Digging for answers: The “strong smell” of fraud from one Bitcoin miner maker

A Butterfly Labs exec loses a probation hearing, but details from the case are worse.

by Cyrus Farivar - Apr 22 2014, 11:00am 


For many crypto-minded libertarians, Bitcoin is the future of money. But that dream 
hasn't been helped much by the numerous high-profile legal cases involving the currency 
in recent years: The Bitcoin Savings and Trust hedge fund collapsed; uncertainty fueled 
the implosion of Mt. Gox, the currency's largest exchange; and the high-profile Silk Road 
takedown is a treacherous story combining Bitcoin, drugs, and alleged murders.

For now, though, one company sits above all others when it comes to cultivating a new 
level of direct customer mistrust in the Bitcoin community: Butterfly Labs.

For the past year, the Kansas-based Bitcoin miner maker has been embroiled in numerous 
accusations of fraud. Customer orders, totaling millions of dollars, were significantly delayed 
or never fulfilled. Through it all, the company insisted that mere manufacturing delays were 
to blame. However, suspicion never died down. In fact, it's getting worse after it came to 
light that Butterfly Labs' largest shareholder—a man who is a company co-founder, current 
"Innovation Officer," and member of the board of directors—pled guilty in 2010 to one count 
of mail fraud (PDF) for his involvement in an international, multi-million dollar lottery scam.

For months now, Butterfly Labs has faced anger regarding delayed orders.

Now, the company's critics have fresh ammunition because of this same executive. A federal 
judge in Kansas has ruled that the man in question, Sonny Vleisides, violated the terms of 
his probation in the lottery scam case. As a result, Vleisides’ probation—previously slated to 
end in September 2013—will now continue for another two years. This ruling is Butterfly Labs' 
least concern. In light of new details from the recently published transcript of that January 
2014 probation hearing, the legitimacy of the Butterfly Labs operation could soon be decided 
once and for all.

“I’m on a good track now”

According to the United States Postal Inspection Service, victims collectively lost more than 
$25 million during the lottery scam Vleisides participated in. The government accused his father, 
James Ray Houston (who has since passed away in prison), of being the mastermind behind the 
entire scheme. As the USPIS wrote in January 2011:

According to the indictment, the victims were purchasing “positions” in tickets for lotteries 
that would be grouped together or “pooled” to buy larger blocks of tickets, thereby increasing 
their chances of winning. Funds received from victims were not used to purchase tickets, but 
to pay “winnings” to other victims, to fund the scheme, and to benefit the defendants. 
Victims were sent checks falsely represented as lottery “winnings;" however, the amount of the 
alleged “winnings” was far less than the amount the victim had sent in.

Vleisides and three others were also implicated in the scam, and he took a plea deal. 
In a post on Bitcoin Forum in September 2012, Vleisides described the experience this way:

After two and a half years preparing, we neared trial. The prosecutor calls for a meeting and 
offers me a deal. I can go home if I accept a single count of mail fraud and skip the trial. 
They would drop 23 charges and leave me with a simple postal violation (lesser count of mail fraud). 
I thought about it and it didn't take long for me to agree to get the shackles off. 
I signed and went home to my mother's house in Kansas City. I sat there looking at the wall for a 
long time. I didn't feel like leaving the house much. It was difficult to get over the emotional loss. 
My life was ruined. Mom got me an account on match.com and encouraged me to date. I met a 
wonderful girl and we had a little boy. We named him Indy. My life continued and I started to look 
for a new project to begin again. A fresh start. I'm on a good track now, trying to put the past 
behind me.

When Vleisides moved to Missouri, his case was transferred to that federal district for judicial supervision 
of his probation, which included this “special condition”:

The defendant shall not engage, as whole or partial owner, employee or otherwise, 
in any business involving loan programs, gambling or gaming activities, telemarketing 
activities, investment programs, or any other business involving the solicitation of funds 
or cold-calls to customers without the express approval of the Probation Officer prior to 
engagement in such employment. Further, the defendant shall provide the Probation Officer 
with access to any and all business records, client lists, and other records pertaining to 
the operation of any business owned, in whole or in part, by the defendant, as directed 
by the Probation Officer.

Vleisides recovered from his mental slump and soon helped start Butterfly Labs. 
According to a 2012 court document, Vleisides’ lawyers say that BFL “began on napkins, 
scraps of paper, and spare parts on his kitchen table," adding that "the hours that Mr. 
Vleisides has put in to develop the product have been long and arduous. There have 
been times when he arrived before the sun came up and left after it went down." 
While Vleisides was "remorseful about what has occurred," he was looking toward a 
better future, they added. "The justice system could not ask for more from a person 
that has been punished."

Revenue and a growing rap sheet

But on September 3, 2013, Vleisides’ probation officer, Courtney Pierce, filed a 
violation report with the Missouri federal judge handling his case (just over two months 
after Ars published our first articles about Butterfly Labs and its mining machines). 
In her memo to the judge, Pierce wrote that Vleisides was now an employee of and 
the dominant shareholder in BFL, a company which "advertises all of its technology 
for purchase through pre-order... Vleisides did not seek the express approval of the 
probation officer prior to engaging in a business that involves the solicitation of funds 
through pre-orders."

She continued:

The Probation Office has been notified by the US Postal Inspection Service that hundreds 
of complaints have been filed against BFL from individuals who have placed pre-orders for 
hardware from BFL.

The seriousness of Vleisides' instant offense [the lottery scam], coupled with his 
current involvement in a somewhat similar business enterprise are cause for concern.
Before Vleisides' violation, BFL was already facing accusations of fraud and mismanagement.
In December 2013, a German-Polish man who lives in China filed a lawsuit over a $62,000 
order that was never fulfilled; he accused BFL of breach of contract, fraud, and negligent
representation. And Butterfly Labs lost a civil case by default in Kansas’ Johnson County 
Court in late November 2013. The plaintiff, a Californian named William Lolli, won a judgment 
of more than $13,000 but told Ars that he has not yet collected the award.

The company's troubles may only worsen from here. A new lawsuit filed in early 
April 2014 (read the 21-page complaint) accuses BFL of engaging in “deceptive 
and unconscionable business practices.” The suit, which seeks class-action status, 
was filed earlier this month in Kansas. It accuses BFL of collecting payment for 
“non-existent Bitcoin mining equipment, failing to ship Bitcoin mining equipment orders 
for which consumers have pre-paid, misrepresenting the date such equipment is to 
ship to customers, and profiting from Bitcoin mining for Defendant’s own benefit using 
customers’ equipment without permission or authorization from customers.”

BFL, its corporate attorney, Vleisides, and Vleisides' criminal attorney all failed to 
respond to Ars’ repeated requests for comment. But it's clear that despite all the legal 
wrangling, the company is doing well. According to testimony from BFL’s de facto chief 
financial officer, the company expected to earn $25-$30 million in revenue in 2013.

Buying a pool and an Audi

Vleisides appealed before US District Court Judge David Kays on December 17, 2013 to 
answer Pierce's probation claims. There, government prosecutors submitted a 
seven-page document from Vleisides’ lawyers detailing the structure of BFL and Vleisides' 
relationship to it.

One of the noteworthy revelations is that Butterfly Labs acquired a local Kansas-based 
Bitcoin mining pool, Eclipse Mining Consortium, for $100,000 in 2012. The pool's founder, 
Josh Zerlan, is now a vice president at BFL. (Zerlan publicly announced that he took a 
job with BFL in 2012, but he did not mention that he actually sold his company to BFL. 
Zerlan did not respond to a request for comment for this article.)

The revelations get murkier from there. For the first time, the public learned that Butterfly 
Labs runs its own Bitcoin mining pool for “testing” purposes—and the company uses this 
test pool to make money. “[BFL] earns mining income from their burn testing of machines 
as well as service fees charged to Eclipse customers,” documents state. This revelation 
represents some of the worst fears held by skeptics of BFL—that the company is using its 
own hardware to profit privately before sending miners to people who actually paid for them.

Also coming to light during testimony was the depth of BFL customer frustration. 
In court, probation officer Pierce talked about how she uncovered thousands of 
complaints filed against BFL at the Federal Trade Commission and PayPal. 
She said that Chad Williams, a PayPal global asset protection officer, 
told her that as of September 2013, PayPal froze BFL’s account containing 
$11 million and that PayPal received 6,000 complaints in total. Notably, 
200 more complaints were filed between mid-November and mid-December 2013, 
and, on the day of court testimony alone, three more complaints were filed.

“Butterfly Labs is permanently barred from accepting PayPal as payment for 
their products," Pierce added. (PayPal spokesperson Anuj Nayar declined to 
comment specifically on Butterfly Labs, but he did say that the company is 
"no longer processing payments through PayPal.")

“PayPal is not the only place we have received complaints from,” Pierce told the 
court. “There is [the Federal Trade Commission] Consumer Sentinel, a law 
enforcement website where people can get online and submit complaints 
about different companies. As of October 18 of this year, there had been 
173 complaints submitted online to Consumer Sentinel, with a total of over 
$600,000 complained to being losses from Butterfly Labs.”

Pierce testified that Vleisides’ 2012 tax returns show his ownership interest in 
a Bahamas corporation called Future Engineering that was incorporated 
November 2, 2012. According to BFL's tax returns, the company lost more 
than $800,000 in 2012, Pierce said—and yet the letter from Vleisides’ lawyers 
notes that the company loaned $150,000 to CEO/CTO Nasser Ghosieri, $26,000 
to VP Jeff Ownby, and $65,000 to Vleisides himself. Those loans all came in 
below market rates and all were “based on expected future profitability.”

CEO Ghosieri, an Iranian who lives in France, previously told Ars he never met 
Vleisides and has never been to visit the BFL operation in Kansas. (Although, 
this photo from Ghosieri's Facebook page dated April 2014 appears to show 
him with Vleisides in person at BFL's headquarters, although it could have been 
altered.)

Furthermore, Pierce noted that "Vleisides' finances have been in question for 
the past several months," particularly because his residence "was recently 
purchased by BFL for approximately $400,000 in cash." BFL even bought him 
an "expensive vehicle" (an Audi) that Vleisides uses.

"I'm pulling for you"

During the hearings, Vleisides' lawyers made the case that these were all 
normal business operations. The Bahamas corporation, they said, was 
created by a law firm which represented Butterfly Labs previously, but it 
was now a “dormant corporation.” And de facto Butterfly Labs CFO 
Bruce Bourne, who resides in San Francisco but commutes to Kansas City 
two weeks each month, took the stand to explain Vleisides’ house and car situation.

“The car itself, you know, my understanding is that this is not the first car 
that the company has owned and that the original car that the company 
owned when customers came from out of town to visit the facilities, the 
company loaned them the vehicle to use instead of them having to rent a car,” 
he testified. “Other executives who traveled from Chicago—
I come from San Francisco—had access to using that car. Other people 
who are employed by the company come to town from out of town are 
able to stay at the corporate residence.”

The bigger issue centers around BFL's core operations and all those delays 
after taking people's pre-order money. Bourne described the company's 
current operations and past financial performance, saying that BFL had a 
peak of 110 employees, but it's smaller now.

“At current time, because we’ve manufactured and shipped all the products 
in the backlog and we are not yet producing the next version of the product, 
we have downsized, laid off staff who were assembling parts and components 
that are not necessary right now,” he said. “So at this point the company is 
about 60 people. But our expectation is when we do begin to construct the 
next iteration of these products, [we] will increase staff to manage that production.”

"You need to get your toothbrush and get your things in order, because 
fraud will not be tolerated."

As for revenue, in 2012 BFL earned $2.5 million. “For 2013 we have not 
finalized the financial statements, but I expect that the revenue for 2013 
is going to be between $25 and $30 million,” he said, adding that BFL's 
liabilities are “north of $10 million.”

Bourne also provided more details about resolving the PayPal situation 
by shipping long-delayed products to customers.

“By [September 2013] there were 23,000 PayPal orders, of which about 
2,000 had been shipped. About $1.5 million out of $19 million total,” 
he said. “That’s mid-September. Every week after that I updated that 
report so that we could show them progress against reducing the backlog 
and lowering PayPal’s exposure, although there were $5 million more in 
orders than there was in money held. So it took a while to get down to 
where that backlog was—even with the amount they were holding. 
We reached that point in about mid-November.”

Ars contacted Bourne, who declined to be interviewed in person or by 
phone as he was "in a different time zone and working some long hours." 
At Bourne's suggestion, Ars submitted questions via e-mail, but has not 
yet received a reply.

Despite the testimony of Bourne and other witnesses, Judge Kays expressed 
clear reservations about BFL's business and Vleisides' involvement in a 
company taking so much cash up front. He ordered two supplementary 
years of supervision for Vleisides, along with a new set of conditions that 
include regular government access to his "person, his property, house, residence, 
office, vehicle, papers, computer, other electronic communication or data, 
storage devices or media, and effects." He said Vleisides must work with 
Pierce "to communicate, create transparencies. Any loan, especially $64,000 
or whatever it is, is something she needs to know about before it's made, no matter [what]." 

The judge's most damning comments, however, centered on his overall BFL observations:

Now, there is a stench coming from Butterfly Labs. It's a strong smell. 
It's not enough to send you to prison today, because, to be quite honest with 
you, if it was, we'd be talking about 24 months in prison. It's not—I think it's 
too close. I think [defense witness] Mr. Bourne did a very good job of testifying, 
and it assisted your defense greatly. But if I find out that there is this fraud 
word involved in this part, you know, Mr. Vleisides, as we say here at the courthouse, 
you need to get your toothbrush and get your things in order, because fraud will not 
be tolerated, you understand that? So I would work very hard to make these 
consumers happy consumers who you've dealt with.

The wheels of justice

On the heels of Vleisides' probation, BFL now moves immediately to the new lawsuit. 
Kyle Alexander, and Dylan Symington et al. v. BF Labs (PDF) describes two 
attempted purchases made by the named plaintiffs. Alexander claims that he paid 
$308 to BFL in June 2013 for a low-end mining machine. However, despite repeated 
inquiries to BFL, Alexander was simply told “shipping had begun”—yet his box didn't arrive.

In March 2014, Alexander again asked about his order and was simply informed that 
it was changed to a “Mining by the GH” (gigahash) product, an as-yet-unreleased 
product from BFL.

“Plaintiff Kyle Alexander never changed or modified his order and never gave 
Defendant permission to use the equipment he ordered to mine bitcoins for itself or 
for anyone else,” says his complaint. “To date, Plaintiff Kyle Alexander has not 
received any mining equipment from Defendant. Since Plaintiff Kyle Alexander 
pre-paid for his order of mining equipment from Defendant in June of 2013, numerous 
bitcoins have been mined by others, and the difficulty of mining new bitcoins 
has substantially increased over such time.”

The other named defendant, Dylan Symington, paid $1,333.00 to BFL in April 2013 
but did not receive his order for seven months.

Both men allege that BFL engaged in deception under the Kansas Consumer 
Protection Act, received unjust enrichment, and made negligent misrepresentation. 
BFL has yet to formally respond to the new charges.

Jody Drake, BFL's general manager and one of the three members of BFL's board of 
directors (Vleisides and Ghoseiri being the other two), told Ars that the company 
"shipped 45,000 units last year." Despite many lawsuits alleging the opposite, 
she said that "everyone received their orders after much delay."

When asked how BFL got involved with Vleisides to begin with, Drake simply said: 
"I know his family," before ending the call. In her September 19, 2013 affidavit as 
part of Vleisides' court filings, Drake said that she worked for his stepmother for their 
commercial photo-finishing business and has known the family for 25 years.

Despite the "strong smell" coming from the Vleisides' probation hearing, it's still 
not exactly clear whether BFL is an out-and-out scam. Butterfly Labs' refusal 
to answer basic questions—such as how a man convicted of mail fraud came 
to do business with another man in France that he's never met—does not 
engender confidence. But as more complaints pile up, some are now turning into 
lawsuits. And in light of a federal judge specifically calling out a co-founder's 
questionable actions, the evidence is mounting. The questions of fraud surrounding
BFL may get answered sooner rather than later.