Crypto Caselaw Minute #60 — 11/1/19
By: Nelson M. Rosario
Tags: Bitcoin

This week’s Crypto Caselaw Minute has a munitions blast from the past, the government after some cash, and a quadrillion market of all the money ends “not with a bang but a whimper.”

Disclaimer: Crypto Caselaw Minute is provided for educational purposes only by Nelson Rosario and Stephen Palley. These summaries are not legal advice. They are our opinions only, aren’t authorized by any past, present or future client or employer. Also we might change our minds. We contain multitudes.

(As always, Rosario summaries are “NMR” and Palley summaries are “SDP”. Our Image credit: https://pixabay.com/photos/money-dollars-success-business-1428594/ (Pixabay license).

Securities and Exchange Commission v. Reginald Middleton et al., “Final Judgment” (S.D.N.Y, 19 Civ. 4625, 11/1/19) [SDP]

Link to judgment

Less than three months after getting sued by the SEC, erstwhile self-described quadrillion dollar crypto ICO issuer Veritaseum a/k/a “the market of all the money” has entered into a consent judgment that shuts it down and transfers assets to the SEC for distribution to a receiver. With sincere apologies to T.S. Eliot fans everywhere, this is the way the quadrillion dollar market of all the money apparently ends, not with a bang but a whimper.

As reported on August 13, the SEC sued Veritaseum and Reggie Middleton and again on August 24 for alleged securities fraud after spending approximately $8 million from an ICO undertaken in 2017 and 2018. What really frosted the regulators giblets is that when SEC staff — in the middle of an open investigation — told the defendants not to spend the money they went ahead and spent $2 million anyway to buy “precious metals”. This was a Really Bad Idea, apparently, and led to an immediate lawsuit seeking an asset freeze.

Per the original SEC lawsuit, so-called VERI tokens were plainly unregistered securities and claims about their functionality were plainly horse puckey.

A proposed final judgment, consented to by the defendants, was filed by the SEC on October 31, 2019. The judgment was signed by the Court the next day, on November 1. The judgment contains a permanent injunction against the defendants to not violate securities laws again (I mean you’re already not supposed to), a permanent bar on selling digital securities (a bit more teeth, that), collection of $9.4 million from the defendants, and establishment of a fund with that money “so that the victims of Defendants’ fraud may be compensated.”

The order provides that “Defendants are jointly and severally liable for disgorgement of $7,891,600, representing certain profits gained as a result of the conduct alleged in the Complaint, together with prejudgment interest thereon in the amount of$582,535, for a total of $8,474,137. Defendant Middleton is liable for a civil penalty in the amount of $1,000,000, assessed pursuant to Section 20( d) of the Securities Act [15 U.S.C. § 77t(d)] and Section 2l(d)(3) of the Exchange Act [15 U.S.C. § 78u(d)(3)].”

While this sounds like a really onerous payment obligation, the defendants don’t actually have to pay this if they transfer certain assets, by the terms of the Order. Specifically, both the disgorgement AND the civil penalty are satisfied if certain assets (including a bunch of precious metals) are transferred to an intermediary chosen by the SEC. As the Order puts it:

“Defendants’ obligation to pay disgorgement and prejudgment interest of$8,474,137, and Defendant Middleton’s obligation to pay a civil penalty of $1,000,000,shall be deemed fully satisfied by the transmission of the ‘Frozen Metals’ to the Independent Intermediary in the manner set forth in paragraph VIII herein, by the transmission of the “Frozen Bank Assets” to the Commission in the manner set forth in paragraph XVI herein, and by the turnover of the ‘Frozen Digital Assets’ in the manner set forth in” the Order.”

On the one hand, Veritaseum and Reggie Middleton are very (sorry) much out of the digital asset business and have to give up all of the money they apparently raised. On the other hand, Mr. Middleton doesn’t have to write a personal check to the SEC if the referenced assets are transferred. All things considered, this actually doesn’t seem like such a bad deal.

Bernstein v. U.S. Dept. of Justice, 176 F.3d 1132 (9th Cir., 1999)[NMR]

Link to opinion

Link to lower court opinion 1 and 2

These are in some respects rather turbulent times. Protests rage around the world. Even Rage Against the Machine is getting back together. Technology is advancing at break neck speed, and many people wonder just what the future may bring? Cryptocurrency and blockchain based systems seem to factor into all of that, but how? Will these new tools be used to advance society and human endeavors, or to quell dissent and keep order? The question is an open one, but as Shakespeare said “what’s past is prologue,” and so, let’s look at a case from the 90s to get some better context on where all this may be heading. This is Bernstein v. The Federal Government.

In the early 90s Daniel Bernstein was a graduate student at Berkeley who came up with a new encryption method that he called Snuffle. Bernstein wanted to publish his development, and give talks at all the conferences, etc. Bernstein out of an abundance of caution “asked the State Department whether he needed a license to publish Snuffle in any of its various forms.” Wait, what? Timeout. Moar context needed.

During the 90s cryptographers/computer scientists and the US government, as well as other governments around the world, were engaged in a battle of sorts over the future of encryption of digital communications. At one point a chipset with a built in backdoor called the Clipper chip was put forward by the NSA and others with the intention of the chip being deployed on all mobile phones. The US government at the time considered sufficiently advanced cryptography a munition that was subject to regulation for right alongside other munitions like flamethrowers. Suffice to say, there was a bit of tension between cryptographers and the government. Throw in this new fangled thing called the Internet, and it was a spicy cocktail. Back to Bernstein.

Bernstein was trying to make sense of regulations that might apply to Snuffle, and after some back and forth with the State Department he got fed up and sued challenging the constitutionality of said regulations. This opinion, which was ultimately withdrawn (more on that in a minute), from the Ninth Circuit ultimately upheld two lower court decisions where Bernstein won on an argument that Code is Speech, and the regulations were an unconstitutional prior restraint on his speech. Code is Speech is in some ways the more meaningful aphorism than Code is Law, but I digress. Why write about an appellate opinion that has been withdrawn? Because, the opinion masterfully grapples with these ideas of what speech is with respect to computer code. The crux of the case was the question is “encryption source code [] expression for First Amendment purposes?” The lower court ruled yes, and the appellate agreed.

As the Court put it “[t]he distinguishing feature of source code is that it is meant to be read and understood by humans and that it can be used to express an idea or a method.” I mean, isn’t all speech concerned with expressing ideas and methods? Ultimately, the Court came to the conclusion that:

cryptographers use source code to express their scientific ideas in much the same way that mathematicians use equations or economists use graphs. Of course, both mathematical equations and graphs are used in other fields for many purposes, not all of which are expressive. But mathematicians and economists have adopted these modes of expression in order to facilitate the precise and rigorous expression of complex scientific ideas. Similarly, the undisputed record here makes it clear that cryptographers utilize source code in the same fashion.

And that, in a nutshell, was that. The Court goes through how the regulations amounted to prior restraint, and prior restraint is bad, real bad, and so the regs in question were struck down as unconstitutional. The rest is history, or is it?

The Ninth Circuit ended up granting the government’s request for an en banc hearing, and consequently withdrew its opinion. What that means is that the lower court opinions survive, so point Bernstein and Code is Speech. However, it should be noted that the Supreme Court has never addressed the issue. The encryption debates were hotly contested, and today the idea is taken for granted that Code is Speech, but there’s new technology at play that involves money and has regulators on edge. What happens if every crypto becomes a privacy coin? As the Court put it in its background on cryptography “[f]or much of its history, cryptography has been the jealously guarded province of governments and militaries.” Remember, what’s past is prologue.

USA, v. $194,073.14 in United States Currency, Case №5:19-CV-00837 (W.D. Lou. entered October 22, 2019)[NMR]

Link to ruling

Will criminals ever stop using bitcoin? AAHhahahah…… no. Here, the underlying case was a criminal case brought against a father and on team, the Lords, who were convicted on counts of money laundering, failure to file currency transaction reports, wire fraud, and drug conspiracy. The Lords “pled guilty to conspiracy to operate an unlicensed MSB, namely a bitcoin exchange business.” As part of that plea the father “agreed to forfeiture of all interests he owns or over which he exercises control, directly or indirectly, in any asset that is subject to forfeiture to the United States.” That brings us to this case.

This particular case is an in rem action against a lot of cashola. We’ve talked about in rem actions before, but here is a quick refresher. In rem is one way that a court can exercise jurisdiction. In particular, in rem actions allow a court to exercise power of a piece of property. Here, $194,073.14. Where did this money come from and what is there a dispute about?

Apparently, the Lords were opening shell companies that they used to get access to credit card processing services. One of the processors reached out to the government and said, uhh, we got this pile of cash here, wat do? The government claimed it was directly connected to the Lords, because it was in the name of one of their shell companies, Quantum Health, LLC.

According to the facts of the related criminal case Quantum Health, LLC “was a shell entity created solely for the purpose of operating the Lords’ unlicensed bitcoin exchange. TSYS [the credit card processing service] initially held the funds because a large amount of chargebacks suggested or indicated fraudulent activity. No further action had been taken.” The government started civil proceedings to claim that money. The father was notified, and he protested claiming that “the question is whether or not the remedy of civil forfeiture is available at all under the facts of this case and the applicable statutes.” He had never disclosed the existence of that cash, and the Lords did not plead guilty to a forfeitable offense, but they did agree to forfeit any assets subject to forfeiture. In essence, the father wanted the in rem action to be treated like part of his criminal case.

Why would he contest this? Well, civil and criminal cases are subject to different standards. As you might suspect the criminal standards are higher. Do you think the Court bought this argument? No, of course not.

The evidence is uncontradicted that Quantum Health, LLC, is a shell corporation used as an unlicensed MSB, wholly unrelated to the delivery of healthcare as Randall Lord fraudulently claimed. [Doc. №1–3, ¶¶11, 38, 39, 42, 43, 45–47]. Randall Lord used his Quantum account to knowingly conceal proceeds from multiple fraudulent transactions. [Doc. №1–3, ¶¶6, 11–13, 33–48]. Clearly, Special Agent Heusel’s Declaration establishes a substantial connection between Defendant Property and the respective offenses cited therein by a preponderance of evidence. See 18 U.S.C. § 983(c)(3). Randall Lord has failed to rebut that evidence or raise a genuine issue of material fact.

I mean, duh.