Tencent supported instant messaging App Kik raised $150 million in August 2017 1CO. A few weeks before that, SEC (SEC) issued a guide saying that 1CO might constitute an illegal issuance of securities. Therefore, it was not surprising that Kik received one of the submissions issued by SEC last year to the encryption project.
But in November last year, SEC informed Kik that it was considering enforcement actions against Kik in violation of the US Securities Law. Why is this important? It may reveal some information: how far is the regulator willing to extend the existing laws to reach the encryption project?
There are very few accurate information that can be accessed in regard to the actual mode of work of regulators. I share my findings in the context of the government and technology industry: how the SEC survey took place (all industries, not just the encryption industry), and how the use of the Internet affected the “Kik’s encryption currency whether it is regarded as a securities”, and what will happen next in the industry.
In December last year, Kik submitted an essential legal briefing. Usually, SEC will give people an opportunity to sue before enforcement action. But now, it is not far away from SEC to decide whether or not to take enforcement action against Kik for 180 days.
We are not Kik investors, but Kik’s argument in this process is interesting because they represent the whole industry’s response to emerging technologies, because it is not yet clear which regulations are applicable and how they should be applied.
1. What did SEC do and how did the case start?
As an independent body within the federal government, the main functions of SEC are to protect investors, maintain a fair, orderly and efficient market, and promote capital formation. In order to achieve its goal, SEC has formulated a series of regulations, and its law enforcement departments have jurisdiction over the United States and overseas personnel and companies in order to ensure compliance with these regulations, at least in the case of overseas acts that have a major impact on the United States or take significant measures.
Most SEC surveys start with matters under inquiry or MUI, and SEC can start without reason. They are initiated in a variety of ways: sometimes they are initiated externally, such as complaints from investors or investors.
But they can also come from internal initiatives of law enforcement officers, usually because of media reports or some internal data analysis projects. Or they can be recommended from other agencies or SEC departments, such as compliance inspection and inspection office, FINRA, state securities regulatory body, Congress or judicial or financial department.
The first step of MUI is to publish requests for documents, but it is optional to comply with these requests. In fact, in the MUI stage, SEC staff have not yet obtained the summons. The only person who has to give up information is the entity registered in SEC, such as broker dealers and registered investment advisers.
Within a few months after launching the MUI, SEC staff decided whether to proceed. If they want to do so, SEC management must approve a formal investigation order (rarely rejected). The true meaning of this stage is that the SEC staff are entitled to summons at this time – and can force the investigation of documents and swearing testimony, or may obtain testimony from anyone else who may get information.
Although SEC summons are not popular, it is wrong to equate them with the ultimate law enforcement action. A summons is only a way for SEC to gather information (including collection from third parties), so it can decide whether to take further actions.
The summons receiver can obtain a copy of the official investigation order at any time, but few people use or know that they have the right to obtain the investigation. These investigations do not provide much details, but will reveal the contents of the investigation. SEC staff usually provide some concerns in subsequent discussions.
If SEC staff decide to conduct an investigation, they will want to be as strong as possible in case the court finally appeals. Therefore, they may issue additional summons or interview more witnesses. A former SEC law enforcement director once called it “investigation litigation”.
Two, Wells process, Kik, controversy
If SEC staff decide to take further action after examination of evidence, they usually provide Wells notice. This is basically a letter or a telephone call to let the main body know that SEC has initially decided to recommend enforcement action.
The idea here is to involve participants in a round-trip decision whether to submit a written statement to explain why they are not a particularly good goal, or why SEC may fail in the argument of the case, or to request a higher level meeting.
A striking Wells’s Wells submission actually allows staff to reconsider the original plan of law enforcement action, and it is estimated that the probability of such an occurrence is about 20%. But there are two disadvantages in participating in the process: the Wells proposal may also help SEC to try to solve the weaknesses in the case before deciding to initiate a lawsuit; and the statement of Wells’s proposal can also be used for the theme of future investigation.
Kik took part in the Wells Process (Wells Process), but they made public the submitted reply, and through it let SEC know that their company will take SEC to court.
This is unusual because the Wells process is usually private, and the parties usually do not say to SEC – conversely, the parties usually say that no action should be taken. This is serious and has put more pressure on SEC to decide whether to take Kik as a leading case in 1CO, a test case that tries to solve widely controversial issues.
The arguments presented in this process are interesting because they represent how the whole industry is dealing with a new technology, and it is not yet clear which regulations are applicable and how to apply them.
I find Kik’s submission response very noticeable, especially from the perspective of people who have been observing and co operating with entrepreneurs for some time.
One thing I learned over the years, especially in the work of a federal judge, is that you can read a briefing on one side and think, “this is the case, they obviously have won the argument of victory”, and if you only read the other party’s briefing and think, “it doesn’t matter, in fact, this person has the winning argument”.
At present, we haven’t seen the briefing of SEC to evaluate their arguments. If we appeal later, we will see later.
But Kik did a good job. They stressed:
(1) their encrypted currencies are consumer goods, known as “Kin”, and their integration with millions of active users of Kik, that is, focus on using;
(2) they are trying to find a way to replace advertising based monetization of digital goods and services records, which is a way of competition with FAANG companies.
(3) their good faith compliance efforts – the completion of KYC / AML and OFAC screening, tax payment for token sales, and their self restraints in certain jurisdictions.
Is encrypted currency a real security?
Kik put forward a direct and thorough legal argument that all currencies are not bound by securities law. Kik believes that, since the government has already said that the encrypted currency is money, they can not regulate it as securities. So SEC must let go.
This statement is based on the definition of securities both existing in the trading law and the securities law. Interestingly, the “transaction law” explicitly excludes the currency in the definition of its securities (the term “securities” refers to any bill, stock, stock stock, but not currency), but the securities law does not include or exclude “currency” in its definition of security.
Is money excluded from legal limits? The Kik proposal does not involve some important statutory building codes – the rules of thumb that help the court determine legal significance. You can hardly blame them because SEC has almost no chance to run parallel with SEC on the lack of jurisdiction over encrypted currencies. So, really, Kik is only attacking SEC’s arguments that may be brought to the court on the way ahead.
The more interesting question is whether encrypted money is legally a currency.
Whether or not money can become a securities, the more interesting question is whether the encrypted money is legally monetary. At first glance, given that some of its earlier statements define the currency as “currency”, it seems hard for the government to say that Kin is not a currency.
On the other hand, some courts believe that “currency” means legal tender, which means that if it is provided in the form of debt repayment, it must be accepted. Now, although Kin may be used, Kin is not legal tender. It is expected that the court should pay attention to the simple meaning of the term “currency” when solving this problem.
Where does the Howey test come in?
Kin is not a more predictable argument for securities, which is now a familiar Howey test. The test shows that, if there are the following conditions, it is considered as securities: (1) investment funds, (2) the common enterprise, (3) gain the profit expectation through the efforts of others.
The best argument for Kik seems to be (2) that there is no common enterprise between them and Kin buyers. The court believes that the sale of something rather than more promises will not produce a common enterprise. In accordance with the public information I have examined, Kik’s obligation to the buyer is not obvious except for the delivery of tokens.
Once the delivery occurs, Kin holders control their tokens and use them according to their wishes – whether they are buying goods or other ways, and so on. Kik created an open market to achieve real communication among participants, so Kik is not necessarily a participant in all transactions.
So, (3) what is the expectation of profit through others’ efforts? In his Wells response, Kik tells a good story about consumption, because it integrates with the communication platform, and the communication platform has millions of users in token sales.
Apparently, 20% of Kin buyers link their wallets with Kik to buy everything from games to digital products and services. Some participants bought only 9 cents at Kin, which seems to be “using” rather than “investing”.
If I am defending the case, I want to know how many people have bought such a sum of money, because this is a strong evidence of “consumption rather than investment”. I will also collect the statements of several purchasers of Kik, in order to use them to explain in detail how they use it.
SEC is also likely to have more evidence against this argument – as we know, they have interviewed dozens or hundreds of people who only buy Kin for investment purposes. Of the 10000 Kin purchasers, there are bound to be two categories: investment and use.
But anecdotal evidence about the reasons why buyers buy Kin is not related to the evidence that Kik guides buyers. This is because the case law pays little attention to the idea of the particular buyer at that time, and pays more attention to the contents of the seller’s “offering or undertaking” the purchaser.
So the key is what Kik can be attributed to before sales, which is a good example of how public relations, marketing and other company building functions are really important in many encryption projects.
The focus of the law is not on the idea of a particular buyer at that time, but more about the seller’s “offer or commitment” to the buyer’s content.
Kik says its main marketing information is focused on the use of Kin rather than Kin as an investment, which makes sense because the project is effective only when people actually use Kin. If this is true, SEC will need to deal with some of the facts:
(1) 50% of token sales participants bought less than $1000 of Kin, which seems to be more in line with the debate over consumption and investment purposes.
(2) the way Kik builds things encourages widespread participation and discourages speculation, for example, limiting the amount of personal purchases to ensure that more participants use their networks.
(3) it delays the sale of tokens to ensure that the functions of the network are first ensured and that it can now be used for the future.
(4) since the sale of token money, the use of Kin has increased.
Of course, we do not know what additional facts, documents and witness statements SEC has gained as part of its own investigation process. Is there an e-mail or witness to confirm the fact that it is contradictory to the Kik document? Even the video of the conference is talking about the planned 1CO, just like the CEO. If SEC wins in the Howey test, it is best to have more evidence in this regard.
Three, what’s next?
In a typical Wells process, many people choose to close their cases, whether they know they will fail or because they think that fighting with SEC will be costly and distracting, or because they do not want to fight major regulatory agencies and face more severe sanctions.
Facts are objectively bad. For example, the e-mail of Equifax insider is about how he can exercise all his options before reconciliation. The vast majority of cases have been resolved, which is what SEC knows and relies on, because if everyone chooses to sue, there is not enough resources to solve all cases.
Reconciliation is usually submitted as an administrative order and automatically takes effect. Reconciliation is not common in court. These reconciliation applications are subject to very few court reviews and are usually approved.
Kik told us in Wells’s reply that it did not reconcile.
Therefore, if neither side reconciled – or SEC was not persuaded in the Wells process – SEC staff suggested enforcement action. The reason why I say “recommend” is that SEC law enforcement departments can not act on their own initiative. Most of the 5 members must vote before proceeding.
The law enforcement department wrote a memorandum to the committee, recommended action, attached the views of Wells’s proposal, and had to prepare to answer the Commissioner’s question. Most of the votes are identical, but there are only 4 members, so there may be a split vote.
If SEC staff propose to implement and there are 2-2 split votes, the implementation action will not be carried out. Although this is a good result for Kik, it will leave the possibility of taking enforcement actions against similar facts in the future, and will not provide meaningful guidance for the encryption industry.
In the case of 3-1 voting, action will be taken, but we may also see different opinions – objection may produce an important signal effect, that is, there is sincere disagreement between the public, the Congress and the facts or laws of the public.
What other potential outcomes are there? SEC staff can convince Kik’s Wells to reply that the case is not the best tool for action (based on open facts, which I think is not the case), and therefore chooses not to recommend action.
The whole point of Wells process is to make full use of argumentation. Such a result is a good result for Kik, and is also true for the wider field of encryption, especially if the reports issued by SEC provide prior reasoning.
In theory, the compromise is another possibility, but it seems unlikely that the Kik declaration will bring the struggle to court, and Kik has the financial resources to do so, unlike some start-up companies. Nevertheless, the settlement plan is not a good result here because it will leave unsolved important legal issues.
The solution is not law. Only the court can tell us what the law is.
Why should we solve problems for entrepreneurs and other technicians working in emerging fields? Because for the identified cases, SEC has great influence in drafting the solutions, which will divide the law into black and white. The solution to SEC is not law. Only the court can tell us what the law is.
Therefore, if more courts weigh the content of the securities law applicable to the field of encryption, it may actually benefit the encryption industry and eliminate some regulatory uncertainties. After all, what is the relevance of the case law of 1944 – for companies before the software age – and what we are now doing to centralization of autonomous organizations in 2019?
The Kik case is an early example of interesting issues in the field of encrypted money, and we will soon find out what SEC stands for.
One of the most common misconceptions I hear is that “SEC will put them in prison clothes”. This is not true, because SEC can only bring civil cases. But they can submit questions to the Ministry of justice. Sometimes these two agencies will bring parallel cases (such as Theranos).
However, this is rare because criminal cases require criminal intent and are more burdened by evidence beyond reasonable doubt. SEC only needs to prove the advantage evidence, which means that SEC’s statement does have a probability of over 50%.
All this is not to frighten anyone to create interesting things. This is just to let entrepreneurs know about the process of the securities and Exchange Commission. So what can you do besides observing how this particular situation works?
If we appeal to the courts, we will see various projects, foundations, non-profit organizations and scholars participating in the amicus briefing. “Amicus” refers to people who are not interested in the subject but are part of the case. This briefing is very common, especially in important cases that raise new questions. A good Amicus briefing is very convincing for the judges.
But in addition to observing this situation, the best way of thinking for uncertain navigation is to consider how events should deal with facts. You always want to prove your sincerity, common sense and rationality. But when people can do this, they are extremely unlikely to become the best (or winning) tool of the government, so we should look at everything from this perspective.
Author: Katie Haun
Translator introduction: ELO ox, block chain research society contributing author.
Statement: This article is an independent view of the author and does not represent the position of block chain Society (public number), nor does it constitute any investment advice or suggestion.
Original link: https://a16z.com/2019/05/15/kik-and-the-sec-whats-going-on-and-what-does-it-mean-for-crypto/