On August 6, 2013, a federal magistrate judge in the Eastern District of Texas ruled that Bitcoin, the virtual online currency, is a security under the federal securities laws, thereby green lighting a suit by the SEC’s Enforcement Division against a defendant accused of running a Ponzi scheme using the digital currency. To the extent that other courts follow this decision, the road for SEC regulation and enforcement of Bitcoin markets is open.
Bitcoin is an electronic currency that is not backed by any real asset and is without specie, such as coin or precious metal. It is not regulated by a central bank or any other form of governmental authority; instead, the supply of Bitcoins is based on an algorithm, which structures a decentralized peer-to-peer transaction system. Bitcoin can be used to purchase items online, and some retail establishments have begun accepting Bitcoin in exchange for gift cards or other purchases.
In the Texas case, the SEC alleges that defendant Trendon Shavers, the founder and operator of Bitcoin Savings and Trust, solicited investors to provide him with over 700,000 Bitcoin, worth as much as $4.6 million, in return for up to 7 percent weekly interest. Shavers allegedly claimed that he could pay the interest based on certain Bitcoin arbitrage activities that he would conduct online. The SEC claims that there was no such arbitrage activity; instead, Shavers paid interest to old investors with new investor Bitcoin and also converted some Bitcoin to U.S. currency for his own expenses.
Shavers argued that the SEC had no jurisdiction to bring the case against him because the subject matter – Bitcoin – is not money and is not part of anything regulated by the United States. The Court disagreed, citing the definition of a “security” which includes “investment contracts.” Investment contracts involve the investment of money, in a common enterprise, with the expectation that profits will be derived from the efforts of a promoter or third party. The Court had no problem concluding that Bitcoins involve money since they can be used to purchase goods and services and are exchangeable for currencies such as U.S. dollars. The Court also found a common enterprise to profit where the investors relied in Shavers as a promoter and purportedly knowledgeable Bitcoin trader to make money for them.
On a somewhat related note, Cameron and Tyler Winklevoss, the twins who became famous for alleging that Mark Zuckerberg stole their idea for Facebook, have applied for SEC approval to launch a Bitcoin-tracking exchange-traded product known as the Winklevoss Bitcoin Trust (“WBT”). As of April, 2013, the twins personally held approximately 1% of all outstanding Bitcoin valued at about $10 million. They claim that through the proposed WBT shares they would be giving ordinary retail investors access to this meta-market and further legitimizing it in the mainstream world. Whether the SEC will approve this venture is unclear. It is also unclear what Bitcoin true believers, many of whom use this meta-currency precisely to avoid “mainstream” currencies, think of the proposed WBT.