Feds: Butterfly Labs mined bitcoins on customers’ boxes before shipping

On Monday morning at 9:00am, lawyers from the Federal Trade Commission (FTC) will ask a judge in a Kansas City federal courtroom to impose a preliminary injunction on Butterfly Labs (BFL), the embattled Bitcoin miner manufacturer. This would extend the temporary restraining order set down earlier this month, leaving the company controlled by a court-appointed receiver.

For the last 15 months, Ars has followed BFL as it has gone from being a curious hardware startup in a nascent industry to becoming the target of a federal investigation.

The FTC believes the three named members of the company’s board of directors—Jody Drake (aka Darla Drake), Nasser Ghoseiri, and Sonny Vleisides—spent millions of dollars of corporate revenue on non-corporate expenses like saunas and guns, while leaving many customer orders either wholly unfulfilled or significantly delayed.

In a slew of new court documents filed Saturday, FTC lawyers allege for the first time that not only did BFL engage in deceptive practices, it specifically used customer-ordered machines to mine its own bitcoins before shipping the machines out. (BFL has specifically denied mining for its own benefit.) The FTC also claims that BFL had its employees mine for personal gain using machines that had been refused by their purchasers or that had been returned after having arrived too late to be worthwhile.

Amazingly, amidst all this alleged fraud, BFL is accused of printing giant foam pitchforks to make fun of its intensely frustrated customers. As Helen Wong, an FTC attorney, wrote to the court:

Once Defendants got around to producing Bitcoin mining machines using what were essentially interest-free loans from consumers, their first actions were not to benefit their long-suffering customers, but to pad their own bottom line. Specifically, the testimony of several former employees and Vice President of Product Development Josh Zerlan 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!”

Ars’ request for comment to BFL officials, its attorneys, and its spokesman went unanswered late Sunday evening; BFL has rarely responded to Ars’ repeated requests for comment in recent months.

In an earlier September 23 court filing of its own, argued that the entire FTC action was an overreaction. According to the company, the issues were already being worked out with local authorities:

The FTC has taken a sledgehammer to a fly. Tellingly, BF Labs has been negotiating with the Johnson County, Kansas District Attorney for months and what began as an all-encompassing review turned into a productive negotiation limited to a fine for alleged past transgressions. The Johnson County DA and BF Labs were incredibly close to resolving their negotiations and finding an acceptable compromise. There was no threat of shutting the business down to protect the public, no need at any point in the negotiations to worry about secretion of assets. Yet the FTC rides into town in the name of consumer rights waving the banners of dissipation of assets and a manufactured fraud that needed to be ended to protect an unwitting public (in a way that perversely comes at the expense of the alleged victims).

“The burn-in process was set up to mine bitcoins for the company’s benefit”

The new government filings state that when FTC officials arrived at BFL’s offices and two storage facilities on September 19, they imaged a number of computers belonging to the company’s employees, including Vleisides’ and Zerlan’s laptops.

Vleisides’ computer contained spreadsheets, one of which was a log of transactions to known BFL wallets that had names like “Received with … New Eclipse burnin mining account,” “Received with… Bitcoin mining – Eclipse pool,” and “Received with … Forfeiture from Janette to company of 15 bitcoins from office mining project.” Meanwhile, on Zerlan’s computer, investigators discovered a Skype text chat log that begins on June 10, 2013 and ends on July 9, 2014, and which contains a detailed record of internal communications among the company’s principals during that period.

According to the FTC, these documents, combined with other records, depositions, and sworn testimony from former BFL employees show a systematic pattern of fraud. Bank records allegedly show that Vleisides, Ghoseiri, and Jeff Ownby, a vice president for communications, all took out tens of thousands of dollars in loans against future earnings or dividends.

As Wong, the FTC lawyer, wrote to the court:

After filing this action, the FTC discovered that when Defendants finally manufactured products, they first used them to mine Bitcoins for themselves under the guise of testing—a process they referred to as “burning in.” Former employees and Mr. Zerlan admitted that Defendants mined Bitcoins with customer equipment. Defendants likely mined for themselves on each and every machine before they were shipped to consumers. One former employee stated that Defendants would run up to 500 Bitcoin mining machines in three separate “burn-in” rooms at the same time. Another former employee testified that some machines were “burned in” for up to two days, even though testing usually required only 10 to 30 minutes, and that Defendants generally did not ship out machines until they had manufactured machines to be burned in their place.

Defendants not only engaged in this practice despite repeated and public denials, but kept the Bitcoins they generated for themselves. Moreover, Defendants did not need to mine with customer equipment in order to test it. A “test-net” exists, which enables machines to be tested without being used to mine. In fact, one employee inquired with company management as to why they chose to test by mining rather than using the test-net and was told that the company would not make any money using a test-net.

It wasn’t just some random employee saying that BFL used customer machines to mine for its own benefit, either; the charge came from Samuel Johnston, the firm’s former head burn-in technician, who held that position from June 2013 until November 2013.

In a seven-page declaration, Johnston told the court:

At the time I started working at Butterfly Labs, I was aware that the company had made statements to consumers that its bitcoin mining machines were tested on the bitcoin testnet, which meant that the machines would not produce any bitcoin value while being tested. From the time I started, I observed that the machines were not in fact tested on the testnet. Instead, I found that they were mining with the machines on the bitcoin network…

While I was employed, with the exception of a two-to-three-week period, all tested machines were set up to mine bitcoins in the Eclipse Mining Consortium (“EMC”). I believe that EMC was owned by Josh Zerlan. I was told by [Production Manager] Mark Goodpasture at one point that the mined bitcoins generated by the burn in process would be put into a fund to benefit employees or charity. However, I later learned from discussions with Mark and other personnel that there was no such charity or employee fund. Instead, the burn in process was set up to mine bitcoins for the company’s benefit.

When I asked Mark why the machines were not tested on the testnet, he responded that there was no point in doing so because the company would not make any money from the testing. I understood, based on my conversations with Mark, that he received direction from Sonny to test the machines in a way that generated bitcoins. I was present in at least one brief meeting with Sonny and Mark in which it was suggested that the machines be tested on the testnet, but Sonny and Mark agreed the company would not do so. I understood that the sole reason for burning in the machines rather than using the testnet was to make money.

This wasn’t just a little bit of hashing power, either. Johnston said that at the time (August 2013), “The machines being tested were collectively hashing at a rate of 12 terrahashes per second (TH/s). At that time, this comprised approximately 3 percent of the hash rate of the entire bitcoin network.”

“Then if we deliver in March, we look good.”

Beyond the FTC’s claims of temporary Bitcoin-based thievery from its own customers, BFL was “aware of the potential for long delays but simply chose not to inform consumers of that fact,” according to the feds.

In September 2013, for example, BFL stated publicly that it was in the final testing phase of its chip production, a stage known as “tape out.”  But November 12, 2013 chat logs obtained from Zerlan’s computer show that the tape out had not occurred until that very month—and that the company expected even further delays.

[11/12/2013 12:59:18 PM] Josh Zerlan: We will not ship anything before February
given the new timeline, it’s impossible.
[11/12/2013 1:00:08 PM] Josh Zerlan: We need to start telling people they aren’t
going to see their products until March or later. There is no way we are going to
make this soft or easy, we are going to take all sorts of shit and there’s not a
single thing that can be done about it.
[11/12/2013 1:00:29 PM] Sonny: Why not tell them next June?
[11/12/2013 1:00:32 PM] Josh Zerlan: We also need ot offer refunds to those who want
it at this point.
[11/12/2013 1:00:36 PM] Sonny: it’s just as arbitrary as March
[11/12/2013 1:00:53 PM] Josh Zerlan: Well, I’m all for June actually
[11/12/2013 1:01:00 PM] Josh Zerlan: Then if we deliver in March, we look good.
[11/12/2013 1:01:19 PM] Josh Zerlan: Instead of giving them false promises for
November when we didn’t even tape out until November.

…

[11/12/2013 1:11:26 PM] Nasser Ghoseiri: We can announce that we’ve taped out on
Friday
[11/12/2013 1:11:35 PM] Nasser Ghoseiri: and let everyone know how it goes
[11/12/2013 1:11:55 PM] Josh Zerlan: No, I don’t think we should mention when we
taped out. We were suppose to tape out in September. Telling them we taped out
last week is suicide.

“The illegal conduct here did not occur in isolation”

Earlier this year, Ars spoke with two former BFL employees who corroborated some of what is now laid out in the new court filings. In particular, as of April 2014, the company’s planned 28 nanometer “Monarch” mining card was six months behind schedule.