Five Men Indicated for Worldwide Cryptocurrency Fraud Scheme

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On December 10, 2019, three men were arrested in connection with an alleged $722 million cryptocurrency mining fraud scheme.  An additional defendant was arrested following the Department of Justice’s press release, and another remains at large.

From April 2014 through December 2019, Defendants solicited investments in its BitClub Network, a purported bitcoin mining pool which was operated by Defendants.  They are charged with exploiting unsophisticated investors with “false promises of large returns for investing in the mining of Bitcoin.”  The “complex world of cryptocurrency” allowed Defendants to take advantage of investors, which Defendant Matthew Brent Goettsche referred to as “dumb” investors, “sheep,” and “morons.”  Defendants manipulated the daily mining earnings amounts reported to investors in order to attract new investors and to encourage reinvestment of earnings, amassing at least $722 million in ill-gotten gains.

Exploiting a Perplexing Concept

In order to understand the allegations against the defendants, it is important to have a foundational understanding of the service they purported to sell to their customers.  Bitcoin is a digital, decentralized currency, which is created through a verification process, referred to as  “mining,” on a peer-to-peer network.  Mining is the act of performing complex algorithms within this network in an attempt to be the first to reach a conforming solution.  Once the solution is computed, the other network participants, or “nodes,” verify and accept the resulting block which is added to the chain, or the “blockchain.”  In order to incentivize miners to find new blocks, a reward in the form of Bitcoin is generated and debited to the miner who successfully reaches the solution.  The process of mining is incredibly complex, time consuming, and costly.  In the case of the defendants, shares of various mining pools were sold to unknowing victims under the pretext that the average investor could now participate in the mining process (and enjoy the rewards), without having to invest in computational infrastructure and facilities.

SEC Regulatory Guidance

According to the indictment, BitClub Network was marketed as a “profit-seeking business venture.”  Investors could purchase a $99 membership fee to join the network, and from there could purchase additional shares in the three purported mining pools.  BitClub Network represented that investors could “earn passive income” through the three different investment options.  These options were distinguished by the share cost and the percentage of profit paid out to investors versus reinvested in the mining operation.  Investors who opted to buy in to the more expensive pool were promised a higher percentage of the profits.  It is ascertained in the charges against the Defendants that this type of arrangement, in which shares of BitClub Network were sold to the public, is rightfully classified as a securities offering as defined in Title 15, United States Code, Section 77b(a)(l) and thus required to be registered with the U.S. Securities and Exchange Commission (“SEC”).  Despite their acknowledgement of this fact which was documented via electronic communication, the Defendants did not file a registration statement for the shares in BitClub Network with the SEC.

 

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Sample Structure of an ICO

The SEC has issued guidance on whether certain cryptocurrencies would qualify as securities.  In April 2019, the SEC indicated that Initial Coin Offerings (“ICOs”) may qualify as accordingly and be subject to SEC jurisdiction.  An ICO, much like an Initial Public Offering (“IPO”), seeks to promote a particular idea and project, which will be accomplished using blockchain technology.  The masters behind the idea seek to raise funds via an ICO in order to be able to execute the creation or further the development of the new coin.  In the eyes of the SEC, this arrangement parallels the sale of a security, not a mere exchange of currency.  It is therefore required to either be registered with the SEC, or to qualify for one of the registration exemptions.

Initial coin offerings (ICOs) are a means of raising capital using blockchain technology.

  • The Issuer typically uses the proceeds to typically finance a project.
  • The Investor, in exchange for the financing, typically receives a token which may be connected with the right to receive, e.g. a dividend, a voting right, a license, a property right or a right to participate in the future performance of the issuer.

Similarly, the arrangement of the defendants was not the mere sale of cryptocurrency.  There are dozens of platforms by which the average investor may purchase cryptocurrency and hope to benefit from the appreciation of its value.  Rather, the Defendants were operating as a purported node in the mining process, and were selling the benefit of such via the sale of shares in their operation.  There were essentially three classes of shares in which victims could invest, which Defendants referred to as “pools.”  It is therefore alleged by the Department of Justice that the Defendants engaged in the sale of unregistered securities.

Consequential Charges

The defendants are charged with one count of conspiracy to commit wire fraud and one count of conspiracy to offer and sell unregistered securities.  The former stems from the illegitimate investments in a Bitcoin mining node.  It is not specifically stated in the indictment how much, if any, mining capacity the defendants had within their operation.  In other words, was there some legitimate mining operation or was the entire scheme smoke in mirrors?  The indictment does refer to many internal electronic communications which supported that those charged were knowingly and intentionally manipulating information related to the existence of the pools and the related profits.  The latter charge relates to the sale of unregistered securities via sales of shares in “mining pools” as previously discussed.

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The Dangers of Irresponsible Investing

The perpetrators of this scheme were competent enough to effectively promote and sell their idea and allegedly dupe their investors out of hundreds of millions.  They were able to successfully capitalize on the average investor’s lack of understanding of the technology.  “Bitcoin,” “Blockchain,” and “Cryptocurrency” are buzzwords in today’s tech-hungry climate.  Consequently, it is of utmost importance to treat these investments with the appropriate level of diligence and scrutiny.  Conduct the appropriate level of research and ask yourself challenging questions about the investment and its profit making capabilities.

Advanced Meta Model of Fraud Marks

Above all else, bear in mind that as with any investment, if it sounds too good to be true, it probably is.

We welcome your thoughts and comments!

Best,

Jonathan Pic
Jonathan T. Marks, CPA, CFE and Lead Authors –  Lauren P. Berret, JD, CPA and Melissa A. Dardani, CPA

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