Bitcoin Bros Beware

Bitcoin and other virtual currencies (also known as cryptocurrencies, digital currencies or digital tokens) have surged in price in 2021 on the back of increased interest from institutional investors, who see it as a store of value akin to gold. Meanwhile, major companies like Tesla and PayPal have also made significant moves in the space.

Tesla bought $1.5 billion worth of bitcoin earlier this year and, for sometime, accepted it as payment for its cars – until their mercurial (and crypto market manipulating) CEO Elon Musk announced an abrupt about face. Meanwhile, PayPal announced in March 2021 that it had agreed to buy Curv, a start-up that helps clients store their digital tokens securely, for nearly $200 million.

This follows PayPal’s move in November 2020 to allow its US users to buy and sell cryptocurrency directly from their accounts in November 2020, and PayPal’s addition of the “Checkout with Crypto” feature that allows users to instantly convert their Bitcoin, Ethereum, Litecoin, or Bitcoin Cash to US dollars (with no additional transaction fees) that PayPal then uses to complete the transaction. If a merchant doesn’t take US dollars, PayPal also converts those dollars into local currency at standard conversion rates set by PayPal.

Although some skeptical economists view bitcoin as a bubble waiting to burst, clients who are more bullish on this new frontier and would like to replicate some of PayPal’s moves, will need to make sure that they are aware of and comply with a still developing legal and regulatory framework, otherwise they risk legal jeopardy.

The subject of this article, however, isn’t to analyze the worth of bitcoin (or sketchier options like dogecoin). Instead, we ask (and answer):

  1. What laws and regulations apply to a business, which seeks to buy and sell virtual currencies?
  2. How can one structure such a business legally, if at all?
  3. What are the potential consequences if such a business is deemed not to conform to law?

Abstract

U.S. law does not currently provide for direct, comprehensive Federal oversight of Bitcoin or virtual currencies. As a result, regulation of virtual currencies in the U.S. has evolved into a patchwork regulatory approach, as follows:

  • The Treasury’s Financial Crimes Enforcement Network (FinCEN) monitors Bitcoin and other virtual currency transfers for anti-money laundering purposes.
  • State money transmitter laws regulate certain U.S. and foreign virtual currency markets.
  • The Internal Revenue Service (IRS) treats virtual currencies as property subject to capital gains tax.
  • The Securities and Exchange Commission (SEC) takes increasingly strong action against unregistered initial coin offerings.

Analysis & Application: Researching and complying with such a complex and poorly defined legal regime can be time-consuming, costly, and likely would not eliminate all legal risk associated with operating a business and accepting bitcoin, particularly at the state level. As a result, and particularly with respect to state money transmitter laws, some businesses have preferred to take an alternative, fly-under-the-radar approach, until their business is large enough that enforcement becomes more likely. That said, this “ask for forgiveness, not permission” approach is not without its own risks, which is discussed in more extensive detail below.

FinCEN and The Bank Secrecy Act

In 2013, FinCEN stated that exchanges and administrators of virtual currency are subject to the BSA and must register as a Money Services Business (MSB) at the federal level.

FinCEN went further in 2019, when they penalized for the first time a peer-to-peer exchanger of convertible virtual currency, Eric Powers, for willfully violating the BSA’s registration, program, and reporting requirements.

In addition to paying a $35,000 fine, Mr. Powers was prohibited from providing money transmission services or engaging in any other activity that would make him a “money services business” for purposes of FinCEN regulations.

As “money transmitters,” peer-to-peer exchangers are required, at minimum, to

  1. Register with FinCEN;
  2. Develop, implement, and maintain an effective anti-money laundering program;
  3. File Suspicious Activity Reports (SARs) and Currency Transaction Reports (CTRs); and
  4. Maintain certain other records.

Mr. Powers conducted over 200 transactions involving the physical transfer of more than $10,000 in currency, yet failed to file a single CTR.  For instance, Mr. Powers conducted approximately 160 purchases of bitcoin for approximately $5 million through in-person cash transactions, conducted in public places such as coffee shops, with an individual identified through a bitcoin forum.  Of these cash transactions, 150 were in-person and were conducted in separate instances for over $10,000 during a single business day.  Each of these 150 transactions necessitated the filing of a CTR.

Analysis & Application: Based on the Powers case, the BSA is likely applicable to a business, which—much like Mr. Powers’ business­—operates as a peer-to-peer exchanger of currency. As a result, we regularly advise businesses to register as an MSB with FinCEN, which can be done relatively painlessly and inexpensively through the online BSA eFiling System and otherwise comply with the BSA, by developing, implementing, and maintaining an effective anti-money laundering program; filing Suspicious Activity Reports (SARs) and Currency Transaction Reports (CTRs) as warranted; and maintaining certain records. The failure to take these steps could result in a business facing the types of penalties incurred by Mr. Powers.

State Money Transfer Laws

There exists no uniformity among the states with respect to how businesses that deal in virtual currencies are treated. On one hand, all U.S. states, except Montana, will define businesses as an MSB (sometimes also referred to herein as a money transmitter), if they receive “money” and sends it elsewhere. On the other hand, while some states have issued guidance regarding whether virtual currencies are “money” under existing state rules, others have merely enacted piecemeal legislation, amending existing definitions, to either specifically include or exclude digital currencies from the definition.

Whether or not a particular state’s laws apply to you will most likely depend on whether or not you have customers in the state. If you do and it is a state that considers virtual currencies to be “money,” then it’s likely you will need to obtain a license to operate a money services business in that state.

While registering as an MSB with FinCEN is a relatively painless online procedure, getting your MSB license in your state(s) of operation is a more costly process.

That said, there are some commonalities between states’ licensing requirements of MSB’s. Specifically, you can expect at a minimum to be asked to complete these tasks prior to sending in your licensing application:

  1. A license application form
  2. Financial statements
  3. Business plan(s)
  4. Anti-money laundering compliance program
  5. Surety bond or other form of security
  6. Background check
  7. License fees
  8. Minimum net worth threshold

In recent years, there has been an exodus of virtual currency businesses from states attempting to treat all virtual currency operators identically with traditional MSB’s, which tend to be better equipped to deal with such a restrictive regulatory framework. New York is one such state whose laws are famously not friendly to virtual currency businesses, and although a full 50-state survey of money transmitter laws is beyond the scope of this article, as a Texas-based attorney, I will note that Texas was the first state to release an official position on bitcoin, clarifying that no MSB license is required to sell Bitcoin or other virtual currencies, in Texas.

Texas

In 2014, the Texas Department of Banking issued Memorandum 1037, which states that Bitcoin and other virtual currencies will not be treated as legal money in Texas.

The memorandum goes on to state specifically that the exchange of cryptocurrency for sovereign currency, like the dollar, between two parties is not money transmission. The department concludes that such a transaction is essentially a sale of goods between two parties. Therefore, if your business is limited to the direct exchange of cryptocurrency for sovereign currency, you will need to comply with any Texas laws applicable to MSB’s in order to operate your business.

Notwithstanding this determination, Memorandum 1037 also concludes that the exchange of cryptocurrency for sovereign currency through a third-party exchanger is generally money transmission, and Texas’ money transmitter laws would apply to the third-party exchanger, i.e., the company that facilitates exchanges by acting as an escrow-like intermediary. In a typical transaction, the buyer of cryptocurrency sends sovereign currency to the exchanger who holds the funds until it determines that the terms of the sale have been satisfied before remitting the funds to the seller. Irrespective of its handling of the cryptocurrency, the exchanger conducts money transmission by receiving the buyer’s sovereign currency, in exchange for a promise to make it available to the seller.

Analysis & Application: Businesses should clearly distinguish the two scenarios above, and if your business ever operates as a third-party exchanger that facilitates the purchase and sale of virtual currencies between two other parties, then it will most likely trigger certain legal obligations under Texas’ money transmitter laws.

Flying Under the Radar

Even where a business’s operations would trigger money transmitter’s obligations in a particular state, many businesses decide to “fly under the radar”, on the assumption that smaller operations are less likely to attract regulatory scrutiny.

In this model, startups commence money-transmitting operations in a state but only apply for the requisite license when they have the resources to do so. For example, PayPal refused to get licenses early on, but finally caved in after coming under pressure from a multi-state alliance of regulators. Square operated without the full set of required money transmitter licenses since 2009 but was hit with its first cease-and-desist order only in 2013 by Illinois regulators. Square also had to pay a $507,000 fine to Florida’s regulators, who quickly followed in Illinois’ footsteps.

First, transmitting money without a license can be a felony in some states, although regulators often content themselves with cease-and-desist letters and fines. More importantly, state regulators are on the lookout for potential unlicensed money transmission activity and have indicated that they pay close attention to customer complaints and competitor concerns, in order to identify unlicensed activities. In addition, regulators frequently share information on enforcement activity across states, and even resort to scanning startup news websites such as TechCrunch for business models that constitute money transmission. Finally, this strategy hinges on getting large enough in a short period of time to survive regulatory scrutiny. Startups that take longer to mature, or that happen to be caught earlier in their lifecycle, may be out of luck.

That said, a quick analysis of enforcement orders reveals that when Illinois, for example, issued cease-and-desist orders in January 2013 against five money transmitters, only one target seems to have ceased doing business. This despite the fact that orders uniformly required the businesses to cease and desist their activities and produce accounts of money transferred on behalf of Illinois consumers. These businesses were also liable for the total of (1) $1,000 per violation, (2) $1,000 for each day they were in violation of Illinois’ Transmitters of Money Act, and (3) up to four times the amount of unlicensed money transmitted. The high survival rate may indicate that discovery tends to happen late enough that the businesses can afford to cure and comply.

If the risk of breaking the law is too high, some companies will choose outsource funds transfers to backend payment processors to avoid falling afoul of money transmitter laws. TaskRabbit, for example, collects money from users and pays workers on its platform. However, it avoids taking possession and control of customer funds by contracting Braintree to handle the payments workflows.

Analysis & Application: If a suitable partner cannot be found or if control of the payments is integral to the business model, startups who don’t want to risk violating the law face two options—terminate the venture or terminate services in states with tougher regulation.

Let's Not Forget

IRS

The IRS treats virtual currencies as property subject to capital gains tax, meaning that every virtual currency user must track the gains or losses of every one of their virtual currency transactions to stay in compliance with IRS regulations.

SEC

Although likely inapplicable to your business, the SEC has taken increasingly strong action against unregistered initial coin offerings for not registering as a national exchange or alternative trading system. That said, SEC regulations only applies to trading securities.

While new coins are probably securities. Older coins, like bitcoin generally treated as commodities. In making this determination, courts typically use the “Howey Test,” set out in a 1946 Supreme Court case. The ruling basically says that a security involves the investment of money in a common enterprise, in which the investor expects profits primarily from the efforts of others. While newer coins, whose value is more speculative, tend to meet this definition, the value of older coins tends to behave more like commodities, and thus are regulated as such.

CFTC

In 2014, the CFTC declared virtual currencies to be a “commodity” subject to oversight under its authority under the CEA. While the CFTC has not, to this point, issued much in the way of specific regulations, they do seek to enforce fraud and market manipulation, and therefore the CFTC may, in some cases, require a business to register as a futures commission merchant with CFTC, to meet this goal.

This is an overview and not intended to be a replacement of legal advice tailored for your business. If you have further questions, please reach out to our firm.

Endnotes