Friday, April 25, 2014

Elusive Bitcoin: Regulation of Bitcoin in the U.S. Part III

In this third chapter of my blog about Bitcoin regulation, I am going to focus on regulation of Bitcoin by the CFTC and the SEC.

The U.S. Commodity Futures Trading Commission (the "CFTC") is an independent federal agency that regulates derivative products tied to interest rates and commodities, such as swaps, options and futures.  Currently, the CFTC does not regulate Bitcoin or transactions involving Bitcoin.  However, as this article indicates, this may change quickly.

So, what could the CFTC regulate? It could treat Bitcoin as a “commodity” and regulate certain spot transactions involving it pursuant to its anti-manipulation rules in the spot market (although the CFTC jurisdiction over spot transactions is limited). As Bitcoin derivative market develops (and according to this article, it certainly is developing), the CFTC could also regulate certain Bitcoin transactions as swaps, options or futures. Check out also this article as well that goes into depth regarding the CFTC potential regulation.

However, as of now, the CFTC does not regulate Bitcoin or any transactions involving it.

The Securities Exchange Commission (the "SEC"), a federal agency charged with regulation of the U.S. securities markets, also currently does not regulate Bitcoin.

The definition of a “security” under the U.S. Securities Act of 1933  includes an investment contract. According to the well-known to all U.S. legal professionals case, SEC v. W.J. Howey Co.,  “an investment contract, for purposes of the Securities Act, means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party …”.

Bitcoin in itself is not an investment contract. Bitcoin users do not invest their money into a common enterprise with an expectation to derive profits solely based on the efforts of others.  They typically use bitcoins to pay for goods or services.  However, investments into funds or other investment vehicles that transact in Bitcoin are securities, and the SEC does have authority to regulate those offers and sales.

This was settled in August 2013, when a U.S. magistrate judge stated in a published memorandum opinion that investment in Bitcoin-related fund is an investment contract, and therefore, a security.  This ruling gave the SEC the mandate to charge Trendon T. Shavers, founder and operator of Bitcoin Savings and Trust (“BTCST”), with defrauding investors in a Bitcoin-related Ponzi scheme. Shavers advertised in 2011 that he was in the business of “selling Bitcoin to a group of local people” and offered investors "up to 1% interest daily.” He offered and sold Bitcoin-denominated investments through the Internet. Shavers raised at least 700,000 Bitcoin in BTCST investments, which amounted to more than $4.5 million based on the average price of Bitcoin in 2011 and 2012. According to the SEC, BTCST was a sham and a Ponzi scheme in which Shavers used bitcoins from new investors to make purported interest payments and cover investor withdrawals on outstanding BTCST investments. Shavers also diverted investors’ bitcoins for day trading in his account on a Bitcoin currency exchange, and exchanged investors’ bitcoins for U.S. dollars to pay his personal expenses. The SEC complaint can be found here.

Shavers main argument was that the BTCST investments were not securities because Bitcoin is not money, and is not part of anything regulated by the United States. The judge disagreed.  He said that 
“It is clear that Bitcoin can be used as money. It can be used to purchase goods or services, and as Shavers stated, used to pay for individual living expenses. The only limitation of Bitcoin is that it is limited to those places that accept it as currency. However, it can also be exchanged for conventional currencies, such as the U.S. dollar, Euro, Yen, and Yuan. Therefore, Bitcoin is a currency or form of money, and investors wishing to invest in BTCST provided an investment of money.”
The judge then reviewed other requirements of an investment contract. He determined that there was a common enterprise and that the investors were dependent on Shavers’ expertise in Bitcoin.  Also, investors clearly expected profits to come solely from Shavers’ efforts.

Contemporaneously with this case, the SEC issued an investor alert warning people about fraudulent investment schemes involving Bitcoin.

Interestingly, the same judge said that “Bitcoin is an electronic form of currency unbacked by any real asset and without specie.” However, as of now, neither the Federal Reserve Board, nor the U.S. Treasury, nor the CFTC stepped in to regulate Bitcoin exchanges or currency exchange-related transactions involving Bitcoin (although I think this is imminent).

The next, and final, post about Bitcoin regulation will focus on the treatment of Bitcoin by the IRS, and regulation by the states.

Thursday, April 17, 2014

Elusive Bitcoin: Regulation of Bitcoin in the U.S. Part II

Today, I am going to summarize FinCEN’s regulations relating to Bitcoin.

The Financial Crimes Enforcement Network (FinCEN) is an agency within the US Treasure Department. Its mission is to safeguard the financial system from illicit use, combat money laundering and promote national security. Among other things, it regulates money services businesses (MSBs). All MSBs have registration requirements and a range of anti-money laundering, recordkeeping, reporting, and know-your-client responsibilities.

On March 18, 2013, pursuant to the authority granted to it by the US Bank Secrecy Act, FinCEN published guidelines about the applicability of the US Bank Secrecy Act to virtual currencies.

The guidelines list circumstances when virtual currency users may fall under the definition of MSB. FinCEN concluded that a user of virtual currency is not an MSB, but an administrator or an exchanger is. Specifically, administrators and exchangers are money transmitters (a category of MSB), and therefore, are subject to the requirements applicable to all MSBs. Bitcoin exchanges fall under the definition of “exchangers” and therefore are MSBs. The definition of an “administrator” is less clear. An “administrator” is a “person engaged as a business in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (to withdraw from circulation) such virtual currency.” “An exchanger or an administrator that (1) accepts and transmits a convertible virtual currency or (2) buys or sells convertible virtual currency for any reason is a money transmitter.” It is not clear how this definition of an administrator would apply to the Bitcoin network.

So, to clarify things, FinCEN issued two rulings on January 30, 2014. The first ruling relates to the activities of “miners” and states that a user who “mines” a convertible virtual currency solely for its own use, not for the benefit of another, is not an MSB because these activities involve neither “acceptance” nor “transmission” of the currency. So, without registration, miners can use the bitcoins they mined to purchase goods or services for their own use, covert bitcoins into a real currency, pay debts incurred in the ordinary course of business, or, if the miner is a corporate entity, make distributions to shareholders. However, “any transfers to third parties at the behest of sellers, creditors, owners, or counterparties involved in these transactions should be closely scrutinized, as they may constitute money transmission.”

The second ruling titled “Application of FinCEN’s Regulations to Virtual Currency Software Development and Certain Investment Activity” deals with two things. First, it addresses the question of whether the production and distribution of software to facilitate purchases of bitcoins would make developers “money transmitters.” According to the ruling, “the production and distribution of software, in and of itself, does not constitute acceptance and transmission of value, even if the purpose of the software is to facilitate the sale of virtual currency.”

Second, the ruling clarifies that a company purchasing and selling convertible virtual currency exclusively as an investment for its own account is not considered to be a money transmitter but is rather a user within the meaning of the guidance. However, if the company were to provide any investment-related or brokerage services to others that involve accepting and transmitting virtual currency, or if it transferred money to third parties at the behest of the company’s counterparties, creditors or owners entitled to direct payments, then it may be subject to regulation and additional analysis by FinCEN would be necessary.

This seems to suggest that investment funds that invest in Bitcoin can do so without registration with FinCEN, as long as all transactions in Bitcoin are done for the Fund’s own account, and not the accounts of individual investors. If, however, the fund engages in brokerage services, then it needs to investigate not just registration with FinCEN as an MSB, but also registration as a broker-dealer with the Securities and Exchange Commission.

As you can see, the FinCEN guidance and rulings are all very recent as the laws and regulations relating to Bitcoin develop. I strongly recommend for everybody who is involved with Bitcoin to monitor the Bitcoin regulatory landscape closely, since it changes “as we speak.”

More to follow in Elusive Bitcoin: Part III.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Wednesday, April 16, 2014

Elusive Bitcoin: Regulation of Bitcoin in the U.S. Part I

The phenomenon of Bitcoin (and virtual currency in general) presents an interesting legal conundrum. It is still not clear for many where does Bitcoin fit within our legal system, and whether and how to regulate it. Today, I would like to take a closer look at the Bitcoin network, the recent legal developments in the U.S. relating to the classification of Bitcoin, and its (non)-regulation.


First, let’s take a look at Bitcoin itself. Bitcoin is a peer-to-peer convertible digital currency and payment system. There is no central authority that issues bitcoins or tracks transactions in bitcoins (i.e., no central bank). The Bitcoin network is based on open source code and is managed by an army of volunteers. All Bitcoin transactions are anonymous and get recorded on the public ledger called a “block chain” by people or entities referred to as “miners”. Miners get compensated for their efforts in new bitcoins and transaction fees. Users keep bitcoins in their own “digital wallets”, which are essentially virtual uninsured bank accounts. If the digital wallet gets accidentally deleted, stolen or lost, all bitcoins in it will be irretrievably gone. Users can obtain bitcoins in four ways: (i) by purchasing bitcoins on a Bitcoin exchange; (ii) accepting bitcoins as payment for goods or services; (iii) earning bitcoins through competitive mining process; or (iv) exchanging bitcoins with others.

Bitcoin is a relatively recent phenomenon. It all started in early 2007, when an anonymous user or group named “Satoshi Nakamoto” began working on a cryptographic-based network. In January 2009 (just slightly over five years ago), the first Bitcoin block was mined, and the first transaction in Bitcoin occurred. In February 2010, the first Bitcoin exchange was created. In September 2012, the Bitcoin foundation was created, and this foundation is presently the core development team behind the Bitcoin network. Since the Bitcoin software is open source, any developer can contribute to the Bitcoin code. You can read about how to do it here.

Presently, Bitcoin is by far the most popular virtual currency. As of today, its market capitalization is approximately $6.7 billion, whereas the market for the second largest currency, Litecoin, is only $373 million, followed by Peercoin at $63 million. You can check the current market cap here.  The value of Bitcoin (here I mean the Bitcoin-USD exchange rate) fluctuates greatly. Just within the past six months, the exchange rate changed from under $200 per Bitcoin to over $1,000 and currently it is at $512.  You can view the chart here.

It remains uncertain whether the Bitcoin will become widely accepted by retail merchants around the world although the list of entities accepting Bitcoin as payment is broadening. For example, the first university (University of Nicosia in Cyprus) announced in November 2013 that its students can now pay tuition in bitcoins. In February 2014, a medical marijuana dispensary in Washington State started accepting bitcoins as payment.  For full story, click here.

For now, many governments are battling with the issue of whether and how to regulate Bitcoin. Many believe that some type of regulation is necessary due to the potential of Bitcoin being used to fund illegal activities. Known to many as the currency of choice for the online black marketplace called Silk Road, Bitcoin has attracted a lot of negative attention and concerns over it being used for illegal purposes and terrorism.

Now, let’s review current regulation of Bitcoin by the federal governmental agencies such as FinCEN, the CFTC, the SEC and the IRS, and the states.

Now, please continue reading Elusive Bitcoin: Part II.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.