On May 28, 2020, the Securities and Exchange Commission (SEC) reached a $25 million settlement with BitClave Pte Ltd. (BitClave) after concluding that BitClave had conducted an initial coin offering (ICO) without registering the offering, or qualifying for an exemption from registration, as required under the Securities Act of 1933 (the Securities Act). The SEC has, in recent years, cracked down on numerous ICO sponsors, who often will offer to the public a virtual currency with an apparently legitimate business function, in that the token may allow the holder to engage in certain activities on the sponsor’s platform, but which also contain attributes of an investment. The BitClave matter illustrates, consistent with prior enforcement actions, that the SEC takes an expansive view of what constitutes a security and continues to view tokens as securities that require SEC registration, or an exemption therefrom, where the token functions as an investment opportunity for purchasers.

The facts 

BitClave was a blockchain services company headquartered in California. BitClave’s advertised business plan was to develop a platform called the BitClave Active Search Ecosystem on which businesses would be able to provide digital advertising and customers who viewed and interacted with the ads on the platform would receive Consumer Activity Tokens (CAT). 

In order to raise funds to develop this digital platform, from June 2017 to November 2017, BitClave commenced an unregistered ICO of CAT tokens. In its ICO, BitClave raised $25.5 million through the sale of 680 million CAT to approximately 9,500 investors, including individuals in the United States. Shortly thereafter, the CAT began to trade on digital asset trading platforms.

The SEC concluded that the CAT were offered and sold as investment contracts and therefore were securities that required SEC registration or an exemption therefrom. The SEC order found that:

  • BitClave widely marketed and sold CAT to the general public;
  • BitClave undertook efforts to ensure that CAT traded on digital asset trading platforms;
  • in the marketing materials for the ICO BitClave emphasized the expectation that CAT would appreciate in value over time, and purchasers of CAT had a reasonable expectation, in part based on statements made by BitClave, that the future value of CAT depended on the efforts of BitClave in developing and expanding the digital platform; and
  • while the marketing materials indicated that when finally developed participants on the platform would be able to use CAT on the platform, the marketing materials for the ICO did not articulate any means for token holders to use CAT.

What is a security?

The SEC’s jurisdiction over ICOs hinges on whether the tokens offered in the ICO constitute securities. The definition of “security” in Section 2 of the Securities Act includes the term “investment contract.” In 1946, the Supreme Court established in the oft-cited Howey case that an investment contract exists when there is (i) an investment of money (ii) in a common enterprise (iii) with a reasonable expectation of profits (iv) to be derived from the efforts of others. The Howey investment contract test has been used over the years to establish that all manner of pooled investment schemes constitute securities, and it is the primary analytic framework the SEC has used in recent years to classify tokens issued in ICOs as securities.

In August 2019 the SEC published its “Framework for “Investment Contract” Analysis of Digital Assets” (the Framework), which outlines the key factors the SEC considers in analyzing whether a token issued in an ICO constitutes a security. The three key factors set forth in the Framework are discussed below.

Reliance on the efforts of others

This prong focuses on whether: (i) the investor reasonably expects to rely on the efforts of the sponsor in building the value of the digital platform, and thereby of the tokens, and (ii) whether the efforts of the sponsor are the critical element in growing the value of the tokens. The greater the role of the sponsor, particularly if the digital platform is still under development, the more the tokens look like securities.

As in many of the prior ICO enforcement actions without fully functioning platforms at the time of the token offerings, investors were reliant on the efforts of BitClave for the completion and launch of the platform and growth of the numbers of partners on the platform. As part of its marketing efforts, BitClave emphasized the work it planned to perform to increase the value of the platform in the future and that the value of the tokens would increase with the increase in the number of partners on the platform. The SEC concluded that “[a] purchaser in the offering would have had a reasonable expectation of obtaining a future profit based on BitClave’s efforts to develop and market the platform after the offering, to support the growth of the platform, and cause the price of the tokens to increase.”

Reasonable expectation of profit

This prong focuses on whether investors have an expectation of profit resulting from, among other things, capital appreciation or earnings sharing from the underlying business. Profit expectation together with other attributes that look like an investment, like trading on a platform and wide distribution of the tokens beyond the group of platform participants who might use the tokens to purchase goods and service on the platform, weigh in favor of a finding that the token is a security.

In a White Paper it prepared regarding its platform, BitClave stated that “since the total volume of CAT is fixed, token exchange among the growing population of retail partners and customers implies a general growth model for CAT value,” and ”as more service providers join, the amount of CATs required for an equivalent service will gradually decrease, corresponding to a CAT value increase.” In connection with the ICO, BitClave also released a short video promoting the profit potential of the CAT offering. The SEC therefore concluded that BitClave emphasized an expectation that the price of CAT would appreciate.

The economic reality of the transaction

Tokens that serve a use on a digital platform, and for which any appreciation in value is an incidental benefit of holding the token, are less likely to be viewed as securities.

With respect to BitClave, the SEC noted that BitClave marketed the CAT to the general public, BitClave undertook efforts to ensure that CAT traded on digital asset trading platforms, and the marketing materials for the ICO neither articulated any current use for CAT given the development stage of the platform, nor any use for CAT by anyone other than partners on the platform.

BitClave and takeaways

The SEC had no trouble in concluding that CAT constituted securities. The CAT had no clearly articulated use for investors, were marketed as an investment, were sold to the general public, and raised money for an undeveloped platform whose future growth was dependent on the efforts of the sponsor. This was not a close case.

BitClave was required to disgorge $25.5 million, pay interest of $3.4 million and a civil penalty of $400,000, and dissolve the tokens, among other sanctions.

This case is a reminder that the SEC is continuing to monitor and review ICO activities. Those considering an ICO must view their plans in light of the SEC’s existing guidance on the construction of the term security. If the token offered functions like an investment, the SEC will likely view it as one.