Localbitcoins Trader Pleads Guilty to Money Transmitting Business, Should He Have? | dinbits



Here we go again. It's becoming the exact thing FinCEN and other United States based agencies have been warning us about since March of 2013. If you involve yourself in a virtual currency business, you had better do it legally or they are going to reach out and bitch-slap you.

That's an important date. March, 2013 as is another one about a year later, on March 2014.

The dates refer to the Financial Crimes Enforcement Network guidance document FIN-2013-G001 released on March 18th, 2013 ad IRS Notice 2014-21 release a year later in 2014.

The latter being just a few months prior to an undercover IRS agent randomly locating the Localbitcoins user "jrklien", an alias and username for one Mr. Jason R. Klein. After learning Klein was advertising bitcoin trades in exchange for cash (USD), the agent contacted Klein in January of 2015.

Just 7 months prior to this engagement, the IRS had no formal opinion or guidance on bitcoin or virtual currency in general at all, nothing. It's sister agency, FinCEN, had released a single ultra-confusing document with new terms they made up categorizing Administrators, Exchangers, and Users as the three types of classifications covering virtual currency related activity.

This began in November of 2014 when an IRS agent located Klein, but at this point, there was no evidence, is no evidence, nor any reasonable expectation that anything involving the IRS would be to the point of any illegal activity that would necessitate any evidence of a crime in the first place.

Got No Evidence? Make Your Own!

Now let’s make no mistake about it, in 2013 (when Klein opened his LBC account), bitcoin was far from squeaky clean. However no more so and still nothing remotely close to cash (fiat currency). Regardless, to say there was not any illicit activity being conducted using bitcoin would be naive and a simply false. Like every other payment method on earth, bitcoin was and still is used for things that are illegal, however in 2013 this activity was at an all-time high so it's no wonder federal agencies weren't looking for whatever they could to circumvent this activity (we all know how things went down with Silk Road).

Needless to say, just because Klein had created an account and had done a couple trades, there was no evidence in November 2014 or by January 2015 when the IRS agent contacted Klein, that any of these trades had, or were, being conducted in exchange for cash or an equivalent in a manner that would constitute money transmission or facilitate any kind of money laundering.

Without any evidence of anyone doing anything wrong, and note this individual had only a few trades (less than 30) at the time, the IRS decides to create their own evidence and set Klein up in what appears to be borderline entrapment but since it's the IRS, they can pretty much do whatever they want to because they are the IRS.

That is exactly what they did. Between February 2015 and July 2016, the IRS conducted 5 trades of various cash values where Klein allegedly sold bitcoin in an illegal fashion to the IRS agents. Why was this illegal? It was illegal because the IRS conducted these transactions with the intent to launder money and Klein allowed them the happen.

You cannot argue with the IRS. If they say they the money was to launder money when they conducted these transactions, then who is going to be able to say otherwise? You can't. This is the IRS.

Fast forward 7 months and Klein is onward to Klein things, such as his computer consulting firm, and the IRS has 5 transactions where Klein clearly participated in money laundering. Unfortunately, Klein didn't have to know anything about it to be be charged or found guilty. The laws governing this and money transmission are very clear on this point. The individual’s knowledge of his or her involvement in the transaction is irrelevant and simply not a valid defense. In fact, this is specifically outlined in 18 U.S. Code § 1960.

This is the reason that the intent of any trading partner opposite the one selling bitcoin is so damaging to unsuspecting traders. They can't always know specifically what the other party intends to do with the bitcoin other than what they tell them and the other party can outright lie about it.

This is one of the dangers traders face when conducting these transactions because it doesn't matter if the other party lies about their intended use of the bitcoin, if money transmission happens, the entire transaction is encompassed. These are known as inadvertent transactions or inadvertent violations.

The Fine Line of Money Transmission

If John sells Mary 14 bitcoins for what Mary says is for personal banking and Mary then puts those 14 bitcoins in her wallet and they are used by Mary personally, then no money transmission has occurred. Depending on the jurisdiction in which John conducts this transaction, he would not be required to be registered with a federal agency and in some states, he would not be required to hold any type of money transmitting or money services license.

However, if John sells Mary 14 bitcoins for what Mary says is for personal banking and puts them in her wallet but then a week later Mary sends those coins to someone in Italy, then as ridiculous as it may well sound ... if that is what Mary purchased bitcoins for, then money transmission has occurred. Even if John knows nothing about this or was lied to about the intent. What's worse is the potential for liability if anything additionally illegal is part of that transaction such as financing terrorism or as with Klein's case, money laundering.

It's a very fine line to walk and even if Klein had been registered as a money services business, it would not have cleared him from the money transmission violation due to Missouri's money transmission laws apparently covering bitcoin transactions. He would have also had to have had a Missouri money transmitting license.

However, in states where bitcoin transactions are not considered money transmission, federal registration would have cleared Klein from everything.

Admit Defeat and Plea Bargain

So, what is a defendant and his attorney to do facing the mountain of indisputable evidence against them? Negotiate a plea of course. Klein plead guilty to a lesser charge of operating an unregistered money services business (money transmitting business) regardless of the fact there wasn't any evidence at all that Klein transmitted money.

At best, FinCEN could say that Klein took part in what's known as an IVTS cash transaction which is indeed considered money transmission. IVTS stands for Informal Voluntary Transaction System and can be anything from roller skates to paper airplanes that form a method of transmission or a network to facilitate transmission.

You can literally make a paper airplane out of a $100 bill and throw it to someone and that could be viewed as money transmission if that person paid you a dollar to throw it and gave you the $100 bill to throw. It's that silly and that serious.

Of course, the law and rulings are not meant to take down the paper-airplane throwing population in the Unites States. They're not meant for taking down the bitcoin trading population either and this guy had 30 trades to his name over the course 2 years that may not have even been in cash with only 5 trades listed as evidence and even with the 5, the amounts could be reasonably viewed as a personal investment. However, the personal investment umbrella would be rather difficult to prove in this case since Klein himself solicited the sales on the Localbitcoins.com (LBC) platform.

Klein plead guilty to the lesser charge and in doing so he faces a lesser sentence which can be as little as three years’ probation and a fine.  Regardless of why the IRS decided to pick on this individual, the case seems pretty cut and dry and Klein faces some punishment, although it is unlikely going to be any prison time and the maximum allowed by law is 5 years.

Except a few things don't exactly add up.

Answers Deserve Questions

Aside the fact that this individual is barely a blip on the LBC trading radar with a total of 30 trades all time, meaning it was likely more like 15 or less when 1st discovered, the trades conducted by the IRS with Klein amount to less than $30,000 over predominately a 6-month period.

If we assume those were 5 of the 30 trades on LBC we can guess that Klein traded around $175,000 over the course of three years. If he earned a 10% markup, that comes to about 17,550 or about $5800 per year. $8775 if we say 2 years.

In November of 2014 there were copious amounts of people on LBC with cash ads and just about every single other payment method available for trade. The IRS state that they just "came across" Klein's advertisements and went after him.

That alone doesn't make allot of sense. Why Klein? In November of 2014 there were many others with substantially more volume, doing more cash exchanges, and more known for their activity than Klein.

So why Klein?

Well here's the thing. If you're trying to locate violators for something like money laundering or money transmission, obviously the first thing you need is someone you can catch. Klein was openly trading bitcoin for cash in the agent’s area and didn't have too many trades and obviously pretty high limits (one trade was for $15,000) that exceed reporting thresholds that the IRS and sister agency FinCEN expect to be alerted of when cash is exchanged for anything (regardless of license or registration).

He was inexperienced, had no license, was not registered and easily coaxed into meeting with the agent for an in-person trade where agents could easily obtain all the evidence they needed by manufacturing the situation to create it.

In other words, he was easy pickings.

Here's the other thing, they might well be making a point. FinCEN and other agencies have been warning of this coming since 2014.

There's been a string of small independent traders being slapped around by various law enforcement agencies, most of which had been in one way or another link to a more serious crime but not the case with Klein. He was green, quiet, and seemingly harmless to anyone. At least on paper, a normal guy who simple traded a few bitcoins for some extra money on the side.

So why the IRS?

The IRS has investigators, FinCEN doesn't. It's as simple as that. Most, if not all, leads that result in FinCEN actions of enforcement primarily come from the Internal Revenue Service. They are both divisions of the same agency, the United States Department of the Treasury.

Maybe this was exactly the point they intended to make, maybe the agent at the IRS didn't have anything else to do on that day, or maybe Klein rear-end the wrong car in the parking lot but one thing is seemingly clear. Klein did almost nothing to deserve the situation he's in. Almost.

He did in fact, transmit money (at least by definition) on one or more occasions. However, not exactly the way it's been disclosed and not deserving of the punishment about to be sentenced in its entirety.

Well ... Not So Fast

Per the IRS and the evidence presented in the case, the IRS conducted 5 transactions with Klein that they considered money laundering and later money transmission. The simple fact is that Klein had not registered as a money services business or obtain a money transmitting license from the state of Missouri.

Those transactions were:

February 6th, 2015
$1,000
March 4th, 2015
$2,000
July 14th 2015
$7,650
September 9th, 2015
$15,000
July 27th, 2016
$3,600

There was no evidence outside of these transactions that were presented by the prosecution and the IRS had no way of knowing what trades, if any, had been conducted for cash previously by Klein and it may well be that the IRS manufactured transactions were the only cash transactions he ever conducted.

Given that, the first transaction conducted by Klein was on February 6th, 2015. The last conducted being on the 27th of July, 2016.

This is important because the way sentencing is considered is based on the severity of the crime. In this case the amounts and one thing immediately apparent from the dates of the transactions is the fact that there's 4 of them in a row and then one out of nowhere on July 27th, 2016.

The only transactions that Klein could be held accountable for would be the transactions on September 9th, and July 27th totaling $18,600 and not the $29,250 he is currently going to be sentenced for, however it is important to note that even at $18.600 he remains at the same classification level on paper, but the numbers don't look nearly as bad.

Here's the real kick in the groin. Not only are the IRS transactions the only evidence to support the crime, they had to go back and do one more transaction nearly a year later to put the nail in the coffin so to say, without the final transaction n July, 2016 Klein would be at a lower sentencing classification and a lesser fine with only a single violation.

The fine of $5,000 per violation should not be up to $25000, it should be up to $10,000 and would have been only up to $5,000 without that last coffin nail.

Additional Charges Need Not Apply

Klein should not be liable for $10,650 of the current amounts being considered for sentencing. The reason being that Klein had 180 days from February 6th to register with FinCEN as a money services business and contacted the state of Missouri in regards to a money transmitters license or an exemption from the state.

Unless the IRS had additional proof, which they likely did not else it would have been disclosed, showing that Klein did indeed conduct a regulated transaction before February 6th, 2015, then that is the date of the 1st transaction that could have been considered regulated and federal law allows for a 180-day (6 month) grace period by which Klein was required to register himself or his company as a money services business.

FinCEN guidance explains¹ the federal law as 180-days from the point the business is established. Since Klein did not have an operating company the date of the 1st transaction that is applicable is the what would establish a business since noting prior to this date is evident.

If you review the dates, it's rather clear that the IRS knew exactly what they were doing here. There is only a 3-day different between what would have cleared Klein on September 6th to what was manufactured to lead him into conducting on illegal transaction on September 9th. Then to solidify the charges they conducted one final transaction in July or 2016 and that one single transaction is the one that did him in.

This is where the case becomes difficult to defend since July of 2016 was well over one year past Klein deadline to register and the additional $3600 elevates the severity of the crime to the next level under federal guidelines.

Assuming a 10% markup on sales once again, it results in Klein getting into all this trouble over a single transaction with a probable profit of less than $360 which would have been his fee for the transaction that took place in 2016.That likely only bought him a consultation with his attorney for an hour.

Entrapment? Personal Investment? Anything?

Many of the comments and opinions being circulated in regards to this case surround entrapment, personal investment, and lack of guidance.

Regulatory Guidance


To address these in reverse order, the lack of guidance simply doesn't hold any water at all given the specific guidance issued by FinCEN was published nearly two full years prior to the date of these transactions. There is simply nothing to stand on here. Had it been a couple years earlier, this might have been something to consider. Conducting a transaction in 2016 in this manner? Not likely.


Personal Investment


Others claim that Klein having only 30 trades, many less at the time in 2015 when the IRS discovered Klein's advertisements, should be exempt due to the fact these transactions could be considered personal investments.

There's two problems with that. First of all he himself was advertising on Localbitcoins.com and soliciting the exchange for bitcoin and US currency. Whereas the amounts and volumes could be considered reasonably to be person investments, part of the difficulty in defending this activity is the premeditated advertisement, however, not impossible.

What makes is very difficult to make this claim is the second problem, he has no way to prove the IRS wasn't laundering money. FinCEN offered guidance in response to an inquiry in guidance document FIN-2014-R001 where is clearly state that personal investments, or even a business investments, as defined are not considered money transmission:

"In undertaking such a conversion transaction, the user is not acting as an exchanger, notwithstanding the fact that the user is accepting a real currency or another convertible virtual currency and transmitting Bitcoin, so long as the user is undertaking the transaction solely for the user’s own purposes and not as a business service performed for the benefit of another. A user’s conversion of Bitcoin into a real currency or another convertible virtual currency, therefore, does not in and of itself make the user a money transmitter." - Jamal El-Hindi. Associate Director, Policy Division, FinCEN (FIN-2014-R001),

However, where the problem lies is in the fine print. Well not really, it's in big fat regular print, it's just that it's on the next paragraph. The guidance document states:

Any transfers to third parties at the behest of sellers, creditors, owners, or counterparties involved in these transactions should be closely scrutinized, as they may constitute money transmission. (See footnotes 8 and 9 above.) And of course, should [the Company] engage in any other activity constituting acceptance and transmission of either currency of legal tender or virtual currency, it may be engaged in money transmission activities that would be subject to the requirements of the BSA.

Then notes footnotes² 8 and 9 which basically explain the various reasons in which money transmission can occur anyway.

Joe Ciccolo, President of BitAML, an AML (anti-money laundering) firm in Illinois specializing in AML compliance for virtual currency business models, reviewed both the case and this article prior to publication and offered this statement:

There continues to be a great deal of confusion as to the line between trading for one's own benefit and regulated money transmission activities. While traders believe FinCEN offered a "green light" on trading, it's not that simple. In fact, it's quite nuanced. In the case of Mr. Klein, according to the IRS, he solicited his services as an "exchange" and charged a percentage fee for facilitating the transaction. These characteristics are similar in nature to that of a bitcoin ATM operator or legacy currency exchange, both of which require FinCEN registration and state licensure. I would be curious to know if Mr. Klein had merely offered to sell his own bitcoin at an advantageous price and removed references to "exchange" from his profile, would he be under investigation? There's no question that the bitcoin trading community and FinCEN would both benefit from further clarity. - Joe Ciccolo CAMS, CFE, AMLCA - President, BitAML

Despite the seemingly solid personal investment, money transmission is additionally defined by the circumstances of the transaction and the other parties involved, including those related to the selling party. What they do or intend to do with the bitcoin is a key factor in determining if money transmission occurs.

Again, this is with or without the knowledge of the one selling the bitcoin pursuant to 18 U.S. Code § 1960 and note this wasn't always the case, the law previously required the individual conducting the transaction to have knowledge of the intent or purpose of the transaction. This is no longer the case in 2017 and hasn't been for many years.

Thus, in Klein's case, he has no way to prove the IRS agent didn't launder money or transmit money and since that is the exact purpose of the IRS agents’ transaction, Klein is guilty of money transmission. He may have been guilty of money laundering as well (the actual charge against him) but due to the plea bargain agreement where he is admitting his guilt of operating an unregistered and unlicensed money services and transmitting business, he faces reduced charges.

Clearly, the evidence being considered for sentencing however, may not be completely accurate due to the registration deadline allotted by FinCEN and this may well be factor influencing the court who is now tasked with this decision.

Hopefully the court realizes or is shown by the defense, these facts so that they can be taking into consideration before the final sentence is ordered.

Entrapment


Finally, the first thing that pops into everyone's mind is entrapment. Had the IRS not conducting these transactions, it’s unlikely Klein would be facing this sentencing at all. This is probable. However, to use "entrapment" as a defense, it would have to be proven that Klein was unlikely to have committed the crime had the IRS otherwise not conducted them with him.

The only thing to go by here, and what the prosecution would say, is that Klein was soliciting this on Localbitcoins.com and the original court filing clearly states the IRS agent had found Klein's advertisement in January of 2015. This coupled with the fact that a month later Klein conducted this exact type of transaction with the IRS agent shows his intent to do so prior to to the actual transaction and thus would likely prove that he would have conducted this transaction regardless of it being with the IRS agent or another person in Missouri.

This would have been nearly impossible to win using an entrapment defense.

That said, it still doesn't make it right. It's rather apparent that the IRS set this guy up to burn him to the ground. It's very clear when you look at the transaction amounts, dates, and information provided in the case filings and then compare it to the regulations governing this activity, guidance at the time, and published warnings.

The IRS did exactly what needed to be done with precision to meet the minimal requirements to charge Klein. Thus, one can speculate that the Treasury department is sending a message to back up its warnings about engaging in this activity illegally.

It seems as if Klein could have fought a bit harder to defend his actions but the one thing that got him was the transaction in 2016. Without that he'd have had a chance, but that was a strategic blow that ultimately put him in exactly the position he is in now.

Based on everything available on the case and past records, that single 2016 transaction is what sealed his fate and Klein will likely receive a $25,000 fine, plus 3 years’ probation. That is our assumption based on the case and the most likely sentence unless someone manages to realize the above findings prior to sentencing. If that happens then this may be reduced.

This may well effect Klein in the future if he wishes to continue trading bitcoin in this manner because FinCEN might deny Klein's registration or suspend him for a lengthier period if he chooses to enter the industry again and try to obtain an RMSB number. It's within their right to do so and one of the prerequisites of federal registration is that all controlling interests of the filing entity be clear of any financial crimes and this is most certainly going to be considered a financial crime.

The worst part however is in the plea agreement. Probation, fines, and whatever else they impose is nothing compared to stipulation under which during his entire sentence duration he must obey and that is ... he won't be allowed to trade bitcoin.

Now that's just mean.




Written by dinbits
Edited by Georgiana Quinn
Artwork: Banner image created dinbits.com staff

References
  1. Jennifer R. Taylor and Emre N. Ilter of McDermott Will & Emery LLP (Ref.5)
  2. FinCEN guidance publications
    1. FIN-2014-R001
    2. FIN-2013-G001 
  3. Joe Ciccolo, CAMS CFE AMLCA & President, BitAML
  4. IRS Notice 2014-21
  5. Publication "Domestic and Foreign Money Transmitters Face Complex Hazardous Web of Federal and State Laws and Regulations". Financial Fraud Law Report by A.S. Pratt & Sons
  6. Federal case 17-3056-01-CR-MDH 
    1. Indictment waiver
    2. Case file information
    3. Plea Agreement
  7. 31 US Code 1022.380 - Registration of money services businesses 
  8. 18 U.S. Code § 1960 - Prohibition of unlicensed money transmitting businesses
Footnotes:
  1. 31 US Code 1022.380 - Registration of money services businesses
  2. FIN-2014-R001 notes 8-9 
    1. Footnote 8: "However, a user wishing to purchase goods or services with Bitcoin it has mined, which pays the Bitcoin to a third party at the direction of a seller or creditor, may be engaged in money transmission. A number of older FinCEN administrative rulings, although not directly on point because they interpret an older version of the regulatory definition of MSBs, discuss situations involving persons that would have been exempted from MSB status, but for their payments to third parties not involved in the original transaction. See FIN-2008-R004 (Whether a Foreign Exchange Consultant is a Currency Dealer or Exchanger or Money Transmitter - 05/09/2008); FIN-2008-R003 (Whether a Person That is Engaged in the Business of Foreign Exchange Risk Management is a Currency Dealer or Exchanger or Money Transmitter - 05/09/2008); FIN-2008-R002 (Whether a Foreign Exchange Dealer is a Currency Dealer or Exchanger or Money Transmitter - 05/09/2008).
    2. Footnote 9: "As noted in footnote 8 above, however, a user engaging in such a transaction, which pays the Bitcoin to a third party at the direction of the counterparty, may be engaged in money transmission.



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