Bridging the Week by Gary DeWaal: August 5 - 9, and August 12, 2019 (Securities or Not; Swap Dealer Misleading Information; Market Abuse)
Last week a Canada-based social media company answered charges filed against it by the Securities and Exchange Commission in June 2019 that alleged its 2017 initial sale of digital tokens constituted an unlawful securities offering under US securities laws. The company argued that its digital tokens were not securities but were more akin to virtual currency like bitcoin. In any case, said the company, the SEC never provided it with adequate notice regarding what cryptoassets it might consider to be securities. As a result, the following matters are covered in this week’s edition of Bridging the Week:
Canada-Based Social Media Company Kicks Back at SEC for Enforcement Action Alleging Digital Token Sale Constituted Unlawful US Securities Offering ;
Swap Dealer Sanctioned $2.5 Million by NFA for Providing Customer Misleading Information Regarding Forward Contract Pricing;
Brokerage Company Fined by LME for Failure to Maintain Adequate Risk Management Systems That Did Not Detect Potential Disruptive Trading by Client; and more.
Canada-Based Social Media Company Kicks Back at SEC for Enforcement Action Alleging Digital Token Sale Constituted Unlawful US Securities Offering: Last week Kik Interactive Inc. denied it conducted an unregistered security offering in its answer to the June 2019 complaint filed against it by the Securities and Exchange Commission in a federal court in New York City.
In its complaint, the SEC alleged that, from May through September 2017, Kik conducted an initial coin offering of one trillion Kin digital tokens without registering the cryptoassets with the SEC as required by law. According to the SEC, investors who purchased Kin tokens made an investment of money in a common enterprise with Kik and with other investors, and reasonably expected profits through the business and management activities of the company and its agents. The SEC alleged that, through its Kin offering, Kik raised almost US $100 million, including more than US $55 million from US investors. (Click here for background regarding the SEC’s complaint in the article “SEC Kicks Canada-Based ICO Issuer; Claims It Conducted Unregistered Securities Offering to US Persons” in the June 9, 2019 edition of Bridging the Week.)
In its answer, Kik said its Kin token was not an investment contract, but instead was a non-security digital token of the nature of a “community currency” more akin to bitcoin. Kik claimed that the SEC based its allegations on quotes taken out of context, and documents and testimony provided to the SEC that the SEC also misrepresented. Additionally, Kik claimed that the SEC wrongly conflated its pre-token distribution event (“TDE”) token sale to accredited investors in the United States and its subsequent TDE to retail and non-retail persons as a single unlawful event. (“TDE” is the term used by Kik to describe its initial coin offering.)
Kik’s answer provided extensive, specific examples purportedly supporting its claim that the SEC selectively used or misrepresented quotes, documents and testimony, as well as numerous legal arguments as to why Kin tokens were not investment contracts. Principally, Kik argued that it consistently noted that Kin’s success would “involve the efforts of users and content providers other than Kik,” and the price of Kin would depend on ordinary forces of supply and demand and not from Kik’s efforts.
Additionally, Kik posited that even if the SEC now believes that Kin tokens are investment contracts (and thus securities), a prosecution based on such a view violates its due process. This is because, prior to the TDE, the SEC never provided sufficient guidance for Kik to understand that the sale of Kin in its TDE would violate relevant law.
Kik also claimed the its TDE pre-sale to US accredited investors was authorized by applicable SEC rule (click here to access background regarding Reg D) and was a distinct event from the TDE. As a result, it submitted it should receive judgment in its favor at least as to that portion of the SEC’s complaint.
My View: Both the SEC and Kik have diametrically different views regarding the circumstances that led to the issuance of Kin, both during its pre-TDE fund raise and during its TDE. In its answer, Kik requested that triable facts be heard by a jury, and it may likely be that a jury determines the ultimate outcome of the SEC’s enforcement action if it is not resolved earlier through motion practice or settlement.
However, Kik makes a compelling argument regarding the lack of concrete guidance from the SEC regarding its view of the types of cryptoassets whose offer or sale could lead to an SEC enforcement action for violating registration requirements. Kik argues that its prosecution by the SEC without concrete advance guidance deprives it of due process. This is an argument that will likely be addressed further through motion practice.
Although the SEC has issued frequent, thoughtful guidance regarding the qualities of cryptoassets that might implicate securities registration requirements, the guidance has generally been high-level, and solely offered broad considerations as opposed to detailing how such considerations might be applied to specific fact patterns.
For example, during the same week in June 2018 that William Hinman, SEC Director of Corporation Finance, provided useful insight into how the virtual currency ether may once have been a security but is no longer, as well as general views on when sales of a cryptoasset might implicate US securities laws, the Canadian Securities Administrators issued similar guidance but included 14 specific fact patterns derived from actual episodes it has considered, and provided its conclusions as to whether the referenced digital token had characteristics of a security or not. (Click here for details in the article “Anything but Sleep Inducing: SEC Corporation Finance Director Says Ether Not a Security and Canada Issues Guidance on Utility Tokens” in the June 17, 2018 edition of Bridging the Week.)
Similarly, in April 2019, SEC’s Strategic Hub for Innovation and Financial Technology issued guidance on what characteristics a cryptoasset might possess that could make it more likely to be deemed an investment contract, and thus a security, under US securities laws. This guidance included 38 factors to consider. According to SEC Commissioner Hester Peirce, this “Jackson Pollock approach to splashing lots of factors on the canvas without any clear message leaves something to be desired.” (Click here to access background on the FinHub guidance in the article “SEC Staff Outlines Characteristics of Cryptoassets That Could Cause Them to Be Regarded as Securities” in the April 7, 2019 edition of Bridging the Week. Click here for more on Ms. Peirce’s observations in the article “SEC Crypto Guidance Employing Jackson Pollock Techniques Too Cryptic Says Commissioner Hester Peirce” in the May 12, 2019 edition of Bridging the Week.)
Contrast FinHub’s approach with that of the Financial Conduct Authority two weeks ago when the UK regulator issued its own guidance regarding how different types of cryptoassets likely fall within its regulatory perimeter. Rather than just being high-level, in many cases, the FCA provided alternative examples of characteristics of a cryptoasset that are critical to such a determination in the form of “case studies” and provided a clear statement of the FCA’s legal conclusion (e.g., the referenced token was likely regulated or unregulated). (Click here for background in the article "UK Chief Financial Conduct Regulator Provides Final Guidance on Interface Between Cryptoassets and UK Regulatory Perimeter" in the August 4, 2014 edition of Bridging the Week.)
Although the SEC often cites the 1946 Supreme Court decision in SEC v. W.J. Howey to support its high-level views, it is one thing to set forth elements that should be considered, and another to provide practical guidance that practitioners can use to apply Howey to different specific fact patterns involving a relatively new financial asset that does not fit neatly within traditional product boxes and may often change determinative characteristics over time. Due process, let alone fundamental fairness, requires more specific guidance. (Click here to access a copy of the Howey decision.)
Swap Dealer Sanctioned $2.5 Million by NFA for Providing Customer Misleading Information Regarding Forward Contract Pricing: Wells Fargo Bank, NA, agreed to settle charges brought by the National Futures Association that it misled a customer regarding the method of pricing regarding a four-month Canadian Dollar forward contract during 2014 sold to the client. NFA alleged that WFB told the customer that it would set the settlement price for the forward contract at the average price of Canadian dollar spot contracts WFB purchased on August 27, 2014 (the forward contract had a settlement date of December 31, 2014). In fact, WFB priced the forward contract at a higher price WFB thought the client would accept and not at the average price, claimed NFA. NFA also alleged that WFB misled its customer regarding when it actually acquired the spot contracts to complete its transaction with the client. NFA charged that WFB’s actions violated a Commodity Futures Trading Commission rule that requires fair and balanced communications by a swap dealer with a counterparty and thus also an NFA rule that incorporates the CFTC rule by reference. To settle this matter, WFB agreed to pay a fine of US $2.5 million without admitting or denying any of NFA’s allegations. (Click here to access CFTC Rule 23.433 and here for NFA Rule 2-49(a).)
Brokerage Company Fined by LME for Failure to Maintain Adequate Risk Management Systems That Did Not Detect Potential Disruptive Trading by Client: ED&F Man Capital Markets Limited (“EMV”) consented to pay a fine of GB £180,000 to resolve a disciplinary action by the London Metal Exchange. LME charged that EMV did not have “appropriate and adequate risk management systems in order to detect, deter, and deal with potential instances of market abuse which could have been routed by its clients to the LME” by direct electronic access. LME brought its charges after identifying suspicious order book trading activity routed to LME by a client of EMV by DEA. In settling with EMV, LME acknowledged that the firm was “open and cooperative” during the course of its investigation and implemented enhancements to its risk management systems and controls. At the end of its published order related to EMV, LME cautioned all members to maintain appropriate and adequate systems to spot, help prevent and address trading conduct that may constitute market abuse.
ICE Futures U.S. Proposes No Delay in Hedging Trades Related to Pre-Execution Negotiated Options Cross Trades: ICE Futures U.S. filed proposed rule and guidance amendments with the Commodity Futures Trading Commission that would authorize persons engaging in pre-execution discussions to potentially cross options orders to pre-hedge such transactions in related markets as soon as a transaction is agreed and prior to the execution of such orders. Currently, no trader may hedge any proposed futures or options transaction agreed during pre-execution discussions until after execution. However, the new authority would not be available to an intermediary taking the opposite side of its own customer order. Options orders involving intermediaries and their customers would first have to be executed on IFUS’s electronic market before a hedging order could be entered. IFUS’s proposed pre-execution hedging authority would solely apply to options but not futures transactions. IFUS believes that its proposed rule and guidance amendments would, if adopted, help narrow spreads option traders would be willing to quote to counterparties during pre-execution communications.
Forex Dealer Member Sanctioned by NFA for Failing Timely to Adjust Customers Hurt by Ongoing Trading Platform Malfunction: Gain Capital Group LLC, a retail foreign exchange dealer, a forex dealer member and futures commission merchant, agreed to pay a fine of US $50,000 to resolve charges brought by the National Futures Association that it failed timely to assess the widespread impact of a possible execution system malfunction and make appropriate adjustments to harmed customers after it first learned of the malfunction. According to NFA, beginning in June 2017, a few customers detected execution errors in their account, complained to GCG, and in response GCG provided adjustments. However, said NFA, GCG did not timely take steps to assess the extent of the malfunction of the execution platform that caused the errors. Ultimately, acknowledged NFA, GCG conducted a broader inquiry and made adjustments totaling US $167,000 to all adversely impacted customers; it did not seek refunds from positively impacted customers. GCG determined that over 7,400 of its customers were affected by the malfunction which occurred from April 2016 through August 2017. In addition to paying a fine, GCG agreed to undertakings set forth in an unpublished side letter in order to resolve the NFA’s charges; GCG did not admit or deny any of NFA’s allegation. GCG was charged with violating an NFA rule that requires forex dealer members to favorably adjust all customers harmed by circumstances beyond their control unrelated to market price movements. (Click here to access NFA Rule 2-43(a)(1)(i).)
FINRA Reminds Members It Is in Their Best Interest to Prepare for Compliance With New SEC Regulation Best Interest by June 202o: The Financial Industry Regulatory Authority issued a Regulatory Notice reminding members of the adoption by the Securities and Exchange Commission of Regulation Best Interest. (Click here for background regarding the SEC’s new rule in the article “SEC Adopts New Regulation to Ensure Retail Customers’ Best Interest Takes Priority Over Broker-Dealer’” in the June 9, 2019 edition of Bridging the Week.) FINRA reminded members that they must comply with Reg BI and relationship summary form requirements by June 30, 2020.
Two Traders Charged With Disruptive Trading and Failure to Cooperate by CME Group Exchanges: CME Group Exchanges barred two persons from permanently accessing its markets for engaging in disruptive trading practices and not answering disciplinary charges filed against them. Each person was charged with entering orders without the intent of execution. In addition to access bars, Daesoon Park was assessed a fine of US $60,000 by the New York Mercantile Exchange, US $80,000 to the Commodity Exchange Inc. and required to disgorge profits achieved through purportedly illicit trading on both exchanges. Han Keun Kim was required to pay a fine of US $60,000 to the Chicago Mercantile Exchange.
For further information:
Forex Dealing Member Sanctioned by NFA for Failing Timely to Adjust Customers Hurt by Ongoing Trading Platform Malfunction:
Swap Dealer Sanctioned $2.5 Million by NFA for Providing Customer Misleading Information Regarding Forward Contracts Pricing:
Two Traders Charged With Disruptive Trading and Failure to Cooperate by CME Group Exchanges: