By Jonathan D. Joseph
When the US Treasury’s Financial Crimes Enforcement Network, a/k/a FinCEN, published an interpretative ruling on March 18, 2013 discussing how its regulations applied to users, exchangers and administrators of virtual currencies, Mt. Gox, the world’s largest exchange for Bitcoin transactions, should have taken note. Mt. Gox and other early pioneers in the virtual currency space have anarchist roots and generally eschew governmental regulation; however, it is now clear that the survivors in the Bitcoin and cryptocurrency ecosystem will be those that successfully navigate the complex web of federal and state money transmission laws and regulations.
Earlier this week, Homeland Security Investigations (“HSI”) obtained a warrant, issued by the U.S. District Court of Maryland, authorizing U.S. government seizure of assets of Mt. Gox held at Iowa based payment processing start-up Dwolla and Wells Fargo Bank. HSI acted after it discovered that Mt. Gox, based in Tokyo, Japan, was operating as an unlicensed money transmission service through its American affiliate, Mutum Sigillum LLC, and it may have lied to Wells Fargo when it opened its initial US bank account.
FinCEN is the bureau of the Treasury Department that seeks to prevent money laundering and terrorism financing through its regulation of Money Service Businesses (“MSBs”). Its March 2013 guidance states that those dealing in or administering virtual currencies such as exchanges like Mt. Gox, but not users or “miners”, need to register as MSBs and comply with anti-money laundering regulations. While Bitcoin is the best-known cryptocurrency or digital currency, others have sprung up recently, including Opencoin, Litecoin, Terracoin, Feathercoin and Novacoin, among others. While concepts underlying virtual or cryptocurrencies can be mind- numbingly complex, the FinCEN guidance is reasonably clear as to who is regulated:
“A person that creates units of this convertible virtual currency and uses it to purchase real or virtual goods and services is a user of the convertible virtual currency and not subject to regulation as a money transmitter. By contrast, a person that creates units of convertible virtual currency and sells those units to another person for real currency or its equivalent is engaged in transmission to another location and is a money transmitter. In addition, a person is an exchanger and a money transmitter if the person accepts such de-centralized convertible virtual currency from one person and transmits it to another person as part of the acceptance and transfer of currency, funds, or other value that substitutes for currency.” FIN-2013-G001, March 18, 2013.
FinCEN categorizes participants in the virtual currency market into three generic categories: “user,” “exchanger,” and “administrator.” A user is a person that obtains virtual currency to purchase goods and services. An exchanger is a person engaged as a business in the exchange of virtual currency for real currency, funds or other virtual currency. An administrator is a person engaged as a business in issuing (circulating) a virtual currency and who has the authority to redeem or withdraw from circulation that virtual currency.
A person may engage in “obtaining” a virtual currency in a number of different manners such as “earning,” “mining,” “harvesting,” “manufacturing,” “creating,” and “purchasing,” depending on the details of the specific virtual currency model involved. FinCEN concluded that how a person obtains a virtual currency is immaterial to the legal characterization under the Bank Secrecy Act of the process or of the person engaging in the process. This means that a user who obtains convertible virtual currency and uses it to purchase real or virtual goods or services is not a Money Service Business under FinCEN’s regulations. Users must still be cautious, as an activity which is exempt from FinCEN’s rules, may still violate other federal or state statutes, rules and regulations. Additionally, almost all states have money transmission laws that may apply even if FinCEN rules do not.
An administrator or exchanger that (1) accepts and transmits a convertible currency or (2) buys or sells convertible virtual currency for any reason is a money transmitter under FinCEN’s regulations, unless a limitation or exemption from the definition applies to the person. As one illustration, a federally-insured commercial bank is exempt from the definition. However, in most cases, whether a person is a money transmitter is a matter of facts and circumstances. Under FinCEN’s interpretations and the law of many states there is no differentiation between real currencies and convertible virtual currencies. Accepting and transmitting anything of value that substitutes for currency makes a person a money transmitter under BSA regulations. 31 CFR section 1010.100(ff)(5)(i)(A).
An exchange’s activities most often involve acting as a seller of Bitcoins or other virtual currency where it accepts real currency or its equivalent from a user/purchaser and transmits the value of the real currency to fund the purchaser’s virtual currency account held by an administrator. In the Dwolla/Mt. Gox case described above, users were transferring U.S. Dollars to Mt. Gox’s American affiliate via Dwolla. Prior to the HSI seizure, the American affiliate had been transferring U.S Dollars received from Dwolla to Mt. Gox in Japan and Mt. Gox allegedly used the Wells Fargo account to route funds from Japan to and from accounts at Dwolla at the direction of users. Dwolla, headquartered in Des Moines, offered an easier way for people to buy or sell Bitcoins through Mt. Gox, rather than attempting international wires to and from the company’s Japanese bank.
Under FinCEN regulations, sending “value that substitutes for currency” to another person or to another location constitutes money transmission, unless a limitation to or exemption from the definition applies. Consequently, based on the HSI warrant, Mt. Gox was transmitting funds to another location, namely from the user’s real currency account at a bank to the user’s virtual currency account with the administrator. The government alleges this is illegal since the only services being provided are unlicensed money transmission services.
Once a person or entity is engaging in the business of money transmission (both real or virtual currencies), doing so without registering with FinCEN as a Money Service Business and obtaining licenses under State money transmitter laws is mandatory unless certain enumerated exemptions apply. Most States including California, New York, Florida, Texas and Illinois and the District of Columbia require money transmitting businesses to obtain a license and comply with the other regulatory requirements (unless certain exemptions apply). Failure to be registered and licensed can constitute a felony.
The fervor of the cyrptocurrency movement is starting to resemble the California Gold Rush after gold was discovered in 1849. Millions of dollars are being invested in starts-up companies mainly in the Silicon Valley as Bitcoin entrepreneurs and venture capitalists race after what some believe could ultimately be worth billions. In fact, Opencoin recently announced it had completed an angel round which included Silicon Valley heavy hitters Andreessen Horowitz, Lightspeed Venture Partners and Barry Silbert’s Bitcoin Opportunity Fund.
Importantly, it doesn’t appear that Homeland Security or FinCEN is cracking down on Bitcoin itself, just on how it’s being exchanged by Mt. Gox. This is good news for Mt. Gox’s US-based competitors, such as Seattle-based CoinLab and San Francisco-based Coinbase, Bitcoin exchanges that have registered with the Treasury Department as money transmitters.
An important lesson for entrepreneurs and VCs entering the virtual currency space is that virtual currency business models must be analyzed by lawyers with corporate and venture capital expertise, as well as deep familiarity with state and federal currency and money transmission laws. For those that would turn a blind-eye to the necessity of robust legal compliance at an early stage based on libertarian or anarchist beliefs, naivety or an extraterritorial structure, failure is almost certainly guaranteed.
Smart entrepreneurs understand this. Success stories include PayPal, Square and presently Google Payment Corp., and Facebook Payments are muscling into the space. Staying lean until proof of concept has been achieved is important, but when it comes to federal and state money transmitter regulation, early angel and VC investment rounds must include funds for legal compliance. Joseph & Cohen has the expertise and experience to successfully establish and plan innovative legal compliance programs for VCs, virtual currency and Bitcoin start-ups.
Jonathan Joseph is the Managing Partner of Joseph & Cohen, Professional Corporation, a Financial Services and Litigation Boutique headquartered in San Francisco that emphasizes complex banking, corporate and venture capital transactions, regulatory and money transmission activities, securities, M & A, bankruptcy and insolvency, employment law and commercial and executive employment litigation services.