While the SEC has worked over the last several months to provide meaningful guidance around the offer and sale of digital tokens, state securities regulators have now begun to take action, with Texas leading the way. In the last month, the Texas State Securities Board (TSSB) has issued two emergency cease-and-desist orders against cryptocurrency-related issuers, showing a strong focus on emerging issues in this area.

In an order issued on December 20, 2017 against USI-Tech Limited, the TSSB cited the Dubai-based company and its U.S.-based sales agents for using advertisements on craigslist, YouTube, and standalone websites to solicit Texas investors for the purchase of interests in Bitcoin mining contracts. The TSSB order alleges that, in addition to promising guaranteed returns and providing very little disclosure regarding the company’s management or the structure of its mining contracts, USI-Tech also failed to fit its offering within any available exemption from registration at either the federal or state level, as it used general solicitation to reach potential investors without taking reasonable steps necessary to verify their accredited investor status.

On January 4, 2018, the TSSB issued an order against BitConnect, which, in addition to operating a Bitcoin exchange and a Bitcoin lending platform, recently launched its own “BitConnectX” token aimed at facilitating those lending and exchange activities. On January 16, 2018, BitConnect announced that it would be shutting down its exchange and lending platforms, at least in part as the result of state enforcement actions. The TSSB order cited a variety of infractions, including:

• BitConnect’s lack of disclosure about its ownership and operations and unsupported claims regarding projected returns from participation in its lending program.
• The payment of participating “affiliates” for referrals of new investors.
• BitConnect’s failure to register (or find a proper exemption for) its offering of (a) the BitConnectX token, (b) participation in its lending program, or (c) participation in its “staking” process, all of which the TSSB deemed to be securities.

As some of the earliest cryptocurrency-related actions at any level, these orders highlight a number of issues that need to be considered by issuers and investors alike:

1. Securities laws may even apply to the mining of certain tokens, not just their offer and sale.  The recent cease-and-desist order issued by the SEC against Munchee, Inc. highlighted the fact that even self-proclaimed “utility tokens” may be deemed securities, particularly if they are marketed through offering materials that discuss the potential for investment returns based on the issuer’s development efforts. But the TSSB’s BitConnect order potentially goes a step further, treating as a security not only the BitConnectX token, but the “proof of stake” mechanism by which BitConnect proposed to improve the security and functionality of its network. Proof-of-stake is often cited as a potential replacement for (or enhancement to) the energy-intensive “proof of work” mechanisms currently employed by most well-known cryptocurrencies. In both models, participants are compensated for processing transactions. But in a proof-of-work model, participants earn the right to process transactions by expending large amounts of computing effort, while in a proof-of-stake model participants earn the right to process transactions based on their ownership of (and in some cases, willingness to risk) some amount of the subject cryptocurrency itself. If the SEC and other regulators take the same approach as the TSSB and treat participation in a proof-of-stake mechanism as an investment in a security, that could have significant implications for technical efforts in this area.
2. Quality of disclosure matters. Both USI-Tech and BitConnect are cited by the TSSB as being woefully deficient—and in some cases actively misleading—in their disclosures regarding the structure and management of their businesses.  In the BitConnect order, the TSSB pays particular attention to conflicts between BitConnect’s claims about the low-risk nature of its lending program on one hand, and its own risk factor language regarding the various pitfalls of the offering on the other. This highlights both the tension between the legal and marketing purposes of  the typical private placement memorandum and the importance of thoughtful legal review in preparing offering materials.
3. Cryptocurrency investors participating in referral programs may be subjecting themselves to additional risk. The TSSB cites as misleading BitConnect’s proposal to pay commissions to “affiliates” who refer additional investors into their offering, because that would necessarily require those affiliates to register as broker-dealers. Under state and federal securities law, a person receiving compensation for effecting transactions in securities is likely to be deemed a broker-dealer in need of registration, regardless of whether the compensation is paid in cash or in securities. The affiliate programs being touted by a number of token issuers fall squarely within this definition, and may result in liability for affiliates deemed to be operating as unregistered broker-dealers (in addition to potentially triggering rescission rights for investors who purchased tokens through such affiliates) in the event that the subject tokens are deemed to be securities.