned over the years, particularly clerking for federal judges, was that you can read one side’s brief and think “that’s it, they’ve clearly got the winning argument”… only to read the other side’s and think “never mind, actually this one has the winning argument”. We don’t yet have the SEC’s brief to assess their arguments — that would come later if and when this goes to court — but Kik did a good job highlighting:
Kik makes a straightforward yet sweeping statutory argument that all currencies are exempt from securities laws. Given that the government has said cryptocurrencies are currencies, Kik argues, they can’t be regulated as securities… so the SEC must be hands off. This argument is based on the definition of securities in both the Exchange Act and the Securities Act. Interestingly, the Exchange Act explicitly excludes currency in its definition of securities (“The term ‘security’ means any note, stock, treasury stock…but shall not include currency.”). But the Securities Act neither includes or excludes “currency” in its definition of security.
So are currencies excluded from securities as a statutory matter? Kik’s submission doesn’t address some important canons of statutory construction here — the rules of thumb for helping courts determine a law’s meaning. And you can hardly blame them, since there’s little chance the argument that the SEC lacks jurisdiction over cryptocurrencies at all would fly with the SEC. So really, Kik is just flagging the argument that it’d presumably make to a court down the road.
The more interesting question is whether cryptocurrency is legally a currency?
Regardless of whether currency can ever be a security, the more interesting question is whether cryptocurrency is legally a currency? At first blush it would seem difficult for the government to argue Kin isn’t a currency given some of its prior pronouncements characterizing cryptocurrencies as “currencies”. But on the other hand, some courts have held that “currency” means legal tender, meaning it must be accepted if offered in payment of debt. And right now, used though it may be, Kin isn’t legal tender. Expect a court to look to the plain meaning of the term “currency” in resolving this question.
The more predictable argument that Kin is not a security falls under the now familiar Howey test. This test says something is a security if there is: (1) an investment of money, (2) a common enterprise, and (3) an expectation of profits through the efforts of others.
Kik’s best argument seems to be (2), that there’s no common enterprise between them and the Kin purchasers. Courts have held that the mere sale of something, without promising more, doesn’t give rise to a common enterprise. Based on the public information I’ve reviewed, it’s not obvious that Kik was under any contractual obligation to the purchasers other than to deliver the tokens. Once that delivery occurred, Kin holders controlled their tokens and could use them how they pleased — whether to buy items or otherwise. And plenty did. Kik created a marketplace that was open and that was meant to achieve real exchange between participants, so Kik wasn’t necessarily a participant in all transactions. Thus, the SEC may have a hard time demonstrating common enterprise between Kik and token purchasers — unless they can come up with evidence showing that Kik had obligations to purchasers after token delivery.
What about (3), the expectation of profits through the efforts of others? In its Wells response, Kik tells a good story about consumptive uses, given its integration with the messenger platform, which had millions of users at the time of the token sale. Apparently, 20% of Kin purchasers linked their wallets to Kik to buy everything from games to digital products and services. That some participants purchased as little as 9 cents in Kin also seems more consistent with for “use” than for “investment”.
If I were defending the case, I’d want to know how many people purchased such small amounts, since that is powerful evidence of a consumptive use rather than an investment. I’d also be gathering declarations from several purchasers who purchased Kik to use it with details about how they used it. It’s also entirely possible the SEC has more evidence against this argument — for all we know, they’ve interviewed dozens or hundreds of people who purchased Kin solely for investment purposes. And with 10,000 purchasers, there’s sure to be people in both categories of purchasing for investment vs. purchasing for use.
But anecdotal evidence about why purchasers bought Kin won’t matter as much as the evidence around what Kik led purchasers to expect. This is because the case law focuses less on what was in a particular purchaser’s mind at the time, and more on what the seller “offered or promised” those purchasers. So the key will be what statements can be attributed to Kik before the sale — a great example of how PR, marketing, and other company building functions really matter when it comes to many crypto projects.
The law focuses less on what was in a particular purchaser’s mind at the time, and more on what the seller ‘offered or promised’ those purchasers
Kik says its primary marketing message focused on Kin’s use rather than on Kin as an investment, which makes sense since the project would only work if people actually used Kin. If that’s true, the SEC will need to contend with some of these facts:
Of course, we don’t know what additional facts, documents, and witness statements the SEC has obtained as part of its own investigative process. Are there emails or witnesses who testified to facts that contradict Kik’s filing? Even conference videos talking about the planned ICO, like the CEO’s here, may. If the SEC is to prevail on the Howey test, it had better hope there’s a lot more evidence in this regard.
In a typical Wells process, many subjects opt for settlement, whether because they know they’ll lose, because they believe battling the SEC would be costly and distracting, or because they do not want to fight their primary regulator and face worse sanctions.
Where the facts are objectively bad — for instance, the Equifax insider’s emails about how he was going to exercise all his options before their data breach became public — settling is probably the right call. The vast majority of cases are settled, which is something the SEC knows and relies on because there simply aren’t enough resources to bring all the cases if everyone chose to litigate. Usually, settlements are filed as administrative orders and are automatically in force. Less often, the settlements are filed in court. These settlement filings are subject to very minimal court review and usually approved.
Kik told us in its Wells reply that it’s not settling.
So if the parties don’t settle — or the SEC isn’t persuaded in the Wells process — the SEC staff recommends an enforcement action. I say recommend because the SEC enforcement division can’t bring an action on its own. A majority of the 5 Commissioners must vote to proceed. The enforcement division writes a memo to the Commissioners recommending an action, attaches the Wells submission, and must be prepared to answer Commissioner questions. Most votes are unanimous, but right now there are only 4 commissioners so there could be a split vote.
If SEC staff recommends enforcement and there is a 2-2 split vote, an enforcement action would not proceed. While that would be a good outcome for Kik, it would leave open the possibility of future enforcement actions on similar facts and would not provide the crypto industry with meaningful guidance. In the case of a 3-1 vote, an action would proceed, though we might also see a dissent — dissents can have an important signaling effect that there’s a good faith disagreement about the facts or law to the public, to Congress, and to judges who may examine the issue down the road in the case of litigation.
What are some of the other potential outcomes here? The SEC staff could be persuaded by Kik’s Wells submission that this case isn’t the best vehicle to take action on (based on the publicly available facts, my own view is that it’s not), and thus choose not to recommend an action to the Commission. While some have suggested this would leave the SEC with egg on its face, I disagree. The entire point of the Wells process is to have a productive airing of arguments. Such an outcome would be a great result for Kik, but also for the broader crypto space as well, especially if the SEC issued a report that provided its reasoning as it has before.
The two parties settling is theoretically another possibility, but that seems highly unlikely given Kik’s statements that it will take this fight to court — and unlike some startups, Kik has the financial resources to do so. Still, a settlement wouldn’t be a great outcome here because it would leave important legal questions unanswered.
A settlement is not law, only the courts can tell us what the law is
Why should settling matter to entrepreneurs and other technologists working in emerging areas? Because for cases that do settle, the SEC has a lot of leverage in drafting settlements that present “the law” as very black and white. An SEC settlement is not law, only the courts can tell us what the law is. So it might actually benefit the crypto industry and clear up some of the regulatory uncertainty if more courts weighed in on what the securities law is as applied to the crypto space. After all, what relevance does 1944 case law — made for corporations before the era of software — mean in 2019, where we now have things like decentralized autonomous organizations?
The Kik case is an early illustration of interesting questions playing out in the cryptocurrency space, and we’ll find out soon what the SEC’s position is.
One of the most common misperceptions I hear is that “the SEC is going to put them in an orange jumpsuit”. That’s incorrect, because the SEC can only bring civil cases. But they can refer matters to the Justice Department, and sometimes the two agencies will bring parallel cases (like Theranos). However, this is rare because criminal cases require criminal intent, and are subject to the higher burden of “proof beyond a reasonable doubt”. The SEC need only demonstrate preponderance of the evidence, which simply means there’s a greater than 50% chance that the SEC’s claims are true.
All this isn’t meant to scare anyone off from building interesting things! It’s simply meant to give entrepreneurs some insight into the SEC’s process. So besides watching how this particular case plays out, what can you do? If this does go to court, expect to see a variety of projects, foundations, non-profits, and academics get involved by filing amicus briefs. An “amicus” is someone who is not a party to the case but has a strong interest in the subject matter. Such briefs have become common, particularly in an important case raising novel issues, and a good set of amicus briefs can be extremely persuasive to judges.
But beyond watching this case, the best mindset for navigating uncertain regulations is to consider how will things look after the fact? You’ll always want to be able to demonstrate your good faith, common sense judgment, and reasonableness. The cases where people are able to do so are highly unlikely to be the best (or winning) vehicles for the government, so everything should be viewed through that lens.
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