The Kik lawsuit vs the Securities and Exchange Commission (SEC) got even uglier with Kik’s latest reply. Indeed, the company accused the SEC of “playing dirty,” and claimed the dreaded Enforcement Division was seeking favorable “news cycles” not blind justice. 

Of course, in theory the elected and judicial branches police alleged agency abuses. Reality is a different story. And the SEC’s tortured path to token securities shows how.

But instead of Congress or courts setting borders to cabin the SEC, the Commission has played unsupervised. It has produced a mishmash of conference statements, enforcement actions, tea-leaf reading, and finally “guidance” that confused more than enlightened.

The SEC should have shunted token rules through a rulemaking where affected parties comment. And would-be issuers can immediately challenge without pain of enforcement processes. Instead emerged the SEC’s Horsemen of Reaction: Chairman ‘Shallow-End Jay’ Clayton, Senior Advisor for Digital Assets and Innovation ‘NPC Valerie’ Szczepanik, and Corp Fin Director ‘Bill the Butcher’ Hinman.

And that is why the Kik lawsuit is so important. Kik’s present resolve to fight through trial allows courts to review the Commission’s legal and policy bearings. And prime among them is where decentralization fits in the securities milieu.

Kik lawsuit enables court to judge decentralization as a Howey extension

The SEC and courts use the dated Howey test to determine what products are securities. The test has four parts: (1) a contract, transaction, or scheme (2) whereby a person invests money, (3) in a common enterprise, and (4) expects profits solely from the efforts of others.

But it’s not that simple. The courts urged by government enforcers have oft twisted the factors. For instance, the first part needn’t include a “contract,” the second needn’t include “money,” no one takes “solely” seriously and so on.

Decentralization ideally rids “efforts” from the fourth prong thereby removing the securities status from ‘investment contracts.’ But as the Competitive Enterprise Institute and others show, the Howey test doesn’t include decentralization.

Bill the Butcher announced decentralization at a San Francisco shindig 

How did it get there? In typical commission fashion, Bill the Butcher, a staff-level functionary exclaimed this new criterion at a fancy San Francisco conference where security (the kind with badges) block the hoi polloi. And the ruling class pay upwards of $1,000 to attend. While discussing the Ethereum network last year he remarked:

If the network on which the token or coin is to function is sufficiently decentralized — where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts — the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.

. . .

Based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions, and, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value. Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.

The SEC Horsemen of Reaction stick together 

And when forced, Shallow-End Jay backed him in a public letter:

I agree with Director Hinman’s explanation of how a digital asset transaction may no longer represent an investment contract, if for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts. Under those circumstances, the digital asset may not represent an investment contract under the Howey framework.

NPC Valerie then issued widely panned “guidance”:

There are essential tasks or responsibilities performed and expected to be performed by an AP [Active Participant, yet another SEC invention], rather than an unaffiliated, dispersed community of network users (commonly known as a “decentralized” network).

And just like that the Howey test expanded.

The Enforcement Division now cites “decentralization” in pleadings:

At the time of all these [token] sales, there was nothing to purchase using Kin, and critical elements of the decentralized economy that Kik had marketed – including a blockchain capable of processing transactions between buyers and sellers at the volume and speed necessary for running consumer applications, and a functioning rewards engine – did not exist.

Ultimately, Kik pursued the ICO without first achieving a decentralized economy for Kin, and without even ensuring that investors would be able to buy goods and services with the tokens upon their receipt.

Decentralization is good, clear rules applied evenly are better

Some applaud SEC willingness to provide a security-less token pathway absent attendant expense and rules.  

But the Commission has not answered decentralization questions. And perhaps it has not even considered them.

The theory behind the decentralization comes from blockchain features. Blockchain ecosystems don’t function like normal issuers. Indeed lots of parties play substantive roles including miners, nodes, developers, and users. Thus, onerous disclosures don’t make sense when issuers have scant control. In the Bill the Butcher’s words, it wouldn’t be “meaningful.”

Kik lawsuit should answer how SEC applies decentralization to blockchain issuers

But the theory invites lots of theoretical and real-world problems. And the SEC fallback of relying on individual “facts of circumstances” welcomes bias and arbitrary enforcement as the Kik lawsuit claims.

As Angela Walch asks:

When we talk about decentralization in context to the Hinman test, what do we refer to? Do we refer to the amount of developers involved in a project? To the amount of nodes? Amount of miners? Is it about the degree of influence the issuer has on the governance and future development of a project? Do we talk about the degree in which a token’s value is derived from businesses building on top of a protocol?

The system’s decentralization is in part a description of its governance [power] and part a description of the numerical, geographical, and ownership distribution of the computers within the network [physical attributes].

Hinman focuses on the network as the decentralizing factor: “if the network…is sufficiently decentralized,” “as a network becomes truly decentralized,” “[t]he network on which Bitcoin functions….appears to have been decentralized for some time,” “based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure,” and “there may be other sufficiently decentralized networks and systems”). As Walch explains Hinman conflates the physical network as a gateway to explain power structure.

In crisis Bitcoin and Ethereum centralize  

Adding to the confusion, Bill the Butcher seems not to consider Bitcoin and Ethereum crises that caused temporary but dramatic centralized moments. For instance, in the fall of 2018 programmers discovered a bug in Bitcoin’s software that could affect coin output and ultimately kill the network.

A select group patched the bug in secret and got major mining pools on board minutes later. But the public didn’t know for days. And a similar hard fork occurred in 2013.

Likewise, Ethereum forked after the infamous DAO fiasco to deny a hacker stolen tokens. And in 2018 an invitation-only meeting took place to discuss Ethereum changes.

In fact, Kik’s lawsuit argues under these metrics Kin was more decentralized than either Bitcoin or Ether at the time of sale (or introduction) and achieved higher trading volumes since.

Kik lawsuit argues it’s as decentralized as others without legal troubles

But there’s more. It is interesting to note similarities between Kik’s lawsuit pleadings and Blockstack and Brave statements, both devoid of legal troubles.  

Kik:

Kik sold Kik Points [precursor to Kin] to advertisers, who – rather than siphoning user data and using it to run targeted advertisements –would offer them as rewards to users who interacted with advertisers’ surveys or polls within Kik Messenger.

It envisioned a decentralized, widely adopted currency that would be used for earning and spending within a variety of digital services offered by developers.

[CEO Ted] Livingston reiterated that “the ultimate dream is for Kik to launch Kin, to launch this broader ecosystem, then for this broader ecosystem to not need Kik.”

In this vision, Kik would be just one of a vast number of participants in this new digital economy.

Blockstack:

Ultimately, Blockstack anticipates that the Blockstack network will become an independent, decentralized ecosystem, over which no one party, including Blockstack, will have control. Changes to the Blockstack Core will likely be proposed by third parties, without Blockstack’s approval

[A]s the Blockstack network becomes increasingly decentralized, core developers other than those employed by Blockstack may become primarily responsible for the development and future success of the network.

Brave (from Life After Google):

Into this breach [Brendan] Eich is hurling his one billion BATS—the unit of exchange for an ingenious new decentralized open-source and efficient digital advertising platform based on Vitalik Buterin’s Ethereum blockchain. Advertisers award BATS to publishers based on the attention of users measured by the pattern of their usage. Users too will be paid in BATS for acting ads that they want to see or choose to tolerate in exchange for micropayments. They can donate they BATS back to favored publishers or use them in exchange for content.

Kik Lawsuit should define rules everyone knows in advance

The easy answer is Brave is a closed system and Blockstack played by the rules and got Reg A+ qualified. But Ethereum did neither. And it’s hard tack to say as did Bill the Butcher did, “putting aside the fundraising.” The SEC’s problem with Kik is “the fundraising.”

From the outside it appears unelected bureaucrats with unlimited power deciding winners and losers based on obeisance, media coverage, or worse. But this not to say Kik has clean hands. It knew the risks by avoiding certain jurisdictions. Moreover, it could have stopped after its $50 million SAFT sale and sought a Reg A+ public sale. It took a risk and is now rolling the dice in court.

No one should oppose decentralization as a factor or perhaps the sole factor in when the magic transition happens. But it’s the government process that makes it distasteful. A court can better apply standards evenly and interpret rules openly and fairly. The Kik lawsuit should not leave Bill the Butcher, Shallow End Jay, and NPC Valerie to roam like unsupervised children in billion-dollar playgrounds.  

By Jossey PLLC via www.thecrowdfundinglawyers.com