After investigating both Kik Interactive and the Kin Ecosystem Foundation, only Kik was named in the SEC complaint, why is that so and what does this distinguish about the details of the case?

Great question. I think this is one of the least understood elements of the case, and how the US securities laws do, or do not, apply to this industry. Let me backup for a minute. The Securities Act of 1933, as amended, is the law that was enacted to govern the offering of securities, so it’s important to understand what a “security” is. There is a definition in the statute that defines “security” quite broadly, to include notes, stocks, bonds, debentures, and a host of other intangible interests including “investment contracts” that represent an investment in a business.

The crux of the SEC’s Complaint is whether Kik’s 2017 sale of Kin was an “investment contract.” Kin (which is a cryptographic token that functions as a medium of exchange or a currency) does not meet any of the enumerated instruments set forth in the Securities Act, other than possibly “investment contract.”

The famous case called U.S. v. Howey established that an “investment contract” could be something that is not itself a security as it was traditionally understood, but which could be sold in such a way as to make the sale of the thing a security. In Howey, the thing was orange groves. No one thinks land is a security, although owning a piece of a limited partnership that invests in income-oriented real estate could be. However, the Howey court found that the promoter sold plots of land — orange groves — and promised the buyers, who weren’t farmers, that he would farm the land, sell the oranges, and split the profits with those buyers. That promise, that if the buyers contributed money to a common enterprise, with the promise of profits derived from Howey’s efforts, became a security. It’s actually very much like the limited partnership real estate interest example. The investor doesn’t manage the apartment building and collect the rents, but is entitled to a share of the income generated.

Accordingly, under Howey, the SEC is attempting to make the case that Kin was sold in a way that makes the sale subject to the Securities Act (i.e., the promise of profits from the efforts of others as a result of an investment in a common enterprise). We of course disagree that the Howey factors are met — particularly that there is any kind of “common enterprise” and that token purchasers were led by Kik to believe that they would profit from Kik’s managerial or entrepreneurial efforts. (As an aside, it’s important to note that the SEC’s version of the facts is alarmingly inaccurate, as was detailed in our answer to the complaint filed earlier this week.)

SEC Chairman Jay Clayton has stated that in his view all token sales have been securities offerings, but he agreed with Corporation Finance Director Bill Hinman that even though a token sale might have been a securities offering, it doesn’t necessarily make the tokens a security today. (“A cryptocurrency may be sold as a security when it is first launched if it meets the definition of an investment contract, but the digital asset may later be sold or offered to consumers without being investments.” Clayton Letter to Congressman Ted Budd, March 7, 2019).

So, it is very significant that the SEC did not pursue an action against the Kin Foundation, and is not challenging any of the current activity involving Kin in its complaint. The Kin Foundation is the entity that administers Kin grants under developer agreements and the Kin Rewards Engine. When the SEC notified the Company, in what is referred to as a Wells Notice, of its intention to recommend to the Commission that an enforcement action be authorized, the SEC staff targeted both Kik and the Kin Foundation; however, the SEC filed suit only against Kik, focusing solely on the manner of the 2017 sale, and did not sue the Foundation at all. This lack of action against the Kin Foundation supports our view that the transactions currently taking place within the Kin Ecosystem — Kin being earned and spent by over 500,000 people per month — do not fall under the federal securities laws and, of course, we think it is the right result. In that regard, it is notable that the SEC has acknowledged that current offers and sales of Ether are not securities transactions, and excluding secondary market transactions, Kin blockchain transactions exceed Ether today.

2. Can you go into more detail about the relationship between the Kin Foundation and Kik, as well as the extent to which they are tied?

Sure. The Kin Whitepaper identified the Kin Foundation as an independent, not for profit entity that would administer the Kin Rewards Engine (KRE) and oversee the fair and productive growth of the Ecosystem. The Foundation was created on September 12, 2017 to receive the 6 trillion Kin allocated to it. It is a Canadian tax exempt, non share capital corporation, meaning it does not generate income for the benefit of shareholders.

The Foundation has two directors at present, and the two directors are also the sole members. Over time, the Foundation’s membership and governance will open up to other Ecosystem participants and eventually become fully decentralized.

When it was formed, (because a corporation is required to have directors), the two directors were Ted Livingston and Kik’s then-CFO. Two other directors who were not affiliated with Kik were identified early on to join the Foundation’s board. Unfortunately for the Ecosystem, because of the SEC investigation, one of those gentlemen bowed out. (As an aside, this is another instance of how the SEC’s heavy hand combined with regulatory uncertainty with respect to crypto has impacted innovation by scaring good people away from projects.) Ultimately, though, the other director, William Mougayar, joined the Board and the Kik CFO dropped off. So, there are 2 directors of the Foundation: Ted and William.

The directors have fiduciary duties to act in the Foundation’s best interests, not their own and not for the benefit of other organizations they might be a part of, such as Kik. However, with only two directors, each having an equal vote, both are required to vote in favor of corporate action. Therefore, the Foundation’s bylaws contain a provision that one director may act (rather than both directors as would otherwise be required) if one of them has a conflict of interest.

Since the Foundation doesn’t currently have any employees, the Foundation’s functions are carried out by some Kik employees — such as the Kin business units in Tel Aviv and San Francisco — under a Services Agreement between Kik and the Foundation. Over time that may change — other providers might contract with the Foundation or the Foundation might employ people directly — but the ultimate expectation is that the Foundation will transition to a fully decentralized and autonomous organization. Also, I should mention that the Kik business unit — the unit of Kik Interactive that works on its chat messenger application — does not, generally speaking, work on Kin-related matters, other than as a member of the Kin Ecosystem. In other words, they don’t contribute to the blockchain technology, the KRE, or the website, and they don’t work with developers to integrate Kin into their applications.

3. What does the SEC suit against Kik mean for the rest of the Kin Ecosystem at large? Do developers have anything to worry about?

I don’t think so. Well, developers always have something to worry about — how they will acquire users, how to monetize, how to compete — these are things that Kik is also solving for, and it’s working really well. Kin makes it possible for teams to grow, make money and come together. So, I think there is very low risk to developers from engaging with Kin and integrating into the Ecosystem. But, I get it that developers may be nervous about being roped in to the controversy associated with a major enforcement action.

As I discussed earlier, even the SEC does not appear to be viewing Kin itself as a security, so there is little risk that developers who distribute Kin to their users or otherwise engage with Kin would be viewed as violating the securities laws, unless someone did it in such a way that made it an “investment contract” between that app developer and its users. It’s hard for me to see how that would come about, though, but I never underestimate the creative ability of innovators.

A bigger risk, and one that doesn’t get talked about as much as the securities issues, is whether a developer might create an application that crosses the line into money transmission, by offering to exchange Kin for other currencies, in a way that would require licensing. We don’t advise app developers about that, and I think most use cases don’t implicate money transmitter (MT) rules, but it’s a possibility that developers should think about if an application facilitates the exchange of value for value and doesn’t have an exemption. I don’t want to spook anyone, but a good way for devs to think about it is whether they have the ability to take control of their users’ funds. If so, they probably should seek out good counsel on the MT issue. Kik has spent a lot of time researching these issues and designing products to be compliant by, for example, storing private keys on device so that Kik does not become a custodian.

4. What are some common misconceptions about the case against Kik or TDE (Token Distribution Event) in general?

Wow, there are so many, really. We were really disappointed and surprised by how much the SEC, an agency of the government which is supposed to seek justice, twisted the facts and took them out of context to try to make its case. I don’t say that lightly. I’ve been a securities lawyer for over 30 years, and I’ve always held (and still do hold) the SEC in high regard.

However, some of the statements that were made in the Complaint were just plain wrong — for example, the narrative that Kik was desperate to raise money to avoid going out of business — that is very far from the truth. Take that famous quote by a Kik director that the TDE was a “hail Mary pass”; that comment was actually made to a third party who was interested in possibly acquiring Kik. Also, there was actually another director who used the concept of a “hail Mary” in exactly the opposite way: ‘I think this is a great idea. People call [a cryptocurrency] a hail Mary, but to me that is a longshot and I really do not think it is a longshot.’ In addition, we had a lot more runway than the SEC implied, and many more options. We never even went back to our VCs to ask if they would invest more, and it’s very likely that we could have obtained financing that way. Kik still is one of the top 100 apps in the world, which is extremely valuable. Our CFO testified that he had a high level of confidence that we could obtain traditional financing and extend that runway, but the traditional advertising model that most social media companies follow was not viewed as a long term monetization model primarily because of Kik’s core value of protecting its users’ data. Kik had a vision to break out from that trap of companies having to abuse user’s data to succeed — cryptocurrency made that possible for the first time — and Kik’s board decided to go “all in” on that. It’s funny that the SEC seized upon the term “hail Mary” as a negative, though. As Tanner Philp has said, “A Hail Mary is a designed play. It’s a big play designed to win the game. That’s what Kin was. We saw the increasing monopolization of big tech and more developers struggling to find a sustainable business model, so we pulled out our big play we had been working on for 6+ yrs.” The point is, the SEC tries to paint a picture that the Kin project was an act of desperation rather than the bold move that it was to win the game, and one that Kakao, Line, Telegram and Facebook have all now followed.

Another misleading trope that the SEC has pushed is the idea that Kik knew that Kin was a security, that we had been warned over and over, and that we ignored professional advice but moved ahead, willy nilly, as if we were above the law. That is so far from the truth as to be offensive. The fact is, there was really very little guidance available, and what there was — the DAO Report was issued during the time when Kik was planning the Kin token sale — was actually viewed by us favorably for our token offering. What we were offering was very unlike what occurred in the DAO case, so it reinforced our view that the token sale was not a sale of securities. Our First Affirmative Defense (pg. 118) goes into a lot of analysis on this point, and it is a good read. The fact is, no reasonable company would ever voluntarily submit themselves to a regulatory regime that they honestly didn’t believe was applicable. It is a very challenging and interesting area of the law, and anyone who thinks there was an easy answer is being intellectually dishonest or just not very thoughtful.

It’s unfair, really, because a lot of people expressed disappointment in Kik as a result of the allegations in the Complaint. They felt that Kik was a bad actor, when in fact Kik spent a lot of time, effort and money trying to get it right. We think we did. It’s notable that the SEC has always stated that this is “not a fraud case” — but then it put out a complaint that insinuates that Kik misled (which is another word for fraud) token purchasers. That seemed an intentional effort to prejudice the community against us. That’s why we went to the trouble of writing a detailed answer, and I encourage everyone to read it and get the other side of the story. We know it’s long but we needed the community to know why the SEC’s complaint represents the agency’s misdirection relating to its case.

5. The SEC recently approved a Reg A+ offering in the form of a token sale, which has been regarded favorably by the crypto industry; but it has also left many asking, “Why didn’t Kik do that?”. Can you explain the decisions that Kik made in terms of how to structure the sale of Kin, and why you didn’t choose to go the same route as that other project?

Actually, the SEC has now qualified two Reg A+ offerings — it’s improper to say that the SEC “approved” an offering, though. (Actually, it’s illegal to say that.) — and it’s a great step forward for the cryptocurrency industry, and frankly, for small capital formation generally. So, I applaud Blockstack and YouNow for getting those deals done, even though as I understand it, the Blockstack deal in particular took a year and a half and cost several millions of dollars in legal and accounting fees to accomplish. But, hopefully, the SEC will get quicker about qualifying those deals, and they will start to take on some consistent formats that make it easier for other projects to do them when appropriate. But there are challenges to using Reg A+ offerings that the SEC has not solved yet.

Reg A+, which was created as part of the JOBS Act in 2012, allows companies that want to raise between $3 million and $50 million to do so from anyone — regardless of assets and income levels. That’s a big step away from small offering exemptions that start-ups have traditionally relied on using another exemption under the Securities Act, because those have generally been limited to “accredited investors.” Small offerings also require the issuer to impose restrictions on transfers to avoid a back-door way for securities getting into the public’s hands without registration. That has meant that a lot of investors who are not rich cannot participate in early stage investing. But, that $50 million limitation (which I think has recently been raised to $75 million) is limiting, and if one wants to raise funds, it can be faster and cheaper to do a private placement.

Kik is a company that always tries to look at all the options. But, for us, Reg A+ was not the best option at the time. For one thing, there was no precedent for it in 2017, and no one could be assured that the SEC would ever qualify a cryptocurrency Reg A+ offering. In fact, it was almost 2 years after our token event that the first one happened.

Foremost, as a “security”, Kin could only have been traded in the secondary market on registered securities exchanges, and there still are none that trade cryptocurrencies. Perhaps the SEC will finally allow an alternative trading system (ATS) or exchange to list cryptocurrencies, but no one knows when that will happen.

Additionally, a Reg A+ probably would not have worked for the Kin project because it is a securities offering. To be eligible for an exemption, Reg A+ issuers are required to use the services of registered transfer agents, and if their companies’ public floats exceed $75 million, then shares have to be registered with the SEC within two years. Essentially, the company is going public, and in a decentralized economy like the Kin Ecosystem, who is the entity that is going to continue to publish financial statements? Kik Interactive is not really relevant to the Kin Ecosystem, other than that it is a participant (currently, the largest participant.) But, what does publishing Kik’s financial statements and information about its executives have to do with how the decentralized Kin Ecosystem is doing?

When you think about what Kin is, a general purpose cryptocurrency for every day digital life, treating it like a security makes it nonfunctional for its intended purpose. Under the US securities laws, every transaction in a “security” has to be registered or exempt, and exemptions carry many restrictions for the reason that I mentioned earlier — that you don’t want someone using an exemption as a back door way to engage in a public distribution without registration. It’s complicated, but under the securities laws, resellers of securities can be “underwriters” so developers dealing in Kin (if it were a security) might themselves be subject to regulation. You can see that it would quickly become so burdensome that it would kill the Ecosystem.

Instead of trying to regulate through enforcement, the SEC should propose thoughtful regulations that provide consumer protections, allowing for appropriate commentary from interested parties, but that make sense for this industry and recognize that this hybrid instrument doesn’t fall neatly into existing regimes. I know Kik and many other legitimate projects would welcome the clarity and would try to comply.