How Cryptocurrency Creates Legal Issues

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In less than a decade, cryptocurrency evolved from an obscure peer-to-peer electronic cash system into a system of major assets sold on exchanges in an open market. News about Bitcoin and other cryptocurrencies has appeared regularly in mainstream news sources. As Jay Clayton, chairman of the SECURITIES AND EXCHANGE COMMISSION, said, “The world’s social media platforms and financial markets are abuzz about cryptocurrencies and ‘initial coin offerings’ (ICOs). There are tales of fortunes made and dreamed to be made. We are hearing the familiar refrain, ‘this time is different.’”

As an asset class, the value of cryptocurrencies has indeed grown. In April 2018 the total value of those currencies surpassed $300 billion, thanks largely to a sharp rise in trading of Bitcoin, which is the most prominent form of cryptocurrency. Well-known investment groups, such as Venrock Venture Capital, started viewing these currencies as a viable investment opportunity.

Others, however, have likened the sudden rise in value of cryptocurrencies to the increase in value of the so-called “dot com” companies during the late 1990s. Although the value of those Internetbased companies was based largely on speculation by investors, stock prices continued to increase during a period of about six years.

During the height of this era, investors could make millions of dollars from an initial public offering (IPO), even if the Internet company had never earned revenue. In 2001, however, the “bubble” burst—those stock values plummeted quickly, and many investors were left with nothing.

Naysayers have warned that investors in cryptocurrencies could have similar experiences. Despite the major gains during the latter half of 2017, the market for cryptocurrencies has been volatile. For example, Bitcoin’s price reached a peak of $17,900 on December 15, 2017. One week later, the price had dropped to $13,800, and the value continued to drop during the first quarter of 2018. The price increased sharply in April, but by June, Forbes was reporting that Bitcoin’s value had dropped 50 percent during 2018, largely due to concerns about security, a lower volume of trading, and the potential for regulation.

However, there was sharp increase in Bitcoin during April 2021, reaching as high as $63000.

The trading of cryptocurrencies has given rise to numerous legal issues that have yet to be resolved. Agencies in the United States have had to consider how to regulate these currencies, and several lawsuits have introduced a variety of legal theories that would support PLAINTIFF recovery claims.

What is Cryptocurrency?

A cryptocurrency is decentralized, meaning that it does not require a central authority such as a bank. Ownership of this type of currency is proven through cryptography, which means that each unit of the currency has hidden code that reveals ownership. Records of ownership are provided in a blockchain, which is analogous to a ledger used for traditional accounting. A blockchain reveals various transactions, and these blockchains are ordinarily managed by peer-to-peer networks.

Since 2014 the INTERNAL REVENUE SERVICE has treated cryptocurrency as a form of property rather than a form of currency for tax purposes. Accordingly, a gain in value from the sale of cryptocurrency is taxed at capital gains rates as opposed to ordinary INCOME TAX rates, the latter of which is usually higher.

Cryptocurrency is much more prevalent than some members of the general public may be aware. As of June 2018 there were nearly 1,600 different cryptocurrencies globally. The value of Bitcoin, which was developed in the late 2000s and became the first cryptocurrency in the early 2010s, represents about 42 percent of the total market cap for these currencies.

Owners of start-up cryptocurrencies raise funds through ICOs, which are analogous to IPOs for new publicly traded companies. Investors trade traditional money or other cryptocurrencies for “coins” or “tokens,” which are analogous to stock shares issued during an IPO. Promoters of ICOs have not had to comply with regulations that apply in traditional public offerings, but commentators have warned that ICOs are likely to be regulated by U.S. agencies, including the Securities and Exchange Commission.

Many of the cryptocurrencies, including Bitcoin, are finite in volume, meaning that no new units will enter circulation. Thus, if demand for Bitcoin grows, the value will grow through operation of simple supply-demand economic principles, given that supply remains constant. The stability of the amount of the currency in circulation allows those currencies to avoid the type of inflation that affects traditional currencies.

On the other hand, cryptocurrencies are not backed by anything that has inherent value. U.S. currency, for example, is backed by the full faith and credit of the U.S. government, which issues the currency. With cryptocurrency, the value lies in the ability to trade it or use it in exchange for goods and services. It has become more common for individuals to “carry” cryptocurrencies in a manner similar to carrying traditional currency. Owners can carry the currency in virtual “wallets,” which may be available through apps on phones, flash drives, or other means.

Regulatory Issues of Cryptocurrencies 

The trading of cryptocurrencies has been largely unregulated throughout the 2010s, but regulators in the United States have taken notice of problems. Clayton’s letter in December 2017 outlined a few questions that investors should ask when investing in these currencies:

  • Is the product subject to regulation, “including rules designed to protect investors?”
  • Does the product comply with those regulations and rules?
  • Does the product’s offering meet licensing standards?
  • Is the trading market through which investors can buy cryptocurrency fair, or can a market can be manipulated?
  • Does the currency present “substantial risk of theft or loss, including from hacking?”

As of July 2018 no ICO had been registered with the SEC, nor had the SEC approved an exchange-traded product that holds cryptocurrencies or assets related to cryptocurrencies. Clayton warned that potential investors should be especially wary if someone promoting a cryptocurrency suggests that the currency has received SEC approval. Such a suggestion may provide evidence of fraud or deception.

The prospect of greater regulation has caused concerns for those involved in cryptocurrencies. Several commentators have said that the possibility of increased regulation of these currencies has had a chilling effect on ICOs and other aspects of trading, given that promoters are unsure whether they will need to comply with often complicated (and costly) rules and regulations. Others, however, have said that regulations can provide better clarity and can decrease volatility in the markets.

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For example, Diego Zuluaga, a policy analyst for the Cato Institute’s Center for Monetary and Financial Alternatives, wrote that regulations could distinguish between certain cryptocurrencies that should not be considered securities (such as Bitcoin) and others that may be securities, depending on the nature of the cryptocurrency.

One agency in December 2017 revised its rules to allow trading related to Bitcoin. The U.S. COMMODITY FUTURES TRADING COMMISSION (CFTC) announced that it would allow futures trading of the cryptocurrency. As a result of the decision, Bitcoin futures could be traded on the Chicago Mercantile Exchange. Within weeks, the value of Bitcoin jumped dramatically, but the value increase was short-lived.

Cryptocurrency Litigation

Several lawsuits have been filed relating to cryptocurrencies, including a number of class-action suits. Specific theories in those cases have varied depending on the circumstances, but a variety of theories have been common among the different suits.

Violations of Existing Regulations of Cryptocurrency

In several cases, plaintiffs have alleged that existing rules that apply to trading of futures and securities should apply to the sale and exchange of cryptocurrencies. In one prominent case, the CFTC brought a lawsuit against the trader of a virtual currency, alleging that he engaged in fraudulent and deceptive practices. One issue before the U.S. District Court of the Eastern District of New York was whether the virtual currencies were “commodities” subject to CFTC regulations. Judge JACK B. WEINSTEIN concluded that these currencies were indeed commodities.

Weinstein wrote, “Virtual currencies can be regulated by CFTC as a commodity. Virtual currencies are ‘goods’ exchanged in a market for a uniform quality and value.” He added, “They fall well within the common definition of ‘commodity’ as well as the [Commodity Exchange Act’s] definition of ‘commodities’ as ‘all other goods and articles … in which contracts for future delivery are presently or in the future dealt in’” (quoting 7 U.S.C. § 1(a)(9)). Commodity Futures Trading Comm’n v. McDonnell,, 287 F. Supp. 3d 213 (E.D.N.Y. 2018).

Several other cases have focused on allegations that promoters of cryptocurrencies have violated federal or state securities laws. For instance, a plaintiff in California alleged that an ICO of a currency known as Tezos was actually an illegal sale of an unqualified security in violation of California securities law. The plaintiff had sought a TEMPORARY RESTRAINING ORDER to prevent the promoters from “selling, transferring, converting, or otherwise disposing” of the proceedings from the ICO. However, U.S. District Judge Richard Seeborg ruled against the plaintiff, saying he did not prove that he had suffered irreparable harm. MacDonald v. Dynamic Ledger Solutions, Inc., No. 17-CV-07095-RS, 2017 WL 6513439 (N.D. Cal. Dec. 20, 2017).

Despite the victory in the case described above, Tezos has faced four ICO-related class-action suits. Tezos eventually issued units into circulation, but several legal issues have yet to be resolved.

Fraud and Deceit in Cryptocurrency

The basis of several cryptocurrency claims has focused on allegations of FRAUD. In one class-action suit filed in the U.S. District Court for the District of Connecticut in 2016, plaintiffs alleged that those who sold products and investment contracts to thousands of ICO investors had engaged in fraud by promising profits from the currency. The plaintiffs asserted that the defendants had made several misrepresentations that misled investors. The defendants sought in 2017 to dismiss the case, arguing that the plaintiffs had failed to state a claim on which the court could grant relief, but U.S. District Judge Michael P. Shea denied the motion. Shea concluded that the plaintiffs had stated plausible claims based on both federal law and Connecticut state law. Audet v. Fraser, 3:16-CV-940, 2017 WL 4542386 (D. Conn. Oct. 11, 2017).

In another case filed in federal court in Florida, investors characterized the sale of Bitcoin as a part of a Ponzi scheme. The allegations have focused on a platform known as BitConnect, which was purportedly to be used to allow investors to deposit Bitcoins in exchange for a return on the investment. The plaintiffs have alleged that the founders of BitConnect did not make any real return on investment and instead profited existing investors with funds obtained by new investors, which would describe a classic PONZI SCHEME. Wildes v. BitConnect International, PLC, No. 9:18-CV-80086 (S.D. Fla.) (filed Jan. 24, 2018).

Use of Cryptocurrency for Criminal Purposes

In at least one case, use of cryptocurrency has been the focus of a criminal case. A DEFENDANT named Gal Vallerius was charged based on his alleged role in international narcotics transactions. Prosecutors alleged (among other allegations) that Vallerius allowed those buying illicit narcotics to pay by using cryptocurrency. Investigators found evidence that Vallerius had received payment from those buying drugs through a “Bitcoin tip jar,” which allowed users to deposit the cryptocurrency electronically. He sought to suppress evidence of the transactions found on his computer, but U.S. Magistrate Judge Edwin G. Torres denied the motion, concluding that the search did not violate Vallerius’s Fourth or FIFTH AMENDMENT rights. No. 17-CR-20648-SCOLA/TORRES, 2018 WL 2325729 (S.D. Fla. May 1, 2018).

Other Legal Issues Affecting Cryptocurrencies

Cryptocurrencies have given rise to several legal problems in addition to those described above. For example, at least one lawsuit has focused on use of the word “Bitcoin,” which describes a particular virtual currency but has also become an almost ubiquitous term to refer to cryptocurrencies in general (much like Kleenex to describe tissues or Xerox to describe photocopiers). Additional LITIGATION will also likely result from additional regulation, both from agencies themselves and from parties who claim economic damages based on losses sustained due to the purchase of these virtual currencies.

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