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Bitcoin Regulation Remains Murky – Careful Research Pays

By the Bitcoin Legal Team – Martin Mushkin, Joseph Sahid, and Rony Guldmann
Originally published in the September 2016 issue of yBitcoin Magazine. Reprinted here with permission of the publisher.

Any lawyer familiar with Bitcoin regulation will tell any inquiring Bitcoiner that whether his or her activity is regulated, and by whom, is “something that has to be examined.” Some regulators have applied existing law, and simply published guidelines as to whether certain Bitcoiners need register. Other regulators have established, or are in the process of establishing, special rules applicable to some (but not all) Bitcoiners.

FinCEN, the Federal Regulator

For instance, FinCEN, the federal Financial Industry Crime Enforcement Network, has published a guide to which Bitcoiners need to register as MSBs, or Money Service Businesses. A Bitcoiner can sift through the FinCEN guidelines and the underlying regulations to find out what kind of MSB she is, if any. Registering with FinCEN is easy, but once registered – there’s the rub. The MSB regulations have to be complied with, which requires, among other things, that the Bitcoiner abide by Know-Your-Customer rules and install anti-money laundering programs – also known as KYC/AML. That can be cumbersome and time-consuming. Fortunately, there are companies who will set up those programs for you and companies who will automatically run data through their programs to make sure you are not dealing with listed bad guys.

Then there are the 50 states. The problem with state regulation is that the Bitcoiner has to examine the rules state by state. Some states, such as New York and North Carolina, have set up regulations (NY) or passed statutes (NC) strictly regulating who can buy and sell bitcoin. Their particular rules are aimed at Bitcoiners who buy, sell, transmit or hold bitcoins belonging to other people—like a bank or brokerage house. In other words, they regulate Bitcoiners who handle “other people’s money or property.” The national Conference of State Bank Supervisors (CSBS) has proposed a law for each state to adopt, based on the New York bitlicensing regulation. But so far there are no takers unless one considers the North Carolina law, which is modelled on New York’s regulation. The Uniform Laws Commission (ULC), a private not-for-profit organization, has added reciprocal recognition of licenses granted by other states in its proposal similar to that of the CSBC. That would be a very forward-looking provision.

The Nature of Regulation

Regulation may be by specific digital currency statute or regulation, under existing money transmitter law and by court cases. In addition to the Federal and different state rules in this area, we also have to consider two main levels of regulatory approach: statutes/regulations and court interpretation. In that context the recent debate has been over how to regulate Bitcoin and just what Bitcoin is, as well as when it is being sold or exchanged for fiat money. Is digital currency the equivalent of money? Is it property? Is it some commodity? Is it a security such as stock in an enterprise run for profit?

Let’s talk about jurisdiction first. Generally, FinCEN and the state financial institution regulators, want to protect their “residents.” But jurisdiction is a highly elastic concept, and the truth is neither FinCEN nor the states really care where the Bitcoiner subject to regulation actually resides. Take as a general rule that the regulations reach a Bitcoiner wherever he/she is located so long as the Bitcoiner deals with a resident of the regulating jurisdiction. In the banking world, New York’s highest court ruled that its courts had jurisdiction over Lebanese Canadian Bank, which was sued by U.S., Canadian and Israeli citizens resident in Israel who were victims of Hezbollah rocket attacks. The claim was that the bank assisted Hezbollah by “facilitating international money transactions” using its New York correspondent bank to transfer money to Hezbollah agents and therefore was subjected to NY jurisdiction. If that kind of jurisdictional thinking is applied to Bitcoiners, a Bitcoiner located anywhere in the world who cheats a New York resident might find himself subject to the judgment of a New York court because its money passed through a bank account located in New York. To protect itself the popular Bitcoin site, localbitcoin.com, requires a user to check a box assuring localbitcoin.com that he/she/it is not a resident of New York. Localbitcoin.com protects itself this way even though its worldwide service is only to put prospective buyers and sellers together and provide an escrow service to exchange fiat money for bitcoins. And localbitcoin.com is located in Finland!

Fortunately or unfortunately, at least one other court has ruled that jurisdiction under the applicable statute in the case before it only allowed jurisdiction where the offense took place, a “locus delicti” approach, rather than a “locus of effects” approach, eliminating jurisdiction where people were injured.

How It Works

New York’s regulation is not for the faint of heart. It costs $5,000 just to apply. Applicants must submit fingerprints and pictures of employees having access to customer funds, extensive personnel background information, certification of an outside investigator, a detailed business plan and audited financials—much like a bank. Once in business, a licensee must have a written compliance plan, maintain compliance personnel, be audited and report frequently to the regulators. Among other things, if for instance, $10,000 in Bitcoin or money is transmitted in “one day by one person,” … “involving New York or any resident of New York,” the licensees will have to report the transaction to the New York regulators as well as FinCEN within 24 hours. Importantly, the regulators can grant conditional licenses under limited circumstances.

There are exemptions for dealing with some “residents,” such as merchants who accept Bitcoin in payment for goods or services, and for other mere “users,” a defined term. Banks and certain licensed bank-like trusts are deemed covered and need not get an additional license. It appears that people who only buy and sell Bitcoin in arbitrage transactions for their own accounts may be investors or users and exempt.

The New York regulation also requires all advertisements by Bitlicensees to include their names and a statement that they are licensed to engage in “Virtual Currency Business” by New York. The Bitlicense will serve as an advertised badge of integrity, like a bank saying it is a member of the FDIC. Even so, 26 applications have been filed for Bitlicenses and only 4 have been granted to date. At least one applicant, backed by the Winklevoss Brothers, changed its application to be licensed as a trust, a much broader license.

North Carolina has passed a law similar to the New York law but somewhat less stringent. A bill remains before the California legislature that would regulate Bitcoiners similarly to New York. Many states seem to be relying on their existing Money Service Business laws to regulate—or not regulate— Bitcoiners. For instance, while Texas says Bitcoin is not money, it will look closely at Bitcoin wallets and Bitcoin exchanges since they are dealing in an escrow-like manner with other people’s money or property. Georgia has issued a memo that operators of Bitcoin ATMs which merely sell bitcoins need not register under its Money Service Business statute if the Bitcoin ATMs do not hold money or bitcoins (i.e. as in a wallet) for the customers but only send purchased bitcoins to the buyer’s designated location (wallet). It may be another story if the Bitcoin ATM exchanges digital currency for fiat currency beyond mere sale and instant delivery.

In December 2015, the Tennessee Department of Financial Institutions issued a two-page memo under the Tennessee Money Transmitter Act which opined for the purposes of that statute that digital currencies, including bitcoins, were not currency. Therefore, the mere sale or purchase of digital currency for fiat money or the exchange of digital currency for other digital currency or other goods or property (as in a retail sale) was not subject to that law. However, it went on to say that if digital currency belonging to another was being held in a wallet by the Bitcoiner, or the Bitcoiner facilitated the exchange by Mr. A with Ms. B of the bitcoins, it was subject to registration under the cited Tennessee law. That kind of exchange service and wallet availability is akin to what localBitcoin.com does with its matching customers and its escrow service.

How do U.S. courts deal with this? We have dealt with court interpretation of jurisdictional statutes above. The dilemma of the licensing and substantive regulation interpretation is illustrated by two cases in Florida. In January 2014, officers of the U.S. Secret Service Miami Electronic Crimes Task Force contacted Michael Abner Espinoza through localBitcoin.com, and arranged to meet him and his cohort, Pascal Reid, at a local coffeehouse to purchase bitcoins. A small transaction took place in which bitcoins were purchased by the undercover police for cash. A second meeting was later arranged at an ice cream parlor. This time the undercover agent told the prospective defendants that they were in the business of buying stolen credit cards and selling them, and asked the defendants if they would accept the stolen cards. The defendants said they “would think about it.” A third transaction took place via the internet— no indication of illegal activity in that third transaction. The detectives then arranged a fourth meeting at a hotel to buy bitcoins for a roll of cash purporting to contain $30,000. They said they were going to use the bitcoins to buy stolen credit cards. The defendants talked about how to get the cash to their banks and they were arrested. They were charged with (a) violation of two Florida money transmitter laws, and (b) a Florida anti-money laundering law. (Note: no federal law violations were charged.) Mr. Espinoza pleaded not guilty. In a decision rendered on July 22, 2016, the Court analyzed the statutes involved and concluded that Mr. Espinosa was not a “money transmitter” under the statutes since he was not “transmitting currency.” It explained that to transmit means “to send or transfer (a thing) from one person or place to another.” The Court said this is not like Western Union which acts as a middleman to transmit money from one person to another. That is a money transmitting operation. Mr. Espinoza was selling for his own account.

More interesting, the Court said Mr. Espinoza was not a “payment instrument seller.” The Court ruled that under the Florida statute, Bitcoin did not fit into the definition of a “payment instrument” and gave as an example the fact that the IRS had decided to treat virtual currency as property for federal tax purposes, and that “Bitcoin [did not] fit into one of the defined categories listed” as a “payment instrument.” Noting that bitcoins were not taken in trade by many merchants, fluctuated wildly in value, and are not backed by or issued by a central agency, the Court held: “This Court is not an expert in economics, however, it is very clear, even to someone with limited knowledge in the area, that Bitcoin has a long way to go before it is the equivalent of money.” So the Court held that Bitcoin is not currency which was being “transmitted” under the cited statutes. As to the money laundering count, the court added an analysis of the technical statutory meaning of “intent” and held that the actions of Mr. Espinoza simply did not fit the definition. Case dismissed.

This court decision seems to be quite technical and must be read as an analysis of the specific Florida statutes. Poor Mr. Reid. He had pled guilty in 2015. We shall see how this conflict of justice plays out. In the meantime, the moral of the story is never deal with anybody who gives you the slightest indication he/she/it is involved in an illegal operation anywhere in the world. You may think the particular transaction is legal where you live, but you may get stung—and it won’t be by a little bee. It will be a punch.

Where Does This Leave You?

Suppose somebody trades bitcoins over the web. She buys bitcoins on one site and sells them on another, hoping to make a profit. Is she a mere user, or an investor? Suppose she does this, not only for herself but also for her husband, mother, father or best friend. She is successful and soon she and her friends meet regularly to decide how they will individually trade. They then pool their money (digital or fiat) and authorize one person to trade for the group and distribute profits, while requiring the members to contribute funds to cover losses. Putting aside securities laws issues, is the organization just a user or investor or has it become a money service business? The answers will vary with the details of the organization, activity and location. It pays to research your own situation carefully.

Bitcoin ATMs are here. Bitcoin ATMs are being sold and set up in the U.S. and other countries. Their purpose will be to permit people to deposit fiat currency into the machines which will credit them with bitcoins. They can then direct the bitcoins to be instantly sent to their own Bitcoin wallets located anywhere. That is, they are transmitting the value represented by the bitcoins. The transaction can also go the other way— depositing bitcoins and getting cash. The system can be used to transmit money (value) anywhere in the world in short order without passing through the normal banking system encumbered with all its controls, third parties, regulators and high fees. The ATM will have sold bitcoins, exchanged it for fiat currency and transmitted it who-knows-where. Or vice versa. Is the owner/operator of the ATM in some kind of money service business and if so, what kind? In what jurisdictions must he register—if at all? We have dealt only with U.S. law. But what will Greece (or some other country) have to say about this? Suppose the seller of the ATM has nothing more to do with the machine once it is sold. Is he subject to regulation? This seems the same as selling a car. But the answer will not always be obvious. For we are dealing in the financial world where the transmittal of value is highly regulated and constantly scrutinized.

Now suppose the manufacturer remains the owner of the ATM and sells it with a contract to maintain it for a flat fee— no share in any profit or loss. Or suppose the fee is a percentage of the gross value of any transaction. Or suppose he fully owns, operates and controls the ATM to the point of maintaining its Bitcoin and/or fiat money inventory. Now suppose he buys the machine and carries out one or more of these activities from and in the U.S. At what point does he have to comply with U.S. federal and/or state laws? Add to that the possibility that he is outside the U.S. but the machines are in the U.S. How is this activity any different from standard fiat currency transactions for the deposit of checks via your mobile phone, the withdrawal of currency from an ATM at a corner store or paying for a cup of coffee by holding your mobile phone up to a handheld scanner at Starbucks? Suppose the ATM (or mobile phone) sells insurance for digital currency or alternatively for fiat currency. Who must comply with the KYC/AML laws and/or register with the authorities? Think about it. Where are you, Bitcoiner, in this sphere? It’s in your interest to know.