SEC vs Kik: The cryptocurrency match of the year is on

The SEC has dropped major bombshells, while Kik is hoping to change cryptocurrency as we know it.

Key points:

• The SEC has launched a legal attack on Kik, alleging its KIN ICO was an illegal security sale.
• Kik is trying to crowdfund a legal defense team.
• The SEC has revealed some very unpleasant allegations around the state of the Kik before, during and after the ICO.

To recap:

• September 2017: Kik, the popular-ish Canadian messaging app, raises $100 million in an ICO.
• November 2018: The SEC sends Kik a Wells notice – an announcement of impending enforcement actions. Kik then reportedly tries to come to some kind of agreement with the SEC.
• January 2019: Kik publicly reveals the ongoing dispute and accuses the SEC of being unreasonable.
• May 2019: Kik starts a crowdfunding effort to "save crypto" from SEC overreach, and to take on the SEC in court with the hope of setting a new precedent for cryptocurrency.

That brings us to here.

June 2019 (you are here)

The SEC has obliged Kik, and has swung a $100 million lawsuit at the company with a demand for a jury trial. The lawsuit alleges that Kik's ICO sale was an unregistered and all-around shady security offering.

Then today, in its public response to the SEC complaint, Kik said bring it on.

"We have been expecting this for quite some time, and we welcome the opportunity to fight for the future of crypto in the United States," said Kik CEO Ted Livingston.

"For the future of crypto, we all need Kin to win. This case will set a precedent and could serve as the new Howey Test for how cryptocurrencies are regulated in the United States," Kik explains on the Defend Crypto fundraising website.

This could be the cryptocurrency game of the year, as the outcome of this match very serious court case could set a major precedent for the space. The thrust of Kik's argument is that the Howey test currently used by US securities laws is not strictly relevant to the Kik cryptocurrency (KIN) and the space more broadly.

It will be fascinating to see how well that stands up – in front of a jury no less.

• The three points of the Howey test

  The Howey test basically says a token sale is classified as a security offering if it meets three criteria.

  1. It's being sold in exchange for money or something else. Therefore free airdrops will typically never be securities, but ICOs often will be.
  2. It's an investment in a common enterprise. If token buyers are all investing in a common enterprise, such as an issuing company, when they make their purchase it's more likely to be a security. If they're just independently buying tokens for personal use elsewhere it's less likely to be a security offering.
  3. There's an expectation of profits derived from the efforts of others. If the token sale promises or emphasises the potential for big gains because the developers are going to do stuff, the sale is more likely to be a security.

  The SEC is arguing that the Kik token sale is a security because it meets the Howey test criteria.

  Kik is now arguing that the Howey test is not an appropriate test for digital assets.

Place your bets now

Disclaimer: Don't actually.

In the SEC's corner, we have the fact that it outweighs Kik several times over, that cryptocurrency doesn't have the best reputation in the wider world and its $100 million lawsuit drops some bombshells that really aren't a good look for Kik.

On the other hand, Kik's seemingly long-shot counterpoint – that KIN isn't actually a security – is not without legs. The SEC has already conceded that tokens can change category over time, and that what began as an illegal securities sale can turn into a legitimate and perfectly legal cryptocurrency.

Pertinent facts

Did you buy into the Kik ICO? If so, buckle up because the SEC is about to rock your world.

1. Kik was going bankrupt prior to the ICO

"Fewer and fewer people were using Kik Messenger. The company expected to run out of cash to fund its operations by the end of 2017, but its revenues were insignificant, and executives had no realistic plan to increase revenues through its existing operations," the SEC explains.

That seems the kind of thing that should have been disclosed to investors in a security sale.

2. No one wanted to buy Kik and it had never been profitable

Prior to the ICO Kik was trying to sell itself to larger tech companies, but no one was interested.

"Kik has never generated appreciable revenue and has never been profitable," the SEC says. Plus, the picture was only getting worse and worse.

"From mid-2015 to mid-2016, the company recorded $2.2 million in revenue but had total expenses of $29.2 million... from mid-2016 to mid-2017, the company recorded $1.5 million in revenue but had $32.3 million in expenses."

That also seems like the kind of thing that should have been disclosed to investors in a security sale.

3. The ICO was a last ditch effort to avoid bankruptcy

A Kik board member described the ICO as a "hail Mary pass". In other words, it was a desperate last resort for a company that was fast running out of cash.

The plan was devised in early 2017, the SEC says, and was made public when Kik announced it in May 2017.

If the purpose of the ICO was specifically to raise funds for the ongoing management and growth of the company, that helps satisfy one of the prongs of the test, implying that KIN is more likely to be a security.

4. Kik allegedly shilled the heck out of Kin

"Kik enthusiastically described the Kin offering and Kik’s plans to create, develop, and support what Kik called the "Kin Ecosystem," in which, at an unspecified future date (if the project was successful), Kin could be used to buy goods and services," the SEC says.

"From the initial May 2017 announcement through September 2017, Kik relentlessly pitched Kin and the prospect that Kik’s future efforts to develop the Kin Ecosystem would drive an increase in Kin’s value. Kik emphasized that only a finite number of tokens would be created and that rising demand for the tokens would cause their value to appreciate. Kik promised that it would spur such demand by dedicating company expertise and resources – including proceeds from Kin sales – to specific, Ecosystem-enhancing projects."

That sounds a lot like the "expectation of profits derived from the efforts of others" prong of the Howey test.

It also sounds kind of gross when the SEC puts it that way, which may not do Kik any favours in a jury trial.

5. Kik sold tokens to private investors at discounted prices

Kik gave discounts to private investors even while charging public buyers the full price, the SEC alleges, saying about half of the funds raised were from private sales at discounted prices. But to be fair, this sleazy and unfair practice is not unique to Kik.

Firstly, it was a common feature of ICOs. The name of the ICO game was to raise big bucks from private buyers who knew that if they could get in early at a discounted price, they could do well by dumping their bags on retail investors as soon as a token hit the market. Secondly, even beyond cryptocurrency, this is similar to just how most equity works. Initial fundraising rounds are made through private channels, and then if all goes well retail investors can get a taste later when the company goes public.

The first irony here is that ICOs were initially held up as a fairer way of raising funds precisely because they were open to the general public. And then people realised you could maximise the gains by devolving the sales into private channel affairs, so ICOs started experiencing the exact problem they were created to solve.

The second irony is that part of the SEC's solution to preventing retail consumers from getting dumped on is to restrict sales to "sophisticated" (wealthy) investors, which actually makes the problem even worse in a way.

This is why we can't have nice things.

6. Kik knew its token sale was potentially a security offering before it began

Kik almost certainly knew that it was embarking on a potential illegal security sale before it began issuance, the SEC says.

The SEC issued the so-called "DAO report" in July 2017, which warned that token sales would often be security sales. Plus, even before then, Kik had been warned by one of its consultants that the KIN token sale was potentially illegal.

"You don’t want your offering to be a securities offering, as that comes with a huge regulatory burden and expense (it’s essentially like taking your company public). On the other hand, unregistered public securities offerings are not legal in the U.S.," the consultant told a Kik executive.

So, why did Kik decide to knowingly kick on with a potentially illegal securities sale rather than registering it?

Who knows? But the SEC points out that if Kik decided to do things the legal way it would have had to disclose information such as its dire financial straits and the fact that Kin's management was unsuccessfully trying to sell the company. It's safe to say that would have made the token sale much less attractive looking.

7. The KIN token was allegedly designed to be an investment rather than a useful thing

The SEC also provides colourful details which suggest that the number one goal was to raise money by targeting people who perceive KIN as an investment rather than a useful tool.

"If you buy some Kik Points (as KIN was called at the time) today when the demand is low, then you will be able to sell them at a higher price tomorrow when the demand is higher, creating a return. This potential return encourages investors to "buy in" at an ICO," Livingston explained to Kik employees in an email.

8. The Kin sticker packets were created solely for legal reasons

The Kin minimum viable product (MVP) was a sticker pack which was available exclusively to Kin holders who used the messaging app. They primarily featured this cartoon honey badger:

"Let's jam," the SEC said to Kik

"This is NOT an MVP for product purposes, nor to satisfy any good user experience for crypto participants," one Kik executive explained in an email to others. "Once we integrate Kin into Kik we will rebuild the entire product bottom up and the MVP will not be used in any way."

"Basically it 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)," another said in an email.

This is an important point.

The primary thrust of Kik's legal argument is apparently this is a misapplication of securities laws. The SEC's "assumptions stretch the Howey test well beyond its definition," said Kik general counsel Eileen Lyon.

But if that's the case, why was Kik actively going out of its way to (unsuccessfully) avoid Kin being classified as a security?

The results

The SEC's bombshell revelations paint a troubling picture of a disturbed business, while Kik has a history of making desperate last-ditch hail Mary passes to stay in business. Its recent efforts to crowdfund a counterargument and argue against the application of the Howey test itself might be yet another.

It's an interesting time, but it's not clear how all this will shake out for consumers in the end.

It's also not clear how this is helping Kik's "victims", which theoretically includes all KIN buyers.

KIN prices tumbled over 25% as the SEC revealed its bombshells, and if the SEC succeeds in its mission to protect consumers and successfully orders Kik to "disgorge its ill-gotten gains", you're left with a company that has no real product or revenue stream, while somehow needing to pay back a fortune. Add to that the tumbling of cryptocurrency prices since the time of the ICO, and it's looking highly unlikely that people will get their refunds.

Plus, there's the challenge of actually identifying the victims here. Are those KIN pre-sale buyers who bought in early and then profitably dumped on retail investors the victims here? Will the ICO participants who have long since sold their tokens, whether profitably or not, get their money back? Do the people who bought into the ICO with cryptocurrency get reimbursed in fiat or cryptocurrency? Do they get reimbursed as current or previous prices?

And how much of that <$100 million will be spent trying to answer these questions?

Perhaps the most consumer-friendly thing to do is let bad investments be bad investments.

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Disclosure: The author holds BTC, BNB, ATOM, IOTA at the time of writing.

Picture: Shutterstock