By the Bitcoin Legal Team – Martin Mushkin, Joseph Sahid, and Joseph Taub
April 2, 2014
Bitcoin is the latest and perhaps best-known form of digital currency in a long line of digital currencies. The premise of digital currencies is that they try to establish a medium of exchange based on immutable mathematics and are not subject to the control or manipulation of any government. Not long after the computer was invented, people started discussing the development of currency based on computer code, that series of zeroes and ones called bits and bytes. The idea was to develop a medium of exchange without fiat money issues and not backed by a government and subject to its manipulation. Thus far, the primary result has been to raise complex legal dilemmas requiring legal counsel to work through.
First, to understand the context of the legal problems, we need to keep in mind how money has developed. Since the first cavemen exchanged goods in a barter transaction there has been some medium of exchange. When A and B first exchanged goods, each was getting something from the other that he wanted. There quickly came a point when B really did not want that widget but knew that he could exchange it with C and also with D and E for some things B really wanted. Soon he had an inventory waiting to be bartered. And soon after that B (or A) needed some means of storing his wealth other than in the goods he had bartered for. It might have been certain beads, special rocks, or the like. Next came smelted metals, first copper and eventually gold, silver, and other precious metals. Then there was the problem of storage of this inventory of wealth. Banks, places of safe storage, were established. Coins with weights established by government mints came along. It is noteworthy that the words shekel and pound are measures of weight, which we now think of as measures of value.
Finally, we are in the age of paper or fiat money. Until the popularization of credit cards after World War II, there were two kinds of paper currency in circulation: checks and dollar bills, which is a paper currency issued by a government. To this day, checks say, “Pay to the order of….” In other words, they are commands to one’s bank to move wealth stored by them from the account of the maker of the check to the account of the person to whom it is to be paid. Instead of masses of paper moving through the banking system, all this transferring – debiting and crediting – now takes places electronically. As soon as that occurs, we enter into a form of digital currency.
In the United States, currency was measured in terms of ounces of gold until 1971, when the country went off the gold standard. Now the value of a currency is purely dependent on the trust one has in the continuing acceptance of that currency by one’s partner in trade and the trust one has that the currency will continue to be exchanged for a certain value of goods. On the world stage the U.S. dollar has fulfilled that exchange role for half a century.
The white paper upon which the bitcoin is based has this introduction:
Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust-based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for nonreversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party. What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers. In this paper, we propose a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions. The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes. (underlining added.)
We have underlined what we see as the thrust of the white paper. Simplistically, the white paper wants to substitute a theoretical unbreakable mathematical formulation for the trust and subjective valuation inherent in prior mediums of exchange. Existing mediums of exchange obtain their status because their government issuers provide a regulatory framework trusted by their citizens. To be really useful, Bitcoin requires people to be comfortable buying and selling the commodities we use in our daily lives with bitcoin in place of government issued fiat money.
Bitcoin, that long algorithmic string of bits and bytes, zeroes and ones, is currently the most popular iteration of digital currency. Others exist, and surely someone (anonymously, possibly) will develop a new and better model. In the meantime, here is where we are.
Now we get to the law part. For our purposes, law generally establishes the framework within which we conduct our daily life and provides penalties when one moves outside that framework. The framework is a practical method of going about one’s business. We assume that, except for the imprudent or the rogues, drivers will stop and go depending on whether the light is red or green. Law also provides a basic moral code within which we work.
Unfortunately, digital currencies, including Bitcoin, have found that they are subject to economic vagaries and human chicanery. A number of legal cases have already arisen. If you put the word “bitcoin” or “digital currency” into Westlaw, one of the two largest U.S. subscription legal research services, few cases show up. In other words, the legal exposition of digital currency” and “bitcoin” has just begun.
Who has Legal Jurisdiction over Bitcoin Questions? To approach the legal issues, we must first examine how Bitcoin fits into the legal environment. To say it is a digital currency does not answer the question. Is Bitcoin a currency, a commodity, some kind of hybrid, or something else? It all depends on the context. What difference does it make? It makes a difference as to whether it is regulated, how it is regulated, and who regulates it. Here is how it can break out.
Bitcoin can be money, a currency, or a commodity. Some months ago, Japan’s Financial Services Agency took this position: “Bitcoin isn’t a currency; it works as an alternative to currencies, like gold…. The FSA is in charge of currency-based services. Therefore, bitcoin exchanges are not subject to our regulatory oversight.” It appears that in Japan, bitcoin is being treated as a commodity and subject to less regulation than currency or securities. Since the Mt. Gox bankruptcy, the Japanese government is revisiting this issue. Canada has ruled bitcoin is not legal tender. That does not mean that Canada will not regulate it. Interestingly, ATMs exchanging bitcoin for Canadian currency and vice versa are being installed in major Canadian cities. And they may soon appear in Los Angeles and elsewhere in the U.S.
What’s happening in the U.S.? In SEC v. Shavers, decided by the U.S. District Court for the Eastern District of Texas, the court held that since bitcoin could be used to buy things other than bitcoin itself, it was money in this context. The court found that the investment was in an enterprise operated for profit, and therefore was a security. The court did not deal with the nature of what the enterprise was investing in. The investment was in bitcoin itself, and the court could have classified the investment as an investment in a commodity or alternatively a forex transaction. So here we have three ways of looking at Bitcoin and several different regulatory schemes that might be involved: money, securities, commodities, and forex. The Commodity Futures Trading Commission (CFTC) has announced that it is investigating regulating Bitcoin as a “derivative” or a commodity, both of which are within its jurisdiction. The U.S. Treasury has added a Bitcoin representative to its Bank Secrecy Act Advisory Group (BSAAG). The BSAAG consists of representatives from regulatory and law enforcement agencies, financial institutions, and trade associations who advise Treasury on anti-money laundering and counter-terrorist financing policy. The Treasury’s Financial Action Task Force (FATF) is expected to publish a guide on common definitions for the virtual currency world and describes the potential benefits and illicit finance vulnerabilities of virtual currencies. New York State’s Superintendent of Financial Services, Benjamin Lawsky, has said that virtual currency exchange operators should submit formal applications as a first step toward eventual regulation.
What Country Has Jurisdiction Over Whom? There is also the question of geographic jurisdiction. Suppose Company A, which is physically in country X, uses the Internet to find an exchange upon which it can offer an investment opportunity and states it will only accept payment in bitcoin. The exchange is only virtual, and Company A does not know where it is located. Company A makes its securities offering and investors pay for it by depositing bitcoin into Company A’s Bitcoin wallet; mind you, a virtual electronic wallet. The wallet is administered by still another storage facility, perhaps in a third country. Company A does not have the physical name and address of the investor. All it has is the email address of the investor. So the security the investor purchased is really an electronic entry. In the course of time, Company A pays dividends to the investor by sending those dividends to the virtual wallet designated by the investor by use of his/hers/its email address. Any of these entities or people could be anywhere in the world. Is jurisdiction where the physical offices of the various participants are located, the location of their servers, or where the harm complained of hurt a physical entity? What government(s) can take jurisdiction? To what court can the complainant go for justice? It all depends on a number of factors that must be explored on a case-by-case basis.
Assuming U.S. jurisdiction, here are some of the U.S. laws that have to be dealt with when dealing in digital currencies. The penalties for non-compliance can be draconian, including seizure long before trial of all assets, including bank accounts, websites, and email addresses wherever located.
Bank Secrecy Act and FinCEN: The Treasury’s Federal Crime Enforcement Network (FinCEN) describes the Bank Secrecy Act as follows:
|The Currency and Foreign Transactions Reporting Act of 1970 (which legislative framework is commonly referred to as the “Bank Secrecy Act” or “BSA”) requires U.S. financial institutions to assist U.S. government agencies to detect and prevent money laundering. Specifically, the act requires financial institutions to keep records of cash purchases of negotiable instruments, file reports of cash transactions exceeding $10,000 (daily aggregate amount), and to report suspicious activity that might signify money laundering, tax evasion, or other criminal activities. It was passed by the Congress of the United States in 1970. The BSA is sometimes referred to as an “anti-money laundering” law (“AML”) or jointly as “BSA/AML.” Several AML acts, including provisions in Title III of the USA PATRIOT Act of 2001, have been enacted up to the present to amend the BSA.|
In March 2013, FinCEN issued interpretive guidance clarifying the application of the Bank Secret Act to virtual currencies. FinCEN had previously promulgated regulations governing money services businesses (MSBs), including currency exchanges and money transmitters, which are obligated to comply with registration, record keeping, and other requirements. The March 2013 guidance attempts to clarify if and when participants in virtual currency transactions might be engaging in “money transmission” and thus subject to the MSB rules. They may be “users, exchangers or administrators, or combinations thereof.” Depending on classification, different rules may apply.
In October 2013, a bill was introduced into Congress to amend the Bank Secrecy Act to, among other things, broaden its prohibitions of money laundering, to assure compliance with the recommendations of the Financial Action Task Force, and to broaden the personal responsibility of individuals as well as institutions to comply with the Bank Secrecy Act. In January 2014, the bill was referred to the Subcommittee on Crime, Terrorism, Homeland Security, and Investigations.
Counsel must examine these rules along with the virtual currency business client to determine their applicability.
Electronic Funds Transfer Act: This law is most commonly thought of as regulating ATMs, but it goes much further than that. It states:
|…the term “electronic fund transfer” means any transfer of funds, other than a transaction originated by check, draft, or similar paper instrument, which is initiated through an electronic terminal, telephonic instrument, or computer or magnetic tape so as to order, instruct, or authorize a financial institution to debit or credit an account. Such term includes, but is not limited to, point-of-sale transfers, automated teller machine transactions, direct deposits or withdrawals of funds, and transfers initiated by telephone….|
It then goes on to exclude many everyday transactions. Indictments have been issued to people dealing in bitcoin for failure to comply with this law. Establishing a Bitcoin business requires particular attention be paid to compliance with this law.
Money Transmitting Services: The term “money transmitting services” has been broadly defined. One federal law provides that:
|(b)(2) the term “money transmitting” includes transferring funds on behalf of the public by any and all means including but not limited to transfers within this country or to locations abroad by wire, check, draft, facsimile, or courier.|
That law has been broadly interpreted to require businesses which are not banks or other money depositories, but which deal in virtual currencies, to register with both the federal government and state governments.
Transaction Reporting: Federal and state laws and regulations require that organizations through which transactions of a certain size (measured in U.S. dollars) occur must report those transactions to the U.S. Treasury. The reports require the identities of the transmitter and the recipient. Email addresses and e-wallets will not suffice. Currently, the reporting dollar amount is $10,000.
Money Laundering: Generally speaking, money laundering is aiding the movement of money illegally obtained into the above ground legal economy or hiding it from legally authorized scrutiny. To say the least, you can get in trouble.
One federal definition of money laundering is:
|(a)(1) Whoever, knowing that the property involved in a financial transaction represents the proceeds of some form of unlawful activity, conducts or attempts to conduct such a financial transaction which in fact involves the proceeds of specified unlawful activity–
(B) knowing that the transaction is designed in whole or in part -(i) to conceal or disguise the nature, the location, the source, the ownership, or the control of the proceeds of specified unlawful activity; or(ii) to avoid a transaction reporting requirement under State or Federal law,
shall be sentenced to a fine of not more than $500,000 or twice the value of the property involved in the transaction, whichever is greater, or imprisonment for not more than twenty years, or both.
To avoid participation in money laundering, one must know with whom one deals on both sides of the transaction. Silk Road is accused of knowingly becoming a market place for drug dealers. The definition does not mean that all transactions with suspect persons constitute money laundering. There are a number of aspects of a transaction and business that must be explored, but anybody dealing in the anonymous world of digital currencies must be cautious. It’s simple – find out enough about whom you are dealing and what they are dealing in so that you don’t aid crooks.
The same law makes it a crime not to report certain money transaction involving more than $10,000 to the IRS.
Federal and State Securities Laws: The key element in determining whether the federal and/or state securities laws apply to a situation is determining if a “security,” as defined by these laws and the courts, is involved. Securities laws are aimed at establishing disclosure of important information so investors can determine whether to invest, hold, or sell, and to set rules for buying and selling so that there is a level playing field. Companies raising investment capital, whether the investment be in money, bitcoin or something else, may or may not be exempt from registering their securities with the SEC or their state. In 2012, Congress passed the JumpStart Our Business Startups Act (JOBS Act), which substantially liberalized how one can raise capital in some circumstances without having registered the securities. As we have indicated above, a digital currency can be characterized in many ways, depending on how it shows up in a transaction. Businesses dealing with bitcoin have to determine what securities laws may apply, what exemptions are available, and how to comply.
Privacy Acts: There are at least 20 federal privacy statutes dealing with a vast number of subjects. While the Freedom of Information Act permits applicants to obtain certain records, it limits what must be released to whom. Other laws prohibit banks and other financial institutions from releasing information to anybody but registered signatories of the depositor. And other laws require institutions (and individuals) to collect and retain information regarding who they are dealing with and turn it over to the government. People dealing in bitcoin as a business must be familiar with these laws, determine whether they are subject to them, and establish procedures to comply.
Bankruptcy Laws: Mt. Gox, the largest Bitcoin exchange, has filed for bankruptcy in Texas. And Mt. Gox and its founder have been sued in a class action in Illinois. That suit may be transferred by the bankruptcy court to its Texas jurisdiction. Bankruptcy courts have broad powers to capture the assets of bankrupts and protect the debtor’s creditors.
Contract Law: One of the premises of Bitcoin and other digital currencies is that Bitcoin transactions are irreversible. The digital string cannot be broken. However, people paying or receiving bitcoin have claimed that they did not get what they bargained for. In other words, transactions in which Bitcoin is involved are subject to the same contract laws as other transactions.
Taxation, Health Care, and Social Security Laws: U.S. tax laws, health care laws, social security laws and many others will apply to businesses conducting digital currency businesses in the U.S. State laws will also be applicable. Employers in the Bitcoin world must be aware and provide for compliance.
The IRS has Spoken: On March 25, 2014, the IRS published a Notice in which it treats bitcoin as “property,” not currency. Presumably, that means that bitcoin transactions will be dealt with as barter transactions. The taxation of barter transactions raises issues beyond the scope of this article.
As can be seen, the legal issues being raised by the advent of Bitcoin cover a wide range and will require those in the industry to engage competent legal counsel to navigate the area. Beware, regulations are coming.