Tag: bitcoin

SEC Rejects Listing of Two Bitcoin ETFs

The SEC rejected two proposals to list and trade shares in two Bitcoin exchange-traded funds (“ETFs”).

The SEC rejected a proposal from NYSE Arca, Inc. (“Arca”) to list and trade shares of the Valkyrie Bitcoin Fund. The SEC also rejected a proposal from CBOE BZX Exchange, Inc. (“BZX”) to list and trade shares of the Kryptoin Bitcoin ETF Trust.

The SEC assessed whether the exchanges (i) had a comprehensive surveillance-sharing agreement with a significant, regulated market, and (ii) could effectively prevent fraudulent and manipulative activity. In the rejected proposals, the SEC noted its concerns over the abilities of the exchanges to adequately meet the requirements under SEA Section 6(b)(5) (“Determination by Commission Requisite to Registration of Applicant as a National Securities Exchange”) in protecting investors and the public interest by preventing fraudulent and manipulative practices.

The SEC rejected Arca’s argument that (i) liquidity, (ii) price arbitrage, and (iii) frameworks to value assets would be sufficient to mitigate potential manipulation.

Similarly, the SEC rejected BZX’s proposal, concluding “that BZX has not established that it has a comprehensive surveillance-sharing agreement with a regulated market of significant size related to bitcoin,” and “that BZX has not established that other means to prevent fraudulent and manipulative acts and practices are sufficient to justify dispensing with the requisite surveillance-sharing agreement.”

As a result, the SEC found that both exchanges had failed to prove that they could meet their burdens under SEA Section 6(b)(5).

© Copyright 2021 Cadwalader, Wickersham & Taft LLP
For more articles on cryptocurrency exchanges, visit the NLR Financial Securities & Banking.

Thieves Breach Twitter Security to Commandeer Famous Accounts

The Twitter accounts of major companies and individuals were briefly taken over as part of a bitcoin scam. Former and current heads of states, global corporations, and presidential candidates had their twitter accounts compromised. The tweet from many of the twitter account said similar things, for example Kanye West’s feed stated that he is “giving back to my fans”; the message from Bezos’, Barack Obama, and Joe Biden’s account said that they had “decided to give back to my community”; while Elon Musk’s account said “feeling greatful” and provided a link to a Bitcoin wallet to send money to. The tweets would indicate that they would send double the money back to a limited number of contributors.

Twitter, through its Twitter Support account notified users that an internal investigation was conducted into the matter. The investigation revealed that several employees who had access to internal systems had their accounts compromised in a “coordinated social engineering attack.” Twitter’s internal system was then exploited to tweet from high-profile accounts. The attack was at least moderately successful considering the Bitcoin wallets promoted in the tweets received over 300 transactions and Bitcoin worth over $100,000.

These tweets began at about 4 P.M. (Eastern Standard Time) on Wednesday, July 16. The first wave of attacks hit the Twitter accounts of prominent cryptocurrency leaders and companies, but expanded quickly after that. Along with Vice President Biden, President Obama, Kanye West, Bill Gates, Michael Bloomberg, and Elon Musk, large company accounts were also targeted including Uber and Apple. Twitter’s initial response was to take down the offending tweets, but those were quickly replaced by new ones – – an indication that the hackers maintained access to the individual accounts.

The persistence of the attacks led to Twitter disabling some the platform services including the ability of blue-checked (verified) twitter users to tweet. The services were restored around four and a half hours after the suspicious tweets began. However, that shutdown period was not insignificant. Several National Weather Service Twitter accounts were shut down as a line of severe weather and possible tornadoes moved across the Midwest. The National Weather Service felt severely hampered in its ability to communicate with people about the impending storm.

In a tweet, Twitter’s CEO Jack Dorsey said that the company feels  “terrible this happened” and that they are “diagnosing and will share everything we can when we have a more complete understanding of exactly what happened.” The nature of this attack is yet to be determined. The legal implications will hinge on the findings of the investigation, including whether there were sensitive direct messages accessed by the attackers. Considering the compromised accounts includes current and former heads of state (Prime Minister Benjamin Netanyahu, President Obama, and Vice President Biden), there are also questions of national security involved.

The United States does not have a comprehensive federal data breach notification scheme. These obligations are provided by the fifty states and sector-specific laws. More than 40 of the state breach notification laws contain a harm threshold pursuant to which notification is not required unless harm to affected individuals has occurred or is reasonably likely to occur. The EU’s GDPR also includes a similar assessment. As more information is disclosed, we will get a better understanding of Twitter and the attacked users’ incident response processes.

Copyright © 2020 Womble Bond Dickinson (US) LLP All Rights Reserved.

Under Siege from the SEC, Steven Seagal Ponies Up to Settle Charges for Promoting an Initial Coin Offering

Steven Seagal just learned the hard way that, unlike the title of his 1988 police action movie, he is not Above the Law. Unfortunately for the prolific action movie star, the SEC took notice of his recent actions and was Out for Justice. In order to avoid a Maximum Conviction, the SEC recently announced that Seagal made the Executive Decision to settle charges brought by the agency related to the actor’s failure to disclose the nature, scope, and amount of compensation he received for promoting an investment in an initial coin offering (ICO) conducted by Bitcoiin2Gen.

The SEC has taken the position that cryptocurrency coins/tokens may qualify as “securities,” and celebrities or other individuals who promote cryptocurrency may run afoul of the federal securities laws if they fail to make adequate disclosures of the compensation they received in exchange for the promotion. One could think of this as a Code of Honor, but the SEC calls it the anti-touting provisions of the Securities Act of 1933. Specifically, Section 17(b) states:

It shall be unlawful for any person . . . to publish, give publicity to, or circulate any notice . . . or communication which, though not purporting to offer a security for sale, describes such security for a consideration received or to be received, directly or indirectly, from an issuer, underwriter, or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof.

This broad language makes the anti-touting provision The Perfect Weapon for the SEC to go after issuers who seek to use well-known individuals to promote risky cryptocurrency products to vulnerable populations. Indeed, the SEC has previously used this provision to go after other celebrities for similar conduct, including boxer Floyd Mayweather Jr. and music producer DJ Khaled.

Seagal found himself in the Belly of the Beast when he promoted the ICO on his social media accounts and issued a press release titled “Zen Master Steven Seagal Has Become the Brand Ambassador of Bitcoiin2Gen.” He also permitted the company to issue a press release that included a quote demonstrating his strong endorsement. In exchange for this publicity, Seagal was promised $250,000 in cash and $750,000 of the company’s coins.

As a result of the settlement, Seagal was ordered to pay over $330,000 in disgorgement, civil penalties, and interest. Seagal also agreed not to promote any security for a period of three years. With Exit Wounds this severe for the well-known movie star, this case should serve as a stark reminder that the SEC is committed to examining all aspects of ICOs and cryptocurrencies with a careful eye. If the SEC catches wind of similar conduct by other celebrities, future cases could be Hard to Kill.

© 2020 Faegre Drinker Biddle & Reath LLP. All Rights Reserved.

For more on the SEC Segal settlement see the National Law Review Securities & SEC law section.

Five Tips to Mitigate Risk in Cryptocurrency Mergers and Acquisitions

Congratulations!

Your client just closed on the purchase of a cutting-edge, blockchainbased payment processing startup. Before this deal, you had heard of bitcoin and blockchain. But, you had never seen a company that actually accepted payment in bitcoin and other cryptocurrencies. You were a little confused by the whole idea. However, your client liked the prospect of purchasing a company that had dealt in digital assets, so you didn’t think much about it.

Arriving to the office the day after the closing, you open up your computer to learn news of a hack at one of the big bitcoin exchanges. The article explains that hackers had accessed the hot wallets on the exchange and made off with over $150 million in digital assets. News of the hack sent the price of bitcoin tumbling 15% in the four hours following the incident. Other digital assets had plunged even further. The headline jumped out at you because the company that your client just purchased used custodial wallets on the exchange to store a lot of its digital assets.

Five minutes after you finish reading the article, you get a call from your client. Sure enough, a good chunk of the digital assets that your client had just purchased were lost in the hack. To make matters worse, the new company had just lost 5 percent of its book value because of the crashing cryptocurrency market.

Volatility of Digital Assets Means Risk

The world of cryptocurrencies has matured somewhat. But, scenarios like the previous hypothetical above remain a real possibility. Indeed, 15 percent price swings in a matter of hours are still common for cryptocurrencies, also known as digital assets, especially for less established currencies. In addition to big price swings, the digital asset industry continues to face regulatory uncertainty, especially in the United States with the SEC, CFTC, FINRA and other regulators undecided about how exactly to regulate digital assets. Despite the volatility and regulatory ambiguity, for risk hungry participants, the potential for large gains has helped drive an increase in merger activity in the digital asset world during the past two years.

Acquiring or selling a company that deals heavily in digital assets presents a litigation risk. Many of the factors that increase the risk of litigation in mergers or acquisitions in the digital asset industry are outside the control of the parties to a transaction. Deal lawyers try to control for these externalities but, in the new and vibrant realm of companies who deal in cryptocurrencies, those controls can be elusive, which in turn enhances the risk of litigation.

There are, however, ways to minimize the chance of a dispute. The following are a few practical tips for transactional lawyers and litigators to help contain the risks inherent in digital asset M&As.

    • Valuation Methodology: Transaction and litigation counsel should pay close attention to valuation methods used in a digital asset transaction. Cryptocurrencies and digital tokens are new and the methods used to value them may be untested. Different digital assets have different applications, e.g., utility tokens versus value storage tokens, and valuation theories should be tailored to the transaction and assets involved. In light of these unique issues and the attendant risks, transactional lawyers should give particular scrutiny to the valuation formulas to avoid a dispute. Litigators, too, should take note of the valuation methods used since they may be fodder for a dispute. And, of course, litigators should also be aware of the possibility for a Daubert-type challenge of any expert valuation witness that may arise in a subsequent dispute.
    • Earn-Outs/Purchase Price Adjustments: Transactional lawyers should pay special attention to earn-out or purchase price adjustment provisions in a digital asset M&A deal. Valuating digital assets is difficult; thus, inclusion of an earn-out or purchase price adjustment clause might help the parties reach a deal more easily. Given the volatility of digital assets, there is a higher than typical likelihood that the value of the earn-out or purchase price adjustment will also fluctuate substantially. Litigators, in turn, should also be especially cognizant of earn-out and purchase price adjustment provisions. Earn-out provisions can be especially ripe for dispute since the earn-out periods often extend for years after closing. While long earn-out periods might not present problems in more traditional fields, the fast pace of change and high levels of volatility in the digital asset industry mean that long earn-out periods are particularly susceptible to disagreement.
    • Reverse Break Up Fees: Transactional lawyers should consider including a reverse breakup fee or a reverse termination fee. These are fees paid by the buyer if the buyer breaches the governing agreements or is unable to close the transaction. For example, imagine you represent the seller in a deal set to close in three days when news breaks about a lawsuit filed by a state attorney general against a new cryptocurrency company. The enforcement action sends the price of all digital assets plummeting by 20 percent in a matter of hours. Your client still meets all of the closing conditions, but the client’s value, which consists largely of digital assets, has just taken a huge hit and the buyer’s counsel is telling you that her client is going to walk away from the deal unless your client drops the price. A reverse breakup fee will help to lessen the buyer’s willingness to run from the transaction and may also help your client recoup costs incurred in the event the buyer does walk away. Litigators representing a buyer or seller should also pay particular attention to whether the conditions in a breakup fee or reverse breakup fee clause have been satisfied.
  • Heightened Importance of Stock Terms: Transactional lawyers should give extra consideration to the applicable law and venue selection provisions in the deal documents. Some states, e.g., Wyoming, among others, have adopted more crypto-friendly regulatory regimes than other states. Consequently, transaction lawyers should consider the pros and cons of each viable state law. And, corporate attorneys should consider obtaining review of deal documents by experienced cryptocurrency litigators who can help position the transaction as best as possible in case of future litigation.
  • Last, transaction lawyers should consider the appropriateness of a mandatory arbitration provision. Arbitration has its drawbacks, e.g., the cost of the arbitrator, absence of clear rules for discovery, restricted appeal rights, etc., but the benefits of arbitration may be particularly helpful when dealing with a digital asset M&A dispute. For example, the parties can make their proceedings confidential, which can avoid the disclosure of trade secrets or other proprietary information in public court proceedings. Further, in the highly technical field of cryptocurrencies, the parties have greater latitude to ensure that the proceeding is adjudicated by an arbitrator with pertinent knowledge of and/or experience in digital assets or blockchain technology.

Of course, the foregoing is not an exhaustive list of the ways to reduce risk in digital asset M&A deals. Other terms and conditions in the transaction contracts for a digital asset M&A deal should not escape scrutiny. Representations and warranties, contract exhibits and schedules should be tailored to the deal and the nature of digital assets in play. Due diligence is also an especially important component of risk mitigation since the nature of digital assets makes for a more difficult diligence process than a traditional transaction. Regardless of which contractual provisions are used, litigators and transactional lawyers should both be aware of and understand the heightened risk of a dispute in the volatile world of cryptocurrencies and digital assets.

© Polsinelli PC, Polsinelli LLP in California

ARTICLE BY Thomas H. Wagner of Polsinelli PC.
For more on cryptocurrency, see the Financial Institutions & Banking law page on the National Law Review.

Jurisdictional Lessons from Mt. Gox Cryptocurrency Litigation

Last week, on the heels of a significant decline in Bitcoin prices, Forbes reported that China’s Central Bank is set to launch the world’s first state-backed cryptocurrency. The cryptocurrency will be made available initially to seven of China’s largest financial institutions, including three banks and two financial technology companies (including Alibaba).  It is planned to eventually reach the virtual wallets of U.S. consumers, through relationships with Western correspondent banks.

Meanwhile, in the United States, litigation rages on against Mark Karpeles, the President and CEO of Mt. Gox. Formerly the world’s leading bitcoin exchange platform, Mt. Gox filed for bankruptcy protection in Japan in 2014 amidst reports of rampant security breaches and refusal by its Japanese banking partner, Mizuho Bank, to process withdrawals for Mt. Gox users. Before its bankruptcy, Mt. Gox announced that 850,000 bitcoins valued at more than $450 million had gone “missing,” likely due to cyber theft.

In the aftermath, Mt. Gox account holders filed putative class actions against Karpeles and Mizuho in the Central District of California, the Northern District of Illinois, and the Eastern District of Pennsylvania, asserting causes of action for negligence, fraud, and tortious interference. In each action, both defendants filed motions to dismiss, claiming lack of personal jurisdiction due to their residences in France and Japan, respectively.

Earlier this year, all three courts dismissed Mizuho from the litigation, agreeing that the bank did not purposefully direct any activity at the forum states. Mt. Gox’s bank accounts with Mizuho were located in Japan, the decisions not to process withdrawals from those accounts were made by Mizuho employees located in Japan, and all wire transfers were initiated or received in Japan.

However, all three courts denied Mr. Karpeles’ motions to dismiss for lack of personal jurisdiction.  Mr. Karpeles,  a French citizen, argued that his contacts with the forum states were merely the incidental result of where some Mt. Gox users lived. The courts unanimously disagreed.

In the most recent of these three decisions, the Eastern District of Pennsylvania, relying on the previous decisions by the courts in California and Illinois, held that it has specific jurisdiction over Karpeles “because he availed himself of the privilege of conducting business in Pennsylvania through soliciting business from [a named plaintiff] and thousands of other Pennsylvania residents through the Mt. Gox website.” Pearce v. Karpeles, No. CV 18-306, 2019 WL 3409495, at *4 (E.D. Pa. July 26, 2019).

The Court applied the “sliding scale” test established by Zippo Manufacturing v. Zippo Dot Com, Inc., 952 F. Supp. 1119, 1123-24 (W.D. Pa. 1997), which has been characterized as “a seminal authority regarding personal jurisdiction based upon the operation of an internet website,” to determine that Karpeles’ internet presence sufficiently gave rise to personal jurisdiction over him. Karpeles, 2019 WL 3409495, at *4-5. The Zippo scale “ranges from situations where a defendant uses an interactive commercial website to actively transact business with residents of a forum state (personal jurisdiction exists) to situations where a passive website merely provides information that is accessible to users in the forum state (personal jurisdiction does not exist).” Id. at *4. Under that Pennsylvania precedent, a defendant has purposefully availed itself of the privilege of doing business in the state if its website “repeatedly attracts business from a forum or knowingly conducts business with forum state residents via the site.” Id. at *5.

The Court held that Mt. Gox’s internet activity fell at the “interactive end of the Zippo spectrum.” Id. Mt. Gox’s website was interactive, allowing users to open and manage accounts, make purchases and trades, and transfer and deposit cash. Id. Further, Mt. Gox had knowledge of the residences of its users because at the time they opened accounts, they had to provide Mt. Gox with their addresses and other personal information. Id. Users could also purchase “Yubikeys” (a hardware authentication device that allows users to securely log into their accounts) to be sent to their physical addresses. Id. Approximately 4% of all Mt. Gox users (over 19,000 individuals) who registered with addresses were Pennsylvania citizens, making Karpeles’ interactions with the forum state neither random, isolated, nor fortuitous. Id. at *6.

The Court also rejected Karpeles’ assertion that it would be unfair to force him to defend in the United States since he is on probation in Japan and prohibited from leaving the country, holding that the interests of the plaintiffs and the forum state justified any burden of defending in Pennsylvania. Karpeles, 2019 WL 3409495, at *8-9.

The increased use of cryptocurrency looks inevitable, with Facebook’s cryptocurrency, Libra, poised to launch in 2020, and some economists proposing that a cryptocurrency backed by central banks throughout the world will email one day replace the U.S. dollar as the world’s global reserve currency. As cryptocurrency proliferates, it is likely that so too will cryptocurrency litigation, bringing with it a host of jurisdictional challenges for litigants. The Mt. Gox-related orders provide valuable insight into how some such challenges may be resolved in the future.

© 2019 Bilzin Sumberg Baena Price & Axelrod LLP

ARTICLE BY Shalia Sakona and Philip R. Stein of Bilzin Sumberg.

Trouble In Paradise: Florida Court Rules That Selling Bitcoin Is Money Transmission

The growing popularity of virtual currency over the last several years has raised a host of legislative and regulatory issues. A key question is whether and how a state’s money transmitter law applies to activities involving virtual currency. Many states have answered this – albeit in a non-uniform way – through legislation or regulation, including regulatory guidance documents. For instance, Georgia and Wyoming have amended their money transmitter statutes to include or exclude virtual currencies explicitly. In other states, such as Texas and Tennessee, the state’s primary financial regulator has issued formal guidance. In New York, the Department of Financial Services issued an entirely separate regulation for virtual currencies. Still, in others, neither the legislature nor the relevant regulator has provided any insight into how the state’s money transmitter law may apply.

In most states, the judicial branch has not yet weighed in on the question. But Florida is an exception. On January 30, 2019, in State v. Espinoza, Florida’s Third District Court of Appeal interpreted the state’s money transmission law broadly and held that selling bitcoin directly to another person is covered under the law. [1] The decision will have broad implications for the virtual currency industry in Florida.

BACKGROUND: MIAMI BEACH POLICE DEPARTMENT AND MICHELL ESPINOZA

In December 2013, the Miami Beach Police Department (“MBPD”) perused an Internet website that provided a directory of buyers and sellers of bitcoin. In an undercover capacity, an MBPD agent contacted one of the users, Michell Espinoza. Shortly thereafter, the agent arranged to meet and purchase bitcoin from Espinoza in exchange for cash. The MBPD agent who purchased the bitcoin implied that he would use the bitcoin to fund illicit activities. One month later, the MBPD made a second purchase from Espinoza, telling him that the bitcoin would be used to purchase stolen credit card numbers. After a third and fourth transaction, the MBPD arrested Espinoza. The State of Florida charged him with two counts of money laundering and one count of engaging in the business of a money transmitter without a license. Espinoza moved to dismiss the charges, arguing, among other things, that Florida’s money transmitter law does not apply to bitcoin. The trial court agreed and dismissed all counts against Espinoza.

THE THIRD DISTRICT COURT’S OPINION: SELLING BITCOIN CONSTITUTES MONEY TRANSMISSION

Florida appealed, and the appellate court reversed the trial court’s ruling. The court started its analysis noting that the state’s money transmitter law requires anyone engaging in a “money services business” to be licensed. [2] A “money services business” is defined as “any person . . . who acts as a payment instrument seller, . . . or money transmitter.” [3] The court held that bitcoin is regulated by Florida’s money transmitter law, and, as a result, Espinoza was both “acting as a payment instrument seller” and “engaging in the business of a money transmitter.”

Under the Florida statute, a “payment instrument seller” is an entity that sells a “payment instrument.” [4] The phrase “payment instrument” is defined to include a variety of instruments, including “payment of money, or monetary value whether or not negotiable.” [5] The phrase “monetary value,” in turn, is defined as “a medium of exchange, whether or not redeemable in currency.” [6] The court interpreted these definitions – which it described as “plain and unambiguous” – to conclude bitcoin falls under the definition of “payment instrument.” To reach that conclusion, it reasoned that bitcoin, which is redeemable for currency, is a medium of exchange, which falls under the definition of “monetary value.” Therefore, it falls under the definition of “payment instrument.” [7] To purportedly bolster its point, the court noted that several businesses in the Miami area accepted bitcoin as a form of payment. It also pointed to a final order from the Florida Office of Financial Regulation (“OFR”) in which OFR granted Coinbase a money transmitter license. The court noted that Coinbase provides a service “where a Coinbase user sends fiat currency to another Coinbase user to buy bitcoins.” “Like the Coinbase user,” the court reasoned, the MBPD detective “paid cash to Espinoza to buy bitcoins.”

The court also concluded Espinoza was acting as a money transmitter. Under the Florida statute, a money transmitter is an entity that “receives currency, monetary value, or payment instruments for the purpose of transmitting the same by any means….” [8] Espinoza argued he fell outside this definition because he did not receive payment for the bitcoin for the purpose of transmitting the same to a third party. The court disagreed. It held that the law does not require the presence of a third party because the definition of money transmitter does not mention a third party, either expressly or implicitly. [9] It also disagreed with the trial court and Espinoza’s “bilateral limitation,” which would require Espinoza to have both received and transmitted the same form of currency, monetary value, or payment instrument. According to the court, Espinoza fell within the ambit of the law because he received fiat for the purpose of transmitting bitcoin. It explained that the phrase “the same” in the definition of “money transmission” modifies the list of payment methods, and the use of “or” in that list of payment methods – “currency, monetary value, or payment instrument” – means that “any of the three qualifies interchangeably on either side of the transaction.”

As additional support for its position, the court distinguished a final order entered into by OFR: In re Petition for Declaratory Statement Moon, Inc. According to the court’s description, Moon sought to establish a bitcoin kiosk program under which a Moon customer would pay fiat to a licensed money services business in exchange for a PIN, and the customer would then enter the PIN into a Moon kiosk, which would initiate a transfer of bitcoins to the user from a Moon bitcoin address. Once the PIN was redeemed, the licensed entity would pay Moon. OFR determined Moon did not a license. The court distinguished the Moon order because “Moon merely facilitated the transfer of bitcoins through the use of a licensed money services business,” whereas “[h]ere, no licensed money services business was utilized in the exchange of U.S. dollars for bitcoins that occurred between Espinoza and” the MBPD agent.

COUNTERPOINTS TO THE COURT’S OPINION

Several state legislatures or regulators have amended or interpreted their money transmitter laws to apply to virtual currency, but those actions do not take the form of a judicial opinion. Here, the Third District Court provided its specific reasoning for reaching its conclusions. It remains to be seen whether Espinoza will seek review from the Florida Supreme Court, but there are at least a few points in the court’s opinion that warrant further review and analysis.

First, Espinoza did not receive money for the purpose of transmitting it. He received it in exchange for selling bitcoin; he received it for the purpose of possessing it. The court rejected Espinoza’s attempt to impose a third-party requirement, but the most natural reading of the phrase “transmitting” would require Espinoza to send onward whatever value he received. Merriam-Webster defines “transmit” as “to send or convey from one person or place to another.” By using the words “receive” and “transmit,” the Florida law focuses on the act of sending money to another person and excludes the act of selling money or monetary value. If simply selling property were sufficient to trigger the money transmitter law, the statute would likely sweep far more broadly than intended. Here, Espinoza was acting as a merchant selling goods. This would not constitute money transmission under any reasonable reading of the law. Indeed, some states (and FinCEN) have recognized that a party selling its own inventory of virtual currency in a two-party transaction is not a money transmitter.

Second, the court’s conclusion is further undercut by considering the Moon proceeding the court discusses. The opinion notes “the PIN provided by the licensed money services business to Moon’s customers provided a mechanism by which the exchange of U.S. dollars for bitcoins could be identifiable.” The PIN could arguably be classified as a payment instrument because it is an “other instrument” or “monetary value.” If transmission to a third party is not required, as the court holds, then Moon should have needed a license when it received the PIN and then transmitted bitcoins back to the user that was redeeming the PIN. But that wasn’t the conclusion OFR reached.

Third, the court’s interpretation of how OFR would treat Espinoza’s actions is questionable. In 2014, OFR issued a consumer alert stating that “[v]irtual currency and the organizations using them are not regulated by the OFR.” [10] In addition, in January 2018, OFR released another consumer alert regarding cryptocurrency, stating that “[cryptocurrencies] are subject to little or no regulation,” which further indicates OFR does not interpret the money transmission law to cover cryptocurrencies. [11] The court does not acknowledge these statements. Although the court focuses on an OFR order regarding Coinbase, that order granted Coinbase a license and listed a variety of activities in which Coinbase was engaged or planned to engage. The order does not specify what specific activity was licensable, but it is likely that a license was granted because of the receipt and transmission of fiat currency.

CONCLUSION

If Espinoza appeals, the case could go to the Florida Supreme Court, where the virtual currency industry will receive a more definitive answer. In the meantime, virtual currency businesses should be aware that the Florida Attorney General’s Office interprets the state’s money transmitter act to regulate bilateral sales of virtual currency for fiat currency and is willing to prosecute at least certain cases of unauthorized sales. As of now, Florida’s Third District Court agrees. How the Espinoza case concludes and whether and how the Florida legislature responds will be important to the virtual currency industry.

NOTES

[1] — So. 3d –, 2019 WL 361893 (Fla. 3d DCA 2019).

[2] FLA. STAT. § 560.125.

[3] Id. § 560.103(22).

[4] Id. § 560.103(30).

[5] Id. § 560.103(29) (emphasis added).

[6] Id. § 560.103(21).

[7] The court principally discusses whether bitcoin falls under Florida’s money transmitter law. In a few instances, it also references “virtual currency” generally, but it is not clear how broadly it was intending to apply its holding.

[8] Id. § 560.103(23).

[9] As a counterpoint, the court noted that the Financial Crime Enforcement Network’s (“FinCEN”) definition of money transmitter explicitly includes a third party requirement because it defines a money transmitter as someone that accepts value from one person and transmits value to “another location or person by any means….” 31 C.F.R. § 1010.100(ff)(5)(i)(A).

[10] Consumer Alert: Update on Virtual Currency, Office of Financial Regulation, Sept. 17, 2014.

[11] Consumer Alert: Cryptocurrency, Office of Financial Regulation, Jan. 17, 2018.

 

Copyright 2019 K&L Gates

Can I Secure a Loan with Bitcoin? Part I

Each day seems to bring another story about Bitcoin, Ethereum, Litecoin, or another virtual currency. If virtual currencies continue to grow in popularity, it’s only a matter of time before borrowers offer to pledge virtual currency as collateral for loans.  This article does not advise lenders on whether they should secure loans with virtual currency, but instead it focuses on whether a lender can use the familiar tools of Article 9 of the Uniform Commercial Code (“UCC”) to create and perfect a security interest in bitcoin.  (In this article, “bitcoin” is used as a generic term for all virtual currencies.)

Article 9 Basics

Article 9 allows a creditor to create a security interest in personal property. The owner of the property grants the creditor a security interest through a written security agreement. The security agreement creates the security interest between the secured party and the debtor. The secured party must then “perfect” the security interest to obtain lien priority over third parties and to protect its secured status should the debtor file bankruptcy.

Security interests are perfected in different ways depending on the type of collateral. Article 9 divides personal property into different categories, such as goods, equipment, inventory, accounts, money, and intangibles. The primary ways to perfect a security interest are (1) filing, with the appropriate filing agency, a UCC-1 financing statement containing a sufficient description of the collateral, (2) possession, or (3) control.

Bitcoin and Blockchain

Virtual currencies are electronic representations of value that may not have an equivalent value in a real government-backed currency. They can be used as a payment system, or digital currency, without an intermediary like a bank or credit card company. While virtual currencies can function like real currencies in certain transactions, and certain virtual currencies can be exchanged into real currencies, a virtual currency itself does not have legal tender status. Virtual currency is virtual—there is no bitcoin equivalent to a quarter or dollar bill.

Bitcoin operates on a protocol that uses distributed-ledger technology. This technology is called the blockchain. The blockchain eliminates the need for intermediaries such as banks. Unlike a dollar, which is interchangeable, each bitcoin is unique. The blockchain records all bitcoin transactions to prevent someone from re-spending the same bitcoin over and over.

Suppose you wanted to transfer cash to a friend. You could transfer funds from your bank account to her bank account. The banks act as intermediaries. Suppose you wanted to transfer cash to that same friend without a middle man. The only way to do that is meet her and hand over the cash. This exchange many not be practical for many reasons. You might live far from each other. Even if you’re near each other, you might not want to travel around town with a briefcase full of cash. Bitcoin and blockchain technology allow the transfer of cash directly and digitally without a middle man.

The blockchain is both transparent and opaque. It is transparent as to the ownership chain of every bitcoin.  In this way, it is easier to “trace” a bitcoin than to trace cash.  But the blockchain presently does not show liens on bitcoin.  So a secured party can confirm if a borrower owns bitcoin, but not if the borrower or a previous owner encumbered the bitcoin.

Is Bitcoin Money?

At first glance, bitcoin would seem to fall in the category of “money.” Article 9 defines money as a medium of exchange authorized or adopted by a domestic or foreign government. No government has adopted bitcoin as a medium of exchange. Dollars, euros, and pounds meet the definition of money—bitcoin does not. Therefore, bitcoin does not meet the definition of money. And a secured party perfects its security interest in money by physical possession, but because bitcoin is virtual, physical possession is impossible.

Is Bitcoin a Deposit Account?

A deposit account is a demand, time, savings, passbook, or similar account maintained with a bank. With a traditional deposit account, the secured party perfects its security interest by having “control” over that account. This is usually accomplished when the debtor, the debtor’s bank, and the secured party execute a deposit account control agreement. If the debtor defaults, the secured party can direct the debtor’s bank to transfer the funds from the account.

Bitcoin often is stored in a digital wallet with an exchange like Coinbase. The wallet is access-restricted by private keys or passwords, but that wallet is not a deposit account. The bitcoin itself is held by its owner on the blockchain, which is decentralized. Unlike a deposit account, there is no intermediary like a bank. With no intermediary, there is no way to establish “control” over the bitcoin. Consequently, bitcoin does not meet the definition of a deposit account.

Bitcoin is (Probably) a General Intangible

By process of elimination, bitcoin should be treated as a general intangible. A general intangible is personal property that does not fall into any other Article 9 category. A lender perfects a security interest in general intangibles by filing a UCC-1 financing statement. In North Carolina, you file it with the Secretary of State.

Although we can categorize bitcoin as a general intangible for Article 9 purposes, and create and perfect a security interest accordingly, several issues arise that question the overall effectiveness of that security interest. For starters, a security interest in general intangibles follows the sale, license, or other disposition of the collateral, unless the secured party consents to the transfer free of its security interest, the obligations secured by the security interest have been satisfied, or the security interest has otherwise terminated.

This is a problem for the lender wanting a first-priority lien on the bitcoin. Before approaching the lender, the borrower may have granted a secured party a security interest in bitcoin, or granted a security interest in “all assets whether now owned or acquired later” and then acquired bitcoin. In both instances, the bitcoin is encumbered by the security interest. The lender could not confirm prior liens without searching UCC-1 filings in all 50 states (and even that might not catch international liens).

Even if a secured party acquires a senior lien in bitcoin, that party still has the problem of lack of control over the bitcoin. Without control, bitcoin collateral is susceptible to unauthorized transfers. Even if a borrower has an account at an online currency exchange like Coinbase—which allows you to exchange bitcoin into traditional money—the exchange may be unwilling to sign a tri-party control agreement to restrict the debtor’s ability to exchange the bitcoin. Upon default, without the debtor’s cooperation, it will be difficult or impossible to enforce, take possession, and liquidate the bitcoin.

Conclusion

Putting aside its value and volatility, the intrinsically unique nature of bitcoin makes it an imperfect and problematic form of collateral under Article 9. Part II of this article will discuss the pros and cons of using Article 8 of the UCC to create and perfect a security interest in bitcoin. Article 8 has the potential to be a safer and more reliable solution for these transactions.

© 2018 Ward and Smith, P.A.. All Rights Reserved.

This post was written by Lance P. Martin of Ward and Smith, P.A.

               

The Unique Quandaries Faced in Recovering International Cryptocurrency Frauds

Cryptocurrency itself is a string of computer-generated code.  This line of code is accessed by an owner’s unique passcode secret private key.  Each owner’s cryptocurrency is kept in their “Virtual Wallet”. Virtual wallets are similarly anonymous as are the virtual currency balances. The transfer of cryptocurrency is based upon the block chain protocol, a public decentralized ledger that identifies transactions by a digital code with no link to a person or place.

Practically, there is no public record of virtual currency transfers.  Other than the debtor’s own testimony, a creditor would not know where to begin searching for evidence of virtual currency purchases or transactions. There is no way for a creditor to identify either the owner or location of a transferee’s cryptocurrency address. In some cases, the debtor could honestly state that he does not know the identity of the individual who received his cryptocurrency transfers.

For asset protection purposes, a cryptocurrency account currently functions similarly to offshore banking prior to the IRS’s crackdown of anonymous personal foreign accounts.  Today, it is almost impossible for U.S. citizens to establish an anonymous bank account, or any type of bank account, outside of the U.S. With the advent of Bitcoin, a U.S. citizen can open and maintain a financial account that has creditor protection features similar to an offshore bank account in that the Bitcoin account is anonymous and can be maintained outside the geographical jurisdiction of domestic courts. Since block chains are decentralized, they are not subject to any central authority (such as a bank or other financial institution) that might be legally compelled to provide a court with access or control over assets in its possession. Without the complete private key, no court or legal authority can manipulate ownership of a block chain asset.

At the moment, creditors face obstacles of identifying potential defendants and the international nature of the transaction.  Properly selected offshore fiduciaries holding accounts are unlikely to become subject to the jurisdiction of a court where a defendant may be sued.  Absent jurisdictional authority, a court is powerless to compel the fiduciary to turn over assets. Similarly, a US court could try to compel the party to turn over the account or information about the transaction. The court’s contempt powers could be used to coerce compliance. Arrest and incarceration can be utilized. See In Re Lawrence, 279 F.3d 1294,1300 (11th Cir. 2002); FTC v. Affordable Media Inc., 129 F.3d 1228, 1229 (9thCir. 1999). But, on cruel and unusual punishment grounds, incarceration cannot be imposed forever. If the asset is more important than personal freedom, a court’s power of compliance is limited.

There are two equitable remedies that exist under English common law which could be flexibly applied to these evolving transactions. One existing remedy is the equitable pre-trial discovery device known as a Norwich Pharmacal order requiring third parties to disclose information to potentially identify the wrongdoer, to trace funds and to assist prospective plaintiffs in determining whether a cause of action exists.  (There are five states in the U.S. that also allow for pretrial discovery to identify the wrongdoing.)  Norwich orders, being a flexible tool of equity, could assist in claims involving cryptocurrency transactions.  It may be possible that identification information might come from “know your customer” information given a bitcoin exchange.  Proceedings could be constituted as “the bitcoin holder with the public key number…”  However, the hurdle still exists to identify the wrongdoer.

The second equitable remedy is injunctive relief.  Courts have granted world-wide injunctions, particularly when the impugned conduct is occurring online and globally, such as the internet.  InGoogle Inc. v. Equustete, 2017 SC 34, the Supreme Court of Canada recently held that injunctive relief can be ordered against somebody who is not a party to the underling lawsuit, even if that third party is not guilty of wrongdoing.  Google was ordered to stop displaying search results globally for any Data Link websites.  “The problem in this case, is occurring online and globally.  The internet has no borders; its natural habitat is global.  The only way to ensure interlocutory injunction (order) attain its objection was to have it apply where Google operates – globally.”  Thus, if the third party to the block chain transaction can be identified, there may be a remedy to discover information and wrongdoing.

Therefore, courts will need to apply not only new remedies, but expand existing ones.  While the identities of the buyer and seller are encrypted, a transaction record is maintained on the public ledger. In the future, anti-money laundering laws and cryptocurrency exchanges may require the collection of personal data of customers. Until then, the challenge of recovery will require creativity and experience.

 

© Horwood Marcus & Berk Chartered 2018.
This post was written by Eric (Rick) S. Rein from Horwood Marcus & Berk Chartered.

Monopoly Money or the Real Deal? Exploring the Possibility of Paying Employees in Bitcoin

Bitcoin, the most popular form of digital or crypto-currency, is gaining traction as an investment vehicle and a way to pay for goods and services. More than 100,000 merchants worldwide now accept Bitcoin, allowing consumers to book a hotel stay, take a taxi, or buy a car.  The buzz around crypto-currency continues to grow as Bitcoin options will likely soon be traded on the futures exchange and regulators consider how to monitor Bitcoin transactions.

So what about paying employees in Bitcoin? Here are some things to consider before diving into the digital currency market.

What is Crypto-currency?

Virtual or digital currency is a digital representation of value that has no paper or coin equivalent. Crypto-currency such as Bitcoin uses encryption to control its creation.  Virtual currency is electronically created and stored and does not have the backing of a commodity, bank, or government authority. Additionally, virtual currency does not have the status of legal tender.  This means that a creditor can refuse virtual currency as payment for a debt.

Convertible virtual currency is a class of virtual currency that can be substituted for real currency. As of this week, 1 Bitcoin could be converted into to approximately $4,594.69 USD.

How Do I Get and Use Bitcoin?

Bitcoin is available online and may be purchased with cash, credit card, or wire transfer. A Bitcoin user would set up an online “wallet” that manages his or her transactions.  Each user has a unique address that is identified by a series of letters and numbers and each transaction in Bitcoin is also identified by a series of letters and numbers that can be viewed on a public ledger blockchain.info and shared with other devices on the Bitcoin network.

Due to the encryption of the transactions, the users have a certain level of anonymity, but the transactions are public. One of the advantages of Bitcoin is that there are no intermediaries, which gives user’s control to send payments from one party directly to another without a financial institution making fees lower.

To prevent paying twice with the same Bitcoin, each user has its own private key and a public key. Once a transfer is initiated, the transfer is submitted to the network encoded by the public key.  The acceptance occurs when the person accepts the amount on his or her private key.  The sender signs the transaction with the private key.  This log of transactions is continually downloaded by users on the network removing the need for a third-party clearinghouse to monitor the transactions.

Theoretically, paying an employee in Bitcoins would go through the same process. However, to comply with payroll deductions and filings, employers most commonly engage a payroll service experienced in Bitcoin that handles payroll deductions and filings.

What are the withholding implications of using Bitcoins as wages?

Just like wages paid in non-virtual currency, Bitcoin compensation would be considered W-2 wages for employees. Bitcoin is also subject to federal income tax withholding, FICA, FUTA, and the self-employment tax based on the fair market value of the Bitcoin on the date it was received. 

Do Bitcoin payments meet an employer’s minimum wage and overtime requirements?

Regulations under the Fair Labor Standards Act (FLSA) require that wage payments be in “cash or a negotiable instrument payable at par,” meaning that Bitcoin payments may not satisfy an employer’s minimum wage and overtime requirements under the FSLA. An employer could pay in a hybrid of U.S. currency and Bitcoin to meet the federal requirements and pay anything above that amount in Bitcoin.  Several state wage and hour laws also require that wages be paid in U.S. currency so it is important to check both federal and state laws before paying employees in crypto-currency.

What about exempt employees?

Most exempt employees have minimum salary requirements under federal law. The minimum salary requirement under the FLSA salary basis test must be paid in U.S. currency or a negotiable instrument.  Like the minimum wage and overtime requirements, once that threshold is met, employers may pay employees the rest of the amount in Bitcoin.

Other concerns?

For nonexempt employees, there is some gray area as to how to value Bitcoins for the regular rate calculation for overtime purposes. The timing of the valuation may have a significant economic impact due to Bitcoin’s somewhat volatile nature.  Bitcoin valuation may also be a problem when calculating the regular and back pay if an employee is misclassified as exempt.  There may also be other issues tied to Bitcoin’s volatility, the administrative cost of converting wages to Bitcoin and security of Bitcoin wallets.  Before diving into the digital currency world, it is recommended that an employer consult with legal counsel to avoid any potential pitfalls.

This post was written by Taylor E. Whitten  of  Foley & Lardner LLP © 2017
For more Labor & Employment legal analysis go to The National Law Review

Tax Treatment of Bitcoin Has Many Open Questions

bitcoinIt has been over two years since the IRS came out with its initial position on the tax treatment of Bitcoin and other virtual currencies, but there has yet to be any follow-up on questions that this initial position has raised. The American Institute of Certified Public Accountants has written a letter to the IRS urging the Service to publish additional guidance to provide more certainty on these open issues.

IRS Notice 2014-21 stated that virtual currencies are to be treated as property, not as currency. This was potentially good news to Bitcoin investors, since it would allow them to pay the lower long-term capital gains tax rate on profits if they held the Bitcoin for over a year. On the other hand, this position was  inconvenient for consumers and merchants who use and accept virtual currencies as a means of exchange, because each transaction, no matter how small, must be reported in order to determine the amount of gain  or loss every time a consumer uses the virtual currency as a means of exchange, and every time the merchant converts the virtual currency received in a transaction into U.S. currency.

In the two years since the IRS published Notice 2014-21, this classification of virtual currencies as property rather than a currency, many other questions have been raised, but have not been addressed. The letter from the AICPA sets them out:

(1) Determining Fair Market Value of the Virtual Currency: The IRS should publish guidance on whether a taxpayer can use any published exchange rate to determine the fair market value of virtual currencies, and whether the taxpayer must use the same published exchange rate for all other transactions. The letter notes that there are  wide variance in the fair market value of Bitcoin on four Bitcoin published rates (Google, Bitcoin exchange rate, Bitstamp, CEX and Winkdex), citing an example selected at the same time, reflecting a range of value from a low of $227.84 to a high of $231.14.

(2) Expenses of Obtaining Virtual Currencies: Are the expenses to mine virtual currencies currently deductible, or are they to be added to the basis of the mined currency? This would normally be an easy call – costs would normally be added to the basis of the property that is manufactured – but the 2014 guidance intimates that this might not be the case.

(3) Tracking Basis of Virtual Currency: Because virtual currencies are treated as property, the taxpayer must track the cost of purchasing each unit acquired, in order to determine the taxable gain when it is sold (including every time a consumer uses it to purchase goods and services).  The AICPA letter says that tracking the basis for virtual currency is virtually impossible when it is used in everyday commerce, and asked for the IRS to consider alternative means to determine basis.

(4) General Transaction Rules Applicable to Property: The AICPA letter asks whether the general tax rules applicable to property (rather than currencies) would apply to virtual currencies. For example, the letter asks whether a taxpayer would be able to take advantage of the tax free like-kind exchange rules of section 1031 if one type of virtual currency is exchanged for a different type of virtual currency (for example, a Bitcoin for Ethereum exchange).

(5) Character of Virtual Currencies Held By Merchants: How should virtual currencies that are accepted by a merchant be classified for tax purposes – as a capital asset or as an ordinary income asset?

(6) Charitable Contributions: Does a contribution of virtual currencies to a charitable organization require a formal appraisal? The general rule is that if a taxpayer donates property worth more than $5,000 to a charitable organization, the taxpayer must obtain a formal appraisal to support the amount to be deducted as a charitable contribution. There is an exception, where an appraisal is not needed for the donation of securities that are traded on a published exchange. The letter asks whether the donation of virtual currency should be subject to the same exception, since they are traded on published exchanges.

(7) Is Virtual Currency a Commodity: If virtual currencies are treated as a commodity, would it be subject to the mark-to-market rules for commodity traders?

(8) How About a De Minimus Exception For Small Transactions: The letter asks the IRS for an exception to the rule requiring a taxpayer to report each virtual currency transaction as a taxable sale of property when used to make small consumer purchases.

(9) Retirement Accounts: Can virtual currencies be held as an investment in a qualified retirement plan (like a 401(k) plan)? The rules for eligible investments in such plans limit the types of property than can be held in a qualified retirement plan.

(10) Foreign Reporting Requirements: Are virtual currencies subject to Foreign Bank Account Reports (FBAR) and/or Foreign Bank Account Tax Compliance Act (FATCA) reporting?

As these issues get worked out, others are likely to arise. Until they are addressed by the IRS, the uncertainty will likely inhibit the growth of virtual currencies in the U.S. economy.

To see a copy of the AICPA letter to the IRS, please click here.

ARTICLE BY Marvin A. Kirsner of Greenberg Traurig, LLP

©2016 Greenberg Traurig, LLP. All rights reserved.