New Technology, Old-School Fraud: SEC Goes After Bitcoin-Based Ponzi Scheme

A confession: I picked this post topic because I kept seeing articles about Bitcoins and still did not understand what the heck they were. So I figured that if I wrote a post about it, then I’d be forced to learn. After some research, I learned enough to be dangerous. It’s a fascinating system. To me, it seems ripe for fraud by a sophisticated hacker. But, then again, so is the traditional currency system.

The reason Bitcoin came across my radar screen is that the SEC recently charged a Texas man with running a Ponzi scheme involving Bitcoin investments. Here is the complaint filed against Trendon T. Shavers.

A Primer On Bitcoin

Bitcoin has been described as a lot of things. The SEC says it

is a virtual currency that may be traded on online exchanges for conventional currencies, including the U.S. collar, or used to purchase goods and services online. [It] has no single administrator, or central authority or repository.

Wikipedia describes it as

a cryptocurrency where the creation and transfer of bitcoins is based on an open-source cryptographic protocol that is independent of any central authority. Bitcoins can be transferred through a computer or smartphone without an intermediate financial institution.

It was invented—if that is the right word—in 2008. Users have a digital “wallet” where they store their Bitcoins using long strings of letters and numbers as each Bitcoin’s address. The exchange rate for Bitcoins has been fairly volatile. Forbes reported that in February 2013, the value of a Bitcoin was $22 and it April it was $266. There are at least 10 million Bitcoins in circulation.

You may be wondering how the system ensures that someone doesn’t simply create new Bitcoins out of whole cloth and start spending them. Well, every Bitcoin transaction is recorded in a “block chain,” which is a shared public transaction log. In theory, then, the system will catch someone who tries to spend the same Bitcoin twice.

Unlike traditional currency, there is no central authority issuing Bitcoins. Instead, the collective network issues it. The current protocol caps the total number of Bitcoins at 21 million and it creates 25 Bitcoins every 10 minutes.  Some online merchants accept Bitcoin for payment and some organizations—Wikileaks for one—will accept it for donations. It is not yet in widespread use.

This quote in a Forbes article made me feel better about my general confusion as to how Bitcoins work in practice:

The concepts of cryptocurrencies in general are abstruse and abstract, and understanding how and why Bitcoin works requires a fair degree of technological knowledge.

The Alleged Scam

Mr. Shavers was the founder of Bitcoin Savings & Trust (BTCST). The SEC charged him under Section 17(a) and 10(b) of the Exchange Act and under Sections 5(a) and 5(c) of the Securities Act for his alleged scheme to defraud investors.

Mr. Shavers sold Bitcoin-denominated investments through BTCST and ultimate raised at least 700,000 Bitcoin through the scheme. According to the SEC, this was worth approximately $4.5 million. There were at least 66 investors from across the county—yes, they were simply sending their Bitcoin to some guy promoting investments on the internet.

The SEC claims that Mr. Shavers promised investors that they would have a weekly return of up to 7%. He claimed to engage in Bitcoin arbitrage where he would sell Bitcoin to people who wanted to buy large quantities “off the radar.”

The complaint alleges that Mr. Shavers was not selling the Bitcoin to anyone as he promised. Instead, he used the Bitcoins he received for “personal use” and to pay friends and longtime investors. For example, he allegedly used some of his personal payments to engage in day-trading.

The complaint is devoid of much detail as far as how the supposed fraud unraveled. It simply says that “as the scheme collapsed, Shaves made preferential redemptions to friends and longtime BTCST investors.”

Expanding SEC Jurisdiction?

The government has issued one bit of guidance on virtual currency that I could find. The Financial Crimes Enforcement Network (FinCEN) issued guidance in March about the application of the Bank Secrecy Act to “virtual currencies.” But FinCEN’s guidance is limited to Bitcoin exchanges or “miners” (miners process transactions). Unlike regular uses of Bitcoins, exchanges or miners must register as Money Services Businesses and comply with federal anti-money laundering laws.

Can the SEC go after Mr. Shavers? Probably so. As a general matter, the SEC does not have jurisdiction over regulating currency but can regulate securities (or investments). The SEC’s case is based on Mr. Shaver’s fraud, not the fact that he offered investments in Bitcoins. However, it is not at all clear how far the SEC could go in regulating conduct that relates to the actual use of Bitcoin as opposed to the situation here.

This entry was posted in SEC Investigation, Securities fraud and tagged , . Bookmark the permalink.

One Response to New Technology, Old-School Fraud: SEC Goes After Bitcoin-Based Ponzi Scheme

  1. Gail Reed says:

    It almost sounds like Bitcoin is a “bit” like Monopoly Money only real people are using it to purchase real things. Can you buy a house with Bitcoins? gk

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