Citrus Groves in the Cloud: Is Cryptocurrency Cloud Mining a Security?

By Sandler, Darren J. | Santa Clara High Technology Law Journal, May 2018 | Go to article overview

Citrus Groves in the Cloud: Is Cryptocurrency Cloud Mining a Security?


Sandler, Darren J., Santa Clara High Technology Law Journal


Table of Contents  Introduction I. Background    A. Proof of Work    B. Proof of Stake    C. Why Cloud Mining? II. Regulatory Agency Awareness    A. FinCEN    B. IRS    C. FTC III. Certain Securities Considerations    A. The Howey Case    B. Application to Cloud Mining       1. Common Enterprise       2. Expectation of Profits Solely Derived from the Efforts of       Others    C. Recent SEC Enforcement Action    D. Cloud Mining Company Conducts a Private Placement Conclusion 

Introduction

Cloud mining of blockchain cryptocurrency is a growing industry that has largely flown under the radar of regulators, who thus far tend to focus on initial coin offerings ("ICOs"). From an enforcement standpoint, federal agencies such as the Securities and Exchange Commission ("SEC"), Commodity Futures Trading Commission ("CFTC"), Federal Trade Commission ("FTC"), and Financial Crimes Enforcement Network ("FinCEN") have not taken much action in connection with blockchain cryptocurrency mining, a key aspect of blockchain and cryptocurrency technology. Four developments stand out, but more activity would provide greater clarity to legal practitioners, entrepreneurs, investors, and blockchain protocol users. In January 2014, FinCEN carved out certain situations of cryptocurrency mining from its definition of a money services business ("MSB"). (1) In March 2014, the Internal Revenue Service ("IRS") issued a notice to clarify the tax treatment of cryptocurrencies, including those generated through mining. (2) In September 2014, the FTC brought a civil action against a cryptocurrency mining hardware and cloud mining company. (3) In June 2017, the U.S. District Court for the District of Connecticut entered a final default judgment in a case brought by the SEC against two related cryptocurrency cloud mining companies. (4)

Cloud mining is an economic arrangement in which a person pays another person or entity to engage in cryptocurrency mining on their behalf and receives the transaction fees, cryptocurrency or a portion thereof that is generated from such mining efforts. (5) This arrangement, which occurs in a variety of forms, raises securities law concerns, as such arrangements can potentially be viewed as "investment contracts" under federal securities laws.

Under the federal securities laws, an investment contract is: (1) an investment of money; (2) in a common enterprise; (3) with an expectation of profits; (4) derived solely from the efforts of others. (6) The various circuit courts have diverged with respect to how to apply the second prong of this analysis. The Supreme Court case that first articulated this test, SEC v. W. J. Howey Co. (hereinafter "Howey"), (7) provides a direct lens through which to analyze whether certain cloud mining arrangements are investment contracts. In certain instances, cloud mining is a redux of the citrus groves discussed in Howey.

In Section I, this Article provides a background explanation of cryptocurrency mining and cloud mining, which is necessary for attorneys, scholars, and regulators to engage in this topic and for cloud mining companies to comply with federal securities laws. Section II surveys several U.S. regulatory agency responses to cryptocurrency mining. Section III discusses Howey, briefly surveys the circuit split with respect to its interpretation and analyzes cloud mining under Howey (8) and the various circuit court approaches thereunder. Section III also discusses a 2017 SEC enforcement action involving cloud mining. (9) The implications are significant; cloud mining contracts deemed to be securities must be registered with the SEC or otherwise eligible for an exemption from registration (such as a private placement). Issuers and other participants involved in the sale of unregistered securities in violation of the Securities Act of 1933 ("Securities Act") may be subject to liabilities and other investor remedies under state and federal securities laws, including private rights of action and rescission. …

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