Securities Laws as applied to Virtual and Online Items

There’s been a lot of discussion about whether online or virtual accounts can be deemed securities under the U.S. federal securities law.  The most well known at the moment is Bitcoin.

A case was just decided where the court found that Bitcoin was a currency.  Based on that fact, and that the protaganist in the case was offering a money making scheme (you put in money, wait and make more money off Bitcoin), the scheme was subject to the securities laws.   We’ll have to parse out the holding.  The court did not hold that the Bitcoin itself is a security, but rather that Bitcoins are a type of currency – because they can be converted into currency (which I’m not sure I agree with – any commodity, product or item can somehow be converted to currency – and the distinction between selling and converting seems like a big deal). Here’s the link to the case, its actually rather short and sparse on legal analysis for one that makes such huge leaps in legal doctrine as applied to a concept which the court is probably not overly familiar with.  The old adage that bad facts make bad law seems to be the culprit again, as the scheme the guy in Texas was attempting to pull off was not something a judge would let him off on.

I’m pretty sure this isn’t the last we’ve heard of the SEC v. Bitcoin debate.  Mark it up as SEC 1, Bitcoin 0 so far, unfortunately.

I’ll give a breakdown of the securities laws and how they could be, and have been, applied to virtual goods, online items, and currency, including Bitcoin (which I’m not conceding is technically a currency).

Under Section 2(a)(1) of the Securities Act of 1933, “unless the context otherwise requires,” the term “security” includes:

“any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”

15 U.S.C. § 77b.  When looking at how the SEC could come after online items, the operative phrase in the above definition is “investment contract”.  The U.S. Supreme Court has stated that an investment contract is a security under the Securities Act if investors make:

(1) an investment with an expectation of profits arising from

(2) a common enterprise that

(3) depends “solely” for its success on the efforts of others.

SEC v. W.J. Howey & Co., 328 U.S. 293, 298-99 (1946) (also stating that it is “immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise”); Long v. Shultz Cattle Co, 881 F.2d 129, 132 (1989).   The last item, number (3), has been altered by some courts to remove the term “solely” so it would read “with the expectation that profits will be derived from the efforts of others.”  This deletion makes the investment contract definition easier to apply from the SEC’s perspective, because under the Supreme Court’s definition if you have put in any profit making effort into the enterprise, then it can’t be a security, as the profits would not come solely from the efforts of others.  But if you remove “solely”, then theoretically, if anyone other than yourself put in efforts to make profits it could be an investment contract.

In any event, the test for whether something qualifies as an investment contract is how the courts will decide if online transactions and items qualify as securities.

The main type of place that securities regulators could stick their noses would be in MMORPGs (massively multiplayer online role-playing games), which are sometimes called virtual worlds.  Games like World of Warcraft, and others like Second Life have virtual types of money, virtual real estate, etc.  People in these virtual worlds buy and sell items and the items are paid for sometimes with the virtual money and sometimes with real money.  People play some of these games to either find items in these virtual worlds (like gold) or they create characters and invest a large number of man-hours into the character to increase its attributes and make it more powerful.  This is done by individuals or groups of individuals (typically from third world countries but also here) as a money making venture.  Once they have a large number of items or powerful characters they trade them to others for cash (real money).

In Second Life, there is even three virtual stock exchanges.  The seminal case in this area is SEC v. SG Ltd., 265 F.3d 42 (1st Cir. 2001) came from a scheme from one of the stock exchanges.

SG Ltd, a Dominican corporation operated a StockGeneration site which offered people in Second Life to buy shares in eleven different virtual companies, using real money.  SG arbitrarily had the share prices increase and decrease, but one of the eleven companies was a “preferred company” whose value, according to SG, would never go down.  SG made all sorts of promises about its positive returns and how it was a legitimate thing, which I’m not sure how any rational person could believe.  I think you see where this is going.  It was nothing more than a virtual Ponzi scheme.  Everyone invested in the preferred company, and when people sold shares of the preferred company, SG paid them with the proceeds of the people that just bought in.  Eventually, their were more people trying to sell, so SG stopped allowing sales of the preferred company, and did a reverse stock split to drastically decrease the value of the shares of the preferred company.

The people that owned shares of the preferred company complained to the authorities and the SEC looked into it and came after SG.   SG’s lawyers took the position that the virtual stock market was for entertainment purposes only, and that it was merely a game.  They hung their hat on some dicta from the Howrey decision which looked at legislative history from the Securities Act and drew a distinction between what it termed “commercial dealings” and what it termed “games”.  The district court, relying on this distinction, dismissed the SEC action.  The SEC appealed and the First Circuit held in the SEC’s factor that the interests in the preferred company were securities that met the investment contract test. They actually go through the legal analysis, and again, while I can’t say I agree with it all, make a compelling argument as to how the securities laws could apply.

I plan on getting into how the securities laws may apply to more and more things online in future posts.