USA Only: Legality of Bitcoin Securities

[Korbman]

Ladies and Gentlemen, I present to you a paper I wrote on the Legality of Bitcoin Securities in the United States, based on United States Federal and Vermont State laws (where I live). I also consulted with two attorneys, one for Business Law, the other for Securities Law. I included the information they presented me in my paper, as well as research I did on my own.

The result? A long paper, which makes me wonder how many of you have the attention span or interest in reading it
I kid, of course.

The Google Docs version, which is formatted a bit better, is located >>>>>here<<<<<.

This post will now be split into four sections, with this post being the first.



Legality of Bitcoin Securities
Written by: Andrew “Korbman” Korb
Last Updated: October 12, 2012


INDEX

1)  Preface
2)  Notes
3)  Section 1
  a) Bitcoins: Where They Stand with the Law
  b) The Securities and Exchange Commission and Bitcoin
  c) Exemptions
4)  Section 2
  a) Companies
b) Bitcoin Based Funds
  c) Types of Securities and Funds
5)  Section 3
  a) That “What If” Scenario
6)  Conclusion
7)  References

[Korbman]

Preface:
Though I have limited experience in Business Law, I am by no means an expert in the subject, including areas such as Securities Law, Finance Law, and Corporate Law, nor am I a lawyer.

That said, I contacted both a Business Attorney at LegalZoom.com (which I use for all legal needs regarding my business) and a local law firm that specializes in the various financial laws and regulations.

The intent of this document is to disclose information I received from them regarding the legality of Bitcoin for use in trading, funds and securities, and “real world” transactions. I did NOT discuss the implications of operating a Security Exchange, though we touched on it briefly.

This document contains not only both their statements, but also my own research to help clarify and provide a pretext to the information that was presented to me.



Notes:
The information contained here may NOT be 100% accurate as it was just a briefing by both lawyers. If anyone wants to help me cover the $250 an hour to pay for these guys to do some solid research, I’d be more than happy to get more information out of them. The result here is from me “picking their brain” on the subject based on the offhand securities knowledge they had, as well as in depth research I worked on during personal time.

This information is solely based on United States Federal and Vermont State laws (where I live). The information provided may not be applicable to your country.



 
SECTION 1:
Bitcoins: Where They Stand with the Law

   There has been a fair amount of speculation as to where Bitcoin falls under when talking about currency and regulation. Some speculate it can qualify as a fully regulated currency under the government, others note that it can never be regulated. The truth of the matter is that it falls under both categories depending on the coin’s use (implied or otherwise).

   So what is Bitcoin? To us in the community, Bitcoin is a ‘cryptocurrency’. To my securities lawyer, it most aptly describes what is known as a “Community Currency” (which cryptocurrency falls under). This form of currency is used within a certain group of people with a common bond, which serves a different purpose than conventional currency.

   The good news is that Community Currencies are not federally regulated, though local State laws may prohibit them. An example of this would be under the Illinois Department of Financial & Professional Regulation Administrative Code (Title 38, Chapter 1, Part 120) which explicitly prohibits the use of this form of currency. Thankfully there are no other States that currently have these laws in place.

   Another aspect of Bitcoin, and the most important, is that it has no intrinsic value. Meaning that Bitcoins only have value because we say it has value, unlike typical government backed currencies. This means that as long as the Bitcoin economy is contained, Bitcoins can be traded without issue just as Monopoly money can be traded.

   As a result of the above statements, Bitcoin does not meet the definition requirements of “Money” according the SEC, which I was told is defined as “an officially issued currency adopted by a domestic or foreign government”. Backed by the United States’ Constitution, this gives the government full power over the regulation of money, including under the common law version, which notes that money is a “generally accepted object or item used for payment”. The good news is, this definition and regulation only covers public currency, which Bitcoin is not (it’s private, created by private individuals and/or enterprises). Based on this information, it would appear that Bitcoin is in the clear. This, however, is solely the legality of Bitcoin. As talked for a bit longer, things got a little fuzzy when you bring in security and currency exchanges, specifically those operating for profit.






The Securities and Exchange Commission and Bitcoin

   The primary purposes of the Securities and Exchange Commission (SEC) are to a) protect investors and b) provide market stability through law and regulation enforcement. As a result, there are a vast number of regulations that a typical investment firm would need to abide by in order to issue, create, purchase, sell, or otherwise work with securities.

   By the Securities Act of 1933, the SEC defines ‘Security’ as
   “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
And although this sounds quite vague for purposes of covering every security aspect, the definition is actually referring to any financial instrument that is publicly traded, such as stocks, bonds (or other debt), and options, specifically targeting corporations and institutional investors.
   
   As a result, Bitcoin trading is possible as long as it isn’t publicly traded on an open market. Privately trading Bitcoins, as a security or for goods and services, is legally allowed. This is the same definition that can be applied to Investment Clubs, online games with virtual economies, etc.



Exemptions

   To that end, the Securities Act of 1933 (specifically Section 3[a]) also goes on to specify what does not qualify as a Security to be regulated. The crux of the Act focuses on the defining of the term “Investment Contracts”, of which the majority of exemptions are based upon. If a currency or other object for exchange can qualify under the definition, then it is not exempt and under the jurisdiction of the SEC.

   The definition for the previously undefined “Investment Contracts” clause was proposed during the Securities and Exchange Commission v. W. J. Howey Co. Supreme Court case of 1946. As a result of the case, Investment Contracts became defined as:

1.   investment of money due to
2.   an expectation of profits arising from
3.   a common enterprise
4.   which depends solely on the efforts of a promoter or third party

Based on this set of rules, we need to narrow down whether or not Securities based on Bitcoin apply.

Investment of Money
   Proponents of Bitcoin can argue that the coin doesn’t fall under the definition of Money, not only based on what I’ve noted previously, but also because a user is not required to invest their conventional [fait] currencies and instead invest computational time.
   Opponents, on the other hand, can make the argument that most Bitcoin enthusiasts do make a purchase on exchanges to acquire Bitcoins rather than mining them, which would mean their initial ‘real-world’ currency investment would transfer into the coin.
   Another test is proving whether or not Bitcoins are considered more of a commodity than a security. Owning a Bitcoin gives a user the right to use the coin in any way they see fit, including sales or contracts involving the coins. Not only that, but commodities are considered tangible and have inherent value. Bitcoins are indicative of a commodity because of this, and their inherent value is as a result of an economic limit in place to prevent any more than 21 million coins. Securities, on the other hand, confer a claim on another entity, meaning their value is generated based on a third party.

Expectation of Profits
   Supporters of Bitcoin can argue that there is no expectation of profits assuming that their coins are held or exchanged for goods and services, compared to individuals that solely speculate on the Bitcoin exchange rate and trade regularly. Therefore, investing in a Bitcoin fund can be done as long as there is a written statement expressing the investor’s understanding that there isn’t an expectation of a gain, but instead to receive what they put in. That does not mean the gain won’t happen (you can still profit from the investment), but instead you must expect that it won’t.

Common Enterprise
   Defined as “the tying of each individual investor’s fortunes to the fortunes of other investors”, Bitcoin supports can argue that individuals who choose to promote Bitcoin are more than likely independent of each other, essentially meaning there is no one business or person seeking to raise Bitcoins. As a result, the argument for a common enterprise is invalid.

Depends Solely on the Efforts of a Promoter or Third Party
   Bitcoin investors have no active part in the management of the coin, but they are dependent on the ongoing efforts of miners and developers. The case could also be made that due to the limited supply of Bitcoins overall, developers won’t necessarily be needed, just the large number of miners.

   Based on the definitions above, Bitcoins themselves are arguably exempt from being classified as an “Investment Contract”. As a direct result, a Fund solely dedicated to raising Bitcoins for capital could not be considered an Investment Contract because the capital being raised isn’t recognized by the United States Government or the Securities and Exchange Commission.

[Korbman]

SECTION 2:
Companies

   If you’ve read this far, you might be thinking to yourself that you’re in the clear; that it’s looking like the SEC won’t deal with Bitcoins and you’re free to do what you want. Unfortunately, this is far from the case. Though the argument can be made both in support of the creation of Bitcoin funds and also against it, the reality is that it comes down to an extremely fine line between the Bitcoin world and the government run one. What it comes down to is the person or organization behind these funds that makes all the difference. The first thing to ask yourself can be summed up by “Is my company real or fake”?

   According to the information presented to me by my business attorney, fake companies can be both legal and illegal, depending on the context. To fit within the confines of ‘legal’, the fake company must be for the purposes of a game or other virtual experiences, Bitcoins included but online if your Bitcoin company stays within the “realm of Bitcoin” (meaning you or  your company do not make a profit as a result of exchanging your coins for conventional currency). For us Bitcoiners, that means you can have and run “Acme Corp”, “Bob’s Bitcoins, Inc.”, etc just fine as long as it remains within the community. This is the same sort of principle that applies to EVE Online companies, WOW Guilds, and so on.

   But as soon as you try to market this ‘non-existent’ company outside of your community, either in real life or elsewhere on the internet, you may be found to have violated the Corporation laws for your State. If this happens, your local government will give you 30 days to register your company or disperse, after which you can be fined or sued.

   For those of us with registered companies, we are naturally already in the realm of ‘legal’. To us, the fine line is breached when virtual commodities or currency are transmitted into real world value and used to help further our organization. Bitcoins are fine on their own or within its community; it can be traded, bought/sold, hoarded, etc all without needing regulation or other outside interference. Bitcoins can also easily be used for exchange for goods and services provided by real world companies. But where does it stand when attempting to create a Bitcoin fund?


Bitcoin Based Funds
   This topic is heavily argued amongst us within the Bitcoin community. Unfortunately, I cannot say that I can provide solace with a definite answer, even after sorting through the information presented to me by counsel and by research. I can, however, help to provide some insight.

   To create a security for exchange in the United States, an organization must be registered with the SEC as an Investment Company under the Securities Acts of 1933, Securities Exchange Act of 1934, and also under the Investment Company Act of 1940. As the SEC defines it, an “investment company” is
   “a company (corporation, business trust, partnership, or limited liability company) that issues securities and is primarily engaged in the business of investing in securities.
An investment company invests the money it receives from investors on a collective basis, and each investor shares in the profits and losses in proportion to the investor’s interest in the investment company. The performance of the investment company will be based on (but it won’t be identical to) the performance of the securities and other assets that the investment company owns.”
By this definition it would seem that an organization looking to create a fund based on Bitcoins would qualify and be required to register their intent with the SEC.

   In order to meet the definition’s requirements, however, would mean admitting that Bitcoin qualifies as a security in the first place. As a result of this inconsistent definition, the argument automatically falls apart, leaving Bitcoin based companies in the clear. If your company isn’t creating or investing in securities, then it does not meet the criteria to become an “investment company”.


Types of Securities and Funds
   I’ve seen quite a bit of misinformation stemming from the community due to lack of investing knowledge based on the subject of ‘Securities’, specifically the terms “stock” and “bond”. Though not inherently bad because the terms do convey a particular meaning the public understands I still feel the need to try to straighten it out a bit.

Stock
This is probably the most common term, and also the most “properly” used. Company “Stock” is a security that represents the original money paid into or invested in the organization by the owners. Company “Shares” are fractions of this Stock and represent ownership in the business. When investing in a company or fund based on Stock, you are purchasing ownership by acquiring Shares.

Bonds
   Though publically recognized as a form of indebtedness, most individuals don’t understand that a Bond is typically issued with a maturity date exceeding 10 years (usually 12 or more). Based on the typical Bitcoin “bond” based fund, the proper terms would most likely be either Bills (short term, usually under 5 years) or Notes (usually 5 – 12 years, though it can also have a maturity date under 5 years).

   Though we all understand the difference between issuing Shares and Bonds, not all of us have an idea of the laws and regulations behind them. In order to issue company stock or bonds, for example, you must be a registered investment company under the SEC. Notes and Bills, on the other hand, do not need to be registered with the SEC assuming they meet specific requirements under a certain Dollar amount.

[Korbman]

Section 3:
That “What If” Scenario
   As I’ve already noted, nothing in this document is 100% guaranteed. There are arguments both for and against Bitcoin, both as a security and in use within securities. The good news is, uncertainty within the law regarding a topic can lead to successful court cases for the defendant, especially when dealing with criminal cases.
   
   So let’s say you have a real world registered company that deals only in Bitcoins. You have a fund that pools together these coins to purchase mining equipment, equivalent to that of a Note. As you mine away, you pay back Note holders with Coupons and eventually buy all the Notes back to cover your debt. The rest of the mined coins you have you convert into world currency that provides your company with revenue. What happens if there’s a crackdown? There are a vast number of arguments that can be made in this situation. What I will describe, however, is my reasoning and what laws I would point out.

   If your company deals all in Bitcoins it cannot be regulated by the United States government. This is because Bitcoins are not considered a form of government accepted currency, nor are they a security.

   If the SEC decides that you must register your company, assuming you are not a dedicated investment firm, you can claim the Regulation A exemption under Section 3(b) of the Securities Act of 1933. This Regulation allows for the creation and offering of securities to the public assuming the company has less than $10 million in assets, less than 500 shareholders, is looking to raise less than $1.5 million, and provides full transparency to investors.

   Alternatively, registered companies may also apply for a Regulation D, Rule 504 exemption, which allows for the creation and sale of securities totaling under $5 million (which doesn’t require accredited investors, per Section 4[6]). The downsides to this are that a) you must register your offering (essentially telling the SEC that you’re going to offer a security) and b) you cannot publicly advertise your offering.

   Try not to issue company bonds, which not only require quite a bit of regulation, but bonds, specifically, must be registered and underwritten by an investment bank (under the SEC’s definition). Instead, if applicable, it would be easier to create your fund by issuing Promissory Notes. These types of Notes do not need to be registered under the SEC or underwritten by a bank, and they adhere to the same maturity date as a typical Note unless otherwise specified. They also follow the same Coupon structure and “Buybacks” that a bond would typically adhere to. For a mining fund, a Secured Promissory Note would be apt, because it states that the raised funds were used to purchase physical goods. In the event of insolvency, these goods would be liquidated to pay back investors that backed the original Note.

   Regarding company revenue generated by the conversion of Bitcoins to United States Dollars, I’m not entirely sure how to the SEC would react. Unfortunately, this is also a subject that I was not able to discuss with my counsel either given time constraints. I do know, however, that the Internal Revenue Service would be more than interested to take a look at your accounting. If mining results in income for you business, then it will be charged as much. Depending on the structure and registration of your company, it would either be taxed at the corporate level or personal level. If you reinvested those Bitcoins instead of converting them, then the argument could be made to tax the revenue as capital gains (assuming the value of a Bitcoin increases).

 
Conclusion

These arguments and situations are just the tip of the iceberg when it comes to defending yourself in court. It would take an experienced lawyer quite a bit of time to formulate the proper responses and defenses to cover a number of circumstances.

Everything I’ve covered thus far is a result of talking with professional counsel and a few days of research. I created this document to help inform the public and to help get people thinking. There will undoubtedly be a number of you that will find arguments against what I have noted, but many more that may build upon it as well; and I welcome that. The more people we can get brainstorming and piecing together this puzzle, the better off we will be.



References

Grinberg, Reuben. "Bitcoin: An Innovative Alternative Digital Currency (December 9, 2011)." Hastings Science & Technology Law Journal, Vol. 4, p.160. Web. 10 Oct. 2012. <http://ssrn.com/abstract=1817857>.

Grinberg, Reuben. Bitcoin: Today Techies, Tomorrow the World? N.p.: The Milken Institute Review, 09 Jan. 2012. PDF.

"Investment Companies." Investment Companies. Securities and Exchange Commission, 29 Mar. 2010. Web. 11 Oct. 2012. <http://www.sec.gov/answers/mfinvco.htm>.

Landreth Timber Co. v. Landreth - 471 U.S. 681 (1985)

"Q&A: Small Business and the SEC." Q&A: Small Business and the SEC. Securities and Exchange Commission, 14 Nov. 2009. Web. 10 Oct. 2012. <http://www.sec.gov/info/smallbus/qasbsec.htm>.

Securities Act of 1933, P.L. 112-106, §2-4, 48 Stat. 2-24 (1933).

[gweedo]

This is exactly what I been saying the whole time.

[Korbman]

This is exactly what I been saying the whole time.

That may be true, but no one has made any actual attempts to compile anything of substance for everyone to sift through.

[blakdawg]

Thanks for posting this. I don't necessarily agree with every part of it, but it seems like an honest effort to explore the issues, which is better than I've seen before.

[bobitza]

Kudos Korb for putting this together. Especially if this also comes from a trusted legal perspective.

[Korbman]

Thanks guys, took me a couple days to compile and write everything up, so feedback is appreciated!

Thanks for posting this. I don't necessarily agree with every part of it, but it seems like an honest effort to explore the issues, which is better than I've seen before.

Agreed. But which part(s) don't you agree with? I'm more than happy to start up a discussion on this stuff. Maybe somebody would point out a flaw I didn't see before!

Kudos Korb for putting this together. Especially if this also comes from a trusted legal perspective.

The information I got from my counsel was only as a result after telling them about Bitcoin first (they heard about it, but they didn't know the details). If I could pony up quite a bit of cash, naturally they'd be more than happy to research into it for me haha. They gave me a good insight into the basic workings of the SEC, but to say the Bitcoin vs SEC case is closed is far from the end result of this.

[bobitza]

Could we start a donation fund on this topic?

I'm sure the info will benefit the whole community, especially the ones looking to start a "real" business based on BTC.

[BitcoinINV]

This is a great article, good work. The problem with the U.S gov is they do whatever the fuck they want to make the people in the Gov rich. Thank you lobbying! If Bitcoin hits the big time you best believe the underwriting banks are going to want there share, and guess what they got deep pockets for lobbying on the hill.

[Korbman]

This is a great article, good work. The problem with the U.S gov is they do whatever the fuck they want to make the people in the Gov rich. Thank you lobbying! If Bitcoin hits the big time you best believe the underwriting banks are going to want there share, and guess what they got deep pockets for lobbying on the hill.

Thanks! And probably pretty right...but Bitcoin would have to be MASSIVE to get the attention of a bank (or set of banks). At a $100 million market cap, Bitcoin could be bought out by pretty much any executive at any major bank