Cloud Mining and the Sale of Unregistered Securities

    Thomas Ritter is an associate attorney at Thompson Burton PLLC. His practice area focuses primarily on cybersecurity law, which includes an assortment of data protection and privacy-related matters, and a wide-variety of business transactions. He assists diverse businesses from well-established companies to early stage start-ups.

    No bigger buzzwords exist in the general populace right now than “cryptocurrency,” “bitcoin,” or some other derivative. With skyrocketing prices and frenzied market activity, everyone and their grandmother wants to know the best way to collect some cryptocurrencies of their own.

    As a result, new business model after new business model continues to pop up predicated upon the collection of valuable digital commodities. The latest of these models involves a service known as “cloud mining.” Cloud mining is the process by which a person willing to pay money can share in and use the processing power of someone else’s hardware to mine for cryptocurrencies. Unsurprisingly, the offering of cloud mining services has quickly made its way into the world of network marketing. Projected as the latest, greatest path to making easy money, the popular refrain from current and prospective participants is that cloud mining seems “too good to be true.” In all likelihood, it is.

    The Story of GAW Miners

    Just over two years ago, the Securities and Exchange Commission brought one of the very first actions against a cloud mining company. Founded and operated by Joshua Garza, GAW Miners initially offered customers the chance to purchase equipment used to mine cryptocurrencies. However, GAW Miners quickly evolved from merely offering the sale of mining equipment to something entirely different and more hands off – cloud mining. This cloud mining primarily took shape in the form of “hashlet” contracts. A hashlet did not involve the sale of any mining equipment, but rather represented “a divisible and assignable allocation of hashing power from GAW-owned and hosted mining hardware.” In English, this meant purchasers bought a slice of computing power found in the mining equipment owned and operated by GAW Miners. As a result of the these hashlet contracts, purchasers earned a share of the profits made from the company’s successful mine of different cryptocurrencies.

    The SEC found [complaint here] that these hashlets acted as “investment contracts,” or “securities.” As I’ve explained before, an investment contract is generally defined as “an investment of money in a common enterprise where profits come from the efforts of other people.” When companies sell an investment contract (i.e., a security) without filing any of the appropriate registrations, they violate the Securities Act. This violation comes from the sale of securities without a license, and thus represents an act in contravention of the law.

    The SEC concluded all the elements of an investment contract to be present in the hashlet contracts. Purchasers of the hashlets paid a clear investment of money (i.e., investment) to earn profits off the efforts of GAW Miners. The profits earned were inexplicably linked to and dependent upon the success of GAW Miners (i.e., common enterprise), and the profits derived from the mining equipment maintained by GAW Miners data centers (i.e., efforts of others).

    Investors relied solely on the efforts of GAW Miners to generate Hashlets’ expected profits by owning, housing, operating, maintaining, and connecting the computer hardware that would engage in mining. [Complaint, page 11].

    In another case against Munchee, a company who sold its own digital tokens, the SEC heavily relied upon the manner in which the sale occurred in its unregistered security determination. More specifically, the SEC found that a company’s general representations gave purchasers an expectation of future profits. In other words, the general tone used by promoters can land a company in hot water, regardless of what the company publishes in official literature.

    Based on numerous statements by the SEC, coupled with a few of their enforcement actions, it’s clear that regulators have plenty of dry-powder when it comes to cloud mining. Moving forward, it is our opinion that the SEC will start getting more granular in their analysis and pursue cloud mining operators. The answer is best explained in debunking many of the common representations made by cloud mining MLMs of why their respective business doesn’t run afoul of securities laws.

    (1) We sell energy, not machines

    Guess what? Your business offering is basically the exact same thing as GAW Miners’ hashlets. No matter the description (hashing power, processing power, energy power), the essential ingredient remains the same: right to the use of someone else’s computing power, otherwise known as a mining contract. This is a problem and speaks directly to the second and third-prong of the investment contract inquiry — common enterprise in profits derived from the efforts of others. The company and its machines do all the work while you passively sit back and expect a profit.

    (2) I own the mining machine, the company just maintains and uses it.

    The thinking goes that because you own your the machine used to produce returns, such returns don’t then come from the efforts of others. First, what verifiable proof of ownership do you have? A photograph? A serial number? External access? How can you be so sure a machine even exists? Korean regulators recently filed charges against US-based mining firm, Mining Max, alleging misrepresentations and false promises concerning mining returns. Of the $250 million collected, Mining Max supposedly only spent $70 million on mining equipment. Cases like Mining Max exist domestically as well. The SEC has taken action against companies who claimed to have machines that they did not in fact possess (e.g., GAW Miners, Butterfly Labs). Moral of the story: prospective purchasers of mining equipment should do their due diligence on whether or not a company can even produce sufficient proof of machine existence.

    For theoretical purposes, let’s assume one does own a legitimate machine maintained by a third party. Moreover, this machine is used in tandem with other machines to mine for cryptos. Other lawyers have opined this independent ownership over the machine dispels unregistered security concerns. Frankly, I disagree. Essential to any investment contract determination is the presence or omission of investors own efforts. An investment contract can still exist even when an investor performs some duties, specifically nominal duties that have a minimal effect on the receipt of benefits. In the context of cloud mining, even an investor who owns a mining machine rarely makes the kind of significant decisions that affect the success or failure of the mining efforts. Instead, the cloud mining company performs all the work, using the computing power of one machine in connection with others. Collectively, this shared processing power produces returns from the number of cryptocurrency units generated, and participants benefit. What does this look like? The payment of money by a person who produces little to no work that nonetheless produces some sort of financial return. That sounds like a passive investment to me.

    Regulators Speak Out

    The SEC’s recent words and actions reflect a more concerted effort towards active regulation and enforcement of the cryptocurrency space in the near future. In a statement given by SEC Chairman Jay Clayton on December 11, he cautioned that “those who operate systems and platforms that effect or facilitate transactions in [cryptocurrency-related products]” may be operating unregistered exchanges or as broker-dealers in direct violation of securities regulations. He also dispelled the oft-used notion of form over substance, noting that just because certain words are/are not used doesn’t ultimately determine whether something operates as as a security. This cuts to the heart of and completely undermines the idea that any prohibition against the use of the word “investment” means a company is not in the business of selling a security. While a company can be disciplined in their messaging, they’re judged largely by the people shooting videos and showing their Bitcoin wallets saying “Look at this! Money just shows up from the cloud!”

    This domestic approach to cryptocurrencies comes on the heels of international news that saw Chinese authorities are purportedly instructing local governments to shut down mining operations, and the new development that European regulators searched and seized equipment in various OneCoin offices as part of an international investigation.

    Conclusion

    In my opinion, all of this represents a priming of the pump so to speak. While regulators are slow, they’re not stupid. 2018 will feature numerous enforcement actions by the SEC and other governing bodies against cryptocurrency programs. Of course, people are free to disagree with our analysis. But based on our research, we’re confident in the material referenced above.

    Assuming there’s actually a mining machine on the other end of a contract, cloud mining is not as egregious a violation as some of the cryptocurrency ponzi schemes out there. Nonetheless, it’s not a wise decision to leverage one’s goodwill and relationships to build a program that will likely cease to exist in the near future.Note, this does not apply to companies operating outside of the United States. This firm does not opine on the rules in foreign markets.

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      Thomas Ritter is an associate attorney at Thompson Burton PLLC. His practice area focuses primarily on cybersecurity law, which includes an assortment of data protection and privacy-related matters, and a wide-variety of business transactions. He assists diverse businesses from well-established companies to early stage start-ups.

      • Interesting article especially in the world where most companies use cloud computing for hosting websites or running web apps. I wonder how this will evolve as the conversation between utilizing servers not on premise (aka cloud computing) and receiving a particular amount from the processing of the server in the cloud. That’s really a tough one here because the nature of crypto mining is running software on a server that produces what’s becoming an asset. It will be interesting on how this will evolve over time and how cloud computing and software come under the SEC regulation.

        • Kevin Thompson

          Tony, when customers pay for cloud computing i.e. remote servers, they’re paying for a specific service at a specific price. With cloud mining, they’re paying, in our opinion, with the main goal of leveraging capital to derive a passive reward that exceeds the value of the investment i.e. a ROI.

          When a customer pays Amazon for their cloud services, he or she is not expecting to receive tokens from Amazon that might climb in value…

          • Got it. So if they were simply selling cloud mining without any promises or expectations of mining capacity then would they be good? Because mining is software computation, how would a company convey technical specification as it pertains to hardware in how much it can crunch data without showing an expected return?

      • Ken Nairne

        I’m just glad I don’t live in the USA. It seems the SEC don’t want the poor to get better than poor. The USA authorities are only for the rich.

      • Joe Gonzales

        I’ve looked into some mlm based cloud mining services, as well as non-mlm. They all seem to smell of a scam to be honest. Not only from the securities standpoint, but the basic structure. The contracts (or leases or whatever called) typically last for a certain number of days. But they have an open-ended out to them, so that if they aren’t producing a profit on mining to return some investment due to increase in maintenance or power, etc, then they can cancel the contract after xx days. That means that say somebody charges $5,000 for a lease. They then market a claim of “I made a return on investment of 30% in my first 30 days” to get people in. That’s like $125 returned. (annualized). This captures attention of others. But the contract runs for 1 – 3 years. Over time, the contract returns $4,000, but never the full $5,000 PLUS a profit. As long as Bitcoin and coins rise (which they do their payouts in), they can keep paying out (along with new money invested from others). When it decreases, the profits stop. They can set their payout rates to whatever they want, and the ‘hashing power” prices. So you never know what you can really get, and since they will never pay out 100% to get money back, all that’s really doing is the underlying operator is just buying more hashing power for themselves. In the mean time, then the Investor / customer would have been better off just buying the coins themselves on an exchange and hoping for it to go up and get 100% of the profits and cut out the middle man. An analogy I’ve thought of as well – it’s like Renting a house and expecting to get the profits of the Landlord. You’re not an owner of the equipment, or the operator. You’re leasing. If you lease a car or a house, the Lessee never makes money, the Lessor does.

        • Kevin Thompson

          Interesting thoughts, Joe! I had to read your comment twice to get the detail. But…..maybe you’re on to something. Thanks.