ICO issuer avoids chopping block: the latest SEC order signals path for 2020

Link to Order

One of my 2020 crypto law predictions is that we are going to be reading a lot more about FinCEN, OFAC and IRS investigations and less about the SEC and the CFTC.

But for now, the SEC keeps settling ICO cases at a steady clip, including an order entered on December 18 in connection with In the Matter of Blockchain of Things, Inc. (“BCOT”).

Mike McSweeney reported on this initially for the Block soon after the order was issued, and I am not going to repeat his coverage here. There are a couple of additional observations I also took away after reading it, though.

At a high level, we see that the SEC continues to go after issuers who raised money without registering or qualifying for an exemption. This is not a securities fraud case (in comparison with, say, the CentraTech ICO, which has fraud allegations out the ying-yang and a criminal prosecution to boot). Nor is the SEC shutting this company down. Apparently running an ICO wasn’t necessarily a terrible proposition for people who did this in 2017 and didn’t run up Lambo bills right away (cf. Block dot One).

This is another case where an ICO issuer is being allowed, apparently, to walk away with a large chunk of cash.

BCOT was started in 2015 “to develop blockchain technology integration solutions”, available on something called the “Catenis Platform”. BCOT began an ICO with a December 4, 2017 pre-sale of BCOT tokens. In connection with that, the company released a white paper that described the technology (“an easy to use, web services layer encoded into the Bitcoin blockchain”) and a separate “Token Sale Economics” document, which was a common feature of many ICO sales at the time.

At the time of the offering, the company’s platform was functioning in beta and it had “two corporate clients, including one paying client.” It had also generated some revenue already. The white paper also described a bunch of functionality that hadn’t been built yet, including “how it planned to incentivize third-party developers to build applications on the Catenis platform, stimulating an entire “ecosystem of thirdparty apps[.]” Ecosystem was also a common buzzword at the time. (If you were “in the space” in 2017, you will remember that everyone was gaga over token economics and incentivizing ecosystems.)

Following the token sale, purchasers would be able to convert their tokens to credits that would give them access to the Catenis platform and services. The SEC devotes several paragraphs to the so called “token economics” used here:

BCOT’s Token Sale Economics document set forth further details regarding the upcoming token sale, including token pricing, allocation, and distribution. Notably, token prices increased from $ 0.50 USD to $ 2.00 USD based upon the number of tokens sold to date. BCOT also set an undisclosed “hidden cap” (or maximum total token supply) on the number of tokens it would distribute. BCOT stated it was not its intention to allow an unlimited amount of token sales.

According to the Token Sale Economics document, only seven and one-half percent (7.5%) of the maximum token supply was to be distributed through its Offering. The document outlined how the remaining tokens would be allocated. By far the largest portion of the maximum token supply — sixty percent (60%) — was to be held in reserve by the company, to be used or issued by BCOT at its sole discretion. BCOT thus had the ability to restrict, or increase, the number of tokens in circulation at its discretion. The remaining tokens were to be allocated over several years through a Customer Rewards Program (12.5%), “Bounty Rewards” to third-party developers (10%), “Community/Advisor Grants” (5%), and to “Founders/Core Team” (5%).

In addition to the control that the company exercised over token issuance and distribution, users were not restricted in their ability to sell or transfer the tokens on secondary markets.

While BCOT required users to sign an agreement saying that they were not “buying BCOT Tokens for ‘future appreciation’ or ‘investment or speculative purpose[s],’” this didn’t persuade the SEC.

Here again, for the eleventy-millionth time, we see that magic language and formulaic incantations don’t inoculate a crypto asset against securities laws in the eyes of the SEC, which pointed out that:

...purchasers could expect to see their BCOT Tokens increase in value based upon demand for BCOT Tokens increasing, as third-party developers built applications that increased the attractiveness of the Catenis technology — and, by extension, increased the value of the BCOT Tokens. Based on BCOT’s statements in its White Paper and other documents provided in connection with the Offering, purchasers would reasonably have expected that BCOT and its agents would expend significant efforts to develop the Catenis platform, spurring the development of an “ecosystem” and thus increasing the value of their BCOT Tokens.

Furthermore, the fact that there was a live beta didn’t translate into the kind of actual use or utility that might have weighed against a finding that the token was being purchased as an investment and nothing more.

The sale raised $13 million from investors in the U.S. and Asia between December 2017 and June 2018. Most of the money appears to have been raise in a private “presale." $600,000 was initially raised from 69 Americans in the pre-sale via general solicitation efforts. More than $12 million was also raised via foreign resellers who sold tokens to 1,380 individuals.

It is unclear from the order if any of those persons were actually American. Tokens were issued between March 13 to March 15, 2019, which may mean that the SEC did not commence an investigation or enforcement action until sometime thereafter, but in this calendar year, nonetheless.

Long story, short:  the SEC runs through a fairly academic analysis of the issuance and concludes that, yes, it was pretty clearly a securities offering under the Howey Test: “A purchaser in the Offering of BCOT Tokens would have had a reasonable expectation of obtaining a future profit based upon BCOT’s efforts to spur development of an “ecosystem” on the Catenis platform, including BCOT’s use of its Offering proceeds and steps to control and increase the value of BCOT Tokens.”

But … it looks like the company is going to get to keep most of the money.  It is still up and running on the interwebs with a pretty website that has not been seized by the Department of Justice.  It has to pay a $250,000 penalty to the IRS, register with the SEC, and give people the ability to get their money by submitting a claim form. There’s no disgorgement order and the company apparently gets to keep any of the investment made to it by people who don’t file claims (usually a fairly low percentage). 

My guess is that we are going to see several dozen more administrative orders like this one in 2020, and maybe even one or two more before 2019 ends. Non-fraudy ICO issuers who actually built stuff appears to be getting, if not a free pass, the SEC’s grudging permission to pay penalties, register and…survive. As you read securities cases in the crypto space  –  both administrative consent orders like this one and judicial cases  –  you see over and over again how substance matters more than names.  This is not really a surprise, by the way -- the SEC told us back in 2018 in connection with the AirFox and Paragon ICOs that the commission would be amenable to offering a "path to compliance" to (non fraudy) issuers:  "These two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities."

Calling something a utility token was never going to be a way to get it out of registration requirements. We will see the same substantive particularity play out in the tax context. I don’t think there are going to be a lot of surprises from the SEC (or CFTC for that matter).

The regulatory wild card in the ICO space that we have not seen play out in large measure yet is with agencies like IRS, FinCEN and OFAC, which may not be quite as forgiving and from which we have not seen nearly as much enforcement activity. How many ICOs did rigorous AML/KYC screening, for example?

Bottom line :  if 2019 was the year of SEC enforcement activity for Crypto, I suspect that 2020 will see considerably more public activity with and from some other agencies.