Bitcoins regulated by the SEC?Things are quickly getting real in the virtual currency world. Virtual currency providers have endured a series of recent shutdowns, prosecutions, restrictions, court decisions and investigations ranging from a ban on Bitcoin use by the Thai government to an investigation by the New York Department of Financial Services which in a memorandum called  the virtual currency space “a virtual Wild West for narcotrafficers and other criminals.” The U.S. Senate Committee on Homeland Security and Governmental Affairs announced that it has initiated an inquiry into Bitcoin and other virtual currencies and has requested a number of regulatory agencies to provide information on their role in preventing criminal activity in the digital currency space. Regulators seized the United States assets of Mount Gox, the largest global entity involved in exchanging Bitcoins for actual currency, and the SEC recently issued an Alert on some of the dangers of virtual currencies. And now, a federal court has ruled that Bitcoins are securities.

Bitcoin is the major player in the virtual currency industry. Bitcoin’s currency is a true virtual currency which is not sponsored or managed by any country or backed by any asset, and it is not regulated by any central bank or other agency. Bitcoins exist through an open-source software program. Users can buy Bitcoins through exchanges that convert real money into the virtual currency. Users of Bitcoins can keep their identities confidential and can participate in financial transactions on what appears to be a totally secret basis. The value of a Bitcoin is determined by a software algorithm which apparently monitors and controls the available supply of Bitcoins.

A recent federal court decision centered on Bitcoins will have interesting and far-reaching ramifications for virtual currencies and even has some important securities law implications. Trendon Shavers is one of the most visible and prominent players in the virtual currency industry and is heavily involved in Bitcoin matters. As part of his Bitcoin activities, Mr. Shavers formed First Pirate Savings & Trust, which he characterized as a “virtual hedge fund” based entirely on Bitcoins. He wisely changed the name of this “virtual hedge fund” to “Bitcoin Savings and Trust” (“BST”). The “pirate” thing just doesn’t work well in the financial services industry.

BST promised extremely high returns to its investors (as much as 7% weekly). Investors reportedly invested about 700,000 Bitcoins in BST, which equated to about $4.5 million in real monetary value based on the value of Bitcoins at that time. The value of Bitcoins has fluctuated widely, however, and the value of those 700,000 Bitcoins reached $70 million based on recent Bitcoin values. BST eventually ran into significant trouble and the returns were dramatically decreased. BST returned funds to some of its investors, and Mr. Shavers subsequently shut it down. This situation quickly caught the attention of regulators, and the SEC brought a civil fraud action against BST and Mr. Shavers and alleged that BST was a Ponzi scheme in which Mr. Shavers used new investors’ Bitcoin investments to make interest payments to existing investors and to cover investor withdrawals and payouts. The SEC also alleged that Mr. Shavers misappropriated about 150,000 Bitcoins and used them for unprofitable day trading activities and to pay personal expenses. The SEC alleges that the investors in BST eventually lost about 263,104 Bitcoins. The value of these Bitcoins at the time of BST’s default was about $3 million, but this value is considerably higher if based on the current value of a Bitcoin, which has been around $100.

Mr. Shavers based his defense on the virtual nature of Bitcoins. All of his activities with BST involved Bitcoins, a virtual currency. Investors only invested Bitcoins in BST, and no real currency was involved. He also claimed that the SEC could not prosecute him because the investments made in BST were not securities. The SEC disagreed, asserting that Bitcoins are investment contracts and notes, and are thus securities.

In a groundbreaking opinion, Judge Mazzant of the Eastern District of Texas rejected Mr. Shavers’ defenses. The court ruled that Bitcoins can be used as money. They can be used to purchase goods and services (as Mr. Shavers did when he allegedly used BST investors’ funds to pay his personal expenses). The court also noted that Bitcoins can be exchanged for conventional currencies such as dollars, euros or yen.  In view of all of these factors, the court said that “Bitcoin is a currency or form of money, and investors wishing to invest in [BST] provided an investment of money.”

The court also determined that the interests in BST purchased by the investors were securities. This conclusion was based on a conventional Howey analysis. (We previously blogged about how chinchillas, payphone packages, rare coins, live beavers, silver foxes, whiskey receipts, diamonds, and religious cults can be “securities” under this Howey analysis.)  As mentioned above, the court determined that the BST investments were actually an investment of money. The court also determined that a common enterprise existed since the investors were depending on Mr. Shavers’ expertise and experience in Bitcoin matters and that investors were promised a substantial return from these efforts.  Finally, the investors clearly had an expectation that profits would be realized through Mr. Shavers’ efforts since the investors were induced to invest through the promise of substantial returns on their investments.  The court concluded that the BST investments satisfied the Howey test and could be considered securities.

This is obviously only the beginning of this process and the SEC still has a long way to go in its action against BST and Mr. Shavers, but the court’s actions to date are a substantial victory for the SEC. The SEC action survived a crucial challenge at this early stage that could have crippled it, and the SEC is now able to proceed with its case. It’s impossible to determine how this case will end up, but the court’s determinations that Bitcoins are money and that the BST investments are securities will likely have significant ramifications in other investigations and actions involving virtual currency players.

In another interesting turn of events, the Winklevoss twins (who you will remember from their legal actions against Mark Zuckerberg in which they claimed to have significant ownership stakes in Facebook stemming from their days at Harvard) have resurfaced in the virtual currency space and are attempting to establish and operate an exchange traded fund (EFT) based on Bitcoins. This proposed EFT is currently in the SEC review process and subject to a subpoena from New York banking regulators, and I will discuss it in a subsequent post when more details become available.

Virtual currencies are here to stay, and in fact I believe that they will continue to grow in popularity to become a major component of global financial markets. A strong form of regulation needs to quickly be put into effect, however. Notwithstanding the protests of Internet freedom advocates, it appears beyond doubt that virtual currencies have been widely used by some very bad players, such as drug dealers and money launderers, to further their criminal activities. The recent indictment filed against the virtual currency exchange Liberty Reserve by United States prosecutors, which accused Liberty of helping criminals around the world launder illicit funds, is a good example of the dark side of the confidential and unfettered nature of virtual currencies. Hopefully the ruling by Judge Mazzant along with the other regulatory and judicial actions that are occurring in this space will provide the start of a cleansing process.