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Is California Warning to Bitcoin Group a Misfire — or a Dragnet?

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By warning the Bitcoin Foundation to cease and desist from allegedly acting as an unlicensed money transmitter, California may be either targeting the wrong group or trying to ensnare others.

The Bitcoin Foundation, which promotes the use of the digital currency but does not function as a bank or exchange, received a cease-and-desist letter from the California Department of Financial Institutions.  The letter, dated May 30, accuses the foundation of defying the Money Transmission Act, but does not elaborate, and the agency would not disclose further details.

"These communications are confidential (between the regulator and recipient, licensee, representative of the licensee, representative of the recipient, etc.) and regulators do not discuss/comment on C&Ds," says Alana Golden, a spokeswoman for the California DFI, in an email.

Image: ThinkStock

The Bitcoin Foundation is a non-profit organization that creates standards around Bitcoin's use. The Foundation gives grants to entrepreneurs behind Bitcoin businesses, takes membership fees from individuals and companies in bitcoins and accepts donations in bitcoin.

"The foundation is certainly not a money transmitter," says Paul Soter, a California attorney who specializes in banking regulations and money transfer laws. "So I think they have the wrong entity [or] they are, well, shooting at the bank robber and hitting the guy next to him who is a member of an organization called ‘friends of bank robbers.’"

The virtual currency guidance the Financial Crimes Enforcement Network issued in March categorizes administrators and exchangers of virtual currencies as money services businesses, obliging them to register as such and obtain separate licenses in states where they have customers.

The California law allows the state agency to perform further research through legal discovery if follows up its letter with a formal order.

Thus, the DFI could be pursuing the foundation to do more in-depth research on its members, Soter says. "I don't know why they pursued the foundation other than to smoke out some real money transmitters," he says.

Others interpret the action as a misunderstanding of what Bitcoin really is, and potentially a general blanket action where numerous bitcoin entities received the cease-and-desist warning letter.  

"California has likely sent similar letters to all operating bitcoin entities that reasonably appear to be doing business in California and/or with residents of California," says Jay Postma, president of MSB Compliance Inc. in Atlanta, in an email.

Postma says he is surprised the Bitcoin Foundation received a cease and desist letter.

Conventional payments businesses have faced this type of scrutiny from California and other states. Square, the San Francisco company that sells the Square mobile card reader, faced similar scrutiny from California regulators and argued that it does not operate as a true money transmitter — though it eventually complied by obtaining a license, according to the San Francisco Chronicle

Illinois issued a cease and desist to Square this year. The prepaid card marketer NetSpend and six other companies received cease and desist orders from Illinois during that time, notes Jon Matonis, who is on the Bitcoin Foundation's board, in a June 23 Forbes article. Matonis also contributes to PaymentsSource and American Banker.

"If this practice grows among states, it could have a potentially 'chilling effect' on financial services innovation, especially upon lawful businesses that are designing infrastructure to support and grow the Bitcoin technology," Matonis says in his Forbes article.

The Bitcoin Foundation "is not engaged in money transmission and we view this as an opportunity to educate state regulators on issues related to the bitcoin industry," Matonis said in an email. The Bitcoin Foundation plans to publish an official response this week.

If the Foundation is found to be in violation of California law, penalties could range from $1,000 to $2,500 per violation per day, according to the cease and desist letter, which Matonis posted online. The Foundation could also face criminal prosecution, resulting in prison time or more fines.

The Money Transmitter Division of the California DFI regulates and licenses such firms. This includes issuers of payment instruments or money orders, traveler's checks and stored-value products.

The Foundation develops software to make the Bitcoin protocol work more efficiently. It has members but no paying customers for its product.

While the Foundation could fall under the reach of the DFI as issuers of payment instruments in some form, the DFI also acknowledges that software companies without possession or control of money are not subject to the MTA.

"It's going to take a long time to get this all sorted out," says Terry Maher, an attorney at Baird-Holm LLP in Omaha, Neb. who follows Bitcoin developments.

Similar actions happened in the prepaid market a few years ago, with states amending or interpreting their money transmitter laws to include stored-value products, he says.

When there was ambiguity, businesses could negotiate with the state to get a license on file. The state could then decide whether the company could operate while the license was reviewed before approving or denying the application, Maher says. But states also want a small one-time fine for the prior activity, he adds.

Sean Sposito and Marc Hochstein contributed to this article.

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