Navigating the Bitcoin Minefield: Legal Considerations for Venture Capitalists

By:  Ashley Jacoby

This October a Norwegian man made international headlines after he reportedly opened his wallet and discovered an unexpected $850,000.[1]  Four years ago, Kristopher Koch decided to invest approximately $22 in the virtual currency Bitcoin while researching encryption online.[2]  In April 2013, extensive media coverage on this trending peer-to-peer digital currency reminded Koch of his otherwise forgettable investment.[3]  Although Koch struggled to remember the e-password for his encrypted Bitcoin wallet, his efforts paid off; his small investment in 5,000 coins in 2009 enabled Koch to buy an upscale apartment in Osolo with a fraction of his earnings.[4]

Bitcoin is an electronic form of currency designed to decrease transaction costs third party’s employ to offset processing and mediation expenses.[5]  Bitcoin is neither regulated by a centralized authority, nor backed by any real asset.[6]  Instead, an open source algorithm run over the Bitcoin network generates the system’s currency—the aptly named “Bitcoin”—in a process called “Bitcoin mining.”[7]  The process of mining requires many users to connect their computers to the network in order to solve complex cryptographic tasks and uncover buried coins.[8]  Bitcoins can thereafter be traded, bought, or sold to a third party in exchange for real money, or a user may directly transfer the coins online as payment for goods and services.[9]  Given the glamour and ease in which Koch obtained his fortune in Bitcoin, it is not surprising that venture capitalists have continued to invest.[10]  A recent decision in a federal case from Texas—holding bitcoin is in fact currency just like the US Dollar—has even helped Bitcoin branch out into the business world.[11]  However, before potential investors reach for their actual wallets, they may want to consider Bitcoin’s future legal status and its connection to illegal activities.

For instance, following a large-scale FBI bust this fall, authorities learned that the Silk Road—one of the most infamous online marketplaces for drugs and illegal merchandise—generated more than 9.5 million bitcoins, or approximately $1.2 billion, in sales.[12]  Silk Road drug traffickers accepted bitcoins in exchange for their illegal products online, and thereafter anonymously mailed the goods to customers.[13]

Furthermore, recent reports indicate the Bitcoin network is vulnerable to attack from cyber thieves.[14]  Hackers have installed “malicious software” on the network that seeks out and empties bitcoin owner’s virtual wallets.[15]  One phishing gang successfully robbed an owner of thirty-four coins in a malware attack.[16]  With shares at a high of $260, the owner’s loss was not unsubstantial.[17]  

Moreover, scientists at Cornell University have argued that Bitcoin’s susceptibility to a “selfish attack” indicates the system is broken.[18]  The system assumes members honestly report network activity; a mining group that fails to inform the community that it has solved a cryptographic puzzle could, in theory, take over Bitcoin by progressing to the next puzzle while the rest of the community searches through an empty mine.[19]

In addition to Bitcoin’s obvious association with illegal activity, doubts about the system’s legitimacy and its sustainability have created a volatile market. For instance, following the FBI shut down of the Silk Road, bitcoin shares dropped dozens of dollars in one day.[20]  On another occasion, the Bitcoin market saw fluctuation after the SEC charged a Texas man with raising 700,000 bitcoin, or $4.5 million, from investors in an online Ponzi scheme.[21]

Thus, as the Bitcoin system is currently ripe for criminal abuse, the status of the digital currency is unlikely to remain in a legal gray area for long. With legal scholars arguing both for and against the continued use of the Bitcoin system, and very little case law or statutory framework on-point, investors should be mindful to consider both the legal and financial implications of investing in Bitcoin so early in this legal minefield.