Graphics by Anna Gray
Virtual currency investing is like life in wild west, but the Securities and Exchange Commission (SEC) keeps an eye on the showdown, requiring some issuers of securities to register by filing forms. The case of SEC v. Shavers provides an example of virtual currency acting as a security, for which the seller must be registered with the SEC unless they have an exemption or qualify for a safe harbor. In this case, the virtual currency investor engaged in allegedly fraudulent and deceitful behavior. Thousands of investment Bitcoin were stolen – behavior for which he incurred civil liability to the SEC and his investors. Docket No. 4:13-CV-416 final opinion at 2014 U.S. Dist. LEXIS 130781, 2014 WL 4652121 (EDTX Sept. 18, 2014); docket entry #23 jurisdiction opinion at 2013 U.S. Dist. LEXIS 110018, Fed. Sec. L. Rep. (CCH) P97,596, 2013 WL 4028182 (EDTX Aug. 6, 2013).
The same SEC laws that first regulated the stock market are the same laws that apply to virtual currency markets and investors. The SEC monitors fraudulent behavior with rules that require securities issuers to file forms identifying themselves and their investments. SEC v. Shavers is a recent example of the SEC’s enforcement of the registration requirements and anti-fraud laws against Bitcoin investors.
Bitcoin Savings and Trust Failed to Register with the SEC as an “Issuer” of Securities
The Defendant in this SEC action, Trendon Shavers, founded the Bitcoin Savings and Trust (BTCST) from his home in McKinney, Texas. From 2011 to 2012, he sold investments in BTCST online for over a year. Shavers did not register with the SEC as a securities issuer or seek an exemption from such registration. Moreover, he failed to collect any identifying information about the people who bought Bitcoin investments from him or to whom he made Bitcoin loans. Shavers only asked for an internet username, email address, and Bitcoin address from which Bitcoin could be withdrawn and deposited.
Alleged Misrepresentation of Investment Potential and Rate of Risk
Shavers also promoted investments in chat rooms dedicated to Bitcoin and on the Bitcoin Forum. He falsely represented that he was in the business of selling Bitcoin “to a group of local people,” offering investors 1% daily interest, paid until investors withdrew their investments or his “local dealings” dried up. Shavers purportedly earned money by trading bitcoin against the U.S. dollar. In one post he wrote, “Hey all, I have some big orders coming in this week. I just wanted to thank all of my investors as I’m able to fulfill them without the risk of them going elsewhere. Still looking for about 1,000 BTC total in lenders based on negotiations with my buyers in the coming weeks. It’s growing, it’s growing!” And in another, “My clients deal in cash only and I don’t move a single coin until the cash is in hand and I’m out of harms [sic] way (just in case :)). So risk is almost 0.” Shavers made many other alleged misrepresentations about his investments, rates of return, and very low risk derived from his ability to “cover” all investments with personal funds. At the same time Shavers was accepting Bitcoin investments and paying interest from his Bitcoin accounts, he was also using the main operating wallet for personal transactions and for his virtual currency mining company, co-founded with others.
SEC Says Investments Amounted to a Ponzi Scheme
Shavers’ “bank” used new purchases of the investments he offered to pay his outstanding investors’ interest while also diverting investments of Bitcoin for personal use (a Ponzi Scheme). By mid-2012, it became more difficult for Shavers to make payments to his existing investors from new investments of Bitcoin, so Shavers began offering lower interest rates. The rate change prompted a “wave of withdrawal.” The reserve Bitcoin Shavers kept was not enough to pay withdrawal requests and meet his obligations to pay the high interest rates he had promised. The Bitcoin fund eventually ran out.
Millions of Dollars in Investor Funds Misappropriated or Wasted
Shavers received over 700,000 bitcoin from BTCST investors, but he only returned about 550,000 in withdrawals and purported interest payments. In one suspicious transaction, he transferred over 150,000 Bitcoin to his personal account in Japan, which allowed him to exchange bitcoin for dollars. From there he lost almost $165,000 while day-trading against the U.S. dollar (originally how he promised investors he was making money). Shavers then transferred over $142,000 from his Japanese account to his personal checking account which he used to pay his rent, for cars, meals, and at the casino. All told, Shavers ended up with $101 million from his elicit activities, which cost his investors $149 million in losses.
Theft of 202,000 Bitcoin Shows No Honor Among Thieves
Shavers had no proof of lending or even communicating to many of the borrowers to whom he claimed to have lent a large number of Bitcoin. For someone so brazen, it should not have been a surprise for one of his “borrowers” to abscond with a loan. Yet Shavers represented having lost 202,000 Bitcoin to one anonymous borrower to whom he made an unsecured loan. Shavers’ attempt to cover his own theft did not convince the U.S. District Court or deter the SEC from prosecuting his case because he did not have enough Bitcoin to make that loan when he said he made it, nor did he have enough of his own Bitcoin to make investors whole.
The Law: Investment Contracts for a Bitcoin Bank are Securities
An investment contract is any contract, transaction, or scheme involving (1) an investment of money, (2) in a common enterprise, (3) with the expectation that profits will be derived from the efforts of the promoter or a third party. SEC v. W.J. Howey & Co., 328 U.S.293, 298-99 (1946) . The Securities Act of 1933 includes investment contracts in the definition of a “security” it regulates. 15 U.S.C. Section 77b(a)(1)(“any note, stock, treasury stock, security future,security-based swap, bond…[or] investment contract…” ).
In an opinion finding subject matter jurisdiction over this case, the Federal District Court for the Eastern District of Texas determined that the Bitcoin investments Shavers offered through BTCST met the definition of a security, falling under the regulatory authority of the SEC. Docket entry #23 summary judgment at 2013 U.S. Dist. LEXIS 110018, 2013 WL 4028182 (EDTX Aug. 6, 2013). This is significant, because the Court found Bitcoin to be “money,” as contemplated by the Supreme Court in Howey. The SEC asserts its authority in cases like these because virtual currency can be exchanged for money and it has value that can be invested.
Shavers, as promoter with purported Bitcoin expertise and local investors, conducted a common enterprise with investors who depended on him and his expertise. His promises of high interest returns (1% daily) clearly established a profit motive. The District Court concluded that Shavers was selling investment contracts, a form of security regulated by the SEC. While Shavers did contest these proceedings, his attorneys were unsuccessful in opposing this conclusion. Docket entry #23 summary judgment, supra.
Illegal to Sell Securities without Registering with the SEC
“Issuers” of securities are also required to register with the SEC before selling those securities. 15 U.S.C. Section 77f. A violation of this law requires a showing by the SEC that a security was offered or sold, there was no registration statement filed with the SEC, and interstate transportation, mail, or communication was used to make the offer or sale. 15 U.S.C. Section 77e(a) and (c). Without proof of a safe harbor or exemption from registration, a defendant faces strict liability for unregistered sales. Shavers had not registered and came nowhere close to being exempt from registering his Bitcoin investments with the SEC. Without properly planning his business in 2011, Shavers did not have a defense to these allegations.
Anti-Fraud Law & Proof of the Crime
Federal law defines the use of “any device, scheme or artifice to defraud”; the act of “make an untrue statement of material fact” or material omission; and engaging in “any act, practice, or course of business which operates” as a fraud. 15 U.S.C. Section 78j(b); SEC Rule 10b-5. In Texas, individuals accused of this crime must be shown to have done so knowingly, recklessly, or “highly unreasonably.”
Shavers made repeated misrepresentations about the safety of Bitcoin investments, the level of risk, and his actions with investors’ money. He did not sell investments to local individuals looking to buy Bitcoin “off the radar,” earn over 10% return on his trading against the U.S. dollar or do much else of what he promised in online forums. Shavers instead used new investments to pay old ones and for personal expenses, which is similar to a classic Ponzi Scheme. Months of incurring interest obligations without earning money to cover them meant he eventually could no longer repay principal or make interest payments, particularly after investors withdrew large portions of their money. All told, he cost his investors over 250,000 Bitcoin in losses and theft, valued at almost $150 million at the time of the 2014 District Court opinion. Competent, ethical counsel would have advised against such behavior from the outset.
No Mercy from the SEC or the District Court
Full disclosure of the true nature of Shavers’ activities would have been material to BTCST investors to say the least. That is one of the SEC’s requirements of registered securities issuers. It is unlikely that anyone would have invested with Shavers if he had been honest about his plans in SEC filings. Ultimately, the attorneys Shavers hired to defend against SEC enforcement determined his best defense was to claim he had either returned the investments or been robbed of all the Bitcoin he obtained. This was not effective. This unprovable defense did not deter the SEC from seeking judgment against him or the District Court from passing severe punishment on him. He was ordered to repay over $38 million of illicit gains, including over $1.7 million prejudgment interest. Finally, the Court imposed a civil penalty of $150,000 – the highest allowed by statute.
Violating the SEC laws and regulations has serious consequences. This case provides an example of extreme disregard for the SEC registration rules, not to mention common decency. Legitimate entrepreneurs, particularly those interested in virtual currency opportunities, run the risk of also failing to file proper SEC forms or seek appropriate exemptions. It is not always obvious that virtual currency can meet the legal definition of a security regulated by the SEC.