Bitcoin, Blockchain and Consumer Protection Laws

by Holland & Knight LLP
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HIGHLIGHTS:

  • Unsophisticated consumers eager to make a profit remain susceptible to representations by companies that are false and misleading, and constitute deceptive acts or practices in violation of the Federal Trade Commission (FTC) Act.
  • In February 2016, Butterfly Labs and two of its operators agreed to settle FTC charges that they deceived thousands of consumers about the availability, profitability, and newness of machines designed to mine the virtual currency known as Bitcoin, and that they unfairly kept consumers' up-front payments despite failing to deliver the machines as promised.
  • The Butterfly Labs settlement and subsequent private lawsuits are an important reminder to companies and marketers that utilize blockchain technology that the FTC's ongoing mission to protect consumers extends to new and emerging financial technology. In addition, the risk of private suits, including class actions, are a landmine for those focused only on government enforcement.

If the surge in interest and investment in Bitcoin has any historical equivalent, the closest parallel may be the California gold rush in the mid-1800s. Most of the people who flocked to northern California to prospect for gold had almost none of the necessary means to succeed. Merchants and entrepreneurs such as John Studebaker, who manufactured wheelbarrows; Levi Strauss, who received a patent for the now-famous riveted pants; and bankers Henry Wells and William Fargo made their fortunes catering to the mining industry – not mining themselves. Fast forward 150 years and unsophisticated consumers eager to make a profit remain susceptible to representations by companies that are false and misleading, and constitute deceptive acts or practices in violation of Section 5(a) of the Federal Trade Commission (FTC) Act, 15 U.S.C. §45(a).

The Background

In the words of Jessica Rich, director of the FTC's Bureau of Consumer Protection: "[w]e often see that when a new and little-understood opportunity like Bitcoin presents itself, scammers will find ways to capitalize on the public's excitement and interest."1 Soon after this statement, in February 2016, BF Labs, Inc., d/b/a "Butterfly Labs", and its part-owner Sonny Vleisides and general manager Darla Drake, agreed to a settlement with the FTC that included partially suspended monetary judgments and a prohibition against deceptive claims relating to Bitcoin mining products and services. The settlement marks the FTC's first foray into the world of Bitcoin and blockchain technologies.

In Butterfly Labs, the FTC alleged that the defendants participated in deceptive and unfair acts or practices in violation of Section 5 of the FTC Act, 15 U.S.C. §45, in the sale and marketing of Bitcoin mining products and services. Butterfly Labs charged consumers between $149 and $29,899 upfront for machines, largely paid through preorders, that allegedly were never provided to consumers. According to the FTC:

"the testimony of several former employees . . . shows that instead of fulfilling orders immediately, Defendants used their customers' machines to mine Bitcoins for themselves before shipping the now used machines to their customers. Thus, Defendants pocketed Bitcoins that should have gone to their customers. Further demonstrating Defendants' disregard for their customers, they used corporate funds to make and mass order red foam pitchforks mocking their own customers, emblazoned with the words, 'Y U NO SHIP – BFL IS LATE!'"

The FTC also alleged that the defendants misrepresented the profitability and yield of their Bitcoin mining machines. Specifically, they posted a "calculator on all of their social media pages, including Facebook, Twitter, and Tumblr, telling consumers to 'measure your ROI with this cool Bitcoin mining calculator.'" The FTC also alleged that the defendants shipped outdated products to consumers and did not provide refunds.

Butterfly Labs and Vleisides agreed to a monetary judgment of $38,615,161, suspended upon Butterfly Labs' payment of $15,000, and Vleisides' payment of $4,000. Drake, who owed $135,878, agreed to surrender the cash value of all Bitcoins she obtained using company machines. The judgments were suspended based on the defendants' inability to pay.

Lessons for the Future

The settlement with Butterfly Labs and its management is an important reminder to companies and marketers that utilize blockchain technology that the FTC's ongoing mission to protect consumers extends to new and emerging financial technology. In addition, the risk of private suits, including class actions, are a landmine for those focused only on government enforcement. It is essential to understand that "the blockchain" does not exist as a single monolithic thing. The term first emerged to describe the manner in which Bitcoin transactions are aggregated and processed in data objects known as blocks, which in addition to transaction data, includes a cryptographic link to the previous block. Thus, any attempt to change or alter the data in a block results in a cascading effect on all subsequent blocks, which increases the amount of computational power needed to alter the ledger.2

All blockchain technologies have three essential components: peer-to-peer (P2P) network, consensus mechanism and a database or ledger (i.e., hash-linked data structures).3In other words, blockchain amounts to connected computers that reach agreement over shared data and have a means of recording that data or otherwise allowing for its retrieval if desired.4 This simplified explanation gets a tad more complex when we consider that software is used to develop rules for the connected computers that facilitate agreement and cryptographic techniques are applied to the shared data for verification and validation purposes.

While blockchain technology is best known as the foundation Bitcoin, it is now being explored for other consumer-focused uses including payment systems and "smart contracts." Additional future uses for blockchain technologies may include identity credentials, voter records, permissions, security transactions, property/land use records, interbank settlement records and cloud storage.

Conclusion and Takeaways

As blockchain technology advances to expand the ways consumers can store and share data, companies operating in this space must be aware of the current consumer protection laws enforced by federal and state regulators as well as be on the forefront of the evolution of these laws to ensure future compliance. Given the uncertainty that surrounds both the future of blockchain technology and consumer protection laws, it is important for companies to begin creating or modifying current compliance protocols to account for both blockchain technology and its impact on the consumer industry. These protocols may include implementing greater protections of consumer's virtual wallets and accounts, creating disclaimers to educate consumers on the technical aspects of Bitcoin transaction (e.g., the finality of a transaction, effect of lost or stolen funds, evolution of regulation concerning cryptocurrency, etc.), and creating internal compliance rules and committees governing the company's actions relating to its involvement in the cryptocurrency industry.

This preparation is essential for both companies directly operating in the blockchain and cryptocurrency industry and those companies currently accepting (or planning to accept) cryptocurrency as a form of payment. Given the consumer market's interest in cryptocurrency and the concerns regarding the regulation of Bitcoin exchanges, volatility in Bitcoin prices, the development of investment products based on cryptocurrency and the consumer risks associated with bad actors, companies should expect that the FTC and other regulators will pay special attention to all actors operating in the industry. The message is simple: all participants in this space will be required to do their part to protect consumers. Well-intentioned companies should also be sure they have a sufficient understanding of the potential risks associated with any blockchain-based services or goods they are offering for sale to the public, which includes technical matters that may be relevant. A defense based on ignorance of the risks a product poses to consumers is likely to be a weak one, especially where it is shown a basic level of diligence would have made those risks apparent or that the product was based on technology sufficiently complex that to offer it for sale was reckless.


Notes

1 At FTC's Request, Court Halts Bogus Bitcoin Mining Operation

2FinTech Forum: Artificial Intelligence and Blockchain, Peter Van Valkenburgh Transcript - March 9, 2017.

3Id.

4Id.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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