“I'm literally shaking. This can't be happening”

“We all tried warning you”

This can't be it. I lost everything. EVERYTHING”

“1(800)273-8255 – U.S. National Suicide Hotline”

These are thread titles from the Bitconnect sub-reddit on Reddit.

Cryptocurrency speculation and investment in Initial Coin Offerings was always pregnant with the potential for fraud, but the baby has now arrived kicking and screaming. On January 4, Texas became the first state to lead the charge in inducing it when the Texas State Securities Board issued an Emergency Cease and Desist Order against BitConnect, a little-understood cryptocurrency promoter with deep international ties and sales agents throughout the world.

The company is organized pseudonymously and purports to office out of a posh condominium building in Kent, U.K. BitConnect had created a “lending platform” that permitted investors to take their existing cryptocurrency (in Bitcoin) and invest it in BitConnect Coins, which the investors would then “loan” back to BitConnect, who would use a secret trading bot (“volatility software”) to trade the funds and generate a profit. The rates of interest on the investors' loans to BitConnect were represented to be as much as 40 percent interest per month. Investments were raised in part through U.S. “affiliates” who promoted the product through social media sites like YouTube and Facebook and who were paid illegal commissions in connection with the sales.

At the time the Texas State Securities Board issued its Order, the total market capitalization of BitConnect Coins was valued at more than $4.1 billion. By Jan. 17, the company's online exchange platform went dark, and that market capitalization essentially disappeared. By Jan. 24, a law firm representing a group of investors filed a class action in the Southern District of Florida against BitConnect alleging that a giant Ponzi scheme had finally collapsed. Just days earlier, BitConnect had touted its lending program as a “safe way to earn a high rate of return on … investment without having to undergo a significant amount of risk.” Now, Glenn Arcaro, BitConnect's self-proclaimed “top promoter in the U.S.” has deleted his YouTube channel and disappeared. Investors were crushed and are wondering, “What just happened?”

Texas State Securities Board Action Against R2B Coin

In addition to the BitConnect Order, and within the last 24 hours, the Texas State Securities Board has issued an Emergency Cease and Desist order to R2B Coin, a virtual currency promoter, claiming that the pre-issuance contracts for purchase of R2B Coin are, themselves, securities that have not been registered, are not exempt, and are at serious risk for fraud. Nowhere are the risks of investment in virtual currencies more obvious than in R2B: No one knows for sure who its principals are, and its office address is described simply as 8 Finance Street, Central, Hong Kong. For those who may not make Hong Kong a vacation destination, this is the address of Two International Finance Center—an 88 story, 2 million-square-foot office tower. The company and its proprietors are ghosts. No one knows its financial condition, how it sets its prices, or the backgrounds of its principals.

R2B claims it is managed by Williams Corp. Ltd., a “licensed securities dealer.” The Texas State Securities Board and FINRA, however, find no such registration. A simple YouTube search yields dozens of videos about R2B Coin, including recordings of U.S.-directed conference calls hosted by American voices extolling the virtues of their offering. According to the Texas State Securities Board, R2B Coin itself—not an exchange operating in the open market—determines the coin's price during the current pre-trade sales period. R2B Coin touts its plan to secure a listing for stock on a public exchange, at which point investors may swap their R2B Coin for shares in the company. Until then, however, R2B states that “unlike any other market, all coins that has [sic] been released have increased in price after ICO (Initial Coin Offering).”

In Bounds or Out of Bounds?

While the Texas Securities Act and federal securities laws do not regulate convertible virtual currencies (like Bitcoin), they do regulate what the law calls investment contracts under the SEC v. Howey test. BitConnect's lending program and R2B's pre-trading contract are 1. investments of money, 2. in a common enterprise, 3. with an expectation of profits, 4. to be derived primarily from the efforts of others. So, while the virtual coin itself may not be a security, the contractual lending program or pre-trading contract (and all other types of investment strings attached) may “securitize” the relationship. This requires that those companies (and many others involved in ICOs) step into a securities compliance regime and either 1. register the securities or 2. fall within an exemption from registration.

While the SEC reserves unto itself the ability to determine whether certain securities are required to be registered, the various states retain the right and duty to investigate and prevent fraud in the securities markets within their states. Because the internet reaches all 50 states, countless virtual currencies and the securities offerings they have spawned have been laid at the doorstep of every state securities regulator, with Texas being the first to step out to stem the tide.

Because of the unique characteristics of cryptocurrency and blockchain, it could prove exceedingly difficult for investors to recover from the scammers who took their money.

Cryptocurrency transactions are generally anonymous and are tamper-resistant. The currency is stored with a digital key (just imagine a long series of letters and numbers) in a password-encrypted digital wallet. The key can be stored on a desktop computer, on a mobile device, on the web, on a jump drive, or even on a piece of paper as a QR Code. If a scammer makes off with investor money in Bitcoin or another virtual currency like Ethereum or Ripple, it can be accessed anonymously, untraceably, and virtually anywhere in the world. Until there is greater regulation or transparency with regard to these transactions, perhaps investors should consider electing to defer and play defense first.

Mitch Little is a Securities Litigation and Enforcement partner with Scheef & Stone in Frisco, Texas, where he has practiced for 14 years. A graduate of Harvard and the University of Texas School of Law, Mitch counsels individuals and business organizations in state and federal courts in Texas and beyond.