On December 1st the Securities and Exchange Commission (SEC) filed charges against bitcoin mining companies GAW Miners and ZenMiner, and their founder Homero Joshua Garza.  The complaint alleges Garza and his companies fraudulently sold $19 million worth of unregistered securities, called Hashlets, to over 10,000 investors in the latter half of 2014.  The SEC believes Hashlets constitute “investment contracts, and thus ‘securities’” under the Exchange Act and the Securities Act.

Why it Matters to You

While many who read the SEC complaint may come away feeling relieved that they have never made the kind of egregious misrepresentations alleged to have been made by GAW Miners, this case could well turn into an example of bad facts making bad law. The real problem for the rest of the mining community is not the fraud claims, it is the possibility that mining pool interests may be characterized as investment contracts, which are a security.  If a mining pool interest is a security, it could not be offered to the public without filing a Registration Statement with the SEC or otherwise complying with U.S. securities laws.

Investment Contracts — Background

An ‘investment contract’ is a catch-all provision used to capture unusual instruments that don’t have the traditional characteristics of a ‘security.’ Nearly 70 years ago, the Supreme Court defined an ‘investment contract’ in S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946) as “a scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”  The Howey test, as it has come to be called, has been further refined by subsequent case law.  Certain aspects of the Howey test remain subject to further clarification, so it can be a challenge to apply.

Examples of schemes that have been deemed ‘investment contracts’ include the sale of parcels of citrus groves with accompanying maintenance contracts, fractionalized interests in pools of home mortgage or auto loans, animal breeding programs and pyramid schemes.

Are Virtual Currency Mining Pools Investment Contracts?

There are a wide variety of mining pool arrangements. Given the fact-intensive nature of the Howey test, it is likely to be the case that at least some of them may be found to be investment contracts.  GAW Miners started out as resellers of equipment and evolved into Hardware Hosted Mining and later Cloud Hosted Mining and finally to Hashlets.  The SEC only took issue with the Hashlets.  While the SEC chose not to take a position on GAW Miners’ earlier mining pool arrangements, this may be a reflection of the fact that the Hashlet arrangement was an easier target with simpler facts to prove.

While the SEC did not lay out specifically which facts supported which prongs of the Howey test, here are the facts that appear most relevant to the test:

  • The company’s terms of service stated, a Hashlet was ‘a divisible and assignable allocation of hashing power from GAW-owned and hosted mining hardware.’
  • Hashlet customers were not buying computer hardware…they had no right to receive any piece of computer hardware at the end of their Hashlet contract. Instead they were buying the rights to profit from a slice of the computing power owned by GAW Miners and or ZenMiner.
  • Hashlet investors were required to do very little to purportedly mine virtual currency. Investors only needed to select the pools in which they wished to mine. From there, 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.
  • The company’s marketing materials advertised one of its pools as “the most profitable pool.”

Take Aways

This is the first complaint filed by the SEC alleging a virtual currency mining pool arrangement is an investment contract. It leaves open the possibility that many or even most mining pool arrangements would also constitute investment contracts.  At a minimum, mining pool operators will need to analyze their mining pool arrangements in light of this new case and determine whether they have sufficiently distinguishable facts to conclude their mining pool arrangements do not constitute investment contracts.

The above is a summary. The complaint is short and worth reading.  SEC Complaint Against GAW Miners et al.