Last week’s arrests^[1] of Robert Faiella, an alleged seller on online marketplace Silk Road, and Charlie Shrem, the CEO of the startup BitInstant, marked a recent round in a series of law enforcement actions against what the government characterizes as a “rise in criminal activity”^[2]by people using the cryptographically-controlled digital currency, Bitcoin.^[3]  The arrests of Shrem and Faiella occurred nearly contemporaneously with hearings by the New York Department of Financial Services to determine how to regulate Bitcoin in the State of New York.  More than one source has suggested the timing of the arrests may have cast at least some cloud on the New York hearings on regulation of Bitcoin.

The government has not yet convinced a grand jury to return an indictment against Faiella or Shrem and a preliminary hearing is set in the Southern District of New York for February 26, 2014.^[4]  Faiella and Shrem’s cases may raise issues about how to apply federal statutes, including money laundering statutes^[5] and money transmitting statutes^[6], to new forms of digital currency.

At issue in Faiella’s case appears to be the liability of those accepting payment for illegal items with Bitcoin.  If Faiella’s case is to proceed, the government will likely have to show that Faiella had knowledge that bitcoins were intended to promote and support sales of narcotics over Silk Road.  The government may have to address similar issues in various other actions alleging illegal sales of narcotics^[7], firearms and weapons^[8], stolen credit cards and personal information^[9], and other illegal items.  Prosecutions of people shown to have known they have anything of value representing the proceeds of illegal conduct may not appear too troubling.  More specifically, most would agree conventional theories of money laundering allow the government to bring criminal charges for processing Bitcoin transactions that a seller knows involve the proceeds of illegal activity.  As a result, the charges against Faiella may not appear too surprising or troubling to most.

Shrem’s case, however, presents the more difficult issues of liability of Bitcoin exchangers who are charged with knowledge about suspicious activities of sellers.  A criminal prosecution simply for providing a digital currency exchange that could potentially be misused is more problematic than a criminal prosecution against a seller, because any form of exchange is potentially subject to abuse.  Such prosecutions may potentially subject all digital currency providers to prosecution.

Past decisions involving the pseudonymous digital currency e-Gold provide limited guidance about these issues.  In 2008, the DOJ indicted E-Gold for violations of federal money laundering and money regulation statutes.  In response to a motion to dismiss the indictment, the court held digital currencies are not exempt from the federal money laundering statutes^[10], as those statutes were intended to apply to transfers of funds, not solely currency^[11].  The court further denied the defendant’s due process challenges under the doctrines of vagueness and lenity^[12].  Ultimately, the E-Gold defendants pled guilty and did not receive prison sentences.

Although E-Gold may provide reasoning that is instructive to Shrem’s case, the precedential value of E-Gold is limited.  E-Gold involved a decision by the Federal District Court for the District of Columbia.  As a result, E-Gold is not binding on other jurisdictions.  Further, E-Gold involved a decision at a preliminary stage of trial.  As a result, the analysis of E-Gold may be limited to interpretive issues that may not be relevant at more advanced stages of a case.

Further complicating the issue of Shrem’s liability are the particular allegations against Shrem.  The Complaint against him alleges several general aspects of Shrem’s conduct, including:  that Shrem was aware Silk Road was a drug trafficking website, that BitInstant fulfilled Faiella’s orders, that Shrem gave Faiella discounts on high-volume orders, and that Shrem did not file suspicious activity reports regarding Faiella[13].  These general allegations, even if proven true, may not appear extremely suspicious to most, as these allegations could apply to other Bitcoin exchangers whose participants engage in illegal activities.

However, also present in the Complaint are more particular allegations regarding Shrem’s conduct.  The Complaint alleges Shrem personally processed Faiella’s transactions, and that Shrem deliberately helped Faiella circumvent BitInstant’s Anti Money Laundering provisions.  Such allegations, if proven true, may muddy the lines between Shrem’s liability as an exchanger and Shrem’s liability as a participant in Faiella’s activities.  Moreover, such allegations, if proven true, may make Shrem’s case difficult to use as a precedent to draw any clear legal lines for Bitcoin exchangers that are the subject of future actions by law enforcement.

While Faiella and Shrem’s cases are still in their early stages, the government’s investigation in these cases is at least a year old.  These cases are likely to have a significant impact on the legal climate affecting digital currency providers, because precedents in the area are so scarce.  The cases may also lead to further regulation of Bitcoin and other digital currencies.

^{[1] See complaint here.}

^{[2] Statement of Mythili Raman Acting Assistant Attorney General, DOJ Office of Public Affairs, Release dated November 18, 2013 (available online here).}

^{[3] Bitcoin is a form of digital currency characterized by what many call “pseudo anonymous” transfers between users. Often, transfers of bitcoins are facilitated through “Bitcoin wallets.”  As discussed in a Wiki article about Bitcoin anonymity:}

^{[E]very transaction is publicly logged.  Anyone can see the flow of Bitcoins from address to address (see first image).  Alone, this information can’t identify anyone because the addresses are just random numbers.  However, if any of the addresses in a transaction’s past or future can be tied to an actual identity, it might be possible to work from that point and guess who may own[] all of the other addresses.  This identity information might come from network analysis, surveillance, or just Googling the address.  The officially-encouraged practice of using a new address for every transaction is designed to make this attack more difficult.}

^{https://en.bitcoin.it/wiki/Anonymity (last accessed February 3, 2014 (archived version availablehere)).  In adhering with developer conventions, the capitalized and singular word, “Bitcoin,” refers to the technology and network of exchange, while the lowercase and plural word, “bitcoins,” refers to the actual digital currency.}

^{[4] See USA v. Shrem, 14 Crim. 00164, docket entry 5 (S.D.N.Y. filed Jan. 24, 2014).}

^{[5] See, e.g.,  18 U.S.C. §§ 1960 and 1956.}

^{[6] See, e.g., 31 U.S.C. §§ 5318(g) and 5322(a).}

^{[7] See, e.g., prosecution of Ross Ulbricht, the alleged operator of Silk Road.  In Ulbricht’s case, an order was entered January 16, 2014 authorizing forfeiture of all Silk Road assets, including nearly $28 Million in Bitcoin, and all property traceable to Silk Road servers.  See also:  arrest ofDr. Olivia Bolles, who allegedly sold controlled substances over Silk Road using the alias “MDPRO.”}

^{[8] See, e.g., arrest of Mathew Crisafi, who allegedly trafficked firearms over Black Market Reloaded, a site that allegedly facilitated sale of items using Bitcoin; see also arrest of Jesse Korff, who allegedly sold toxins through Black Market Reloaded.}

^{[9] See, e.g., arrest of Sean Robinson, allegedly associated with site Fake Plastic.  Fake Plastic allegedly allowed people to purchase credit card data and other data from individuals known as “skimmers.”}

^{[10] See U.S. v. E-Gold, 550 F. Supp. 2d 82, 85 (D.D.C. 2008).}

^{[11] See E-Gold, 550 F. Supp. 2d at 88-97.}

^{[12] See E-Gold. 550 F. Supp. 2d at 98-101.}

^{[13] See Complaint at 4, para. 11.}