The Securities and Exchange Commission (“SEC”) recently charged two Bitcoin mining companies and their founder with conducting a Ponzi scheme. The SEC claims the defendants sold unregistered securities by selling hashlets that entitled their purchasers to a share of the profits from the computing power used by the defendants to mine Bitcoins.1 The SEC alleges the defendants engaged in: (i) fraud in connection with the purchase or sale of securities, in violation of Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5; (ii) fraud in the offer or sale of securities, in violation of Section 17(a) of the Securities Act of 1933 (“Securities Act”); and (iii) the offer and sale of unregistered securities, in violation of Sections 5(a) and 5(c) of the Securities Act.

This case is the SEC’s most recent effort to regulate digital currencies and will focus on whether a hashlet is a security. It also is a reminder that anyone interested in owning a collective investment vehicle focusing on mining or investing in digital currencies should do so cautiously and with counsel.

Bitcoin 101

Bitcoin is a digital, private crypto-currency that can be “mined” by anyone. Mining requires the ability to solve a complicated mathematical algorithm. Once mined, Bitcoins can be exchanged and traded through exchanges for conventional currencies, such as U.S. dollars, or used to purchase goods and services. Bitcoins are identified by a public “key” – like an account number – and protected by a private “key.” Transactions are recorded on a “block chain,” a universal public ledger that can be viewed by any computer on the Bitcoin network. 

Mining

Certain digital currencies, including Bitcoin, self-generate units of the currency by rewarding miners with newly created coins when they are the first to solve the algorithms that validate transactions in the currency. The Bitcoin network collects all transactions made during a set time period, usually around 10 minutes, into a list called a “block.” Bitcoin miners compete to be the first to confirm the transactions in the block and write them into the blockchain. The first miner to solve the algorithm that confirms a transaction is rewarded with a preset amount of newly issued Bitcoins by the Bitcoin protocol. This process of solving equations to confirm transactions and to earn new coins is known as “mining” that currency.

Hashing

As interest in Bitcoin increased, miners began to seek enhanced computer processing power. The processing power of computers used to confirm virtual currency transactions is measured by their “hash rate” – the number of calculations they can perform per second. The greater a computer’s hash rate, the greater its chance to solve the equation that confirms transactions, and the more virtual currency coins the miner may earn.

The increasing competition to solve the equations that confirm blockchain transactions has led miners to combine their computing power into mining “pools.” The more computing power directed to a particular mining pool, the better the chance that pool will be the first to confirm a block of transactions and receive the payout for mining.

SEC Complaint

The SEC alleges Homero Joshua Garza perpetrated a fraud through his companies GAW Miners and ZenMiner by purporting to offer shares of a digital Bitcoin mining operation. The SEC claims GAW Miners and ZenMiner did not own enough computing power for the mining it promised to conduct, so most investors paid for a share of computing power that never existed. The SEC believes the returns paid to some investors came from proceeds generated from sales to other investors.

The SEC claims Garza and his companies “cloaked their scheme in technological sophistication and jargon, but the fraud was simple at its core: they sold what they did not own, misrepresented what they were selling, and robbed one investor to pay another . . . ” The SEC alleges that from August 2014 to December 2014, Garza and his companies sold $20 million worth of purported shares in a digital mining contract they called a hashlet

The SEC argues the hashlets were contracts that entitled their purchasers to a share of the profits from defendants’ purported “hashing power,” or the computing power (measured in megahash per second), that the defendants purportedly devoted to virtual currency mining. The SEC alleges the defendants sold more hashlets worth of computing power than they actually had in their computing centers. There was no computer equipment to back up the vast majority of hashlets that defendants sold. 

The SEC claims more than 10,000 investors purchased hashlets, which were touted as always profitable and never obsolete. Although hashlets were depicted in GAW Miners’ marketing materials as a physical product or piece of mining hardware, the promised contract purportedly entitled the investor to control a share of computing power that GAW Miners claimed to own and operate. The SEC argues investors were misled to believe they would share in returns earned by the Bitcoin mining activities when in reality GAW Miners directed little or no computing power toward any mining activity. 

The SEC claims the defendants earned about $19 million in revenue from their sales of hashlets and that the defendants made false and misleading statements about GAW Miners’ virtual currency mining operations to potential and actual investors, including:

  • That all the hashlets of computing power purchased by investors would bepooled to engage in virtual currency mining, and that investors’ returns, or “payouts,” would be calculated based on the success of those collective virtual currency mining operations;
  • That buying a hashlet would allow investors to mine virtual currency without the expense and expertise that would be required to purchase and maintain their own virtual currency mining equipment;
  • The actual profitability and life-span of hashlets; and
  • The extent of GAW Miners’ mining activities.

Because Garza and his companies sold far more computing power than they owned, the SEC alleges they owed investors a daily return that was larger than any actual return they were making on their limited mining operations. The SEC also alleges the investors were simply paid back gradually over time under the mantra of “returns” out of funds that Garza and his companies collected from other investors. The SEC claims most hashlet investors never recovered the full amount of their investments, and few made a profit.

Are Hashlets Securities?

The SEC has argued the sale of the hashlets by the defendants constituted the sale of securities. However, a fractional interest in a computerized mining operation (a hashlet) is not within the definition of “security” under the Securities Act or the Exchange Act. Section 2(a)(1) of the Securities Act defines a “security” as “any note, stock, treasury stock, security future, security-based swap, bond . . . [or] investment contract . . . ”2 Section 3(a)(10) of the Exchange Act defines “security” in similar terms.

The SEC claims the hashlets are investment contracts that fall within the scope of the Securities Act and the Exchange Act. In SEC v. W.J. Howey Co.,3 the United States Supreme Court established a three-part test to determine whether an offering, contract, transaction, or scheme constitutes an investment contract.4 Under the Howey test, a contract, transaction, or scheme is an “investment contract” if it involves: (i) the investment of money; (ii) in a common enterprise; (iii) with the expectation of profits to come solely from the efforts of others.

The complaint sets forth facts meant to establish that hashlets are securities under the Howey test.

The Hashlets Were Obtained Through an Investment of Money

The SEC claims that beginning in August 2014, GAW Miners and ZenMiner decided to sell the hashlets to the public. The SEC alleges the purchasers of hashlets paid money in return for a share of the profits that GAW Miners and/or ZenMiner would purportedly earn by mining virtual currencies using the computers that were maintained in their data centers.

The Hashlets Were Sold as Part of a Common Enterprise

The SEC claims the hashlets were sold to purchasers with the promise they would earn a return based on the number of virtual currency units generated when the pools to which their computing power was directed succeeded in processing and confirming digital currency transactions. The SEC notes ZenMiner’s terms of service indicated a hashlet was “a divisible and assignable allocation of hashing power from GAW-owned and hosted mining hardware.” The SEC believes hashlet customers were buying the rights to profit from a slice of the computing power owned by GAW Miners and/or ZenMiner (by then, purportedly, a division of GAW Miners).

The Hashlet Purchasers Were Passive Investors

The SEC alleges the hashlet purchasers were required to do very little to purportedly mine virtual currency. Investors only needed to log into their accounts and click-and-drag their hashlet icons over to the icons of the mining pools in which they wished their hashlets to mine. The SEC claims investors relied solely on the efforts of GAW Miners and/or ZenMiner to generate hashlets’ expected profits by owning, housing, operating, maintaining, and connecting the computer hardware that would engage in mining.

If the SEC is able to establish that hashlets are investment contracts, they will be deemed “securities” under Section 3(a)(10) of the Exchange Act,5 and Section 2(a)(1) of the Securities Act.6

Violations of Securities Laws

Should the court deem the hashlets securities, the SEC may then be able to establish the defendants violated Sections 5(a) and 5(c) of the Securities Act – sold unregistered securities without an applicable exemption from registration. The SEC may also be able to prove the defendants violated Section 10(b) of the Exchange Act and Rule 10b-5 and Section 17(a) of the Securities Act (fraud in the sale of securities).

Conclusion

Any firm planning to develop a collective mining operation for Bitcoins or other digital currencies should proceed with caution. Similarly, anyone looking to invest in a collective investment vehicle that focuses on mining or investing in digital currencies should make sure the vehicle is properly structured to comply with the securities laws. Due to the lack of clearly defined guidance with respect to the authority of the SEC and state regulators to supervise digital currencies, it is important that you engage experienced counsel to assist in navigating the regulatory requirements that may apply to any business you are building.