Keyword: tokens

The SEC Gets its Kiks out of a Successful Application of the Howey Test

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In a closely-watched cryptocurrency case, on September 30, the Southern District of New York ruled in favor of the SEC in SEC v. Kik Interactive, Inc., holding that the Kin tokens Kik had offered and sold through a pre-sale and ICO were securities under the Howey test. The case illustrates the difficulties cryptocurrency companies face when they try to avoid having their tokens classified as securities; even though Kik intended to create a decentralized ecosystem for their Kin tokens on which third parties would supply products and services, the Court reasoned that Kik’s essential role in driving that ecosystem meant that token holders were reliant on Kik’s efforts to realize a profit on their Kin holdings.

Kin tokens were issued on the Ethereum blockchain, and Kik planned to develop an ecosystem of products and services that accepted Kin as currency. Kik stated in its white paper that Kin purchasers would profit through an appreciation of the value of Kin – as more products and services became available within the Kik ecosystem there would be a greater demand for Kin, but the supply of tokens would remain fixed. This increased demand against a fixed supply would drive up the price, which Kin holders could realize by selling their Kin on secondary markets. Kik would not be the sole developer of products and services in the ecosystem – third party participation was expected.

Courts use the Howey test to analyze whether a cryptocurrency is an “investment contract,” which is a type of security. The Howey test is comprised of three prongs: (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profit derived from the managerial or entrepreneurial efforts of others.

Kik’s critical role to the development of the Kin ecosystem was enough for the Court to find that Kin holders expected to derive their profit from Kik’s efforts, thereby making Kin a security (the other two prongs of the Howey test were more clearly met). The Court found that “the economic reality is that Kik, as it said it would, pooled proceeds from its sales of Kin in an effort to create an infrastructure for Kin, and thus boost the value of the investment,” and that, while Kik planned for Kins to have a “consumptive use,” those uses were not available at the time of the Kin distribution and would “materialize only if the enterprise advertised by Kik turned out to be successful.” Growth of the company “would rely heavily on Kik’s entrepreneurial and managerial efforts,” the Court found, because Kik would play an “essential role…in establishing the market” and “Kik had to be the primary driver of [the] ecosystem”; Kik planned to provide significant resources to develop the Kin ecosystem, to integrate Kin into their Kik messenger product, and to provide incentives for developers to create new uses for Kin. Furthermore, if Kik did not follow through with the aforementioned efforts and no ecosystem developed, “Kin would be worthless.”

This reasoning around the “efforts of others” prong is similar to what the Southern District of New York said in SEC v. Telegram, where the Court applied a “Bahamas Test,” reasoning that were the Telegram team to immediately decamp to a tropical island after launching their blockchain, the TON Blockchain project and Grams would “likely lack the mass adoption, vibrancy, and utility that would enable the Initial Purchasers to earn their expected huge profits.” Telegram, like Kik, also had plans to integrate their token into their proprietary messaging product.

A determination of whether a financial instrument is a security based upon the Howey test depends of course upon the facts and circumstances of the particular matter. The Court ruled against Kik Interactive principally because the company disclosed that the value of tokens purchased could increase based upon the company’s efforts, and because at the time of the token sales the tokens did not yet have an immediate utility. A different result might have been reached if the company already had established a working infrastructure in which the tokens had a use independent of investment value. It is not clear that would be enough in all cases to defeat application of the securities laws, but it is at least one helpful argument.

Playing Catch-Up: Commissioner Peirce Proposes a Safe Harbor for Certain Token Offerings

SEC Commissioner Hester Peirce has once again earned her title as “Crypto Mom” by expressing support for building a “non-exclusive safe harbor” for the offer and sale of certain cryptocurrency tokens. Peirce explained that the concept of a safe harbor is still in its infancy and did not propose a timeline for the project. Nevertheless, her support is welcome news for the industry, which can hope that her well-stated views will influence the rest of the Commission to move to adopting a separate securities regulatory framework for cryptocurrency.

We expect that the SEC will take its time in moving forward with the development and implementation of a safe harbor for token offerings. Peirce previously defended the SEC’s slow approach to crypto regulation, indicating that delays in establishing crypto regulations “may actually allow more freedom for the technology to come into its own.” Peirce is cognizant of the repercussions of moving too slowly and seems to be trying to balance the need for regulatory certainty with the need to get the regulatory framework right.

Peirce explained that in developing its crypto regulatory regime, the SEC can learn from other countries that have taken the lead in developing a regulatory framework for token offerings. For example, Peirce explained that the “nebulous” definition of a security in the U.S., coupled with the difficulty of determining the precise nature of a digital asset – is it a currency, commodity, security or derivative? – has slowed our regulatory progress. Peirce suggests looking at the approach taken by Singapore for the classification of offerings as non-securities, since Singapore does not treat every token offering as a securities offering. Similarly, earlier this month the SEC and FINRA issued a joint statement explaining that there are still unanswered questions regarding custody of digital assets that have led to delays in approving ATS applications. Peirce recommends reviewing Bermuda’s guidance on the subject because “Bermuda is one of the only jurisdictions to address the custody question in detail.”

With so many countries so far ahead of the U.S. in developing regulatory regimes for token offerings, the SEC has an abundance of approaches to review. Ideally this will speed up the development and implementation of the safe harbor. If, however, the SEC continues to drag its feet, token projects that would otherwise prefer to launch in the U.S. might be expected to continue to choose jurisdictions with clearer regulatory regimes.

The FCA Reclassifies Cryptoassets, But Is It Moving Away From Its Technology Neutral Approach?

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The Financial Conduct Authority (FCA) has released final guidance on cryptoassets in a policy statement that includes feedback from their January consultation paper. It is important to note that the policy statement is of a limited scope and focuses on whether different types of cryptoassets fall within the regulatory perimeter of the Financial Services and Markets Act 2000 (FSMA) and Electronic Money Regulations 2011 (EMRs). While the policy statement does touch upon the use of cryptoassets for payment services, prospectus requirements and anti-money laundering issues, it does not provide much new guidance on these areas.

In terms of whether cryptoassets fall within the regulatory perimeter, there is not much new or groundbreaking in the FCA’s approach – which is a good thing. The guidance closely follows the FCA’s views that it had set out in the consultation paper, and the FCA is aware that regulation outside its purview would require legislative changes. This being said, the guidance is useful in assisting token issuers and market players to classify whether the cryptoassets they deal with are subject to, or could potentially be subject to, the regulatory regime.

The guidance confirms that cryptoassets will fall within the regulatory regime, if they meet the definition of specified investments, under the FSMA (Regulated Activities) Order 2001 (RAO), the definition of transferable securities under the Markets in Financial Instruments Directive (MiFID) or the definition of e-money in the EMRs. The guidance notes that the most relevant specified investments for cryptoassets are:

  • Shares
  • Debt instruments
  • Warrants
  • Certificates representing certain securities
  • Rights and interests in investments

The guidance deviates from the consultation paper in classifying the different types of cryptoassets. The previous categories had been security tokens, which were regulated, and exchange tokens and utility tokens, which were unregulated unless they met the definition of e-money under the EMRs. The new categories are:

  • Security tokens
  • E-money tokens
  • Unregulated tokens

The definition of security tokens remains the same, that is, those tokens that meet the definition of specified investments under the RAO and fall within the regulatory perimeter. The previous categories of utility tokens and exchange tokens have been reclassified as e-money tokens, which are those tokens (either utility or exchange tokens) that meet the definition of e-money, and unregulated tokens which, as the name suggests, fall outside the regulatory sphere. This new approach is far clearer from a regulatory standpoint and acknowledges that utility and exchange tokens did not need to be classified separately when considering whether they were regulated.

Less obvious, and potentially more interesting, the policy statement also indicates a change from the FCA’s previous technology-neutral approach. This is not spelled out, and we suspect the FCA would still claim to be technology-neutral; however, the guidance notes that the use of particular technology may raise operational issues unique to that technology and the FCA will consider this as part of its ongoing regulation.

The policy statement also notes the transposition of the 5th Anti-Money Laundering Directive (5AMLD) into UK law by January 2020, although separate guidance on this will be issued. The policy statement confirms that the UK’s approach goes beyond that required by the 5AMLD with regards to cryptoassets, and the Government proposes to extend the Anti-Money Laundering regulations to all cryptoasset exchanges, cryptoasset transfers on behalf of another person and issuance of new cryptoassets, for example an ICO.

This shift towards a less technology-neutral approach is also shown in the FCA’s recent consultation on banning contracts for difference (CFDs) and CFD-like products that reference cryptoassets to retail investors. This consultation comes on the heels of the FCA imposing restrictions on the sale of all CFDs and CFD-like products to retail investors. We would argue, and suspect a technology-neutral approach to support, that CFDs and CFD-like products that reference cryptoassets should be treated in the same way as CFDs and CFD-like products that reference other assets. Given that the ban which is being consulted on only targets those products that reference cryptoassets, is it possible that the FCA is moving away from its technology-neutral approach and towards specific cryptoasset regulation?