NC Secretary of State Cracks Down on Cryptocurrency-Based Security

By Andrew Steffenson

As cryptocurrencies, blockchain technologies, and virtually all things containing the words “crypto” or “blockchain” continue to experience a meteoric rise in popularity, regulators face an abundance of issues related to the classification and regulation of cryptocurrencies and activities related to cryptocurrencies. Likewise, investors and consumers are besieged by an ever increasing number of fraudulent and exploitative individuals and companies attempting to defraud investors and consumers by capitalizing on the frenzied enthusiasm and excitement surrounding cryptocurrencies and blockchain technology. The North Carolina Secretary of State Securities Division (the “Division”) recently cracked down on one such company, which operated under the name Power Mining Pool. The Division found that Power Mining Pool was, among other things, selling securities in violation of the North Carolina Securities Act (N.C.G.S. §78A) (the “Act”).

Cryptocurrencies are encrypted digital currencies that are used in peer-to-peer transactions. Unlike traditional currencies, cryptocurrencies only exist in computers and are not represented by physical coins or notes. Cryptocurrencies are generated by a process called “mining.” Mining is the process of validating cryptocurrency transactions and adding them to a transactional ledger called the blockchain. A blockchain is a distributed transactional ledger that serves as a record of all of the holders of the cryptocurrency, and the amounts they hold. When a digital transaction is carried out, by one party transferring cryptocurrency to another party, the transaction is batched together in a cryptographically protected block with other transactions that have occurred around the same time. The batch is then sent out to the entire network for validation. Because blockchain technology relies on a distributed transactional ledger and does not utilize a centralized database to process transactional information, the validation of transactions by miners is critical to keeping track of who owns what. Miners validate the transactions by solving complex coded problems. Once a block of transactions has been validated, the block is timestamped and added to the last validated block. This establishes a chain of transactions that shows every transaction that has ever occurred on the network. The chain is continuously updated as miners validate new blocks and the new blocks are added to the chain, thus establishing a continuous record of which parties own the cryptocurrency and in what amounts.

The validation of cryptocurrency transactions is very computationally intensive and generally requires the use of large, sophisticated and expensive computing equipment. In addition to the substantial amount of technology and equipment required for large-scale cryptocurrency mining, the mining operation itself can consume tremendous amounts of electricity and may require a dedicated, temperature controlled environment and support staff. Mining can be a very expensive process, so why does anyone do it? Despite the substantial costs that must be incurred to run a cryptocurrency mining operation, mining can still be a profitable venture. Miners are compensated for validating and adding transactions to the blockchain. Whichever miner validates and adds transactions to the blockchain first receives a cryptocurrency payment. The following simplified example illustrates how mining can be a profitable venture. Bitcoin is currently one of the most popular cryptocurrencies. Miners are currently awarded 12.5 Bitcoins for each block that is validated. At its peak on December 17, 2017, one Bitcoin was worth approximately $19,783.21. If a miner validated a block on that date they would receive 12.5 Bitcoins with an aggregate value of approximately $247,290.13. This high revenue potential makes investments in cryptocurrency mining operations very attractive.

Because the costs associated with starting and maintaining a cryptocurrency mining operation can be substantial, many large-scale mining operations raise capital for their operations by turning to pools of investors. Power Mining Pool represented that it was doing just that. Power Mining Pool offered mining pool shares to the public on its website and targeted residents of North Carolina directly by advertising on social media and online classified listings. Power Mining Pool represented that it owned and operated several mining operations and that investors could purchase mining pool shares that would receive distributions as the mining operations collected cryptocurrency payments for validation and adding transactions to the blockchain. Investors were also promised commissions and bonuses based on referrals and sales of mining pool shares. Investors were never informed or warned that offering or selling the shares may expose them to liability for acting as an unregistered dealer under the Act.

On March 2, 2018 the Division issued a Temporary Cease and Desist Order against Power Mining Pool to prevent the sale of mining pool shares, and on April 19, 2018 the North Carolina Secretary of State made the order permanent. The North Carolina Secretary of State found that the mining pool shares were securities. The Act requires a seller of securities to register both itself and its securities with the Secretary of State’s Office or qualify for an exemption from registration. Power Mining Pool did not register itself or its securities and did not qualify for an exemption from registration. After an extensive investigation, the Division was unable to find any evidence that Power Mining Pool actually owned any cryptocurrency mining operations. In fact, it appeared that Power Mining Pool was just a website and not a cryptocurrency mining company at all. The website was allegedly run by two brothers based in Europe, but the website contained no additional information about the principals other than pictures of cartoon characters with fictitious names designed to represent the brothers. In addition to violating the Act, Power Mining Pool was likely committing fraud by knowingly lying to its investors about the existence of its mining operations. Likewise, some market observers consider Power Mining Pool’s referral based bonus system to be nothing more than a pyramid scheme to funnel more capital to the principals. On March 6, 2018 Power Mining Pool removed its website from the Internet. On March 8, 2018 Power Mining Pool issued the following statement: “We are coming back and no, you haven’t lost your money. Hopefully next week the site will be back online.” That was the last known communication by Power Mining Pool to its investors.

The rapid emergence of cryptocurrencies and blockchain technology has given rise to new challenges and new opportunities for investors, regulators and attorneys. Power Mining Pool should serve as a cautionary tale of the risks that investors may encounter in this new crypto environment. Attorneys should caution their clients about the potential risks associated with cryptocurrency ventures and clients should be advised to engage in substantial due diligence before investing in any such venture. Likewise, clients should be made aware of any potential securities issues arising from the ownership, sale or distribution of a cryptocurrency or any ownership interests in mining pools or other cryptocurrency ventures.