Author: Dan Stroh, Associate Member, University of Cincinnati Law Review
The Securities and Exchange Commission (SEC) took a bold step in the regulation of virtual currencies on July 23, 2013, when it charged Trendon Shavers and his company, Bitcoin Savings and Trust (BTCST), with defrauding customers in a Ponzi scheme.[1] The defense offered by Shavers in the motions leading up to the judgment was that bitcoin[2] is not a real currency or money recognized by the U.S. government.[3] Because securities fraud law requires an “investment of money”[4] to form an investment contract, Shavers argued that because the SEC could not show this investment, the statutes did not apply to Bitcoin and the SEC’s prosecution must be dismissed.[5] However, on September 18, 2014, a Texas court granted the SEC’s motion for summary judgment on the violations of anti-fraud and registration provisions of several securities laws and imposed fines of over $40 million on Shavers and BTCST. Because Shavers admitted most of the factual basis of the SEC’s argument, once the court held that an investment contract existed, he had no defense to the charges.[6] This ruling was one of the first to determine the status of bitcoin as a security in a United States court. Although Bitcoin may be a newcomer to the securities industry, defining bitcoin as a security gives regulators at the SEC significant and necessary power to combat fraud in this developing area of finance.
What Is Bitcoin and How Does It Work?
Bitcoin describes itself as a “peer-to-peer payment network.”[7] However, government officials and regulators refer to bitcoin as a bidirectional virtual currency that can be exchanged for and converted into real currency.[8] Bitcoin is the most prominent type of bidirectional virtual currency and is a decentralized payment system that does not depend on a central bank. Promoters of Bitcoin state that this allows for payment freedom and fewer risks of both financial shock and theft.[9] However, critics of Bitcoin also point out that this means that no one is in control of the virtual currency and there is no backing for it should there be a rapid decrease in its value.[10] While the United States Federal Reserve controls the flow of cash and value into the American economy, no such organization exists to protect the flow of bitcoins. Thus, if the value of each bitcoin suddenly plummeted, there is no guarantee for those holding bitcoins that the currency would have any value in relation to other worldwide currencies.
According to the Bitcoin Foundation, bitcoins can be acquired in one of four ways.[11] They can be mined, given as payment for goods or services, purchased on an exchange, or exchanged locally through an escrow-like service.[12] Originally, Bitcoin depended on “miners” and their computers to crack complex math problems.[13] This takes the place of printing legal tender from a central bank and distributing the virtual currency. The last three options for acquiring bitcoins listed above are much more frequently used today because it takes an immense amount of computing power to mine bitcoin, and the mining problems get harder as more bitcoin is distributed.[14] Today, the value of each bitcoin is determined solely by supply and demand on market exchanges.[15]
Once acquired, bitcoin can be transferred among anyone who has an e-wallet associated with the virtual currency.[16] This includes businesses and individuals, both online and in brick-and-mortar stores.[17] The transfers sometimes include a percentage fee assessed by exchanges conducting the transaction, like those associated with credit cards. Notably, as of July 2014, bitcoin was not accepted as legal tender in any jurisdiction.[18]
Securities in the United States
The definition of a security is set out in the Securities Act of 1933, which also grants the SEC powers to regulate securities. Congress passed the Securities Act following the Great Depression in the late 1920s and required the registration and regulation of securities. In an effort to prevent another financial catastrophe, Congress decided that it was necessary to provide mechanisms to oversee investments and securities to protect individual investors.[19] Prior to Shavers, bitcoins were not considered securities and thus could be more freely traded and invested without regulation. In an effort to bring order to this part of the wild west of internet investing, bitcoins should be classified as securities. Allowing the SEC to regulate this growing industry introduces a greater confidence into the market that exists for bitcoins and continues to grow.
While the definition of securities includes multiple types of financial instruments, the definition applicable to this case, and to bitcoin in general, is that of an investment contract.[20] An investment contract, while undefined in the Securities Act, was later deemed by the Supreme Court to mean “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 . . . .”[21] It is under this definition that bitcoin falls and why the SEC has the power to—and should—regulate it.
Shavers as an Illustration of Why Bitcoins Are Securities
1. An Investment of Money
The first criteria for a security entails an investment of money, which only requires that two parties execute an exchange of value but does not require actual legal tender to be used in the transaction.[22] Shavers accepted only bitcoins into his investment scheme; therefore, the SEC needed only to show an exchange of value without legal tender changing hands.[23] In Shavers, the court was satisfied that bitcoins are money for the purposes of an investment contract[24] because bitcoins are accepted as payment in various places and can be redeemed for cash through market exchanges.[25] Due to this exchange of value, for purposes of the Securities Act and securities regulation, bitcoins meet the definition of an investment of money.
Even if the definition of an investment contract were to require legal tender, all bitcoins are initially obtained through an investment of money because all bitcoins are originally obtained through one of the four ways explained above.[26] If all of these involve an investment of legal tender, the acquisition of bitcoins through any of them meets the first specification for bitcoins to be securities. Bitcoins purchased on an exchange are a prototypical investment of money. Those traded for real currency are also clearly an investment of money. In addition, mining bitcoins requires time, effort, and the financial costs associated with running a high-powered computer system to acquire bitcoins.[27] No matter how a bitcoin is initially acquired by an individual, an investment of money is necessary and so bitcoins satisfy the first element of an investment contract.[28]
2. Common Enterprise
The second required element of a security as an investment contract is common enterprise. Courts have viewed common enterprise in three ways.[29] Horizontal commonality focuses on the relationship between the investors in the venture.[30] Narrow vertical commonality focuses on whether the gains and losses of the investor and promoter are correlated.[31] Broad vertical commonality focuses on the performance for investors dependent on the efforts of a promoter.[32] Shavers relies on Fifth Circuit jurisprudence that uses the broad vertical commonality test.[33] Under this line of reasoning, a court will find broad vertical commonality if investors relied on the promoter’s expertise in order to make money in the investment. Shavers promised his investors a return and the investors were forced to rely upon him to obtain these returns.[34] Pure reliance by the investors was required and Shavers alone could control the funds and “profits.” This situation is the epitome of broad vertical commonality.
Bitcoin also easily satisfies both other commonality tests. All holders of bitcoins rely on each other for the value of those bitcoins and thus satisfy the horizontal commonality test. The Bitcoin Foundation itself states, “[a]s with all currency, bitcoin’s value comes only and directly from people willing to accept them as payment.”[35] Furthermore, Bitcoin satisfies the narrow vertical commonality test, which requires that the promoter’s gains and losses be correlated with the gains and losses of investors. Bitcoin Foundation, the main promoter of bitcoins, is made up mostly of people who invested in bitcoin early in its creation by mining or purchasing bitcoins and are commonly called “early adopters.” Many of these adopters “have large numbers of bitcoins because they took risks and invested time and resources in an unproven technology.”[36] The promoters admit a vested interest in the success of Bitcoin and because early adopters benefit when prices rise, the interests of later investors and early adopters strongly correlate, satisfying the narrow vertical commonality test for being a security.[37] Thus, Bitcoin satisfies all three tests for common enterprise and would be considered to meet the common enterprise criterion of an investment-contract security in any jurisdiction.
3. Profits Expected from Third Party
The last requirement of an investment contract security demands that investors in the security expect profits. In Shavers, defendant Shavers explicitly promised high returns for investors. Because all investors believed to be investing in a risk-free arbitrage system with a 1% daily return, they expected to make significant amounts of money. Although Bitcoin Foundation acknowledges a risk in investing in bitcoins,[38] it essentially admits that there are expectations for profits to continue for those that invest. [39] Investors with this expectation clearly satisfy the last prong of the test for a security under U.S. law.[40]
Bitcoin Is a Security
While many argue that one of the advantages to bitcoin is its lack of regulation, there are many problems with little or lax regulations on securities. Congress has indicated—through legislation like the Securities Act of 1933—that regulation of securities is necessary. As the court determined in Shavers, bitcoins are a security. There is an investment of money, common enterprise, and expectation of profits. Because bitcoins are securities, the SEC should continue, and possibly increase, its monitoring of those using bitcoins. This regulation would continue the original purpose of the Securities Act of 1933 by requiring proper disclosure when dealing with investments and also protecting the interests of individual investors in previously unregulated markets.
[1] U.S. Securities and Exchange Commission, Press Release, SEC Charges Man With Running Bitcoin-Denominated Ponzi Scheme, (July 23, 2013) (on file with Securities and Exchange Commission), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539730583#.VC1dMvldWzo.
[2] Bitcoin as a network is a proper noun. However, bitcoin as an object is not. This is why these terms change capitalization throughout the paper. Regulation of both the system and the items are argued for here, as both would qualify under the SEC’s definition of a security.
[3] Order Granting in Part and Denying in Part Def.’s Mot. For Recons., PAGEID# 1419, 4:13-cv-00415-ALM, SEC v. Shavers, No. 4:13-CV-416, 2014 U.S. Dist. LEXIS 130781 (E.D. Tex. Sept. 18, 2014). Real currency is used to denote a currency issued and backed by a centralized group, for example U.S. dollars, EU Euros, or the British Pound Sterling.
[4] SEC v. W.J. Howey Co., 328 U.S. 293, 302 (1946).
[5] Order Granting in Part and Denying in Part Def.’s Mot. For Recons., PAGEID# 1425, 4:13-cv-00415-ALM.
[6] SEC v. Shavers, No. 4:13-CV-416, 2014 U.S. Dist. LEXIS 130781, at *23-24 (E.D. Tex. Sept. 18, 2014).
[7] Frequently Asked Questions: What is Bitcoin?, bitcoin.org, https://bitcoin.org/en/faq#what-is-bitcoin (last visited Oct. 31, 2014).
[8] Ruoke Yang, When Is Bitcoin A Security Under U.S. Securities Law?,18 J. Tech. L. & Pol’y 99, 104 (2013). There are three types of virtual currency: closed, unidirectional, and bidirectional. Closed are those designed to be earned and used within a virtual framework, such as World of Warcraft gold. Unidirectional is a virtual currency or value purchased with real currency and then can only be used within the framework set up by the creator. Bidirectional currencies however are currencies where real currency can be exchanged for virtual currency and then back into real currency at a later point.
[9] Frequently Asked Questions, supra note 7.
[10] Yang, supra note 8, at 103.
[11] Id. at 112; Bitcoin Foundation is the group generally considered to be responsible for the promotion of bitcoin as a virtual currency.
[12] Frequently Asked Questions: How does one acquire bitcoins?, bitcoin.org, https://bitcoin.org/en/faq#how-does-one-acquire-bitcoins (last visited Oct. 9, 2014).
[13] Frequently Asked Questions: What is Bitcoin Mining?, bitcoin.org, http://www.bitcoinmining.com/ (last visited Oct. 9, 2014).
[14] Julian Reiche, Bitcoin Mining 101, Maximum PC (Jan. 27, 2104, 5:27 PM), http://www.maximumpc.com/bitcoin_mining_101. Maximum PC estimates that in January of 2014 it would have taken well over a year to mine a single BitCoin with a very high level system set up solely to mine BitCoins.
[15] Frequently Asked Questions:What determines bitcoin’s price?, bitcoin.org, https://bitcoin.org/en/faq#what-determines-bitcoins-price. (last visited Oct. 9, 2014).
[16] An e-wallet is an app or computer program that interacts with all other people interacting within the Bitcoin system and stores the values of any accumulated bitcoins of a user. Frequently Asked Questions: How does bitcoin work?, bitcoin.org, https://bitcoin.org/en/faq#how-does-bitcoin-work (last visited Oct. 31, 2014).
[17] Frequently Asked Questions; Is bitcoin really used by people?, bitcoin.org, https://bitcoin.org/en/faq#is-bitcoin-really-used-by-people. (last visited Oct. 9, 2014).
[18] European Banking Authority, EBA Opinion on “Virtual currencies,” 13 (2014), available at http://www.eba.europa.eu/documents/10180/657547/EBA-Op-2014-08+Opinion+on+Virtual+Currencies.pdf.
[19] 1 A.A. Sommer, Jr., Federal Securities Act of 1933 §1.02 (Matthew Bender, Rev. Ed.)
[20] 15 U.S.C. § 77b.
[21] SEC v. W.J. Howey Co., 328 U.S. 293, 298-299 (1946).
[22] Order Granting In Part and Denying in Part Def.’s Mot. For Recons., 4:13-cv-00415-ALM, SEC v. Shavers, No. 4:13-CV-416, 2014 U.S. Dist. LEXIS 130781 (E.D. Tex. Sept. 18, 2014).
[23] Shavers, 2014 U.S. Dist. LEXIS 130781, at *3-4.
[24] Id.
[25] SEC v. Shavers, No. 4:13-CV-416, 2013 U.S. Dist. LEXIS 110018, at *4-5. Both parties also stipulated to this fact.
[26] This does not take into account theft, however the original acquisition must be in one of the four ways explained below and thus they still originated from an investment of money.
[27] See Tim Ferholz, Mine Over Matter: Miners spend $17 million a day for a shot at $4.4 million of bitcoin, (Dec. 12, 2013), Quartz,
http://qz.com/156479/miners-spend-17-million-a-day-for-a-shot-at-4-4-million-of-bitcoin/. An organization that monitors BitCoin claims that $17 million in energy costs alone to mine $4.4 million worth of BitCoin.
[28] See also IRS Notice 2014-21, 2014-16 I.R.B. 938 (I.R.S. 2014). The Internal Revenue Service has defined bitcoins as akin to property for tax purposes if they were derived from legal tender. In this way, bitcoins are very similar to shares of stock as property.
[29] Yang, supra note 8, at 111.
[30] Id.
[31] Id. at 112.
[32] Id. at 111-112.
[33] Order Granting In Part and Denying in Part Def.’s Mot. For Recons., 4:13-cv-00415-ALM, SEC v. Shavers, No. 4:13-CV-416, 2014 U.S. Dist. LEXIS 130781 (E.D. Tex. Sept. 18, 2014).
[34] Shavers, 2014 U.S. Dist. LEXIS 130781, at *2. In the case of Shavers, the return was an exorbitant one at 1% daily, or 365% annually, and this almost unbelievable amount of return still qualified for reliance on the promoter’s skill.
[35] Frequently Asked Questions: Why do bitcoins have value?, bitcoin.org, https://bitcoin.org/en/faq#why-do-bitcoins-have-value (last visited Oct. 9, 2014).
[36] Frequently Asked Questions: Doesn’t bitcoin unfairly benefit early adopters?, bitcoin.org, https://bitcoin.org/en/faq#doesnt-bitcoin-unfairly-benefit-early-adopters (last visited Oct. 9, 2014).
[37] In addition, exchanges selling bitcoins could also be seen as promoters and clearly have a vested interest in that they generally make a percentage profit off of each bitcoin transaction processed.
[38] Frequently Asked Questions:Can I make money with Bitcoin?, bitcoin.org, https://bitcoin.org/en/faq#can-i-make-money-with-bitcoin (last visited Nov. 7, 2014) (“Bitcoin is a growing space of innovation and there are business opportunities that also include risks”).
[39] Frequently Asked Questions:Doesn’t bitcoin unfairly benefit early adopters?, bitcoin.org, https://bitcoin.org/en/faq#doesnt-bitcoin-unfairly-benefit-early-adopters (last visited Oct. 9, 2014) (“Bitcoin is still in its infancy, and it has been designed with a very long-term view; it is hard to imagine how it could be less biased towards early adopters, and today’s users may or may not be the early adopters of tomorrow”).
[40] Id. (stating that early adopters of Bitcoin have had financial success and that those that adopt today could be the early adopters of tomorrow).
