Week in Review
- Federal Jury says crypto-mining products are not securities
- Biden Working Group recommends regulating Stablecoin issuers like banks
- Historic Bitcoin trial over self-proclaimed “Satoshi” kicks off
- Mayors taking their paychecks in bitcoin
- Ant Group, Tencent, JD.com sign NFT Self-Regulation Convention
- South Africa bans pension funds from investing in crypto
- Australian Bank goes all-in on crypto
- Kazakhstan limits crypto investments for retail traders
Federal Jury says crypto-mining products are not securities
On Monday, a federal jury in a civil class action lawsuit in Connecticut found that certain cryptocurrency mining products are not securities. The jury concluded that none of the cryptocurrency products at issue constituted an investment contract or a security under the Howey test.
The case, Audet v. Fraser, Case No. 3:16-cv-940-MPS (D. Conn.), was filed in June 2016 as a class action against four defendants—two related crypto-mining entities (GAW Miners LLC and ZenMiner LLC), the founder and CEO of the crypto-mining companies, Homero Garza, and Garza’s business partner and investor, Stuart Fraser. The Complaint alleged that the defendants employed an evolving scheme to defraud investors that originated with the sale of “Hashlets” or “hashlet contracts,” which represented an interest in the computing power of the crypto-mining companies. The number of Hashlets sold to investors, however, exceeded the actual computing power at the mining centers, according to the Complaint. Initially, GAW sold physical mining hardware and partnered with ZenMiner to offer remote management software that allowed customers to control their mining hardware online. According to the plaintiffs, GAW and ZenMiner never owned as much mining equipment as they advertised to their customers. To appease investors, the defendants allegedly paid out crypto “returns” on the Hashlets with newer investors’ funds—what the Complaint called “hallmarks of a Ponzi scheme.” In addition to the Hashlets, GAW Miners and ZenMiners also sold “Hashpoints” to investors, which were described as promissory notes that could be converted into the companies’ virtual currency, Paycoin. To store the Paycoin, investors were required to use virtual wallets called “HashStakers.”
It should be noted that the DOJ previously prosecuted Garza, a co-founder and CEO of these crypto-mining companies, for wire fraud related to the mining operations. In 2017, Garza pled guilty to engaging in a scheme to defraud in connection with the procurement of virtual currency for customers and was sentenced to 21 months in prison and ordered to pay nearly $9.1 million in restitution. Similarly, the SEC pursued a civil fraud action against Garza arising out of the same set of facts, resulting in a final civil judgment enjoining Garza from violating securities laws and ordering disgorgement consistent with the criminal restitution penalty.
After it became known that Garza was being pursued by both the SEC and DOJ, the plaintiffs in the civil class action dismissed Garza in late 2016. Shortly thereafter, GAW Miners and ZenMiner defaulted in January 2017, which left Stuart Fraser, who owned a 41% stake in GAW and ZenMiner, as the only remaining defendant.
After an eight-day jury trial, the question of whether the four products at issue—Hashlets, Hashpoints, Paycoin, and HashStakers—were investment contracts, and therefore securities, was submitted to the jury. To answer this question, Judge Michael Shea instructed the jury to adhere to the well-known “Howey test”, which was derived from the U.S. Supreme Court’s decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Judge Shea directed the jurors to determine whether plaintiffs had proven that the products at issue constituted an: (1) investment of money, (2) in a common enterprise, and (3) with profits to be derived solely from the efforts of others. The jury instructions further elaborated that “[i]f there was a reasonable expectation of significant investor control, then profits would not be considered derived solely from the efforts of others,” and the jury would have to find for defendants. During trial, Fraser’s attorney argued just that—the crypto-mining products were not passive investments and that customers actively controlled these investments. After deliberation, the jury concluded that none of the four products at issue constituted an investment contract or a security, which is the opposite conclusion the SEC and DOJ reached in 2017 when the agencies went after Garza under the same facts.
The jury’s conclusion also handed Fraser a complete defense verdict. finding Fraser did not commit any common law fraud. Fraser’s attorney had also argued during trial that Fraser was a victim of the Ponzi scheme, since he lost approximately $12 million and had no decision-making power over the mining operations at GAW or ZenMiner.
Biden Working Group recommends regulating Stablecoin issuers like banks
On Monday, the President’s Working Group on Financial Markets (PWG), along with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, published a report (the “PWG Report”) on stable value coins, also known as “stablecoins.” Stablecoins are blockchain-based cryptocurrencies pegged or linked to the value of fiat currencies. Examples of stablecoins are Tether (USDT), Circle USD Coin, and Binance USD. Since last year, the stablecoin market has grown from $11 billion to nearly $130 billion as of October 31st.
The PWG Report outlined several risks that stablecoins pose to the broader economy, including the potential for destabilizing runs, disruptions in the payment system, and concentration of economic power. To combat these potential risks, the PWG Report recommended that Congress impose a new regulatory framework around stablecoins and limit the issuance of such digital assets to insured depository institutions (aka banks). If Congress does not act, however, the PWG recommends that the Biden administration move to regulate stablecoin issuers via the Financial Stability Oversight Council (FSOC), including designating certain stablecoin actions as payment, clearing, and settlement activities, which would place stablecoins under the purview of Dodd-Frank, Title VIII.
The PWG Report also singled out custodial wallet providers, stating that they should be subject to federal oversight and meet appropriate risk-management standards, such as restricting wallet providers’ business relations with certain commercial entities. But the PWG Report stopped short of further oversight, such as requiring custodial wallet providers to register with the FDIC.
“The rapid growth of stablecoins increases the urgency of this work,” the regulators said in Monday’s report. “Failure to act risks growth of payment stablecoins without adequate protection for users, the financial system and the broader economy.”
SEC Chair Gensler also commented on the report, noting that “stablecoins may facilitate those seeking to sidestep a host of public policy goals connected to our traditional banking and financial system: anti-money laundering, tax compliance, sanctions, and other safeguards against illicit activity.”
Adding comments from Gensler form yesterday.
Historic Bitcoin trial over self-proclaimed “Satoshi” kicks off
On Monday, a federal jury in the Southern District of Florida heard opening arguments from attorneys for the estate of deceased computer programmer Dave Kleiman and attorneys for self-professed Bitcoin inventor Craig Wright. The trial centers around 1.1 million bitcoins and intellectual property related to Bitcoin software that Wright allegedly schemed to steal after Kleiman’s passing in 2013. When the lawsuit was filed in 2018, the 1.1 million bitcoins were worth $10 billion. Today, they are worth $69 billion. Kleiman’s estate alleges that Wright breached an oral partnership agreement with Kleiman to mine bitcoins and develop Bitcoin-related technology, but Wright cut Kleiman out of any assets from the partnership. Wright maintains that the partnership never existed.
In opening statements on Monday, Kleiman’s attorneys showed the jury emails from Wright that said Kleiman had helped him create Bitcoin and helped set up an entity called W&K Info Defense Research LLC that was used to mine bitcoin. After Kleiman died in 2013, Wright filed a lawsuit against W&K to transfer the company’s assets to himself, according to Kleiman’s lawyers.
Wright’s attorneys rebutted the allegations by arguing that there is no evidence that Kleiman claimed to have a partnership with Wright, invent Bitcoin, or mine bitcoin together with Wright. According to Wright’s defense, the entire case against Wright is fabricated by Kleiman’s brother, Ira Kleiman, who is the sole personal representative of Dave Kleiman’s estate.
Wright is an Australian-born computer programmer who currently works as the chief scientist at a blockchain company called nChain. Wright claims to be Satoshi Nakamoto, the pseudonymous author of the 2008 white paper that presented a “peer-to-peer version of electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution.” As part of Wright’s defense, Wright claims that the Bitcoin code was written well before the white paper and before Kleiman was involved in any Bitcoin projects with Wright. During cross-examination on Wednesday, Ira Kleiman admitted that he has never seen any emails between Dave Kleiman and Wright that referred to a formal partnership arrangement.
If Kleiman’s estate is successful at trial, the judge may order Wright to provide a portion of the intellectual property rights and a share of the 1.1 million bitcoins to Kleiman’s estate. However, whether those bitcoins actually exist and whether Wright actually controls those bitcoins—if they do indeed exist—are questions that remain unanswered.
The trial is expected to run for three weeks. The case is Kleiman v. Wright, Case No. 9:18-cv-80176 (S.D. Fla.). A copy of the Complaint can be found here.
Mayors taking their paychecks in bitcoin
In a Tweet replying to Anthony “Pomp” Pompliano on Tuesday, Miami Mayor Francis Suarez declared that he would take his next paycheck “100% in bitcoin.” Mayor Suarez cited the “manipulated central bank currency systems” as the main motivator for him taking his salary in bitcoin. “When governments are spending that kind of money that they are, when you have inflation at the point that it is, when you have rampant overspending in government and deficit spending, all of that pushes in favor of an increase in the price of Bitcoin. So I feel very comfortable getting my entire salary in bitcoin,” he said in an interview two days after he tweeted.
Two days later on Thursday, newly elected Mayor Eric Adams tweeted in reply to Pomp and Mayor Suarez that he would be taking his first three paychecks in Bitcoin. Mayor Suarez congratulated Mayor Adams, saying he looks “forward to the friendly competition in making our respective cities a crypto capital.”
The full Twitter thread can be read here.
Ant Group, Tencent, JD.com sign NFT Self-Regulation Convention
On Sunday, several large Chinese technology companies, including Ant Group, Tencent, and JD.com signed a “self-regulation” convention with Chinese state organizations regarding non-fungible tokens (NFTs). The convention is titled “Digital Culture and Creative Industries Self-Regulation Convention” and comprises eleven tenets. The tenets include “enabling the real economy; promoting national culture; supporting the development of industry; adhering to the original letter of the law; ensuring value support; protecting consumer rights; working with controllable consortium chains; maintaining cybersecurity; ending virtual currencies; preventing speculation and financial risks; and preventing money laundering.”
Reporting from the Chinese state media can be read here.
South Africa bans pension funds from investing in crypto
Under new draft rules published last week, the South African government will ban pension funds from investing in crypto currencies. Specifically, the new draft rule states: “A fund may not invest in crypto-assets directly or indirectly.” This rule would supersede current regulations, which allow portfolio managers to invest as much as 2.5% of funds in crypto as part of an umbrella “other assets” category.
The draft rules can be read in full in the October 29th National Government Gazette.
Australian Bank goes all-in on crypto
On Wednesday, Australia’s largest bank, the Commonwealth Bank of Australia, announced that it would allow its 6.5 million customers to buy, sell, and hold bitcoin and other cryptocurrencies starting in 2022. The Commonwealth Bank will start a pilot program this year in partnership with Gemini and Chainalysis to start allowing Commonwealth’s customers to interface directly with crypto assets through the CommBank app. As part of the pilot program, Commonwealth Bank will allow its customers to trade ten selected cryptocurrencies, including Bitcoin, Ethereum, Bitcoin Cash, and Litecoin.
Commonwealth Bank CEO Matt Comyn said: “The emergence and growing demand for digital currencies from customers creates both challenges and opportunities for the financial services sector, which has seen a significant number of new players and business models innovating in this area. We believe we can play an important role in crypto to address what’s clearly a growing customer need and provide capability, security and confidence in a crypto trading platform.”
The full press release from the Commonwealth Bank can be read here.
Kazakhstan limits crypto investments for retail traders
On Wednesday, the Kazakhstan government announced limitations on the amount of money retail investors can put into cryptocurrencies. Under the new regulations, retail investors will only be allowed to invest up to 10% of their annual income or 5% of their total assets, excluding their main residence, up to a cap of $100,000 per year, provided that the retail investor provides evidence of their finances to the financial regulatory body of Kazakhstan. If a retail investor elects not to provide evidence to the financial regulators, then the limit on investing in cryptocurrencies is $1,000 per month.
These new restrictions come on the heels of a draft regulation circulated a couple weeks ago that would limit the nation’s cryptocurrency mining industry to a total of 100 megawatts (MW), and newly authorized mining companies will be limited to using just 1 MW over a period of two years.