Digital/Virtual Currencies

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Our colleagues Joshua Horn, Ernest E. Badway, and Benjamin H. McCoy have published an article about the recent release by the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations of its 2018 examination priorities, an annual report outlining the areas of the securities industry its examiners will target. This year, the priorities are organized into five broad areas:

  • Compliance and risks in critical market infrastructure
  • Retail investors
  • FINRA and MSRB
  • Cybersecurity
  • Anti-money laundering programs

The priorities also deal with recent hot-button developments in cryptocurrency and initial coin offerings, which we have written about previously (see prior coverage here, here, and here) . Firms should review the 2018 priorities and ensure that internal controls and practices are updated to effectively handle priority risks. You can read their article here.

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BitcoinOver the course of the last two months, we have witnessed a flurry of enforcement activity with respect to initial coin offerings and virtual currency fraud schemes by the Securities and Exchange Commission and the Commodity Futures Trading Commission. The SEC continued that trend today with an announcement that it has obtained a court order halting an allegedly fraudulent ICO that targeted retail investors to fund what was claimed to be the world’s first “decentralized bank” offering its own cryptocurrency. The public sale in question began around December 26, 2017, and was originally scheduled to conclude on January 27, 2018, with distribution to investors on February 10, 2018.

According to the SEC’s complaint, filed in federal district court in Dallas on January 25 and unsealed late yesterday, Dallas-based AriseBank used social media, a celebrity endorsement, and other tactics to raise what it claims to be $600 million of its $1 billion goal in just two months. AriseBank and its two co-founders allegedly offered and sold unregistered investments in their “AriseCoin” cryptocurrency by depicting AriseBank as a first-of-its-kind decentralized bank offering a variety of consumer-facing banking products and services using more than 700 different virtual currencies.  AriseBank’s sales pitch claimed that it developed an algorithmic trading application that automatically trades in various cryptocurrencies.

The SEC alleges that AriseBank falsely stated that it purchased an FDIC-insured bank which enabled it to offer customers FDIC-insured accounts and that it also offered customers the ability to obtain an AriseBank-branded VISA card to spend any of the 700-plus cryptocurrencies.  AriseBank also allegedly omitted to disclose the criminal background of key executives.

The district court approved an emergency asset freeze over AriseBank and its two co-founders, and appointed a receiver over AriseBank, including over its digital assets.  The court-appointed receiver was able to immediately secure various cryptocurrencies held by AriseBank including Bitcoin, Litecoin, Bitshares, Dogecoin, and BitUSD.  The SEC seeks preliminary and permanent injunctions, disgorgement of ill-gotten gains plus interest and penalties, and bars against the individuals to prohibit them from serving as officers or directors of a public company or offering digital securities again in the future.

Today’s announcement from the SEC is the latest foray in an aggressive federal crackdown on virtual currency scams that has been underway since last fall. Both the SEC and CFTC have created specialized units to focus on virtual currency issues. The SEC’s Cyber Unit was created in September 2017 to focus the Enforcement Division’s cyber-related expertise on misconduct involving distributed ledger technology and initial coin offerings, the spread of false information through electronic and social media, hacking, and threats to trading platforms. The CFTC has created a Virtual Currency Task Force to focus on virtual currency fraud schemes.

The SEC’s Cyber Unit filed its first-ever suit to halt an ICO scam in early December (coverage here). Shortly thereafter, the SEC announced that it had obtained a cease-and-desist order to halt a California company’s ICO (coverage here).

Earlier this month, the CFTC weighed in, announcing the filing of two enforcement actions to combat alleged virtual currency fraud schemes (coverage here). The next day, the CFTC and SEC issued a joint statement reaffirming their agencies’ commitment to continuing to address violations and to bringing legal actions to stop and prevent fraud in the offer and sale of digital instruments. Most recently, the CFTC filed suit on January 24 to halt an alleged virtual currency scam involving a currency called My Big Coin (coverage here).

In addition to these enforcement actions, the SEC and CFTC have published guidance warning consumers and investors as to the perils of ICOs and virtual currency schemes. The SEC’s Office of Investor Education and Advocacy issued an Investor Alert in August 2017. In December 2017, the CFTC launched its Virtual Currency Resource Web Page and published a Customer Advisory to inform the public of possible risks associated with investing or speculating in virtual currencies.

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Last week we reported on a flurry of enforcement activity by the Commodities Futures Trading Commission’s “Virtual Currency Task Force” with respect to virtual currency fraud schemes. On Thursday, January 18, the CFTC filed two lawsuits in federal court in New York seeking to shut down two such schemes and to recover funds for victimized investors. The first suit charged a New York resident and his New York-based company with fraud and misappropriation in connection with purchases and trading of Bitcoin and Litecoin. The second suit charged a Colorado resident and his United Kingdom-registered company with a Ponzi-style scheme involving the solicitation of Bitcoin from investors to be pooled and invested in products including binary options. The following day, the Directors of Enforcement for both the CFTC and the Securities and Exchange Commission issued a joint statement reaffirming their agencies’ commitment to address violations and to bring actions to stop and prevent fraud in the offer and sale of digital instruments.

Continuing its crackdown on virtual currency fraud, the CFTC today announced the filing of another enforcement action charging commodity fraud and misappropriation related to the ongoing solicitation of customers for a virtual currency known as My Big Coin (MBC). The CFTC Complaint charges Randall Crater of East Hampton, New York, Mark Gillespie of Hartland, Michigan, and My Big Coin Pay, Inc., a corporation based in Las Vegas, Nevada, with misappropriating over $6 million from customers by, among other things, transferring customer funds into personal bank accounts, and using those funds for personal expenses and the purchase of luxury goods.

The suit was filed on January 16, 2018, under seal, in federal court in Massachusetts. On that same day, the Court issued a temporary restraining order, also under seal, freezing the defendants’ assets. The restraining order also freezes the assets of multiple relief defendants for allegedly receiving customer funds without providing any legitimate services to clients and without any interest or entitlement to such customer funds. The Court’s restraining order also prohibits the defendants and relief defendants from destroying or altering books and records.

The CFTC’s complaint alleges that from at least January 2014 through January 2018, the defendants fraudulently solicited potential and existing MBC customers throughout the United States by making false and misleading claims and omissions about MBC’s value, usage, and trade status, and that MBC was backed by gold. The defendants are also alleged to have fraudulently solicited numerous customers in Massachusetts, receiving in excess of $5 million from those customers.

As alleged in the complaint, the MBC website, maintained and operated by the defendants, conveyed to customers numerous solicitation materials, MBC trade data, and other materials (1) misrepresenting that MBC was actively being traded on several currency exchanges, including the MBC Exchange website, when in fact it was not; (2) misrepresenting in reports the daily trading price, when in fact no price existed because MBC was not trading; (3) misrepresenting that MBC was backed by gold, when in fact it was not; and (4) misrepresenting that MBC had partnered with MasterCard, with the promise that MBC could be used anywhere MasterCard was accepted, when in fact no such partnership existed and MBC could not be used anywhere MasterCard was accepted. In reality, as alleged, the supposed trading results were illusory, and any payouts to customers were derived from funds fraudulently obtained from other customers in the manner of a Ponzi scheme.

As customers began to raise questions about their MBC accounts, the complaint alleges that the defendants attempted to conceal their fraud by issuing additional coins to customers and falsely representing that they had secured a deal with another exchange to trade MBC. The defendants allegedly encouraged customers to refrain from redeeming their MBC holdings until MBC was active on this “new” exchange.

The CFTC alleges that the defendants misappropriated virtually all of the approximately $6 million they solicited from customers, using these funds to purchase a home, antiques, fine art, jewelry, luxury goods, furniture, interior decorating and other home improvement services, travel, and entertainment.

In the litigation, the CFTC seeks civil monetary penalties, restitution, rescission, disgorgement of ill-gotten gains, trading and registration bans, and permanent injunctions against further violations of the federal commodities laws, as charged.

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Bitcoin

Yesterday the Commodity Futures Trading Commission announced two enforcement actions as part of a continuing crackdown on virtual currency fraud schemes by numerous federal agencies. (We have previously written about the Securities and Exchange Commission’s efforts in this area here and here.)  And today the CFTC and SEC issued a joint statement reaffirming their agencies’ commitment to continuing to address violations and to bringing legal actions to stop and prevent fraud in the offer and sale of digital instruments.

Patrick K. McDonnell and CabbageTech, Corp. d/b/a Coin Drop Markets

The CFTC announced the filling of a federal civil enforcement action in the U.S. District Court for the Eastern District of New York against Patrick K. McDonnell, of Staten Island, New York, and CabbageTech, Corp. d/b/a Coin Drop Markets (CDM), a New York corporation, charging them with fraud and misappropriation in connection with purchases and trading of Bitcoin and Litecoin.

The CFTC’s Complaint alleges that from approximately January 2017 to the present, McDonnell and CDM engaged in a deceptive and fraudulent virtual currency scheme to induce customers to send money and virtual currencies to CDM, purportedly in exchange for real-time virtual currency trading advice and for virtual currency purchasing and trading on behalf of the customers under McDonnell’s direction. In fact, as charged in the CFTC Complaint, the supposedly expert, real-time virtual currency advice was never provided, and customers who provided funds to McDonnell and CDM to purchase or trade on their behalf never saw those funds again. In short, according to the CFTC, McDonnell and CDM used their fraudulent solicitations to obtain and then simply misappropriate customer funds.

The CFTC Complaint further alleges that to conceal their scheme, soon after obtaining customer funds, Defendants removed the website and social media materials from the Internet and ceased communicating with CDM Customers, who lost most if not all of their invested funds due to Defendants’ fraud and misappropriation. The CFTC Complaint also alleges that neither Defendant has ever been registered with the CFTC in any capacity.

In its continuing civil litigation, the CFTC seeks, among other relief, restitution to defrauded customers, disgorgement of benefits from violations of the Commodity Exchange Act and CFTC Regulations, civil monetary penalties, trading bans, and a permanent injunction against future violations of federal commodities laws, as charged.

Dillon Michael Dean and The Entrepreuneurs Headquarters Limited

The CFTC also announced the filing of a civil enforcement action in the U.S. District Court for the Eastern District of New York against Dillon Michael Dean of Longmont, Colorado, and his company, The Entrepreneurs Headquarters Limited, a UK-registered company. The CFTC Complaint charges the Defendants with engaging in a fraudulent scheme to solicit Bitcoin from members of the public, misrepresenting that customers’ funds would be pooled and invested in products including binary options, making Ponzi-style payments to commodity pool participants from other participants’ funds, misappropriating pool participants’ funds, and failing to register with the CFTC as a Commodity Pool Operator (CPO) and Associated Person of a CPO, as required.

Specifically, the Complaint alleges that, from approximately April 2017 through the present, Defendants, who have never been registered with the CFTC in any capacity, have engaged in a fraudulent scheme through which they solicited at least $1.1 million worth of Bitcoin from more than 600 members of the public. Defendants allegedly promised to convert this Bitcoin into fiat currency to invest on the customers’ behalf in a pooled investment vehicle for trading commodity interests, including trading binary options on an online exchange designated as a contract market by the CFTC. Potential pool participants were solicited to invest with Defendants by false claims of trading expertise and promises of high rates of return. The Complaint further alleges that, rather than convert customers’ Bitcoin to fiat currency to invest in binary options contracts, as promised, Defendants misappropriated their customers’ funds, including by using the funds to pay other customers, in the manner of a Ponzi scheme.

The Complaint alleges that Defendants solicited customer deposits using company websites, YouTube videos, and Facebook posts, where Defendants claimed that customers’ funds would be pooled and invested in commodity options on behalf of customers, that Dean had “strong skills” in options trading, and that Defendants were generating high rates of return through trading commodity options, among other false claims. But, as alleged, Defendants were not actually engaged in trading on behalf of their customers, and Defendants’ purported trading profits were fictitious. As alleged in the Complaint, Defendants stopped making payments to their customers, having misappropriated over $1 million in customers’ funds, while Dean has launched another similar purported trading venture under the name Real Trade Profits, using a website to solicit customers to deposit Bitcoin for a pooled investment in binary options trading and promising high rates of return.

In its ongoing litigation, the CFTC seeks restitution to defrauded persons, disgorgement of ill-gotten gains, civil monetary penalties, permanent trading and registration bans, and a permanent injunction against further violations of the Commodity Exchange Act and CFTC Regulations, as charged.

Joint statement from CFTC and SEC Regarding Virtual Currency Enforcement Actions

Today the following joint statement was issued by CFTC Enforcement Director James McDonald and SEC Enforcement Co-Directors Stephanie Avakian and Steven Peikin:

When market participants engage in fraud under the guise of offering digital instruments – whether characterized as virtual currencies, coins, tokens, or the like – the SEC and the CFTC will look beyond form, examine the substance of the activity and prosecute violations of the federal securities and commodities laws.

The Divisions of Enforcement for the SEC and CFTC will continue to address violations and to bring actions to stop and prevent fraud in the offer and sale of digital instruments.

CFTC’s Customer Fraud Advisory on Virtual Currencies and Bitcoin

The CFTC has issued a Customer Advisory on the Risks of Virtual Currency Trading to inform the public of possible risks associated with investing or speculating in virtual currencies or recently launched Bitcoin futures and options.

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BitcoinCoindesk is reporting that Coinbase — the largest U.S.-based Bitcoin exchange and the subject of a recently-concluded “John Doe” summons dispute with the Internal Revenue Service — is reminding its customers of their U.S. tax obligations with a new dashboard banner entitled “Please remember to pay your taxes.”  The banner then links to a “Taxes FAQ” page which states, in part, that “[w]e remind all our customers, both U.S. and international, that you have a responsibility to self-report and pay taxes on all taxable gains” and references IRS rules issued in 2014 regarding the tax treatment of digital currency activity.

Coinbase’s move to remind its U.S. customers of their tax obligations comes on the heels of a federal judge’s decision in late November to order Coinbase to comply with a “John Doe” summons issued by the IRS seeking information regarding U.S. taxpayers who conducted transactions in virtual currency during 2013, 2014, and 2015.  The IRS had served a “John Doe” summons on Coinbase based upon concerns that individuals may be using virtual currency for tax evasion.  Coinbase refused to provide the requested information to the IRS, and after a year of litigation in federal court, the IRS eventually prevailed.  As ordered by the court order in late November, Coinbase must now turn over to the IRS records for any account with at least the equivalent of $20,000 in any one transaction (buy/sell/send/receive) in any one year during the 2013 through 2015 time period.  According to documents filed in the litigation, the court’s order will require Coinbase to turn over documents regarding 8.9 million transactions and 14,355 customers.

Once it receives the summoned data from Coinbase, the IRS will cross-check tax returns filed by the individuals in question to determine if they properly reported their Bitcoin trading gains and losses. Individuals who have not properly reported their Bitcoin holdings will likely be contacted by the IRS, and the nature of that contact will be dictated by the magnitude of each individual’s tax non-compliance. For Coinbase customers with a relatively small number of unreported transactions, the IRS may simply send a “soft” letter advising them to file amended tax returns. Coinbase users with a greater number of unreported transactions may be selected for audit and face penalties for not properly reporting Bitcoin transactions. The most egregious examples of non-compliance may well face criminal investigation by the IRS, if there is evidence those customers deliberately intended to evade their tax obligations by trading in Bitcoin.

Coinbase has not stated publicly whether it intends to appeal, but in a blog post the company said it was “in the process of reviewing the order” and would “continue to keep our customers updated.” In that same piece, Coinbase noted that the summons affected less than 1 percent of its customer base. Coinbase also said that “[i]n the event that we ultimately produce the documents under this Court order, we intend to notify impacted users in advance of any disclosure.” This advance notice will presumably afford concerned accountholders an opportunity to quickly rectify their tax filings, if they deem it advisable.

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BitcoinThe Securities and Exchange Commission announced yesterday that a California-based company selling digital tokens to investors to raise capital for its blockchain-based food review service halted its initial coin offering (ICO) and agreed to a cease-and-desist order in which the SEC found that its conduct constituted unregistered securities offers and sales.

According to the SEC’s order, before any tokens were delivered to investors, Munchee Inc. refunded investor proceeds after the SEC intervened.  Munchee was seeking $15 million in capital to improve an existing iPhone app centered on restaurant meal reviews and create an “ecosystem” in which Munchee and others would buy and sell goods and services using the tokens.  The company communicated through its website, a white paper, and other means that it would use the proceeds to create the ecosystem, including eventually paying users in tokens for writing food reviews and selling both advertising to restaurants and “in-app” purchases to app users in exchange for tokens.

According to the cease-and-desist order, in the course of the offering, the company and other promoters emphasized that investors could expect that efforts by the company and others would lead to an increase in value of the tokens.  The company also emphasized it would take steps to create and support a secondary market for the tokens.  Because of these and other company activities, investors would have had a reasonable belief that their investment in tokens could generate a return on their investment.  Munchee consented to the SEC’s cease-and-desist order without admitting or denying the findings.

As the SEC has said in the DAO Report of Investigation, a token can be a security based on the long-standing facts and circumstances test that includes assessing whether investors’ profits are to be derived from the managerial and entrepreneurial efforts of others.

“We will continue to scrutinize the market vigilantly for improper offerings that seek to sell securities to the general public without the required registration or exemption,” said Stephanie Avakian, Co-Director of the SEC’s Enforcement Division.  “In deciding not to impose a penalty, the Commission recognized that the company stopped the ICO quickly, immediately returned the proceeds before issuing tokens, and cooperated with the investigation.”

“Our primary focus remains investor protection and making sure that investors are being offered investment opportunities with all the information and disclosures required under the federal securities laws,” said Steven Peikin, Co-Director of the SEC’s Enforcement Division.

The SEC’s new Cyber Unit is focused on misconduct involving distributed ledger technology and initial coin offerings, the spread of false information through electronic and social media, brokerage account takeovers, hacking to obtain nonpublic information, and threats to trading platforms.  We previously reported on the Cyber Unit’s first action, filed last week, to halt an alleged ICO scam. The SEC also has a Distributed Ledger Technology Working Group that focuses on various emerging applications of distributed ledger technology in the financial industry. The SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin in July 2017 to make investors aware of the potential risks of participating in initial coin offerings.

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BitcoinThe Securities and Exchange Commission announced yesterday that its new Cyber Unit obtained an emergency asset freeze to halt a “fast-moving” Initial Coin Offering (ICO) fraud that raised up to $15 million from thousands of investors since August by falsely promising a 13-fold profit in less than a month.

The SEC filed charges against what it calls a “recidivist Quebec securities law violator” named Dominic Lacroix, and his company, PlexCorps. The complaint, filed in federal court in Brooklyn, alleges that Lacroix and PlexCorps marketed and sold securities called PlexCoin on the internet to investors in the U.S. and elsewhere, claiming that investments in PlexCoin would yield a 1,354 percent profit in less than 29 days. The SEC also charged Lacroix’s partner, Sabrina Paradis-Royer, in connection with the scheme. Based on its filing, the SEC obtained an emergency court order to freeze the assets of PlexCorps, Lacroix, and Paradis-Royer.

The charges are the first filed by the SEC’s new Cyber Unit, which was created in September to focus the Enforcement Division’s cyber-related expertise on misconduct involving distributed ledger technology and initial coin offerings, the spread of false information through electronic and social media, hacking and threats to trading platforms.

“This first Cyber Unit case hits all of the characteristics of a full-fledged cyber scam and is exactly the kind of misconduct the unit will be pursuing,” said Robert Cohen, Chief of the Cyber Unit. “We acted quickly to protect retail investors from this initial coin offering’s false promises.”

The SEC’s complaint charges Lacroix, Paradis-Royer and PlexCorps with violating the anti-fraud provisions, and Lacroix and PlexCorps with violating the registration provision, of the U.S. federal securities laws. The complaint seeks permanent injunctions and disgorgement plus interest and penalties. For Lacroix, the SEC also seeks an officer-and-director bar and a bar from offering digital securities against Lacroix and Paradis-Royer.

The SEC’s Office of Investor Education and Advocacy has issued several warnings to investors about scams of companies claiming to be engaging in initial coin offerings. In an Investor Bulletin published in July 2017, the SEC announced that in the context of ICOs, virtual coins or tokens that are offered or sold may be securities, and if they are securities, the offer and sale of these virtual coins or tokens in an ICO is subject to the federal securities laws:

Virtual coins or tokens are created and disseminated using distributed ledger or blockchain technology. Recently promoters have been selling virtual coins or tokens in ICOs. Purchasers may use fiat currency (e.g., U.S. dollars) or virtual currencies to buy these virtual coins or tokens. Promoters may tell purchasers that the capital raised from the sales will be used to fund development of a digital platform, software, or other projects and that the virtual tokens or coins may be used to access the platform, use the software, or otherwise participate in the project. Some promoters and initial sellers may lead buyers of the virtual coins or tokens to expect a return on their investment or to participate in a share of the returns provided by the project. After they are issued, the virtual coins or tokens may be resold to others in a secondary market on virtual currency exchanges or other platforms.

In an Investor Alert from August 2017, the SEC specifically warned that “[f]raudsters often try to use the lure of new and emerging technologies to convince potential victims to invest their money in scams. These frauds include ‘pump-and-dump’ and market manipulation schemes involving publicly traded companies that claim to provide exposure to these new technologies.”

Bitcoin

The Internal Revenue Service has prevailed in its long-running dispute with Coinbase, the largest U.S.-based Bitcoin exchange, with a federal judge ordering Coinbase to comply with a “John Doe” summons seeking customer information. In an opinion issued on November 28, 2017, the court in San Francisco found that the government’s narrowed request for information on Coinbase’s customers served the legitimate purpose of investigating whether Bitcoin users properly reported gains or losses on their income tax returns. The Court also found that the customer records sought by the government were relevant because they can be used by the IRS to determine whether a particular Coinbase customer is tax compliant. Coinbase must now hand over to the IRS records for accounts that had at least one transaction of at least $20,000 value during the period 2013 to 2015. According to Coinbase, this will require it to divulge trading records regarding nearly 9 million transactions conducted by over 14,000 customers. With this data in hand, it will be relatively easy for the IRS to cross-check filed tax returns to determine if Coinbase customers properly reported Bitcoin transactions on their returns. Individuals who failed to do so can expect to hear from the IRS and should consider prompt corrective action, if necessary, to mitigate the consequences of any such inquiry.

A “John Doe” summons is an information-gathering tool that is being used with increasing frequency by the IRS to obtain information and records about a class of unidentified taxpayers if the IRS has a reasonable belief that such taxpayers are engaged in conduct violating U.S. tax laws. Because the identities of the targeted taxpayers are unknown, the summons is denoted with a “John Doe” moniker. Expressly authorized by the Internal Revenue Code, a John Doe summons must first be approved by a federal judge before it can be served. The IRS sought to serve a summons on Coinbase because of its concern that the anonymous nature of virtual currencies like Bitcoin may allow users to engage in tax evasion and other illegal conduct:

Virtual currency, as generally defined, is a digital representation of value that functions in the same manner as a country’s traditional currency. There are nearly a thousand virtual currencies, but the most widely known and largest is bitcoin. Because transactions in virtual currencies can be difficult to trace and have an inherently pseudo-anonymous aspect, taxpayers may be using them to hide taxable income from the IRS.

In late 2016, a federal judge authorized the IRS to serve a “John Doe summons” on Coinbase seeking information about U.S. taxpayers who conducted transactions in virtual currency during 2013, 2014, and 2015. In court documents, the Justice Department stated that Coinbase was the fourth largest exchanger globally of Bitcoin and the largest exchanger in the United States. The Justice Department further stated that Coinbase offered buy/sell trading functionality in 32 countries, maintaining over 4.9 million wallets with wallet services available in 190 countries, serving 3.2 million customers, with $2.5 billion exchanged in Bitcoin. According to the IRS, only 2,500 taxpayers reported transactions in Bitcoin on their U.S. income tax returns during the three years in question, as compared to nearly 500,000 U.S. customers reported by Coinbase during the same period. Coinbase has vigorously resisted the John Doe summons, and the matter has been in litigation for the past year, with the IRS eventually agreeing to narrow the scope of its summons.

In its ruling approving the Coinbase summons, the Court determined that the summons “serves the legitimate purpose of investigating the ‘reporting gap between the number of virtual currency users Coinbase claims to have had during the summons period’ and ‘U.S. bitcoin users reporting gains or losses to the IRS during the summoned years.’” The Court found that Coinbase is the largest U.S. exchange of bitcoin into dollars with at least 5.9 customers served and 6 billion in transactions while only 800 to 900 taxpayers a year have electronically filed returns with a property description related to Bitcoin from 2013 through 2015. This discrepancy, wrote the Court, creates an inference that more Coinbase users are trading bitcoin than reporting gains on their tax returns.

As narrowed, the IRS summons seeks information regarding 8.9 million Coinbase transactions and 14,355 Coinbase account holders. That only 800 to 900 taxpayers reported gains related to Bitcoin in each of the relevant years and that more than 14,000 Coinbase users have either bought, sold, sent or received at least $20,000 worth of Bitcoin in a given year suggests, the Court concluded, that many Coinbase users may not be reporting their Bitcoin gains. Under these circumstances, the Court ruled that IRS has a legitimate interest in investigating these taxpayers.

In a victory for Coinbase, the Court ruled that the scope of information sought by the IRS was overbroad, and trimmed the types of records that would be required to be turned over by Coinbase. Coinbase is only required to produce the following data for its customers: taxpayer identification number; name; date of birth; and address. The Court refused the government’s request for additional information, including account opening records; copies of passports and/or driver’s licenses; wallet addresses; and public keys for accounts/wallets/vaults; “know your customer” due diligence records; and customer correspondence.

As a result of the Court’s ruling, Coinbase must now turn over to the IRS the following documents for accounts with at least the equivalent of $20,000 in any one transaction (buy/sell/send/receive) in any one year during the 2013 through 2015 time period:

  • Taxpayer identification number;
  • Name;
  • Birth date;
  • Address;
  • Records of account activity including transaction logs or other records identifying the date, amount, and type of transaction (purchase/sale/exchange), the post transaction balance, and the names of counterparties to the transaction; and
  • Periodic statements of account or invoices (or their equivalent).

Once it receives the summoned data from Coinbase, the IRS will cross-check tax returns filed by the individuals in question to determine if they properly reported their Bitcoin trading gains and losses. Individuals who have not properly reported their Bitcoin holdings will likely be contacted by the IRS, and the nature of that contact will be dictated by the magnitude of each individual’s tax non-compliance. For Coinbase customers with a relatively small number of unreported transactions, the IRS may simply send a “soft” letter advising them to file amended tax returns. Coinbase users with a greater number of unreported transactions may be selected for audit and face penalties for not properly reporting Bitcoin transactions. The most egregious examples of non-compliance may well face criminal investigation by the IRS, if there is evidence those customers deliberately intended to evade their tax obligations by trading in Bitcoin. As we previously reported, drug trafficking organizations and other illicit actors are using digital currencies with increasing frequency to engage in money laundering.

Coinbase has not stated publicly whether it intends to appeal, but in a blog post the company said it was “in the process of reviewing the order” and would “continue to keep our customers updated.” In that same piece, Coinbase noted that the summons affected less than 1 percent of its customer base. Coinbase also said that “[i]n the event that we ultimately produce the documents under this Court order, we intend to notify impacted users in advance of any disclosure.” This advance notice will presumably afford concerned accountholders an opportunity to quickly rectify their tax filings, if they deem it advisable.

Bitcoin

Earlier this week, a federal grand jury in Brooklyn returned an indictment criminally charging a self-described “day trader” with various offenses in connection with an alleged computer hacking scheme involving more than 50 online brokerage accounts. The indictment further alleges that the defendant laundered the proceeds of his crimes using Bitcoin, a cryptocurrency.

The indictment alleges that the defendant and others conspired to hack into victims’ online securities brokerage accounts and used them to place unauthorized trades. As a part of the conspiracy, the defendant is alleged to have used brokerage accounts in his name to place “short sale” offers for publicly-traded companies’ stock at artificially high, above-market prices. Simultaneously, the defendant’s co-conspirators are alleged to have hacked into victims’ online brokerage accounts and used them to place buy orders for the stock at the artificially high prices, matching the defendant’s short sale offers. After using the victims’ accounts to purchase the stock, the defendant and his co-conspirators then re-purchased the stock from the victims’ accounts at market or below-market prices. This series of fraudulent trades usually took place within minutes, and the defendant immediately profited based on the difference between his artificially high short sale price, and the lower price at which he subsequently re-purchased the stock. While discussing the scheme in private messages on Twitter, one of the co-conspirators stated: “legal trading too hard.” The defendant responded that he would be a “good trading partner.”

Shortly before the defendant began the securities fraud scheme, he allegedly agreed to pay one of his co-conspirators one-half of his trading profits. Court documents indicate that the defendant was concerned about sending money to his co-conspirator, noting in a message sent via Twitter direct messaging that it was “sketchy but there are ways.” To mask these payments, the co-conspirator instructed the defendant to pay him in Bitcoin. The defendant opened an account at Coinbase, which is an online platform that allows users to convert currency such as U.S. dollars into Bitcoin, and to send and receive payments in Bitcoin. In total, the indictment alleges that the defendant paid his co-conspirator approximately $237,120 in Bitcoin through his Coinbase account. The defendant’s payments to his co-conspirator using Bitcoin is the basis for the indictment’s conspiracy to commit money laundering in violation of 18 U.S.C. section 1956(h).

Numerous government agencies have expressed concern that the anonymous nature of Bitcoin and other virtual currencies facilitates money laundering and other illicit activity. Most recently, the Drug Enforcement Administration published a report that drug trafficking organizations are increasingly using virtual currencies to enable easy transfer of illicit funds internationally, and that Bitcoin is also being used to facilitate trade-based money laundering schemes, particularly those based in China.

In addition to money laundering, Bitcoin and other virtual currencies can readily facilitate tax evasion by users. In 2013, the U.S. Government Accountability Office issued a report concluding that “some taxpayers may use virtual economies and currencies as a way to evade taxes. Because transactions can be difficult to trace and many virtual economies and currencies offer some level of anonymity, taxpayers may use them to hide taxable income.” In 2014, the Internal Revenue Service published guidance on the tax consequences of the use of virtual currencies, making clear that Bitcoin and similar currencies are property for tax purposes, and a taxpayer can therefore have gain or loss on the sale or exchange of a virtual currency, depending on the taxpayer’s basis.

In late 2016, a federal judge authorized the IRS to serve a “John Doe summons” on Coinbase – the same virtual currency exchanger used by the day trader charged this week in the case described above – seeking information about U.S. taxpayers who conducted transactions in virtual currency during 2013, 2014, and 2015. In court documents, the Justice Department stated that Coinbase was the fourth largest exchanger globally of Bitcoin and the largest exchanger in the United States. The Justice Department further stated that Coinbase offered buy/sell trading functionality in 32 countries, maintaining over 4.9 million wallets with wallet services available in 190 countries, serving 3.2 million customers, with $2.5 billion exchanged in Bitcoin. According to the IRS, only 2,500 taxpayers reported transactions in Bitcoin on their U.S. income tax returns during the three years in question, as compared to nearly 500,000 U.S. customers reported by Coinbase during the same period. Coinbase has vigorously resisted the John Doe summons, and the matter has been in litigation for the past year. Just yesterday, the federal judge overseeing the litigation indicated in a hearing that she is inclined to permit the IRS to proceed with its investigation of Coinbase customers.

BitcoinIn its recently-published 2017 National Drug Threat Assessment (NDTA), the Drug Enforcement Administration reports that drug trafficking organizations are turning to Bitcoin and other virtual currencies to enable easy transfer of illicit funds internationally. The NDTA is a comprehensive strategic assessment of the threat posed to the United States by domestic and international drug trafficking and the abuse of illicit drugs. The report combines a wide variety of law enforcement reporting and other data to determine which substances and criminal organizations represent the greatest threat to the United States.

The NDTA notes that in order to avoid law enforcement detection and banking regulations, transnational criminal organizations (TCOs) employ various strategies to move and launder drug proceeds into, within, and out of the United States. Preferred methods to move and launder illicit proceeds – such as bulk cash smuggling, money value transfer systems, trade-based money laundering, and through the formal banking sector – remain the same as in past years. Emerging as a new money laundering threat, however, are Bitcoin and other virtual currencies because of their “anonymizing nature and ease of use.” Bitcoin is the most common form of payment for drug sales on dark net marketplaces and is emerging as a desirable method to transfer illicit drug proceeds internationally. Bitcoin is the most widely used virtual currency due to its longevity and growing acceptance at legitimate businesses and institutions worldwide.

The NDTA notes that Bitcoin’s widespread popularity in China has now spread to trade-based money launderers operating in that country. Many trade-based money laundering schemes are China-based, and have historically consisted of the purchase by TCOs of large shipments of “made-in-China” goods via wire transfer or bulk cash carrying from the United States to China. The “made-in-China” goods are then shipped to business owners in Mexico and South America, who in turn reimburse the drug trafficking organizations in local currency. Now, many China-based firms manufacturing goods used in such schemes prefer to accept Bitcoin for payment.

The use of Bitcoin in this type of trade-based money laundering scheme no doubt facilitates the money laundering process for TCOs, which currently face scrutiny from U.S. banks whenever they wire money to Chinese manufacturers. In contrast, the NTDA notes that a TCO purchasing Bitcoin through a licensed money service business without raising red flags will face no further scrutiny when transferring the Bitcoin to China. Many TCOs can also buy Bitcoin from individuals selling Bitcoin on the Internet without any MSB license. Many TCOs will thus be able to convert their cash drug proceeds to Bitcoin and buy Chinese goods with no fear of oversight from a formal financial institution.

The NDTA also notes that Bitcoin is increasingly being used by Over-the-Counter (OTC) Bitcoin brokers who conduct high-risk Bitcoin trading consistent with Chinese capital flight and money laundering. These brokers likely use foreign Bitcoin wallet-hosting services and exchanges that do not properly conduct “know your customer” or anti-money laundering monitoring on Bitcoin purchases. OTC Bitcoin brokers primarily attract two types of clients: those who want to use Bitcoin to move their money out of China and those who want to convert large quantities of cash into Bitcoin. Chinese underground banking systems money brokers sell Bitcoin to drug traffickers for cash earned from drug sales in the United States, Australia, and Europe. This drug cash is then sold to Chinese nationals in exchange for Bitcoin the Chinese nationals use to transfer the value of their assets outside of China. The NTDA concludes that the increasing use of OTC Bitcoin brokers, who are capable of transferring millions of dollars in Bitcoin across international borders as part of a capital flight scheme, is expected to continue to intertwine criminal money laundering networks with capital flight.