Crime in the Suites: An Analyis of Current Issues in White Collar Defense
Posts Tagged ‘bitcoin’
Sep 07
2017

ICOs Facing an Uncertain Future in China and the U.S.

This week, in a joint statement issued by the People’s Bank of China, the securities and banking regulators, and other government agencies, the Chinese government declared that initial coin offerings (ICOs) constitute “illegal open financing behavior” and immediately froze all ICO activity.  The joint statement explained that the tokens issued in ICOs do not have legal and monetary properties, do not have the legal status equivalent to money, and cannot be circulated as a currency in market use.

Moreover, the Chinese government also ordered that companies should repatriate all funds received from past ICOs to investors, and the companies were further warned that the relevant investigative agencies would ensure compliance. Interestingly, the joint statement did not specify the method of repatriation. This raises a thorny issue of how to refund investors that paid in other virtual currencies (e.g. Bitcoin) for their tokens because the refund transaction in Bitcoin is seemingly prohibited by the joint statement as well.

This is a stark contrast with the approach by the United States’ Securities and Exchange Commission (SEC) which, this past July, released a report outlining how ICOs could qualify as securities under the US securities laws, thus requiring registration or an exemption. The combination of investors depositing funds and expectation of profits from the efforts of others drew the scrutiny of the SEC because this process mimics the main characteristics of securities. Although the SEC did not outright opine that all ICOs would be securities under federal law, subsequent ICOs have taken different forms of responsive actions, such as excluding US investors from participating in their ICO, registering the ICO in foreign jurisdictions, or enhancing the non-financial aspects of the tokens to make them more strongly resemble an asset.

ICOs (initial coin offerings) are digital token sales that have been embraced by both companies and investors as a blend between crowdfunding and an IPO. Companies conducting ICOs offer virtual tokens (virtual coins that are normally recorded on the Ethereum blockchain) for cash or another form of virtual currency.  ICOs are in the midst of a banner year in 2017 and have already raised over $2.16 billion. A large factor in their popularity is that start-up companies view them as a cost-efficient method to raise funds in a very quick timeline because an ICO avoids both the investment bank fees and regulatory compliance requirements imposed by governments when raising capital via traditional means.

Notably, the investors/buyers in an ICO only receive the tokens and, although tokens have a limited purpose for use on the platforms created to support the token’s use (for example, an online gaming platform), a primary goal of investors is to gain from the anticipated increased value in the tokens as the newly created platform increased in utility and value. Tellingly, the fact that investors often purchase a significant number of tokens (which is in excess of what they purchase for use on other online platforms) and they also purchase them well in advance of the launch of any actual platform (as opposed to simply going to a different currently active platform) speaks to speculation as a strong component of the investors’ motivation. In contrast, people do not purchase tokens for use in arcades or buy smartphones months in advance of having the option to actually use their purchased tokens to play the arcade or receive a smartphone for immediate use.

Obviously, the SEC’s approach is far more cautious than that taken by the Chinese regulators. That is partially due to legal restrictions in the US because the SEC cannot (or practically will not) simply prohibit a current business practice and order all completed transactions to be unwound immediately. Thus, it is unlikely that the US will follow the Chinese government’s model of banning ICOs. However, all companies contemplating ICOs should reevaluate the potential market in light of the shutdown of the Chinese market and also carefully consider the possibility and implications of being a security under US securities laws.

Aug 12
2014

Bitcoin Equal to Money According to District Court Ruling

Young businessman opening his shirt and showing bitcoin currency

Is it possible to commit money laundering with virtual currency? At least one federal judge thinks so. Last month, U.S. District Judge Katherine Forrest refused to dismiss a money laundering charge premised on the use of a Bitcoin-based payment system. She is the first federal judge to hold that the federal money laundering statute is broad enough to encompass the use of Bitcoin in financial transactions.

In February 2014, a grand jury in the Southern District of New York returned an indictment charging Ross William Ulbricht on four counts for participation in a narcotics trafficking conspiracy, a continuing criminal enterprise, a computer-hacking conspiracy, and a money-laundering conspiracy. The charges stemmed from Ulbricht’s alleged creation and operation of an underground website known as Silk Road. Prosecutors alleged that Ulbricht designed, launched, and administered the online marketplace to facilitate the anonymous sale of illegal drugs, malicious computer software, and other illicit goods and services. Two features of the site allegedly protected buyers and sellers from government surveillance and tracking. First, Silk Road operated using Tor—software and a network that allows for anonymous, untraceable Internet browsing. The site also required all purchases to be made in Bitcoin, an anonymous, untraceable form of payment.

Ulbricht asked the court to dismiss all four counts, including the charge for participation in a money-laundering conspiracy. Ulbricht argued that the money-laundering charge should be dismissed on grounds that Bitcoin transactions are not “financial transactions,” as defined under the statute.

The federal money laundering statute prohibits “financial transactions” involving the proceeds of illegal activity when conducted by a person who intends to further the illegal activity or who knows the transaction is designed to conceal material information about the proceeds, such as their source or location. The “financial transaction” requirement may be satisfied by: (i) a transaction involving the movement of funds by wire or other means; (ii) a transaction involving a monetary instrument; or (iii) a transaction involving the transfer of certain types of property. To fall within the second definition, the transaction must involve a “monetary instrument”—i.e., U.S. or foreign coin or currency, checks, money orders, investment securities, or negotiable instruments.

Ulbricht argued for dismissal of the money-laundering charge based on the second definition. Specifically, he contended that Bitcoins do not meet the statutory definition for monetary instruments, so the alleged transactions cannot form the basis for a money-laundering conviction.

But according to Judge Forrest, Ulbricht missed the mark by focusing exclusively on the second definition of “financial transaction.” She prefaced her analysis by acknowledging that anonymous financial transactions are not per se criminal. But in Ulbricht’s case, Bitcoins were problematic because they were alleged to be the medium of exchange for commercial transactions related to illegal activity—narcotics trafficking and computer hacking. The prosecution had ample support for its claim that Ulbricht chose Bitcoin as Silk Road’s exclusive payment system in order to conceal the nature of those transactions.

The court also explained that the government had alleged the necessary elements for a money-laundering conspiracy regardless of whether Bitcoin was deemed to be a “monetary instrument.” The statute defines “financial transaction” more broadly to include any transaction involving the movement of funds by wire or otherwise. Bitcoins were deemed to fit this broad definition because they are used as funds to pay directly for things or as a medium of exchange and can be converted into currency which can pay for things. As Judge Forrest noted, “the only value of Bitcoin lies in its ability to pay for things . . . . The money laundering statute is broad enough to encompass the use of Bitcoins in financial transactions. Any other reading would – in light of Bitcoins’ sole raison d’etre – be nonsensical.”

There is an inescapable irony here. While proponents of Bitcoin favor recognition of the currency as a financial instrument, large operators like Ulbricht argue the opposite.

 

Jan 17
2014

Bitcoin Goes Mainstream

As followers of trends in e-commerce, our firm takes a keen interest in new e-payment methods. Last year, we predicted the Bitcoin would emerge as an innovative mode of currency for online transactions.  When Bitcoin – an alternative virtual currency – first appeared in the mainstream media, it was largely portrayed as a wonky, nerdy counterculture experiment in decentralized wiki-currency.  Reports explained that it was based on digital cryptography, but few if any people actually understood the math and even fewer could explain it in language that was comprehensible to most of us.  But things have changed, and it is a whole new Bitcoin world.

Recent reports actually treat Bitcoin like a part of the mainstream economy.  Government officials testifying on Capital Hill warn legislators not to underestimate the value that Bitcoin brings to the economy.  Even leaving aside the federal shutdowns of illicit sites like Silk Road (an eBay-like marketplace for illegal drugs), ever-growing numbers of businesses are accepting Bitcoin as payment.  Online market Overstock.com and social gaming site Zynga.com have both indicated their intent to accept Bitcoin.  The owner of the Sacramento Kings has announced that fans will soon be able to buy tickets and hot dogs using Bitcoin.  And it even appears that it will be possible to make political contributions using Bitcoin – doubling down on the whole issue of transparency versus anonymity in campaign contributions.

So if your organization considers using or accepting Bitcoin, there are some significant considerations:

1.         The value of Bitcoin is extremely volatile.

Individuals can exchange national (fiat) currencies for Bitcoin through a variety of exchanges that have popped up in response to the demand for such services.  The prices on these exchanges vary considerably among themselves at any particular time, and the price of Bitcoin has fluctuated wildly over the course of the past year.  One Bitcoin was worth about $13 a year ago (in January 2013); in November 2013, the price surged over $1000 per Bitcoin.  For a period of time, people in China were reportedly using Bitcoin as a means to avoid currency restrictions in that country; when China issued a ban on Bitcoin, the price swooned, although it later recovered much of that value.

The volatility of Bitcoin obviously poses challenges for businesses that accept them.  Some address the issue by setting prices in national (fiat) currencies, accepting payments in Bitcoin but exchanging them on a regular basis.  Other businesses have proposed engaging in sophisticated hedging transactions to address this risk.

2.         Bitcoin has regulatory uncertainty.

To even talk about regulations and Bitcoin feels like it cuts against the entire vibe of this alternative currency, but there is little doubt that it is coming.  The Financial Crimes Enforcement Network (FINCEN) has stated unequivocally that Bitcoin exchanges (which exchange Bitcoin for fiat currencies) and most Bitcoin “miners” (which process Bitcoin transactions) must register as Money Services Businesses (MSBs) under Department of the Treasury regulations.  And legislators in the U.S. Congress are unquestionably considering what regulations can and should be imposed on the currency in order to safeguard against abuses without extinguishing the innovation to which it is so closely tied.

3.         Bitcoin is anonymous – sort of.

When Bitcoin first emerged in the public eye, it was ballyhooed – and demonized – because of its supposed anonymity.  The belief that its users could indeed remain anonymous gave rise to marketplaces for drugs and murders for hire paid in Bitcoin.  The rub is that Bitcoin is not entirely anonymous: The digital framework of the currency is that each transaction is recorded in the cryptography itself (preventing fraud such as spending the same Bitcoin twice), and it is possible in some cases to use that information to find one’s way back to a Bitcoin user.  The combination of a belief in anonymity and the ability of law enforcement to identify users obviously poses risks related to anti-money laundering obligations of which businesses must be aware.

4.         Bitcoin still has security issues.

The last, but possibly most serious, consideration about accepting Bitcoin is lingering questions about security.  ­­­­Bitcoin are balances (credits) assigned to “addresses” (random strings of letters and numbers) that are publicly available.  To spend the balance associated with a particular “address,” a user must have the corresponding “private key” (a slightly longer random string of letters and numbers) and apply a digital signature that allows some portion of that balance to be transferred to another address.  Thus, the security of Bitcoin relies entirely on the security of “private keys”: Anyone who gains access to a private key gains access to the Bitcoin balance associated with that key.  Given the recent headlines about data security breaches, it is not hard to understand why there might be concerns about accepting a virtual currency that can be purloined simply by stealing digital data from a computer.

The likelihood is that it is simply too early to judge whether Bitcoin is simply a fad or a harbinger of a sea change in our notion of what constitutes money and currency in a global digital world.  Businesses who are early adopters may garner significant gains – or they may get burnt by early “learning experiences.”  Inside counsel are wise to advise their clients about the risks and benefits of Bitcoin so that business leaders may make wise choices about the decision to accept them.

Dec 18
2013

The Bitcoin Bubble Hasn’t Burst Yet, But The First Signs Of Trouble Are Brewing

By: Karl Smith and Casselle Smith 

The value of Bitcoin, the hottest and most widely traded virtual currency, plunged a little over a week ago, after China’s central bank issued a statement that the government is banning financial institutions from trading in the virtual currency.The price of a single Bitcoinfell from roughly $1200 on December 5th to less than $600, early morning December 8th. Thereafter it recovered somewhat selling for around $700 as of December 16.  At the time of this posting (12/18), the price had fallen once again to $571.

This time last year, Bitcoin were selling for roughly $13 apiece. Economists and financial experts have struggled to explain the meteoric rise price to investors and to a public increasingly interested in the virtual currency.  In many ways, the soaring price for Bitcoin looks like a classic bubble: Speculators pay out of the nose for Bitcoin, hoping to unload them to an “even greater fool” who will come along later with the same plan. At first blush, this type of bubble appears to resemble a pyramid scheme that must inevitably collapse once all potential speculators have bought in.

Bitcoin, however, has important features that differentiate them from other bubble-prone assets.  The fact that the crash coincided with a change in policy from the Chinese government makes it even more likely that the special features of Bitcoin have played an important role in their use.

The design of Bitcoin allows for almost completely secure and anonymous transactions.   Users don’t have to trust that a bank or other financial intermediary will keep their information secret. For the most part, the very nature of a Bitcoin transaction does this. Consequently, the currency has attracted substantial interest from users engaged in illicit transactions.  Some of these are of the kind familiar to American readers. The website Silk Road, for example, specialized in selling narcotics and accepting Bitcoin as payment; it has been shuttered by U.S. law enforcement.

The Chinese government’s ban on Bitcoin arose from a different sort of illicit transaction that is less familiar to Americans because it are designed to get around regulations that the United States does not impose… Here’s the rub: the Chinese government limits its citizens’ ability to invest outside of the country because it wishes to provide a large pool of capital available to Chinese industries.  Since Chinese investors have limited choice, Chinese banks can offer them paltry rates of return that guarantee that the value of their investments will fail to keep up with inflation.  Naturally, Chinese investors wanted a way out, and many of them turned to Bitcoin.

Chinese investors would buy Bitcoin using the local currency, the Yuan. They would then transfer the Bitcoin to a bank or other financial institution outside of China and have that institution sell the Bitcoin and invest the proceeds outside of China. When the investor was ready to cash in, she would simply instruct the financial institution to sell the foreign investments, use the proceeds to buy Bitcoin, and then transfer the Bitcoin back to her.

This loophole allowed Chinese investors to earn higher rates of return without being caught by the authorities. For a time, the Chinese government allowed the loophole to remain open. On Wednesday, however, the Chinese government banned financial institutions and, importantly, online platforms like Biadu.com, from doing any business in Bitcoin.  Baidu is a Chinese search engine that, like Google,forms the backbone of how users connect online. Without Baidu’s help,finding someone to buy or sell Bitcoin in the first place becomes exponentially more difficult.

Fear that the Chinese market for Bitcoin would dry up seemed to lead speculators to dump the currency following the announcement.  It also exposes the fundamental weakness of Bitcoin: while they allow enormous anonymity for users, connecting with a broadbase of other users requires using a platform which almost necessarily does not seek anonymity. If it did, potential users would not know of their existence.

Regulators don’t have to crackdown on users themselves but simply on the websites and platforms that connect them.

There is no readily apparent US or European analogue to the Chinese monetary policy that motivated the country’s crackdown. Hence, China’s stance does not necessarily indicate that an international sea change is afoot with respect to the legal nature of Bitcoin and other emerging virtual currencies. Nonetheless, to the extent that Bitcoin’s surge in value was precipitated by Chinese investors’ thirst for international investment capabilities, the recent crash highlights the currency’s deep vulnerability to changes in financial regulation around the world.

Karl Smith is the Creator and Chief Curator of Modeled Behavior, a leading international finance and economics blog currently hosted on Forbes. He blogs mostly on macroeconomics, rationality, philosophy, and futurism. 

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About Ifrah Law

Crime in the Suites is authored by the Ifrah Law Firm, a Washington DC-based law firm specializing in the defense of government investigations and litigation. Our client base spans many regulated industries, particularly e-business, e-commerce, government contracts, gaming and healthcare.

Ifrah Law focuses on federal criminal defense, government contract defense and procurement, health care, and financial services litigation and fraud defense. Further, the firm's E-Commerce attorneys and internet marketing attorneys are leaders in internet advertising, data privacy, online fraud and abuse law, iGaming law.

The commentary and cases included in this blog are contributed by founding partner Jeff Ifrah, partners Michelle Cohen and George Calhoun, counsels Jeff Hamlin and Drew Barnholtz, and associates Rachel Hirsch, Nicole Kardell, Steven Eichorn, David Yellin, and Jessica Feil. These posts are edited by Jeff Ifrah. We look forward to hearing your thoughts and comments!

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