A federal district court has ruled that investors who pay for shares using Bitcoin have effectively invested money, at least for purposes of federal securities laws. The decision has implications for funds that seek to include Bitcoin among their investments or settle purchase orders for fund shares in Bitcoin.

The court’s August 6, 2013 decision involves whether the court has subject matter jurisdiction to hear a case brought by the SEC against the founder and operator of Bitcoin Savings and Trust (BTCST), the originator of the electronic currency. The SEC claims that the founder defrauded investors by misrepresenting the nature of the investments in his company. The founder argued that the interests in his company were not “securities” as defined in the federal securities laws because they lacked an essential element of a security: an investment of money. If interests in BTCST are not securities, he argued, then the SEC has no jurisdiction to sue him.

Bitcoin is an electronic form of currency that is not backed by any real asset and is without specie, such as coin or precious metal. Bitcoin is not regulated by any central bank or other government authority. Rather, the supply of Bitcoin is based on an algorithm that “structures a decentralized peer-to-peer transaction system.” The value of Bitcoin is volatile and has ranged from less than $2 per Bitcoin to more than $260 per Bitcoin.

According to the court, beginning in November 2011, the founder began advertising that he was in the business of “selling Bitcoin to a group of local people” and offered investors up to 1% interest daily “until either you withdraw the funds or my local dealings dry up and I can no longer be profitable.” The founder obtained at least 700,467 Bitcoin in principal investments from BTCST investors, or $4,592,806 in U.S. dollars (based on the daily average price of Bitcoin), when the investors purchased their BTCST investments. The SEC claims that that many investors suffered losses as a result of the founder’s misrepresentations.

But the issue before the court was not whether the founder actually committed fraud. Rather, the sole issue was whether the BTCST investments are securities under the Securities Act of 1933.

The court analyzed whether the BTCST investments amounted to investment contracts, using the three-prong test established by the U.S. Supreme Court in the seminal case of SEC v. Howey. The Howey test generally states that an investment contract is any contract, transaction or scheme involving (1) an investment of money, (2) in a common enterprise, (3) with the expectation that profits will be derived from the efforts of the promoter or a third party.

The court said that Bitcoin is a currency or form of money and, therefore, the BTCST investments satisfied the first prong of the Howey test. Because investors were dependent on the founder’s expertise in the Bitcoin market and he had promised specific returns, the court found that the other two prongs of the Howey test were met and concluded it had jurisdiction to hear the case.

Although narrow in its scope, the holding may have implications for the Bitcoin market as well as derivative financial instruments linked to the value of Bitcoin. It may also have implications for funds that allow investors to pay for shares in Bitcoin. If the court’s decision holds, it may be a catalyst for action by bank regulators to determine what, if any, regulation is appropriate.

Not one week after the BTCST decision, the New York State Department of Financial Services announced on August 12, 2013, that it has launched an inquiry into the appropriate regulatory guidelines that it should put in place for virtual currencies, such as Bitcoin.  The Department is concerned that—at a minimum—virtual currency exchangers may be engaged in money transmission as defined in New York law, a regulated activity.

“If virtual currencies remain a virtual Wild West for narcotraffickers and other criminals, that would not only threaten our country’s national security, but also the very existence of the virtual currency industry as legitimate business enterprise,” the Department said.