How much do lawyers need to know about bitcoin?
Tuesday, April 10, 2018
By Jerrod Bevan
Bitcoin and other “virtual currencies” are building legitimacy as a payment system and are capturing the public’s attention with rapidly increasing frequency. As of late February, the market capitalization of bitcoin is over $170 billion. Much of the attention focused on bitcoin surrounds its volatile price swings. As of the writing of this article, the value of a bitcoin has sunk to approximately $10,000 per coin, representing a fall of almost half its value from the all-time highs set in December 2017. However, even the depressed value today represents an increase of over 1,000 percent since Jan. 1, 2017. By the time this is published, a bitcoin may be worth $20,000 or $2,000, and neither would be completely surprising. The mania surrounding bitcoin and its rapid rise in valuation has drawn comparisons to the .com bubble of the early 2000s, and even the original asset bubble, the Dutch tulip bulb bubble of 1637. While most people by now have heard of bitcoin, and can conceptualize it as some sort of digital currency, very few understand the technical underpinnings and legal issues implicated. This article is intended to be a brief introduction to bitcoin for Montana lawyers, and will hopefully spark reflection on how it may affect our practices in the future.
Virtual currencies arose from a desire to have a digital payment system that didn’t require a trusted third-party to process transactions, such as a bank, credit card, or PayPal. Bitcoin is the first successful decentralized virtual currency. Decentralized meaning there is no central bank or government responsible for issuance and determining monetary policy. While the concept had been implemented previously, bitcoin is the first to withstand the fraud, hacking, and mainstream acceptance issues that plagued earlier attempts. In particular, bitcoin was able to solve what is known in computer science as the “double-spending problem,” or the ability to confirm that a unit of virtual currency is only spent once without confirmation from a third-party intermediary. At its core, a unit of bitcoin is simply a string of 1’s and 0’s. What then, is to stop someone from spending it multiple times the same way one might send a document or photo to multiple recipients? To address this issue, bitcoin creator Satoshi Nakamoto contemplated “a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions.” To put it simply, he suggested a public ledger of transactions maintained through a global network of computers. This public ledger is called the blockchain. The blockchain, which is a record of every bitcoin transaction, serves to confirm that the same bitcoins have not been spent twice instead of using a third-party intermediary. Beyond bitcoin, blockchain is a technology with great potential, with applications ranging from medical record-keeping to land title verification.
Of particular interest to Montanans is the news that a bitcoin mining operation with an expected initial investment of $75 million to $100 million is being developed in Butte and Anaconda. How does one “mine” bitcoins, as is contemplated in the Butte/Anaconda project? Any computer connected to the internet can download the bitcoin software and run what is called a node. Every node keeps a complete copy of the blockchain and is used to broadcast bitcoin transactions around the entire peer-to-peer network of computers. Some of the nodes are mining nodes, which group the outstanding transactions into “blocks” and add them to the blockchain approximately every 10 minutes. In return for this work, the mining node that adds the new block to the blockchain is rewarded with new bitcoins. This is admittedly an oversimplification of the mining process, but is a sufficient introduction to the concept.
Where does bitcoin fit into our legal system?
As bitcoin gains users and mainstream acceptance, it is increasingly capturing regulators’ attention. To know how and where bitcoin should be regulated, we have to start with the base question, what is bitcoin? We call it a virtual currency, but is it actually currency? Black’s Law Dictionary defines currency as “[a]n item (such as a coin, government note, or banknote) that circulates as a medium of exchange.” Virtual currencies are accepted as a medium of exchange, albeit with a significantly more limited audience than U.S. dollars. Microsoft, Overstock.com, and Expedia are some of the larger retailers that accept bitcoin as payment for goods and services.
The IRS has taken the position that bitcoin, and other “virtual currencies” are not currency. The IRS treats bitcoin as property, and the general tax principles applicable to property transactions apply to bitcoin. This means a taxpayer who receives compensation in the form of bitcoin must include the fair market value of the bitcoin on the day of receipt as gross income. Further, if the taxpayer uses the bitcoin for payment of goods or services and it has changed value since receipt, the taxpayer has realized a taxable gain or loss in the amount equal to the fair market value of the bitcoin as of payment less the taxpayer’s basis in the bitcoin spent. The IRS has shown interest in increasing enforcement activity related to virtual currency transactions, as they contend only 800 taxpayers reported gains related to bitcoin from 2013-2015 when at least 14,355 users either bought, sold, sent or received at least $20,000 worth of bitcoin on a single exchange during that time period. Because of this discrepancy, the IRS was able to secure a John Doe summons to serve upon Coinbase, the most popular virtual currency exchange, seeking to identify its customers.
The Commodity Futures Trading Commission (CFTC), the agency of the government tasked with regulating futures and options markets, publicly declared bitcoin and other “virtual currencies” to be a “commodity” subject to oversight under the Commodity Exchange Act (CEA) in 2014. Specifically in the context where “contracts for future delivery are presently or in the future dealt in.” Therefore, the CFTC gains jurisdiction where bitcoin is used in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce. Beyond those instances, the CFTC generally does not oversee “spot” transactions involving virtual currencies. Spot exchanges of U.S. and foreign virtual currencies are regulated largely through state money transfer laws. As of Dec. 1, 2017, after working closely with the CFTC on enhancements to contract design and margin requirements, the Chicago Mercantile Exchange (CME) and CBOE Futures Exchange (CFE) self-certified new contracts for bitcoin futures products, meaning investment products with bitcoin as the underlying asset are now available to the retail investor.
Perhaps the most interesting development, at least from a securities lawyer’s perspective, is the relationship between bitcoin and the Securities and Exchange Commission. The SEC has taken a far more hands-on approach than the CFTC and is active in communicating the risks surrounding bitcoin to the public. As early as November 2013, then-SEC Chairwoman Mary Jo White advised the Senate Homeland Security Committee on “[w]hether a virtual currency is a security under the federal securities laws[.]” The virtual currency activity most often catching the SEC’s eye is the initial coin offering (ICO). The ICO has gained popularity in recent years as a way for companies to raise capital. The ICO has some similar characteristics to the more commonly known initial public offering (IPO), where a company using blockchain technology will issue a customized virtual currency coin, usually referred to as a “token,” in exchange for bitcoin or another established virtual currency as a way to raise capital for the enterprise. Such ICOs have usually not been offered in a manner compliant with securities laws. The reasons range from pure ignorance to a belief the offered tokens are not securities. However, in July of 2017, the SEC published a report on the ICO of the Decentralized Autonomous Organization (DAO), where DAO offered its own tokens in exchange for Ether, another popular virtual currency. The SEC analyzed whether tokens issued by the DAO constituted “investment contracts” under the U.S. Supreme Court’s long-established standard in SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946). Ultimately, the SEC concluded the tokens were indeed securities, due to meeting the Howey test where an investment is a security “if there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived primarily from the entrepreneurial or managerial efforts of others.” In a recent conversation with Montana State Auditor Matt Rosendale and Deputy Securities Commissioner Lynne Egan, both echoed the Howey test as the standard the state would use to determine whether a virtual currency would fall under the scrutiny of Montana securities laws.
Current SEC Chairman Jay Clayton recently went so far as to warn market professionals, including lawyers, who advise clients on ICOs that he has instructed SEC staff “to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.” For lawyers with clients considering raising money via an ICO, it is critical to provide guidance on compliance with the applicable state and federal securities laws.
Although bitcoin and other virtual currencies may not seem like a topic that needs to be on every lawyer’s radar, their adoption has been rapid and the ramifications far-reaching. Estate planning lawyers should inquire whether their clients own any virtual currency and make a plan for how beneficiaries can access them. Bitcoins are usually kept in an electronic wallet accessible with a passphrase. Unlike most passphrases, there are no options for recovery if forgotten or lost. By one estimate, about 3.79 million bitcoins have been “lost,” and are out of circulation forever. Surely many of the lost bitcoins are due to forgotten passphrases and owners who have died without making arrangements for access to their digital assets. Family lawyers should be aware of virtual currencies as a potential source of contention in property division, especially when price volatility can make valuation difficult. Accountants and tax lawyers should advise their clients on the tax consequences of virtual currency transactions. It is widely believed that there are no tax consequences for spending virtual currency, which is not the current view of the IRS. Commercial and in-house attorneys need to counsel clients raising capital through ICOs to the applicable securities laws. While the SEC concluded that the DAO tokens referenced above constituted an unregistered offering of securities, it declined to bring an enforcement action, instead issuing its investigative report as an advisory opinion. However, the SEC’s recently formed Cyber Unit has signaled its intention to enforce securities ules on future noncompliant ICOs. The legal landscape surrounding virtual currency is developing, and the issues presented will almost certainly increase. As lawyers we should all keep an eye on this new and fascinating technology and analyze how it can and does affect our practice.
Jerrod D. Bevan is an associate in the Helena office of Crowley Fleck PLLP. He is a graduate of the Northwestern University Pritzker School of Law. His practice focuses on corporate and securities law. You can reach him at email@example.com.