In the wake of the SEC’s clarifying guidance in Munchee regarding the application of the federal securities laws to initial coin offerings (“ICOs”), there has been increased activity among both federal and state regulators as they seek to deter what they deem to be sales of unregistered securities in the form of token sales. Indeed, following the SEC’s lead, state regulators are undertaking their own investigations of technology companies building platforms on the blockchain who are seeking to raise funds through ICOs. On January 4, 2018, the Enforcement Division of the Texas State Securities Board (“TX Enforcement Division”) joined the apparent crackdown on ICOs in the name of consumer protection, issuing an emergency cease-and-desist order to BitConnect, a Britain-based technology company that was planning to launch its ICO within the week. On January 9, 2018, the Securities Division of the North Carolina Department of Secretary of State (“NC Securities Division”) agreed, issuing a Temporary Order to Cease and Desist to BitConnect (collectively, the “Orders”), alleging similar violations to those in the Texas action.
The state regulators’ reasons for shutting down the BitConnect ICO are consistent with the SEC’s guidance in both the DAO investigative report and its Munchee cease and desist order regarding the features of a token sale that are likely to implicate the securities laws. But beyond reinforcing the SEC’s prior guidance, these BitConnect Orders also emphasize that foreign companies who directly or indirectly market their token sales in the United States may face liability under both the federal and state securities laws, even before an ICO is launched.
BitConnect and the BitConnect Coin
Based in Britain, BitConnect markets itself as an “open source, all-in-one Bitcoin and crypto-community platform designed to provide multiple investment opportunities,” with a present market capitalization of $4.1 billion. According to the Orders, BitConnect offers users guaranteed profits from their participation in (1) BitConnect’s trading of digital tokens through a proprietary, secret automated trading system called “volatility software”; (2) its digital token, the BitConnect Coin; and (3) its referral program.
The Orders describe BitConnect’s two primary investment platforms. The first is called the BitConnect Lending Program, which requires participants to purchase BitConnect Coins, which will be pooled with other users’ tokens and used by the BitConnect Trading Bot to generate profit through trading activities on a proprietary, secret system it calls “volatility software.” BitConnect markets this program as a “safe way to earn a high rate of return on…investment[s] without having to undergo a significant amount of risk,” promising a return on investment of 40% per month. Users can also partake in the BitConnect Staking Program, which promises returns of up to 120%, depending on how many BitConnect coins (or “stake”) the users hold in their BitConnect-QT wallet. BitConnect indicates that the interest in this program is earned through “Proof of Stake Minting,” with investors earning profits by merely holding and staking BitConnect Coins in their wallet, thereby profiting solely from the essential managerial efforts of BitConnect.
To purchase tokens for either of these programs, users could participate in the ICO scheduled to commence on January 10, 2018, or otherwise purchase BitConnect Coins from other owners through the exchange that was integrated directly on the BitConnect website.
The Orders allege that BitConnect marketed its tokens and its ICO through its website that was accessible to the general public in the United States, and used sales agents, who they called “affiliates,” to increase the visibility of the BitConnect Coin and the ICO. The affiliates are encouraged to promote the coin broadly on social media (including Facebook, YouTube, Reddit, Instagram and Craigslist), and through blogs, websites, and newsletters. The Orders describe how the company provided the affiliates with marketing materials, including online advertisements and banners, to assist them in these promotional efforts. In exchange, the affiliates were entitled to “credit” for each token sale made through their efforts, through a “referral link” that would tag a token purchaser to that individual affiliate. The value of the commission was based upon the affiliate’s position on a multi-level matrix, in a range of 2 – 5%, and the commission was paid in Bitcoin.
The Orders also focused on BitConnect’s marketing materials, where the company allegedly touted its platform and the BitConnect Coin as a “safe way to earn a high rate of return,” and did not disclose all of the corresponding risks. In addition, the Orders found that BitConnect’s marketing materials were silent as to (1) the identities of the principals of the company; (2) information about the assets and liabilities of BitConnect; and (3) information about the proprietary, secret trading system that it calls “volatility software,” which was supposed to generate the high rate of return on investment for token purchasers. BitConnect also issued a disclaimer as to the accuracy or completeness of the information on its own website. Finally, the Orders alleged that BitConnect’s public disclosures did not reveal to the affiliates that registration might be required under state and federal securities law, should the BitConnect Coins that they are marketing were deemed securities.
Both the TX Enforcement Division and the SC Securities Division determined that investments in the BitConnect Staking Program and the BitConnect Lending Program constituted “securities” under state law, and that neither the company, its affiliates, nor the tokens themselves had been properly registered as required by law. Both regulators also found that BitConnect’s marketing materials contained materially misleading statements in violation of the securities laws.
As a result, shortly before the BitConnect token sale was scheduled to commence, both the Texas and North Carolina regulators ordered that the company immediately cease and desist from (1) the offer and sale of unregistered securities; (2) acting as a securities dealer without being registered; and (3) offering securities through materials that contained materially misleading statements.
For anyone who has been following the development of the SEC’s guidance concerning ICOs over the past year, it is not surprising that the investment and profit-related language in BitConnect’s marketing materials led to regulatory scrutiny, consistent with the DAO investigative report in July 2017. But there are other features of BitConnect that are worthy of consideration. First, it indicates that foreign ICOs are not immune from state securities regulation, if their tokens are marketed within the United States and can be traced to residents of the state jurisdictions. Second, regulatory action can occur at any time – either before, after, or during an ICO. Third, “bounty” or referral programs will be scrutinized, and could implicate individual liability for the promoters under the securities laws. Fourth, state regulators are looking carefully at disclosures made in connection with ICOs, including pertinent information that the regulators may deem has not been adequately disclosed to prospective token purchasers regarding the company’s management, finances, or technology.
 Munchee Inc., Securities Act of 1933 Release No. 10445 (“Munchee Order”) (Dec. 11, 2017), https://www.sec.gov/litigation/admin/2017/33-10445.pdf.
 In the Matter of Bitconnect, Order No. ENF-18-CDO-1754, Texas State Securities Board (Jan. 4, 2018), https://www.ssb.texas.gov/news-publications/4-billion-crypto-promoter-ordered-halt-fraudulent-sales.
 In the Matter of BitConnect, et al., File No. 17 SEC 091, Secretary of State of the State of North Carolina, Temporary Cease and Desist Order, (Jan. 9, 2017) https://www.sosnc.gov/divisions/securities/Admin_Action.
 See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (the “SEC DAO Report”), Exchange Act Release No. 81207 at 11 (July 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf.
 Based upon the January 4, 2017 Order, it does not appear that the TX Enforcement Division sought any additional relief – in the form of fines or otherwise – beyond the cease and desist order. The NC Order, however, states that “BitConnect’s violations of the Securities Act is willful, subjecting it to the sanctions and penalties described in N.C. Gen. Stat. § 78A-47(c)(1) and (2).”