The SEC intends to recommend an enforcement case against instant-messaging service Kik Interactive Inc. and the Kin Foundation, the nonprofit organization that oversees the Kin cryptocurrency, alleging that they violated Section 5 of the Securities Act of 1933, according to the Wall Street Journal.

Kik and the Kin Foundation argue that the SEC is overstepping its mandate and have indicated that if the Commission votes to authorize the case, they intend to defend the matter in court. This would provide one of the first opportunities for judicial scrutiny on whether cryptocurrencies qualify as securities under the law. Should Kik prevail, precedent-setting case law could make it difficult for the SEC to regulate certain tokens as securities. Should Kik lose, innovation in the US blockchain and cryptocurrency industry could be further pushed offshore or stifled entirely.

In an unprecedented move, Kik has released the Wells Notice it received from the SEC on November 16, 2018, and its response.

It is the hope of the Blockchain Association that the SEC will not vote to move forward with this case. We do not believe that such important policy matters should be determined through enforcement actions. As this case reflects, there is significant debate and lack of clarity about the scope of securities laws as they relate to the cryptocurrency industry. This is a public policy debate that should play out in an open regulatory proceeding or through the legislative process, so that all industry participants can provide input. We want the policy to be set before it is enforced.

If the SEC does move forward with this case, we hope the outcome limits the SEC’s jurisdiction in this space and makes it clear that not all cryptocurrencies are securities. We do not know all the facts of this case, but we do believe that the current lack of regulatory clarity makes it difficult for companies to know how to comply with the rules. We also know that applying securities law to certain types of cryptocurrency transactions would stifle US-based investment and innovation in these important and promising technologies.

Regulatory uncertainty and regulation by enforcement are bad for US competitiveness

SEC chairman Jay Clayton has repeatedly stated the Commission’s desire to foster innovation in the cryptocurrency and blockchain industry. Pursuing and winning this case would work against these goals.

In its response to the Wells Notice, Kik states that this “‘regulation by enforcement’ approach has had a dramatic and negative impact on the development of blockchain and cryptocurrency technologies in the United States as innovators have either directed their activities overseas or shelved their projects altogether.”

For example, Basis, after raising $133 million in April from venture capitalists, announced last month that it was shutting down its operations and returning a significant portion of investors’ money because of concerns that its cryptocurrency model would not work if it was required to register its “bond” tokens as securities with the SEC. Meanwhile, Japan, Singapore, Switzerland, and other countries have seized upon regulatory uncertainties in the US to build strong crypto beachheads.

Fifteen members of Congress are pressing the SEC for regulatory clarity, worried that the lack of prescriptive rules is stifling innovation. “We are concerned about the use of enforcement actions alone to clarify policy,” states a letter they sent Clayton in September. The “current uncertainty surrounding the treatment of offers and sales of digital tokens is hindering innovation in the United States and will ultimately drive business elsewhere,” the letter continues.

One of the many problems with regulation by enforcement is that it ultimately provides little guidance because it is limited to the facts and circumstances of one individual matter. We want certainty on this issue of which token transactions are securities, but regulation by enforcement is not the pathway to that certainty.

Not all token transactions should be deemed securities transactions — and this case highlights why

There are many types of tokens. We agree that some are indeed securities and should be regulated as such. There are, however, a significant number of tokens that do not have the characteristics of a security, according to the SEC’s own criteria and analysis, and should not be regulated as such. The Wells Notice issued to Kik cites a Section 5 violation, which means that this is not an issue of fraud or intentional misconduct. Kik’s response indicates that the facts of the case are not the primary question, but rather the interpretation and application of securities law to cryptocurrencies. How this plays out will establish a precedent for the SEC’s regulatory authority in crypto.

A few key arguments from the response echo our thoughts on how to view the application of securities laws to certain token transactions.

Currencies are not securities

Currencies are explicitly exempt from the definition of a security under federal securities law. The Securities Act of 1933 does not include the word currency in its definition of security, and the Securities Exchange Act of 1934 explicitly states that the definition of security “shall not include currency.”

This could prove to be the key determinant in the application of securities law to any particular token. So this case could set a standard for whether cryptocurrencies are treated as currencies by the courts.

Expectation of profits

When evaluating the application of the Supreme Court’s Howey test for whether something is a security, courts have focused on what is offered or promised. A California federal judge’s recent order denying a preliminary injunction of Blockvest is the most recent example. It is important to separate the intent of an individual purchaser from how the token was marketed. When a token is sold for consumptive use rather than as a passive investment, federal securities laws do not apply.

It appears, from the Wells response, that Kin was not offered as an investment opportunity with the expectation of profits but as a medium of exchange for the digital world; the stated intent was to create a connected ecosystem where developers, creators, and consumers share value with a common currency that can be earned and spent across an ecosystem of digital services.

In addition, the Wells response argues that there is no common enterprise with respect to Kin, which is a prong of the Howey test that the SEC and the courts may have to consider here.

Functionality of the token network at the time of distribution

This leads to a third key argument. As was noted in our recent post on the Hinman Token Standard, a few key variables determine whether a token is a security at the time of launch. These include whether the token network has some basic level of functionality, whether its governance is more open and distributed than a single centrally organized team, and whether at least some purchasers are users rather than speculators.

Kik’s Wells response references similar factors, citing Forman, 421 U.S. 837, and Terracor, 574 F.2d 1023, as two examples where federal securities laws do not apply when purchasers are buying for consumptive use rather than passive investment. Specifically, it references the level of functionality at the time of the token distribution event (TDE), explaining that Kin was already integrated into Kik Messenger at the time of the TDE and that Kin was and continues to be widely adopted by developers and users alike.

This is important context. As the SEC has indicated, tokens can evolve from securities to nonsecurities as their networks become increasingly decentralized. Many of the future enforcement actions that we expect may be related to the network’s maturity at the time of the offering. Functioning software networks should not be regulated as securities, and for 20 years the US has had a light-touch regulatory framework for software innovation. Kik argues it had a fully functioning network at the time of the token sale, so the outcome of this case will set an important precedent for future cases and will influence the future of software development in the US.

We should have an open process to determine the right policy

The potential case against Kik and the Kin Foundation is about far more than any one cryptocurrency. This is about the future of blockchain in the US. We are glad to see Kik and the Kin Foundation exercise their right to challenge this enforcement action. In the absence of regulatory or legislative action, this case could provide additional guidance that the industry needs.

But enforcement cases like this are a blunt instrument for policy-making. Courts can only decide on the facts of the case, not the circumstances of the entire ecosystem. A court ruling could potentially contribute even greater uncertainty and speculation, exerting a massive chilling effect on innovation in the industry.

Instead, the SEC should provide clear guidance on and interpretation of any currently applicable rules and regulations, or engage in an open rule-making process to the extent that new rules are required. If it fails to take such steps, we should look to the other branches of government that are designed to weigh the needs of all stakeholders carefully. We were pleased that, in December, the bipartisan Token Taxonomy Act was introduced to start the conversation on this issue; it is encouraging that debate will move forward in the new Congress.

The question is: Does the US want to be part of the next wave of innovation? Or will it try to regulate through enforcement and push a growing industry into other markets? We hope the SEC will choose the former path and hold off on regulation by enforcement, so that government, industry, and stakeholders can make policy together in an open, democratic manner.