1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 For Defendant: [Defendant present.

] UNITED STATES DISTRICT COURT WESTERN DISTRICT OF MISSOURI WESTERN DIVISION UNITED STATES OF AMERICA, Plaintiff, VS. SONNY CHRIS VLEISIDES, Defendant. ) ) ) ) ) ) ) ) ) Case No. 4:11-CR-00125-DKG-1

January 28, 2014 Kansas City, Missouri

***************************************** TRANSCRIPT OF SHOW CAUSE HEARING BEFORE GREG KAYS UNITED STATES DISTRICT JUDGE ***************************************** APPEARANCES: For United States: Kathleen D. Mahoney U.S. Attorney's Office 400 East 9th Street Suite 5510 Kansas City, Missouri 64106 Jeffrey D. Morris Shazzie Naseem Berkowitz, Oliver, Williams, Shaw & Eisenbrandt, LLP 2600 Grand Boulevard Suite 1200 Kansas City, Missouri 64108

Regina A. McBride, RDR, CRR Official Court Reporter 400 East 9th Street, Room 8652 Kansas City, MO 64106 816.512.5623 Proceedings recorded by mechanical stenography, transcript produced by computer.

2 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 EXHIBITS Defendant Exhibit 100 Order - Page 6 Defendant Exhibit 101 Defendant Exhibit 102 Defendant Exhibit 103 forms - Page 21 Defendant Exhibit 104 Defendant Exhibit 105 firm - Page 23 - Judgment & Probation Commitment - 9/3/13 violation report - Page 8 - 12/17/13 hearing transcript - Page 9 - Probation office financial - Portion of 2012 tax return - Page 19 - Letter from Polsinelli law I N D E X Reporter Certificate - Page 117 WITNESSES: COURTNEY PIERCE Further Cross-Examination by Mr. Morris - Page 5 Redirect Examination by Ms. Mahoney - Page 40 Recross Examination by Mr. Morris - Page 45 BRUCE BOURNE Direct Examination by Mr. Naseem - Page 49 Cross-Examination by Ms. Mahoney - Page 88 Examination by the Court - Page 94 Redirect Examination by Mr. Naseem - Page 100 Recross Examination by Ms. Mahoney - Page 105

3 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 2013. (Begin proceedings in open court at 9:29 a.m.) THE COURT: Okay. This is Case 11-125-01, United This is

States of America versus Sonny Vleisides, defendant.

a case -- it's -- we're here today related to a violation report dated September 13 -- September 3rd, 2013, related to a supervised release violation. The Court called this case earlier on December 17th, At that time we heard evidence through the direct

examination of Ms. Courtney Pierce, United States probation officer. Upon the conclusion of her direct examination there

was new evidence that had just came out related to an interview that she had conducted with a gentleman from PayPal, Mr. Chad Williams, a global asset protection officer. And

since this was new information I gave the defendants a choice of requesting a continuance so they could have an opportunity to effectively cross-examine related to this information. And I think the way we put it, I will show that this case is continued to address these issues related to the new information as to PayPal or any other issues you deem appropriate. So I gave that direction to the defense counsel.

At this time I do note that we have appearing again is the defendant who appears with his attorneys, Mr. Jeffrey D. Morris, Mr. Shazzie Naseem. Also appearing today is

Assistant United States Attorney, Kathleen Mahoney, and United States probation officer, Ms. Courtney Pierce.

4 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 her off. THE COURT: Yeah. Are you sure this is the right So we are at the beginning of the cross-examination of Mr. -- of Ms. Pierce. Is that how you would like to proceed today, Mr. Morris. MR. MORRIS: THE COURT: come forward? oath. THE WITNESS: THE COURT: Okay. Yes, Your Honor. All right. Ms. Pierce, would you please

Since it's been a while we'll give you another

Just -- thank you.

COURTNEY PIERCE, GOVERNMENT WITNESS, SWORN MR. MORRIS: And Your Honor, one quick change to the

people that were here -- that are here today as opposed to last time. office. THE COURT: I'm sorry. Warren. Okay. Victoria who? Today we also have Victoria Warren from our

MS. MAHONEY: THE COURT:

Warren.

MS. MAHONEY:

Victoria works in our office and is And this is her first

thinking about going to law school. time in federal court. THE COURT: MR. MORRIS: Welcome.

Shazzie and I are hoping we don't scare

5 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 BY MR. MORRIS: Q. A. Q. Good morning, Ms. Pierce. Good morning. I have set some exhibits up there that I will discuss with case for Ms. -- no. Welcome, Ms. Warren. Thank you, Mr. Morris. FURTHER CROSS-EXAMINATION I'm sure it is. I'm sure it is.

you today. A. Okay. MR. MORRIS: I've provided copies to Ms. Mahoney,

and I've also provided to you, Your Honor, a set of the exhibits. Q. I want to begin your examination by going to some basics.

And let's start with what's marked as Defendant's Exhibit 100. Do you see that document before you? A. Q. Yes, I do. And would you agree with me that that document is the

judgment and probation commitment order for Mr. Vleisides that sets forth the actual conditions of supervised release? A. Q. Yes. Okay. MR. MORRIS: Exhibit 100. THE COURT: Any objection to Exhibit 100? And I -- I move for the admission of

6 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. MS. MAHONEY: THE COURT: No, Your Honor. Exhibit 100 is admitted.

Thank you.

(Defendant Exhibit 100 admitted in evidence.) And would you agree with me, Ms. Pierce, that your

violation report is premised on the condition that begins at the bottom of page 1, which is enumerated as condition number 3, which talks about what the defendant can and can't do? A. Q. Yes. Okay. Let's talk a little bit about -- I just want to We're not dealing

make sure that what we're not dealing with.

with allegations about a lending company; is that correct? A. Q. Right. We're not dealing with allegations about a gambling or a

gaming company; is that correct? A. Q. That is correct. And there's no telemarketing or investment programs or

cold calls that are involved in the allegation that we're dealing with? A. Q. Not that I'm aware of, no. Okay. And so we are, in essence, dealing with the

reference to the solicitation of a business that involves the solicitation of funds without the express approval of the probation officer prior to engagement in such employment; correct? A. Right.

7 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. Okay. And so there is not a prohibition of Mr. Vleisides It's a situation where if he's going to

engaging in business?

do certain things, he has to talk with you about it and notify you about that information; is that correct? A. Q. That is correct. Okay. And you would agree with me, would you not, that

almost all business and commerce involves some solicitation of funds? right? A. Q. Yes. Okay. And, in fact, Mr. Vleisides, while he was under You sell a product, you get money for that; is that

your supervision, worked for and was involved in a construction company called Spartan Foundation; correct? A. Q. Yes. And he told you about that employment and what he was

doing; correct? A. Q. Yes, he did. They would bid jobs and receive money before the jobs to

partially pay for it, and they would go and they would do the construction work and they would get paid; correct? A. Q. A. Q. I wasn't aware of the intricacies. Okay. But I could agree with that. And Mr. Vleisides was open with you about that work for In fact, I've seen instances where he

Spartan Foundation?

8 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. Q. would actually send you photos from the job sites and things like that? A. Q. A. Q. Yes. Okay. And that work did not concern you; correct?

It did not. Okay. Now, let's look at Exhibit 101, which is the It should be the

violation report dated September 3rd, 2013. next document in your stack. A. I have it. MR. MORRIS: MS. MAHONEY: THE COURT:

I move for the admission of 101. No objection.

Exhibit 101 is admitted.

(Defendant Exhibit 101 admitted in evidence.) And when we turn -- there's a variety of information But when we turn to page 2, towards the

that's provided.

upper part of that page, the real meat of your violation is contained right there in the third paragraph, which says, Vleisides did not seek the express approval of the probation officer prior to engaging in a business that involves the solicitation of funds through preorders. Is that correct? That is correct. Okay. Now, if you would, look at Exhibit 102. And I'll

represent to you, Ms. Pierce, that 102 is a copy of the transcript from the hearing that was held in December, and

9 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 along. Q. this is your testimony. testimony; is that right? A. Q. A. Q. Yes, I do. And have you reviewed the testimony prior to today? Yes, I have. And do you recognize this as being page 17 of your I believe you have a copy of this

testimony and this accurately is a reflection of what you testified to? A. Q. Yes, it is. Okay. And so when we look at -MR. MORRIS: I move for the exhibit -- for the

admission of Exhibit 102. MS. MAHONEY: THE COURT: No objection.

102 is admitted.

(Defendant Exhibit 102 admitted in evidence.) And so Ms. Pierce, as we look at the upper portion of page

17 of your testimony, there's a question actually from the Court, and he says, "So did Mr. Vleisides request permission from you to engage in the business of Butterfly Labs?" And you answered, "Yes. He -- I was involved all

I can remember him talking about it and talking about However, I was not fully informed of the That would have caused

getting investors.

nature that the orders would come in. me concern." Do you see that?

10 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. Yes. Okay. So the -- the -- the violation report suggests that But

Mr. Vleisides did not get approval to conduct a business.

then when you testify you indicate that you were apprised of the business that he was forming, and about information concerning that business? that right? A. Q. A. In a way, yes. Okay. I felt that I was not fully informed as to the nature of You just wanted more details; is

the business, and without being fully informed I was not able to give express approval. Q. Okay. So let's -- let's talk a little bit about that.

Mr. Vleisides told you that he was starting the business; correct? A. Q. Yes. In fact, I've seen numerous emails where he's talking with

you about investors and hardware and technology and things like that; correct? A. Q. Yes. Okay. And you actually even toured the Butterfly Labs

facility on more than one occasion; is that correct? A. Q. Yes. Okay. Oh, yes. So certainly Mr. Vleisides gave you transparency to He didn't try to conceal the

see what he was doing; correct?

11 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 business or the nature of the business? In fact, he took you

to the business and walked you around; is that right? A. Q. Yeah. Is it safe to say that while you were touring the facility

and interacting with Mr. Vleisides, you could have asked any question you wanted to about any particular detail at all? A. Q. Yes. And did you find that when you asked Mr. Vleisides

questions that he would answer them? A. Q. Yes. Okay. And did you -- did you ever believe that he was

trying to conceal something from you? A. Q. No. Now, as you -- as he provided you this transparency to the

business, I want to understand what you did understand at the time. You understood that Butterfly Labs was making

essentially computer hardware; correct? A. Q. Yes. And you understood that it was advertising that for sale;

is that right? A. Q. Yes. And just like when I bought my Christmas gifts on Amazon,

I would order a product and give a credit card and pay for it, and they would ultimately deliver it to me? A. When I order off Amazon I have a definite date. Christmas

12 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Eve was this year. Q. A. Q. Right. And that's when it came. Okay. But in terms of how commerce worked and how

Butterfly Labs would sell something, that's how it sold things? A. Q. A. Q. Yes. And you knew that? To a certain extent, yes. Okay. And when you said to me, "to a certain extent,"

what does that mean exactly? A. It basically means that, first of all, I go back when you

were talking about me being aware of Mr. Vleisides getting investors. I was aware that he initially had a start-up of, I

believe, 8 to $10,000 that he told me came from mostly family members. I was aware of that as an investment. Not

soliciting money from people to be used as an investment to develop the hardware, that I was not aware of. Q. So your testimony is that Mr. Vleisides told you that he

was receiving funds from his family, but he did not apprise you of other efforts to get investment funds? A. Q. I was aware -I'll represent to you we've attached, as exhibits to our

response to the violation report, emails that have that exact content.

13 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Well, this is all prior -- this is all prior. At the time

of the filing of the violation report I didn't have those. Q. A. Okay. I knew that he had, like I said, a small investment to And not even -- because I do know a little about

start-up.

business, but computers and bitcoins, that is not my specialty. So it was his responsibility to inform me of the

full nature. Q. Well, you understood that he was engaged in a company

that -- that generated and made hardware computer products; right? A. Q. Yes. And you understood that that company was involved in

selling hardware that was used in Bitcoin mining; correct? A. Q. Yes. In fact, you asked Mr. Vleisides if he would entertain

agents from the FBI to tour his facility and learn more about bitcoins, because the government's -- the government's trying to better understand this virtual currency; isn't it? A. Q. Yes. And when you made that request, Mr. Vleisides was happy to

entertain not only you but FBI agents, and this is prior to your violation report; correct? A. Q. Yes. So -- so when you say that he should have told you more

14 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 about bitcoins, you certainly were present and involved in exchanges with Mr. Vleisides that involved a discussion of what his company was doing and what the computer hardware was being used for, safe to say? A. Q. A. In a way, yes. Okay. I was aware of bitcoins and that his company manufactured He made me aware of all of that, because I However, I was not aware

mining equipment.

had never heard of either before.

that they took preorders, used that money to develop the hardware and just kept customers waiting for months and months. Q. There's no determinate date.

So -- so the issue -- and I'm trying to make sure that I The issue isn't that

understand what your concern is.

Mr. Vleisides concealed the existence of the company or what it did, because it sounds to me like he couldn't have been more transparent giving you access to it whenever you wanted, hosting FBI agents to tour the facility, answering the questions you asked, and making it known to you, your concern is that you weren't aware of complaints and problems with production delays; is that right? A. Well, I didn't make that his responsibility to -- to tell I was --

me of those complaints. Q. A. Exactly.

-- not aware of the solicitation of funds through

15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 saying -THE COURT: MR. MORRIS: That's what she said. -- that is a different thing to say, preorders. Q. How did you think that people were buying the hardware?

Do you think that they were -- they were ordering the piece of hardware? And unlike any other type of business, that they

weren't going to pay anything until they actually received it? Does Amazon do that or anybody else that you know of? A. Well, like we discussed before, Amazon has a determinate We're talking, I wouldn't expect you to order a shirt

date.

and wait six to eight to ten months to eighteen months. THE COURT: Let me shortcut this. I think her

position is, and correct me if I'm wrong, is that when people order this they would get it in a timely fashion. that's the struggle, right, Ms. Pierce? THE WITNESS: MR. MORRIS: Yes, Your Honor. And Your Honor, if that's what she's That's --

that she didn't understand the fact that they would take orders and receive money just like any normal business would do. THE COURT: I think she -- I think she expected them

to receive money, but she expected the customer to receive this in a very timely fashion, like Amazon. MR. MORRIS: And that's fine.

16 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. THE COURT: MR. MORRIS: THE COURT: MR. MORRIS: THE COURT: Forty-eight hours -That's fine. -- for Prime members. Great. Right?

Is that what you're saying? THE WITNESS: THE COURT: MR. MORRIS: That is it, Your Honor.

All right. Sure.

So -- so -- and I'm trying to understand the heart of Because there's a violation alleged and then there's

this.

concerns; right? A. Q. Yes. Okay. And so when you testified before, you didn't really You testified about what

testify about the violation report. you termed to be red flags. used? A. Q. Yes. Okay.

Do you remember that phrase you

Before we -- we're going to talk about some of your But before we do, I want to talk just a little bit

red flags.

about Mr. Vleisides, because he is the person that's been on supervision, and he's the person that you're trying to either revoke or modify his supervision on. Would you say that Sonny

was cooperative while you were his supervisor? A. Fully cooperative with me.

17 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. And, in fact, he talked with you numerous times about

Butterfly and was very -- and was and is very proud of the company? A. Q. Yes. Okay. And would you describe him as being

entrepreneurial? A. Q. Oh, definitely. And during your exchanges with him as your supervision --

as your -- as his supervising officer, did you ever caution him to not be entrepreneurial? A. Q. No. I had no reason to at that time.

And when you toured the facility, I think you testified

before you had ample opportunity to ask any question you wanted; correct? A. Q. Yes. And FBI agents were present and they could ask any

questions they wanted, and you always found Mr. Vleisides to be responsive; is that right? A. Q. Yes. Now, do you understand that Butterfly Labs is a quite

significant going concern with hundreds of employees that far exceed Mr. Vleisides? A. Q. Do you understand that? What do you mean?

Well, can you rephrase that?

Well, we've talked about Mr. Vleisides and Butterfly Labs But you understand that it's

as almost as if it's just him.

18 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 much more than just him; correct? A. Q. Oh, yes. Not only in terms of ownership but in terms of management

and actual employees? A. Q. Yes. And you've seen that firsthand when you toured the

facility more than once? A. Q. I have. And, in fact, you were aware of Butterfly Labs and had

toured the facility prior to the time that you requested this Court order of the early termination of Mr. Vleisides' supervision; is that correct? A. I did not request early termination. I did not oppose it.

However, I did not request it. Q. And in the vernacular of being a supervising officer, when

you don't oppose early termination, is that the same to say that you supported his early termination of supervision? A. Q. No. If I --

Would it have bothered you if the judge ordered his

supervision to be terminated? A. Q. At that time, no. Okay. And at that time you had already toured the

Butterfly Labs facility and had plenty of audiences with Mr. Vleisides to discuss that business; correct? A. Oh, yes. Of course. I just wasn't aware of the

19 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. complaints at that time. Q. So the red flags, primary of your red flags is the

complaints; right? A. Q. That is where it began, yes. Okay. We're going to get there. But first I want to talk

about in your testimony before, you referenced a company in the Bahamas. A. Q. Yes. Okay. And you referred to a document that you'd seen in But we didn't actually get to see the document. Do you remember that?

tax filings.

Do you recall? A. Q. Yes. Okay. A little bit out of order, but Exhibit 104 in your

stack.

Is Exhibit 104 the document that you were referring to

when you testified back in December? A. Q. Yes, it is. Okay. And Exhibit 104 is a portion of a tax return filed

for 2012 by Mr. Vleisides? A. It is. MR. MORRIS: MS. MAHONEY: THE COURT: I move for the admission of 104. No objection.

104 is admitted.

(Defendant Exhibit 104 admitted in evidence.) And to be clear, this was a -- this was in the materials

that were provided to you when you requested that

20 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Mr. Vleisides provide to you tax return information; correct? A. Q. Yes. Okay. And above on the very top of this form, do you see

that there's the bold header that says, filed pursuant to revenue procedure 92-70 for dormant foreign corporation? A. Q. I do. Okay. And what do you understand a dormant foreign

corporation to be? A. Not active. And I'm just taking my own definition of

dormant. Q. Okay. Now, I want to go back, because if I recall from

your testimony and reviewing the conditions, there was no actual proactive duty by Mr. Vleisides to provide you financial information. You had asked for it and he would

provide it from time to time; is that right? A. Q. Yes. Okay. And would one of the main ways that you would get

financial information is for him to fill out a monthly supervision report? A. There's two ways. There was monthly supervision report,

and then there's monthly cash flow and a declaration of income and assets form. Q. A. Q. Okay. Yes. -- correct? And is Exhibit 103 that's there in your So essentially three types of documents --

21 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. stack, is that the kind of form that your office would use? A. Q. A. Q. Yes. I printed it off from your website. Yes. Okay. MR. MORRIS: MS. MAHONEY: THE COURT: I'll move for the admission of 103. No objection. That's exactly it.

103 is admitted.

(Defendant Exhibit 103 admitted in evidence.) And -- and 103, this form, this form does not have any

type of space or -- or request that Mr. Vleisides indicate any business ownership; would you agree with that? A. Q. Right. And when you talk about the other two financial forms, I'm

very familiar with those, and they -- they ask for questions about cash flow and accounts and things like that; correct? A. Q. Yes. Okay. Now, just to be clear, the tax form that you're

talking about, which disclosed the existence of the company, was something that Mr. Vleisides provided to you; correct? A. Q. Yes, it was. Okay. And also, did you ever ask any questions about

that?

Did you ever try to find out any information about that

company? A. I believe I Googled but didn't find anything.

22 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 105. THE COURT: Any objection? No objection. I would just ask a Q. Okay. And were you aware that the company was actually

formed by the Polsinelli law firm? A. Q. No, I was not. Okay. And were you aware that it has never been an active

company? A. I was aware of nothing until I got -- saw it on the tax

return. Q. Okay. And were you aware that it's never operated any

business, held no accounts, used any money, or had any operations whatsoever? A. I was aware of nothing about the company until I saw the

tax return. Q. As part of your stack, ma'am, there's an Exhibit 105. I requested

It's a letter from the Polsinelli law firm to me. that they provide me information about this.

And I presume

that you've never talked with Mr. Fasel about the Bahamian company? A. No. I've never talked with anyone about it. MR. MORRIS: Your Honor, I move for the admission of

MS. MAHONEY:

question about the date on the top. MR. MORRIS: February of 2014.

Is that a misprint?

It must be, because it's certainly not

23 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. Thank you. (Government Exhibit 105 admitted in evidence.) And so to be clear about this Bahamian company, with that -MR. MORRIS: I requested the letter yesterday. I got the letter I MS. MAHONEY: THE COURT: MR. MORRIS: that change things? THE COURT: So it's mostly February 27th of 2013; is Okay.

So just -If I answered that it wasn't, would

requested the letter a couple days ago. yesterday. THE COURT:

Oh, it's January 27th, 2014.

Okay.

regards to the tax form that you testified about, that's a form that Mr. Vleisides actually provided to you; correct? A. Q. Yes, it is. And then the forms that you would typically use to get

information from Mr. Vleisides, there are not blocks where he would talk about ownership that are essentially nonactive entities? A. There is a form that he filled out after this, this entity

was began, and he did not mention that. Q. Okay. Do you -- do you know whether he even knew that

this company had been created? A. I do not.

24 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. Okay. Okay. And at all times when you interacted with

Mr. Vleisides and you requested things, did you find him to be fairly responsive in trying to get you information? A. Q. Definitely. Okay. Do you really think that he was trying to conceal

something from you? A. Q. I don't know. Another red flag that you testified about before was a --

your interactions with PayPal? A. Q. Yes. Okay. And you testified that on the -- the morning of the

last hearing you reached out and talked to a Chad Williams that's affiliated with PayPal through the global asset protection unit? A. Q. A. Yes. How did you get his contact information? I would have to check my chron notes. I do -- do not

know. Q. A. How did you know to get ahold of him? I was made aware that there were possibly some -- some

complaints regarding PayPal. Q. A. Q. A. Okay. But how did you choose to talk with Mr. Williams?

I don't recall. Had you spoken with him before the December hearing date? I had not.

25 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. A. Q. him? A. Q. I believe it came from Kate. Okay. So Ms. Mahoney said that you should talk with Okay. I had not. Did someone give you his information and suggest you call

Mr. Williams with PayPal? A. Q. That I would be able to talk to him, yes. Have you talked to -- did Ms. Mahoney coordinate the phone

call? A. Q. No. I called myself. But she's the one who gave you the contact

Okay.

information? A. Q. I believe. All right. So, yes. And have you talked with Mr. Williams since

the December phone call? A. Q. A. Q. A. Q. A. Q. Yes. How many times? One. And let me guess, was it today? No. Okay. It was Friday. And tell us, because I'm sure I'll hear about it on What did he tell you

redirect, what did he tell you then?

26 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 when you spoke with him on Friday? A. I contacted him to ask for clarification and -- and

follow-up and to see if there was any additional information. He did not want to talk without a subpoena. He said that an

employee, he described as an account manager from Butterfly Labs, called him and told him they were looking him up on LinkedIn and trying to see if he had the right to speak to me about their accounts. Q. And did he tell you that he's never had any interaction

with the PayPal account involving Butterfly Labs? A. Q. All he told me was he -- what I just said. Did he tell you that PayPal told him that he should stop

talking about Butterfly Labs because he's never had any interactions at all with PayPal's interaction with Butterfly Labs? A. Q. He just told me what I just testified. That's it.

And when you testified in December, you merely recited to

the judge what a person that you know as Chad Williams said to you? A. Q. A. Q. I looked him up to see if he was a global asset -That he was really affiliated with PayPal? Yes. And I was under the impression he was.

Did you speak with anyone else at PayPal to see whether or

not he was actually informed about interactions with Butterfly Labs?

27 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. No, I did not. And when you tried to call him last Friday he told you --

he told you that he couldn't speak with you? A. Q. A. Q. Without a subpoena, no. Did you issue a subpoena? I did not. And for purposes of the information that you provided to

the judge in the December hearing, did you do anything to confirm what Mr. Williams told you and that you recited to the judge? A. I went to Butterfly Labs' website to see if, in fact,

PayPal had been removed as a vendor, because I was aware that they were accepting PayPal, and I did not see PayPal as a way to pay anymore. Q. A. Q. Any other investigation? Not on that matter, no. Okay. Did you ever discuss with Mr. Vleisides any PayPal

issues? A. Q. No, I did not. Okay. And did you ever discuss with anyone at Butterfly

Labs interactions with PayPal? A. Q. No. Now, the one thing that we can be certain of is that there There have been complaints; right?

are complaints. A. Thousands.

28 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. Yes. And you've talked about what Mr. Williams had told

you about for purposes of a PayPal account; correct? A. Q. Yes. Yes.

And he talked about and you said that Mr. Williams at

least said there had been, for instance, three complaints that day? A. Q. Yes. Did he -- did he talk with you at all about what the

nature of those complaints were? A. Q. Not those specifically, no. Okay. And is it your understanding that almost all of the

complaints that have come in have been complaints about delays in production and people not getting the product that they wanted on time? A. Q. Not receiving their merchandise is what I've been told. There haven't been complaints about the quality of their

merchandise, and when someone actually receive it -- receives it that it does exactly what it's supposed to do? heard that; have you? A. Q. Mr. Williams and I did not discuss that, no. Okay. Have you discussed that type of allegation with You haven't

anyone else? A. I have seen complaints through a law enforcement website

that have alleged not good product, yes. Q. And when you say law enforcement website, do you mean the

29 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 FTC Sentinel website? A. Q. see? A. Q. I don't have them broken down like that. Okay. And do you know what the nature of the most recent Consumer Sentinel, yes. Okay. And how many of those types of complaints did you

complaints are? A. Q. No. Okay. And certainly, when you'd had your conversation

with Mr. Williams you didn't discuss that kind of contact; right? A. Q. A. Q. He didn't have access to that at that time. Exhibit 106 is in your stack. Yes. And this is a complaint overview from the Better Business Do you see that document?

Bureau, and it's a -- it's a -- when there's a complaint raised, you can actually follow how it gets resolved. familiar with that process? A. Q. Yes. Okay. And have you seen these types of reviews for recent Are you

complaints that relate to Butterfly Labs? A. Q. No. Okay. And as we look at this complaint as an example, we

see that someone has raised a complaint about the timing of delivery; correct?

30 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. Yes. And we see that this complaint, which was filed on

December 30th of '13, actually relates to an order placed on December the 11th. A. Q. A. Q. I do. Under the complaint detail? Yes. And as we look through this type of document, we see that Do you see that?

the -- the complaint has been resolved, and it's been resolved in that as indicated on the third page, the order was placed on December 11th. It was shipped on January 3rd, and is And then they actually

expected to be delivered January 6th.

have the delivery confirmation to show that this was resolved. Do you see that? A. Q. Yes. Okay. On this complaint I do. And so are you aware that almost all of the

complaints that are presently rolling in involve this type of small time frame window where people want these machines so badly when they don't get them immediately they file a complaint, and it's usually solved within a week or two? A. Q. A. Q. No. I'm not aware of that. Mr. Williams and you didn't discuss that?

Okay.

Our last discussion was on December 17th. Are you aware, Ms. Pierce, that there is a significant

demand for the products that Butterfly Labs sells?

31 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. Yes. Okay. And would you agree with me that when there are

complaints about the timing of delivery, there are a variety of things that a company can do to address those complaints, and one of them is to issue refunds? A. Q. I would agree, yes. And are you aware that refunds have been issued in

significant amounts by Butterfly Labs? A. Q. No. Okay. You haven't read the papers and the materials we

filed in opposition to your violation report? A. Q. Yes. Okay. I've read them. And would you agree with me another way that you

can try to protect customers when there's issues with delays is you can actually escrow and reserve funds? A. Q. Yes. And that's your understanding of what PayPal did; is that

right? A. Q. Yes. And, in fact, PayPal always reserves a portion of funds.

They just started reserving a greater portion because of issues with the complaints; isn't that correct? A. Q. A. I don't know what they normally reserve. Okay. I just know what I was told they had on reserve --

32 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. A. Q. Okay. -- on December 17th. Did you understand from your conversation with

Mr. Williams, at least, that PayPal for a period of time had indicated to Butterfly Labs that it would be reserving a great portion of funds and escrowing that fund away to protect customers? A. Q. Can you rephrase that? It was a horrible question. Too many words. I'm sorry.

The -- the process of PayPal escrowing funds -A. Q. A. Q. A. Q. A. Q. Uh-huh. -- took -- occurred over a period of time? Are you talking about them holding their money? Yes. It didn't just all happen at once? Yes. I wasn't aware of that specifically, no. Okay. And you did understand from Mr. Williams that while

these funds were being preserved and escrowed, that that number was being reduced? A. Q. Yes. I did definitely understand that.

And it was being reduced because Pay -- Butterfly Labs was

still working with PayPal; correct? A. Q. Yes. Okay. So instead of Butterfly Labs saying, well, we're

33 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 having trouble with PayPal escrowing our funds, we just won't do any more PayPal business, they continued to do PayPal business and take orders when they knew those funds would be escrowed to protect the customer; isn't that correct? A. I don't know that they continued to take orders. I was

under the impression that they did not. Q. And do you know where the PayPal relationship with

Butterfly Labs stands right now? A. My last contact where I got information was December 17th.

At that time I was told that they did not want to do business with Butterfly Labs. Q. A. Q. You were told that by Mr. Williams? Yes. Would it surprise you to learn that that's completely

false? A. Q. I would be a little surprised, yes. Did it surprise you when you contacted Mr. Williams and

said, "I can't talk to you anymore"? A. Q. A. Q. Was I surprised? Yeah. A little. If someone called and wanted to talk to you about your job

you would be willing to talk about it, right, because it's your job? A. Probably, I would.

34 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. Uh-huh. So a way that you can handle complaints about

delays is to issue refunds and reserve funds and you would also agree with me, wouldn't you, that you can ship more product? A. Q. Of course. And isn't it true that Butterfly Labs has been shipping

more product and catching up on all those delays? A. Q. That is what I understand from you. Do you not understand it from all the customer information

we've provided to you and provided to this Court? A. I saw -- I saw -- I know that you gave documentation, but

I saw one Better Business Bureau complaint -- or resolution, but I also see default court judgments and other things coming into play. Q. Do you -- do you -- would you agree with me -- and I Would you agree with me that there are

understand your point.

people that are working on this issue? A. Q. A. Q. I believe they are, yes. And those -- those people far exceed Mr. Vleisides? Of course. Okay. And would you agree with me that there's nothing in

the special conditions of supervision that addresses whether there's complaints about the timing of production and delivery? A. Oh, yes. Of course.

35 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. Okay. So let's talk about another red flag. You

testified in December about the company, Butterfly Labs, owning a residence that Mr. Vleisides uses? A. Q. Yes. Okay. Mr. Vleisides told you about that residence;

correct? A. Q. A. Q. Yes. You've been to that residence? Several times. And Mr. Vleisides told you that the company owned that

residence? A. Q. Yes, he did. Did you ever tell him that the company's ownership of that

residence and his use of it was a violation of his supervision? A. Q. No, I did not. And did you ever tell him that you were some day going to

appear in court and testify that that was a red flag that might lead you to file a violation report? A. It -- it was -MS. MAHONEY: argumentative, Judge. THE COURT: arguing with her -MR. MORRIS: Sorry. Sustained. You know you are kind of I'm going to object. That's pretty

36 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. A. Q. please. MR. MORRIS: THE COURT: Fair enough. Thank you. THE COURT: information from her. MR. MORRIS: THE COURT: view necessarily. Very good. Not try to convince her to your point of -- Mr. Morris. I just want you to get

Okay? Sorry. Natural inclination, Judge, but

MR. MORRIS: I'll back it off. THE COURT:

I understand.

So just ask questions,

Did you tell Mr. Vleisides it was a red flag? No. Okay. And during your direct examination there was a

reference to the fact that you had reviewed Mr. Vleisides' 2012 tax return; correct? A. Q. A. Q. His or the company's? His and the company's. Yes. Okay. And counsel elicited from you a reference to the

fact that his tax return from 2012 didn't list or reflect any personal income benefit for the benefit of having corporate housing; is that right? A. Q. Yes. When was the house purchased by the company?

37 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. If I could refer? If you want to refresh your recollection, Exhibit 114,

which is up there in the stack. A. Q. Is it? I should remind you that the house closed in December of

2012. A. Q. Oh, yes. December 6, 2012.

And isn't it true that Mr. Vleisides didn't even reside in

the house until 2013? A. I do not know when he began to live there, because he did I went to his mother's house So I can't

not report a move to me prior.

one day and called him and he said, "Oh, I moved." confirm when he began to live there. Q.

Would you agree with me that if there was no benefit in

2012 to report it shouldn't be on the taxes? A. Q. If there wasn't any. There was also discussion during your direct examination

about a car that the company bought? A. Q. A. Q. Yes. And you were aware of the car as well; correct? Oh, yes. And did you ever advise him that that was a violation or a

red flag concerning his supervision? A. Q. No. I would never advise of a red flag.

And the car itself is a -- is a 2006 car with 100 ,000

38 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. forgot. THE WITNESS: MR. MORRIS: THE COURT: All right. Your Honor, may I approach you? Yes, sir. Yes, sir. miles on it? A. Q. I don't know how many miles are on it. All right. MR. MORRIS: THE COURT: MR. MORRIS: May I approach briefly? Yes, sir. Yes, sir.

I meant to put it in the stack and I

This is just to refresh your recollection, Ms. Pierce.

This is the transactional documents on the car which reflect a 2006 Audi. And when you turn to the second page and look in

the mileage box, it's 109,000 -- 109,690 -- excuse me, 109,000 miles. A. Q. Do you see that?

Yes, I do. Okay. So this wasn't some extravagant vehicle? I mean,

he bought an extremely used car that cost $19,000; is that right? A. Q. Yes. Okay. By my review of your earlier testimony, the other

red flag that you mentioned had to do with losses that were reported by the company on taxes and shareholder loans. you remember that? A. Yes, I do. Do

39 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 witness? MS. MAHONEY: THE COURT: Yes, Your Honor. Did you ask for Q. Okay. The shareholder loans that you referenced are

reflected on the company's financial statements; is that right? A. Q. Yes. And those financial statements were provided to you by

Mr. Vleisides; is that correct? A. Q. Oh, yes. Okay. So there's not a question about those being

concealed in some fashion? A. Q. No. And the tax returns and how they reflect loss for a

company, are you -- are you an accountant? A. Q. Definitely not. Okay. I'm not either. But would you agree with me that

there is sometimes a difference between tax accounting and how it's reported versus business viability, revenues and cash flow? A. Q. A. Yeah. Okay. Yes. MR. MORRIS: THE COURT: Nothing further. All right. Any redirect of this I can imagine there is. Particularly in a start-up tech company?

Now, did we admit 112?

40 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. A. Q. the Audi? MS. MAHONEY: THE COURT: Yeah. BY MS. MAHONEY: Q. So this -- this 112, that reflects Sonny Vleisides buying that to be admitted? MR. MORRIS: Do you want it admitted? I don't need it admitted. It's just

really just to refresh the recollection as to the age and use of the car. THE COURT: MR. MORRIS: THE COURT: Okay. Sure. Very good.

Thank you. Yes, sir.

REDIRECT EXAMINATION

not Butterfly Labs, is that what you see? A. Q. That is what I see. That's what -- yeah. And it shows him as the buyer and

not Butterfly Labs? A. Yes. THE COURT: I'm sorry. You're talking about 112,

Okay. Do you know of another car?

Is there another car maybe? I do not. Okay.

And Ms. Pierce, did you see or hear any explanation

between the discrepancies, very large discrepancies and losses in the financial statement and the claimed tax loss? A. You're asking if I see it?

41 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. I direct your attention that in the financial statement it

was stated in 2012 there is a loss of approximately 139,000, whereas on the tax return it's 836,000. A. Yes. That's -- that's all I see. I don't know the

reason. Q. And you didn't get any kind of explanation or

understanding of -A. Q. No. -- that discrepancy? All right. Now, when you talked to

Mr. Williams with PayPal before he told you he needed a subpoena to talk further. Did you ask him, you know, just to

check the accuracy of the statements that you had testified to? A. Q. Yes. I started off like that.

And did he reaffirm the accuracy to the extent he was --

he talked to you, those few questions? A. Yes, with an um-hum. I said, I went to court per our

conversation.

You know, I just wanted to clarify that there

were -- this is the amount of money the 11 million held and what it went down to, and he confirmed with an um-hum. when I asked questions is when he told me no. Q. Okay. Now, Mr. Morris referenced a visit with FBI out to At that point But

Butterfly Labs and apparently you all visiting.

did Mr. Vleisides say that he was not an officer of the corporation?

42 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. My recollection is that he said no. He was the But

mouthpiece.

I don't know that he used those exact words.

it had something to do with being a mouthpiece for the company. Q. Okay. You talked a little bit that there are some Could you describe those for Judge Kays, what you

lawsuits. know of? A.

I know of two that I have found, and I'll have to go to my I have, in Johnson County, Kansas, a lawsuit brought by

file.

a William, it looks like Lolli, L-O-L-L-I, alleging -- he's a California resident. That has had an issue with the delivery And it's a default judgment that he

of his mining equipment.

got for $16,000 and change. Q. A. Q. What was the date of that default judgment? I believe it's 10-25-13. All right. No. 11-27 of '13.

And you said there was another one you're

aware of? A. Yes. I am aware of one more that I just became aware of

this morning filed in the District Court in Kansas by an individual residing in China that has the same sort of issue. This individual is suing for future profitability. thing. Q. A. Q. Which is the nondelivery of products ordered and paid for? Yes. Mr. Morris had you look at a Better Business Bureau But same

43 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 complaint that had been resolved. Did you look to see if what

the -- if Butterfly Labs had a ranking with Better Business Bureau? A. I did. I looked Butterfly Labs up. They had an F

ranking, and there were more than 100 complaints on there with the same sort of shipping and delivery issues. Q. So is it your understanding Better Business Bureau ranks

from A as in Adam to F as in Frank, and they had an F? A. Q. That's what I understand, yes. And you also mentioned on cross-examination that there

were FTC complaints as well? A. Q. Yes. And so those are available on a law enforcement database

Consumer Sentinel? A. Q. Consumer Sentinel, yes. Do many of those complaints include language such as no

refund, final sale, refusal to refund? A. Oh, yes. I -- I have looked them over and I know that But consistently people

they can't be brought into exhibits.

say that when they've asked for a refund, they've been told that all orders are final. Q. All right. So Mr. Morris gave you the example of Amazon, If -- if a customer orders from

and just as an analogy.

Amazon and then they don't get their product for say eight to ten months and asked for a refund and Amazon doesn't give them

44 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. A. a refund, would you consider that a proper business model? A. Q. No. All right. And is that what is being reported to happen

there? A. Q. Yes. And is it a concern for you, especially when you see some

self dealing in that while not shipping product or often refunds to some customers, there are undocumented loans being made to officers? A. Q. Oh, definitely. Yes.

And then there also is property being bought by the

company for use by the officers? A. Q. A. Q. Yes. Such as a house and a car? Definitely. All right. MS. MAHONEY: Kate, can I -Yes. -- just further on the loans? Mr. Vleisides, if he got -No further.

it's a gray area. reported to me.

But if he got a loan, it should have been

In the past he has asked if he wanted to get And when his

a $500 Home Depot card, he asked me.

girlfriend's car went out, he emailed me asking for approval to get a loan, because per his conditions he cannot apply

45 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 BY MR. MORRIS: Q. You were asked about the undocumented loan and you The without it. Q. A. Q. So it's -- it's problematic.

What is the amount of the undocumented loan? The documentation I got from him says 65,000, I believe. Have you received any documentation as to the terms of the

loan or the paperwork? A. No. MS. MAHONEY: THE COURT: page 4 of 7. All right.

For the record it's in document 23.1, Which shareholder received a There's $65,977.19

It's question 6.

$242,000 loan from Butterfly Labs?

attributed to the defendant, and the annual rate is .22 percent. Q. That's in that document. Okay.

And so my question was, did you have the underlying

paperwork of the terms of the loan, the -- what -- what -A. Q. No. -- what somebody would see the payment -- rate of payment

to be made? A. No. I don't have anything. THE COURT: MR. MORRIS: All right. Mr. Morris, sir?

Just briefly, Judge.

RECROSS EXAMINATION

answered, when he gave me the documentation it showed X. loans for the shareholders are reflected on the company's

46 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 financials, right? A. Q. A. I did not receive that prior to. Did you ask him for it? No. He should ask me before -- like I said before, he's He's asked, can I get a Home Depot I mean --

known per his conditions.

card to replace my washer, or a vehicle loan. Q. And you did receive from Mr. Vleisides on a fairly regular

basis an accounting of how much money he would get from the company; right? He would show you that he would make $500

every two weeks or a certain amount? A. All I ever remember is his salary staying steady at $500.

And then around the time of this violation it got reported that it went up a little bit. Q. Okay. Not 65,000.

And have you ever gone back to check to see whether

or not he was actually showing you the amounts of money that he was getting and then there was a determination of how to classify that as income or shareholder loan? had that discussion with him? A. Q. A. Have I looked back to see or have I had the discussion? Both. No. Do you recall any such discussion? We never discussed any sort of loans to him from Have you ever

No.

the company. Q. Okay. And for purposes of when you asked for financials

from the company, you did receive the financials and they showed at least this book value for the shareholder loan;

47 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 here. correct? A. Q. Yes. You can say that.

And you don't know how that number accumulated over time

or anything like that? A. Q. No. You testified about the house and the car as being

problematic, but you knew all about the house and the car; right? A. I think that me saying red flag, you took to mean that I I looked at a totality

took each one of these individually.

of the circumstances as far as income for what the company was doing or not doing. His prior offense, everything plays into,

like I said, it's just the totality of the circumstances. Q. And you mentioned something new. You mentioned two

lawsuits. A. Q. A. Q.

Are those lawsuits against Mr. Vleisides?

They're -- they're against the company obviously. Against the company? Yes. And is there any reference to Mr. Vleisides in any of the

allegations that are made? A. Q. Not him specifically, no. All against the company.

If Mr. Vleisides worked -- worked at H&R Block in

management -MS. MAHONEY: I'm going to object to argumentative

I mean, I think this is a very good place for argument.

48 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 seat, sir. THE COURT: MR. MORRIS: Yeah. Sustained. Based on the

I'll leave it alone.

redirect, nothing further, Your Honor. THE COURT: Ms. Pierce. MR. MORRIS: THE COURT: Thank you, Ms. Pierce. All right. Call your next witness. Thank you. All right. Thank you,

MS. MAHONEY: government, Your Honor. THE COURT: present evidence? MR. MORRIS: call the next witness. THE COURT: MR. NASEEM:

No further evidence from the

All right.

Mr. Morris, do you wish to

We do, Your Honor.

Mr. Naseem will

All right.

Mr. Naseem, sir. I'm going to call

Thank you, Judge.

Mr. Bruce Bourne to the stand. THE COURT: All RIGHT. Mr. Bourne, would you please

come forward, face our clerk, raise your right hand and be sworn, sir? BRUCE BOURNE, DEFENDANT WITNESS, SWORN THE COURT: Mr. Bourne, if you'll please have a

Mr. Bourne, would you please begin, sir, by

speaking your full name and spelling your last name for us? THE WITNESS: Yes, sir. My name is Bruce Bourne.

Last name is spelled B-O-U-R-N-E.

49 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 BY MR. NASEEM: Q. Mr. Bourne, let's start by talking about your current What is your relationship to THE COURT: Thank you, sir.

Mr. Naseem, sir. MR. NASEEM: Thank you, Judge.

DIRECT EXAMINATION

affiliation with Butterfly Labs. the company? A.

I've been working with Butterfly Labs on a contract basis

since the beginning of September 2013, essentially serving in the role of chief financial officer and providing financial and general management consulting services. Q. A. Q. And are you actually an employee of Butterfly Labs? I am not an employee. So you operate your own independent consulting company;

right? A. Q. That's correct. How many hours a week would you say that you spend with

Butterfly Labs? A. I spend about 75 percent of my time per month working with I come out to San Fran -- or to Kansas City two to

Butterfly.

three weeks out of every four weeks. Q. A. Q. So your -- your home base of operations is San Francisco? Correct. Can you briefly describe some of your daily duties with

50 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 the company? You've touched on some of them, but maybe we can

dive a little deeper into that. A. It's -- it's become a little bit of everything. I oversee

the accounting and financial reporting.

I have been involved I

with the financing aspect with the PayPal relationship.

work with their VP of marketing on press releases and their account manager on new client deals. attorneys on the lawsuits. I've worked with the

So I've got involved in more or

less every aspect of the company at this point. Q. So it's fair to say, then, that you have a firm

understanding of the company's day-to-day operations and of its finances? A. Q. Largely, that would be correct. Okay. Before we dive into the nuts and bolts of Butterfly

Labs and their operations, let's talk briefly about your background. A. What's your educational background?

My undergraduate degree is I have a bachelor in science

degree in accounting, summa cum laude from Florida State University. Q. A. Q. A. I have a master's --

Congratulations on the -Thank you. -- national championship. I have a master's in business administration, with honors

from Harvard business school. Q. And after you got done with your college degree, what did

51 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 you do? A. First thing I did I was an Army officer for four years. Subsequent to that I went to Arthur

Army finance corps.

Andersen and was a certified public accountant for four and a half years in the audit division. into private industry. After that I left and went

Over the last 25 years or so I have

been the chief financial officer of two companies on a permanent basis, and at least three to five others on a contract basis. I've had general management, operating jobs, I've worked in a

senior vice president of strategic planning.

variety of industries, companies from two guys with a business plan up to about $2 billion in revenue. Q. A. Tell us how you came to work for Butterfly Labs. A client that I did work with about 15 years ago was a

childhood friend of one of Mr. Vleisides' co-founders of Butterfly Labs. He introduced me, because the co-founder was

interested in getting some financial help for the company because they had had some challenges. Q. Approximately when did those conversations occur? When

did you find out about the possibility of their need for you? A. I believe they reached out to me in probably early June of I first met with the company at the end of June, and I

2013.

started working with them at the beginning of September. Q. Did you do any kind of due diligence into what Butterfly

Labs was about before you decided to -- to interview with

52 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 them? A. Q. A. Yes, I did. What -- tell us a little bit about that. In my initial call with Jeff Ownby, who's the co-founder, I went to the website, He also So I

Jeff told me what the company did.

looked through the website, Googled the company.

revealed that Sonny had some legal problems in the past.

did some research on Mr. Vleisides and was familiar with the background of his -- the previous reasons we're here today. Q. And did you have a chance to actually meet with

Mr. Vleisides before becoming employed with Butterfly Labs -A. Q. Yes, I did. -- before working with them? Okay. Were you familiar at

all with the computer hardware that they produced before you came to work for them? A. Q. Not at all. In all of the experience that you've had with some of the

companies that you've mentioned, which are both small and large, and you're out in the San Francisco area, which is a -a tech heavy location, you had never heard of this type of -of computer hardware? A. Q. I had not. Okay. Let's shift now to the focus of what Butterfly Labs

does.

Tell me, as best as you can describe it, what is the

product that Butterfly Labs produces?

53 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. A. So their -- their innovation was the creation of a

specialized computer chip, which does extremely high speed mathematical calculations that are used to verify transactions or validate transactions. Around that chip they envisioned

and created a process control board and an enclosure that goes around that, and you attach this to a computer. You plug it

into an electrical source and it runs these high speed calculations. The calculations are actually -- they have

several different applications in different industries, but the most common use for it and the majority of the purchases of their equipment have gone towards mining bitcoins, which are created or released through the completion of these calculations. Q. Okay. And I'm going to show you -MR. NASEEM: MR. MORRIS: MR. NASEEM: What exhibit are we on? Just use 120. Okay. I'm just going to use 120, Your I'm not going to

Honor, for identification purposes only. admit this piece of hardware. Q.

But Mr. Bourne, I'm going to show you what we've marked as

Exhibit 120 for identification. MR. NASEEM: THE COURT: May I approach? Yes, sir. Please. Is that the

I've placed Exhibit 120 in front of you.

computer hardware that we have just been describing?

54 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. A. It's one of several different products in the product But this is one of Butterfly's products. And you say one of the products in the line. Do

line. Q.

Okay.

they -- do they manufacture -- manufacture several different types of products like that? A. They do. They all have the same -- the same basic It's just a matter of

function and the same basic technology.

how much power, how much processing power, and how much electrical power it needs. The -- the products range from

approximately half this size to about eight times this size. Q. Okay. MR. NASEEM: Your Honor. I'm going to retrieve that exhibit, I

I'm going to show this to the Government.

don't know if you've seen that. MS. MAHONEY: MR. NASEEM: THE COURT: All right. No. Judge, do you want to see it? Sure. Sure. Thank you.

Now, these products, do they vary in price as

well? A. Q. They do. So this particular unit that the judge is holding right

now, how much does that run, do you know? A. Well, the prices have changed over time. But I think

currently you could buy that for about $1200. Q. Okay. So the products are very unique, as we were talking

55 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 about, and are you aware that the demand for these particular products was high? A. Q. Yes. Okay. Do you know why the demand for that product is so

high? A. There are not a lot of products that people perceive as

being something they can buy and make money with that product. This product, to the extent that Bitcoin has value and people believe that it will continue to have value, this product is used to obtain bitcoins. And the reason that the demand for

this product is so high, I would attribute to, one, it can have a return on investment. Unlike buying a suit or a shirt,

this is something that can give you a financial return. The other aspect of it is the comp -- this was not the company's first product. worked and worked effectively. Their previous products had So I believe that part of why

there was such demand was that Butterfly was coming out with an improvement on their old technology, and the expectation was that this would function extremely well. Q. And so this is a highly specialized piece of computer

hardware that is designed to mine Bitcoin; correct? A. It's designed to run calculations that are applicable in a But its primary use has

number of different applications. turned out to be mining bitcoins. Q.

But the company itself does not produce bitcoins; right?

56 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. A. Q. A. Q. No. It produces computer hardware? That's right. A physical product? Correct. And this is what people are -- when they go to the website

to order, this is what they are ordering or some variation of that? A. Q. A. That's right. Okay. How large is the company?

There's different ways to measure how large a company is.

The two typical ones are how many employees and how much revenue. Butterfly, since I've been there, peaked at about At

110 employees when we were in full manufacturing swing.

current time, because we've manufactured and shipped all the products in the backlog, and we are not yet producing the next version of the product, we have downsized, laid off staff who were assembling parts and components that are not necessary right now. So at this point the company is about 60 people. But our expectation is when we do begin to construct the next iteration of these products will increase staff to manage that production. Q. And how many facilities are involved just locally with the

manufacture of that product?

57 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. There -- the primary manufacturing spot and company That's the primary manufacturing

headquarters is in Leawood. site.

There is a -- a warehouse where there's some parts and

there's some component assembling that's done that's also in the vicinity. I want to return for just a moment. You asked me

about how large is the company, and I said there were two measures. I talked about employees. In terms of revenue, in

2012 the company did about $2 and a half million of revenue. For 2013 we have not finalized the financial statements, but I expect that the revenue for 2013 is going to be between 25 and $30 million. Q. Okay. So fair to say that that is a -- a significant

increase from where it was just even a year and a half ago? A. It's very dramatic growth. As I mentioned, I do live out

in San Francisco.

I do work with some tech companies, and But

that type of growth is -- you know, it's not unheard of. it -- it's an exceptional growth rate. And generally it's

very difficult to grow at that rate and do it without some hiccups. Q. Would it be fair to characterize some of the growth that

you've seen here on par with some of the growths -- the growth that happens out in Silicon Valley would -A. Q. Yes. -- in your experience?

58 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. Yes. Okay. Now there have been some discussions regarding

customer complaints and PayPal and kind of the ordering process. So I want to focus your attention now on PayPal, In your

because that seems to be one of the largest issues.

capacity as the CFO, have you had a chance to work with PayPal on some of the issues that have been testified to here previously? A. Q. A. Yes, I have. Tell us, what does PayPal do as its primary business. PayPal -- PayPal largely serves as an escrow agent. If you are a -- if you're a

They're a payment facilitator.

person who has set up a PayPal account, you have given them either your credit card information or your bank account information, and if you order an item or a service from a company who uses PayPal, PayPal remits payment to the company, but they draw that payment either off of your credit card or from your bank account. So they serve as a middleman. The

Basically it's to create trust between buyer and seller.

seller, that they're going to get paid, and the buyer, that they are not going to get scammed. Q. So, in other words, within that discussion you describe

almost two ways that you could purchase a product, and tell me if I'm characterizing this fairly. One would be to go to the

company website and purchase it directly, in which case you

59 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 would directly give them funds. A. Q. Correct. And the other way, through the interaction of PayPal, is That's one way; right?

to set up this escrow account whereby the protection the customer seeks is given through PayPal by putting the money essentially in escrow, and the company does not receive it directly? A. That's -- that's correct. Although typically an escrow

account means that the escrow agent is going to hold those funds until they're notified to release them. little differently. PayPal works a

It -- it gives the buyer assurance, to But there

some extent, that they can recover their money.

isn't a formal release of the funds based on performance. That's -- that's not typically the arrangement. Q. Okay. Now, describe how a typical transaction may work

between the customer to PayPal and then PayPal to Butterfly Labs. A. The customer sets up their PayPal account in advance.

They may have purchased multiple times from other suppliers of any sort of good or service that accepts PayPal. The customer

would go to the company's website, fill out the order form, decide what they wanted, create their shopping cart, use PayPal as their payment mechanism, and click submit. That

puts their order into the cue to be produced in the future. And the company -- at the beginning the company

60 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 would have received that money in fairly short order. Later

on in the relationship, when the complaints level increased, PayPal stopped allowing the company to draw money from the company's PayPal account. Q. And that's where I want to go next. Let's talk about,

we've heard some discussion about money being frozen with PayPal. Can you talk a little bit about what it means to have

a frozen account with PayPal? A. Sure. In the same way that an insurance company collects

premiums from a lot of people and expects to have claims, but not claims from a hundred percent of those people, the insurance company holds a portion of all the money that it collected as a reserve for claims, and the rest of that money is available to pay their expenses and hire people and dividends to their shareholders. PayPal works more or less the same way. They

collect payments from everybody who is paying, ordering from a particular company. And generally they hold back a portion of

those funds and release the rest to the company for whatever purposes the company chooses to use the money. Once the volume of complaints had risen to a point that it was getting higher level management attention at PayPal, PayPal decided to start holding a hundred percent of the money, not a lesser percent of the money. So they froze

the account in a sense that Butterfly could not draw from the

61 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 account. But at that time new orders could be placed using

PayPal so the amount in that account could continue to -- to grow. At a later point in time PayPal removed the company's ability to -- to take large orders using PayPal, and then about a month after that they said you can no longer take any orders using PayPal. Q. So, in essence, then, you had this pile of money that was

sitting with PayPal; correct? A. Q. That's correct. Okay. And because the company was not able to access that

money, there was probably some conversation that occurred between Butterfly Labs and PayPal; would that -- would that be fair to say? A. Q. Yes. And when you came to work for Butterfly Labs, that was one

of the first issues that you probably dealt with? A. In -- in late August PayPal had limited the dollar amount I started

of an order that could be placed using PayPal. beginning of September. orders from the company.

September 20th PayPal cut off all new Their concern was that the amount of

money they were holding and the amount of orders that needed to be satisfied was imbalanced, and they therefore wanted to hold a hundred percent of the money that they had. was my first and primary activity with the company. So this

62 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. A. Tell us what you did to look into what could be done. So the company had begun shipping products in late April, Very small in April,

but the production volume was very slow. May and June.

Actually in June and July they started shipping By September the production line, the

a bit more product.

supply of parts, the assembly process was getting resolved to the point where the production volumes were coming up. So I spoke to our PayPal account manager. The way

PayPal works, you know, they have thousands of companies that take PayPal, if not 10s of thousands. You get -- if you're a

company who uses PayPal, if you have a question you call like a call center and you talk to someone. If you're a

significant customer, in the top one or two percent in terms of charged volume with PayPal, you get assigned an individual account manager, who's your primary point of contact. Butterfly Labs has that qualification. percent charge. We have an account manager. said, "Look. So I spoke to him and I The They're a one to two

What are we -- what do we need to do?"

situation at that point in time was that PayPal was holding between 11 and $12 million. The account was frozen. And

Butterfly needed to satisfy about 16 or $17 million worth of orders. So had a hundred percent of those orders come back And that's what

for refund, PayPal didn't have enough money.

they were worried about was that we're underreserved.

63 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 What they said was, "Well, look. Either you got to

ship these people their product, or you need to refund them their money." So what I did is created a report using our

online order system and our online shipping system that listed every order that had been paid through PayPal, whether it had been shipped or not. And for those that had been shipped what

was the shipping tracking number, so that we could match orders placed and dollars paid against orders shipped and dollars earned more or less. At that point in time there were 23,000 PayPal orders, of which about 2,000 had been shipped. About a

million and a half dollars out of 19 million total. That's mid September. Every week after that I

updated that report so that we could show them progress against reducing that backlog and lowering PayPal's exposure, although there were 5 million more in orders than there was in money held. So it took a while to get down to where that We

backlog was -- was even with the amount they were holding. reached that point in about mid November.

After that, as we continued to ship -- and by this time our shipping was between 1 and a half and $2 million a week. After mid November once the backlog was below the Look. Your

amount of the reserve, I said to them, "Okay. exposure is less than a hundred percent. releasing part of this money."

You need to start

And they worked with us

64 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 cooperatively to release -- there wasn't a hard and fast rule. But generally if we shipped a million and a half dollars, I asked them to release a million dollars out of the reserve. So that's what brought the account down by mid December, to about 7 million held versus the 11 million that they initially had it at. Q. Where is that -- and so now this is probably about a month Where are we on that number now? One

later. A.

So there are actually three ways to satisfy an order.

is to refund the individual, the second is to ship the goods, the third is that some people decided, the company's coming out with a new line of this product similar, same function, but a different form factor, a different shape. Some people

chose to transfer their order for that equipment to an order for the new equipment. That equipment is not due to be

shipped until March or April. So where we stand today is out of that 19 million, about a million and a half has transferred into future product orders. All but about $2500 of the remainder has either been So the remaining amount that PayPal

shipped or refunded.

needs to hold is the million and a half for the future orders, plus about $2500. As of last Friday PayPal was holding $6 million. sent them the report that showed where we were at that point in time. At that point in time it was the million and a half I

65 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 plus a hundred thousand of backlog. So they were holding 6 They So

million against a little more than a million and a half. immediately released $3 million to us as of last Friday.

today they are holding 3 million against a million and a half, and I've requested that they release that other 1.5 million. Because at this point, they certainly don't need more than a hundred percent. I would add that the total refunds that we've made related to PayPal, out of $19 million we've refunded $1.5 million. Q. 1,550,000.

And those are to customers, though, the refund to

customers who had an issue with the supply at some point in time? A. That's right. It was -- I mean, all of it was refunds to But generally

customers for, you know, a variety of reasons.

people were unhappy with the amount of time they had to wait. Now some of these were refunds. When you use

PayPal, as a vendor, PayPal can elect to make a refund on your behalf. They don't necessarily ask your permission. So, to a

large extent, those refunds would have been involuntary refunds, but to some extent we would have gotten involved. There's a difference between whether the person requests their money back in -- within 10 days, or within 45 days, or beyond 45 days. At any rate, we've refunded about 8 percent of the So if you use that as a guideline,

total volume of orders.

66 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 they should be holding about $150,000. Q. A. Q. Versus the three million? Versus the three million. And has PayPal indicated to you in your discussions with

your account manager that they would like to do -- continue to work with you not only on doing refunds, but maybe going forward? Is there any indication that they want to

permanently bar you from doing business with them? A. No indication of permanent barment. We are currently

suspended. orders.

They will not allow us to use PayPal for any new

I have talked to them several times about how we can Because, look,

get to the point of being able to use this. their customers are our customers.

And we want to provide our So

customers an easy way to pay for the company's products.

as a convenience to our customers, we would certainly like to use PayPal. Where we stand with them today is that, you know, the -- the issue of the complaints, the bad press that we've gotten they have currently suspended the account. As I

mentioned earlier we haven't been able to produce full financial statements for the complete 12 months of 2013. They've requested that information. returns. They've asked for tax

We've provided them everything that's been created.

They need to do due diligence on any company, especially one where they've had some exposure to be sure that the company's

67 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 financially viable. They have said that they are a hundred

percent willing to evaluate that information once we submit it to them. Q. But presently we are on hold.

Is it fair to say that there is a level of transparency in

terms of providing financial statements and tax returns that exists between Butterfly Labs and PayPal? A. Absolutely. We've reported to them. With -- with respect

to the shipping and refund information we report on almost a weekly basis. At this point the backlog's done, so I'm no We have provided them

longer sending them weekly reports.

everything that they asked for as soon as we were able to produce it. Q. And what would you calculate for all the products that

you've shipped, this $19 million worth of -- of product, what's the rate of return on -- on the product that actually goes out the door? A. Have you looked at that? We had a

In -- in broad terms, about 2 percent.

production meeting about a month ago to talk about, all right. We're coming to the end of this product line's life. spares do we need to create in case we get returns? How many And the

people in the room, which included, you know, marketing and production and purchasing, shipping, the consensus, and it's sort of anecdotal. I haven't studied the numbers, but the

consensus was if we produced two percent of what we had shipped out and held those as backups or replacements, that

68 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 would be sufficient. Q. To satisfy those who maybe had a problem with that order,

you know, it broke or whatever? A. In terms of -- in terms of returns for, you know, quality

or -- or operation problems. Q. Okay. Now, you've described a lot of communication with In all of

PayPal.

You've described having account managers.

the time that you were working with your account managers at PayPal, did you ever work with someone named Chad Williams? A. Q. No, I didn't. Okay. Was -- was Chad Williams ever on any documentation

that you ever received from PayPal? A. No. When his name first came up I -- I knew I hadn't I asked. We have one account manager who

dealt with him.

deals with large accounts and we have a customer service department which is about 10 or 12 people. PayPal. They work with

I asked the manager of that department and I heard

her ask the department, no one has ever had any interaction with Chad Williams. Q. Okay. THE COURT: Now you're not saying Chad Williams

doesn't exist at PayPal, you're just saying the people you dealt with haven't talked to Chad Williams? saying, I guess? THE WITNESS: Well, Your Honor, that's -- that's Or what are you

69 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 correct. In fact, I'm confident he does exist at PayPal

because I asked our account manager, whose name is Matt Popov (phonetic), about Chad Williams, and he said, "Let me check." And he came back to me and he said, "Yes, we have a Chad Williams who's a asset protection investigator." Q. Let's -- let's shift now to talk about some of the

financial issues that are associated with -- with Butterfly Labs, and specifically I want to focus now on this issue of taxable income versus cash flow. First, can you talk about

what the difference is between those two terms? A. Sure. Taxable income is calculated under the IRS

regulations, which are dictated by Congressional tax law. It -- it is used to calculate what the company or individual's obligation to pay in taxes on their income or other activities is. It is separate from financial reporting, which is

dictated by generally accepted accounting principles, and those two are different from the actual cash flow to the company, which is really, you know, at the end of a period of time, do you have more or less cash? I would broaden that to

say, more or -- more assets than you started with or more liabilities than you started with. Q. Okay. And in terms of how Butterfly Labs has been

accounting for these types of taxable issues that come up in the course of business and cash issues, have they been working with an accounting firm to keep track of these things?

70 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. A. Yes, they have. What's the name of that accounting firm? It's a rel -- it's a long name, but it starts with That's how I

MarksNelson, and that's how we referred to them. know them is MarksNelson. Q. Okay.

And have you had a chance to work with MarksNelson

on -- on tax issues related to the company since you've arrived? A. Q. I have, starting with the 2012 tax return. And have you been satisfied, at least in your, you know,

limited exposure here, with the disclosures that -- that Butterfly Labs as a company has been making to the accountants as to how they should characterize income and -- and characterize the books? A. Q. Can you repeat? I'm sorry. In your experience, have you so far with the

company, have you been comfortable with the amount of information that -- that you were providing to MarksNelson? A. Q. Certainly. Would you say that you are holding something back from

them as far as what needs to be disclosed? A. Q. Not on my watch. Okay. So when we talk about the concept of -- of cash,

how does a business view its importance in terms of its day-to-day operations?

71 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Well, the company has no lines of credit, no debt It has -- the company has no means of financing its

facility.

operations, other than through internally generated profits at this point. While they're -- the total capitalization of the And, in fact, that

company at the beginning was $10,000.

$10,000, you know, it's not much when you're doing $20 million of revenue and having to pay the people and buy the components it takes to do that. So for a company like Butterfly, or specifically Butterfly, cash flow is crucial. Q. So I want to shift then in the concept of this idea of the

prepaid orders we've been talking a little bit about that today. Tell us what your opinion is about the function of

prepaid orders in a start-up business like Butterfly Labs. A. It is -- it's sort of viewed -- any sort of prepaid

business model from -- from an entrepreneurial's point of view, from a point of view of operating a company, it's kind of the ideal or holy grail sort of business model. It is a

way to finance the company that doesn't involve getting outside investors. of your own capital. It doesn't mean putting in a huge amount It -- it provides -- assuming you've

been able to price your product properly to allow for some profit, it ensures that the company should be viable as long as you can continue to produce and sell that product. So it's

a -- among the different methods of financing a business, it's

72 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 seen as probably the most desirable. Q. And when a company receives preorders, are there

representations made to customers about wait times or -- or anything associated with the production of the product? A. Q. A. Specifically at Butterfly Labs? At Butterfly. Yes. I -- I didn't come to the company before September,

but my understanding in reviewing screen shots and talking with company executives is that all along they have said to people, you know, this is a preorder, preorder terms, nonrefundable. Delivery of your product may take quite some Essentially don't order the

time, two months or longer.

product if you're not willing to wait the amount of time it takes. Q. And are you aware of efforts that Butterfly Labs made to

try to keep customers informed through its website about what was happening with the process? A. Yes. With this product, in particular, there was a delay

from the expected initial delivery date that caused the company to have to say, this -- you know, we need to do some rework on the product. Once they had a handle on the redesign of their chip or the -- the reengineering of the power that was being consumed and the heat that the chip was producing, they put an advisory on their website that said, Okay. We're -- you know,

73 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 we're nearly at the point of producing at full scale. still going to take a while. several months. It's

We have orders dating back

So if you're in line, we're going to give you Or

an opportunity now to get out of line by taking a refund. you can elect to stay in line for future delivery of this product. And then for people who ordered after that date, when -- when you were ready to place your order, one of the

terms of sale, you had to check a box that said, essentially, I acknowledge that this could be a multi-month delay and I do choose to -- to stay in line for my product. Q. So it sounds like there's some active communication going

on with PayPal, but it sounds also like there's some active communication directly from Butterfly Labs to the customer about what kinds of issues Butterfly Labs is facing with respect to production? A. Yes. For any customer with a paid order prior to May 1st,

they received an active outreach to them saying, you know, we need you to reaffirm your order, or take a refund. And for

anyone who ordered after May 1st that showed as a pop-up on their order screen. Q. Did you ever have a customer support center in place at Was there ever anything like that put in

Butterfly Labs? place? A.

There's a customer service department that operates in the

74 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 headquarters, same place where we do the manufacturing. Q. And would that customer service department also field

calls from -- from consumers about timing, expected delivery, maybe complaints about the product itself? A. Yes. Although I would say not phone calls, unlike a call Everything with Butterfly, as is typical with a lot So the customer service

center.

of tech start-ups, is done via email. center received inbound emails. actual phone call. Q. Okay.

Very rarely was there an

Let's move now also to the issue of these

promissory loans, I'm sorry, the shareholder loans that were -- were discussed. These were made obviously before you got But have you had a chance to look

to the -- to the company. into that issue? A. Q. A. Yes, I have. What have you learned?

So they are on the books as shareholder loans.

They're

not so much loans in the typical sense where you would go to a bank and get $100,000 in one lump sum. characterize as advances. They're what I would

They're -- as opposed to someone

coming and saying, I want to buy something large and I need a -- a -- a sum of money. This has been moneys advanced when

an executive has a credit card, and they use that credit card. They are supposed to use it for company purposes. It's not

infrequent in a small company or a privately held company that

75 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 things. they use it for personal purposes as well. It's actually a very effective mechanism from an accounting point of view or an accounting department's point of view to -- when the credit card statement comes in to look at the charges on there, and anything that isn't clearly business to put it into an account for the holder of the credit card. That is a personal debt to the company. It --

it's a way, from CFO's point of view, to force people who usually are too busy to pay attention to paperwork to sit down and go through all these charges and say, this one's for this, this one's for this. You then move those from that

shareholder advance account to business expense, or, it is a personal expense and then it's something that the shareholder needs to pay back to the company. So what I learned is early on Sonny was -- in fact, no one at the company was employed in the beginning. were all kind of set up as consultants. They

Sonny's pay was In the same

essentially advanced as a shareholder advance.

way if it was legally a partnership, you would have a partner draw. They were working that way for the first few months.

That eventually got changed, got a payroll service, people went on payroll, so those payroll advances. That stopped.

There were payments for a variety of different There were payments for business items that got put There are payments

into that account, subsequently moved out.

76 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 for personal items that went into that account and stayed in that account. That practice has continued, but I would say it's a lot cleaner now because before I started working with the company, I said to Sonny, well, look, if I come to work with you guys, one of the things that I think is important to do is that we begin to operate like a more disciplined established mature company, as opposed to some of the things that get done in a start-up environment. Q. And how is that shareholder either distribution or loan,

or when the company pays for it, treated as far as tax returns are concerned for the individual and then also for the company? A. Q. That's probably a loaded question.

Actually -How should -- how should it be treated for an individual

on their tax return? A. So for an individual, a loan is a loan. A loan is a

personal loan.

So to the extent there's interest on the loan, So even

it's not deductible on an individual's tax return.

though the individual may owe the interest to the company, it will not show up on the individual's tax return. deductible item. It's not a

For the company the interest is income to

the company and it's reported on the company's tax return. The -- the moneys that are sitting in that account are not deducted by the company from its taxes, because --

77 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 it's -- it's a loan to a shareholder. the company is concerned. It's an asset as far as

So it's not an expense and it's not

income other than the interest from the company's perspective. On the individual side, it -- it really wouldn't show up on the individual's taxes if it's in that account until they repaid that. And then to the extent any of those expenditures I

were tax deductible, it would show up on their tax return. will say largely those types of expenses are not tax deductible. Q. Okay. THE COURT: We're going to take a recess. We've

been at this for about an hour and a half. take a 10-minute recess. MR. NASEEM:

We're going to

Thank you, Your Honor.

(Recess at 11:02 until 11:12 a.m.) THE COURT: witness stand, sir. Mr. Bourne, we'd like you to retake the Okay. Mr. Naseem, we'll wait on him.

Are you going to take over? MR. MORRIS: THE COURT: MR. MORRIS: THE COURT: MR. MORRIS: I am not. Okay. Mr. Naseem is using the restroom. Okay. But I did want to inform the Court, I

have to go to a medical appointment. THE COURT: Sure.

78 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. MR. MORRIS: THE COURT: MR. MORRIS: And if I leave -That's fine. -- Mr. Naseem will be handling

everything from here out. THE COURT: MR. MORRIS: Sure. But if I get up and depart, it is not a

reflection on the Court or anyone else. THE COURT: We enjoyed working with you.

At around 11:45, 11:50, if we're still going, I will have to go. THE COURT: MR. MORRIS: THE COURT: All right. continue, sir. MR. NASEEM: Yes, sir. Yes, sir. Thank you, Judge. Thank you. Mr. Naseem, if you would please

Mr. Bourne, we were talking about what appears on the tax I

return as it relates to the -- to the shareholder loans.

want to continue on with the other investigation that you did in regard to any documentation that may have existed for those loans. A. What were you able to find? I'm not sure

So they're -- the company had a controller.

when she started, but she left the company in late May or early June of 2013. I was able to find in her files from

March, there was an email to the shareholders who had loans

79 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 from the company that had a form of a note attached. mid March. This was

She advised that, you know, we need to get these Here's a form of note. Take a look at this

loans documented. and get it signed.

The next day there was a follow-up email from her saying, well, there was some concerns about the wording of that draft note, so don't sign what she had sent out. There

was also a second version of that note that was clearly a -- a much better effort at putting together a formal promissory note. notes. However, I could not find any signed version of those So it appears there was discussion and, in fact, what

I heard from one of the other people there told me that they had intended to run it by the attorneys to get approval on the form of note. finalized. But it doesn't look like that ever got

So there was an effort in March, but it doesn't

look like it ever resulted in a signed note. Q. What efforts are being taken now by the company to make

sure that that is fully accounted for and documented? A. I've asked our corporate external counsel at Polsinelli to

draft a form of note that we can use and put in place to document the existing loans and anything that -- that exists going forward. Q. Okay. What do you understand the market rate to be on

those loans as you go forward? A. So under tax rules, there's a concept called the AFR,

80 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. rate? THE WITNESS: THE COURT: Not in today's economy. Very interesting. applicable federal rate. It's a rate that the IRS either

prescribes or approves as the minimum interest that must be charged in order for this not to be a bargain loan. And that

AFR over the last few years, because interest rates generally have been so low, that interest rate for 2012, the -- it changes during the year. The blended rate for 2012 was 22

basis points or 0.22 percent. Q. Okay. THE COURT: And that's not considered a bargain

Okay.

Now, we've talked a lot about some of the changes that And it

have -- have been instituted since you have arrived.

sounds like some of the things that you have put in place are designed to help the company run better; is that -- is that fair to say? A. Q. Yes. Have you encountered any resistance from either Sonny or

any of the ownership about the things that you're putting in place? A. None whatsoever. In fact, it's -- it's -- it's kind of

good from a bean counter's point of view that people are actually hungry for how should we be doing this? help us operate in a better way? What will

So I've -- I've -- they

81 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 engaged me to help them. They've been very open to all of the

suggestions that I've made as recommendations. Q. And -- and they have done more, they have adopted those

and tried to help those be a part of what the company is trying to do? A. We -- I mean, we have a ways to go, but yes, they have Anything

done that with -- I can't think of an exception. that I recommended we do has been done. Q. Okay.

I want to touch briefly on the -- the purchase of Are you aware of that?

the car and the house by the company. A. Q. I am. Okay.

Let's -- let's talk about that.

What is your

understanding about those two assets? A. So the -- the Audi was purchased, I believe in May of The house, as was discussed earlier, was bought in

2012.

December of 2012. Q. And how does the company, that perhaps is showing loss on

its tax return, buy a house or a car? A. So we talked about the prepaid sales model earlier where

you get cash in advance of delivering on whatever the promised product is. presales. It would -- it would certainly be unwise to spend all of that money that you collected, because you have to pay payroll and you have to buy parts and you have to pay your So the actual cash available comes from those

82 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 taxes, et cetera. But to the extent you can estimate the

profitable portion that will be retained out of that, you can use that for any sort of company expenditure. financing of it is through the presale order. The -- the reasons behind buying it typically a small privately held company will buy assets that they think are going to reduce costs in other areas. For example, you So the

know, if I have to fly all the time, I'm spending a lot of money on commercial airline tickets, the company may end up buying an airplane so that they don't have to put executives on commercial airlines. Similarly with cars versus renting a

car or housing versus putting people into hotels. Q. And is that your understanding about what the company has

done with those particular assets? A. To some extent. The car itself, you know, my

understanding is that this is not the first car that the company has owned, and that the original car that the company owned when customers came from out of town to visit the facilities, the company loaned them the vehicle to use instead of them having to rent a car. Other executives who traveled

from Chicago, I come from San Francisco, had access to using that car. Other people who are employed by the company come

to town from out of town are able to stay at the -- the -- the corporate residence. Q. How does the company account for the assets on its tax

83 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 returns? A. On its tax returns. So any owned asset under corporate

tax laws you have to -- you can expense what you paid, but only over a long period of time. So an example, the car, over

a five-year period the company would be recording depreciation on the car. Any maintenance, insurance, taxes, licenses is

also taken as an expense on the corporate tax return. For the house, similarly, you depreciate it, but it's over a much longer period. 40 years. that. Maintenance, taxes, that sort of thing, that would be deducted on the corporate tax return. Q. How is an individual to characterize the use and benefit I think it's 27 and a half to

It's a long period of time for a building like

of those assets? A. The -- the correct way to handle it is to attribute the

value of the use of that asset to the individual to the extent that it was personal use. So if I have a company car and I

drive it 70 percent of the time for business and 30 percent of the time for personal, 30 percent of the fair value of leasing that car would be added to my compensation on my W-2 as a taxable item. Q. And are those numbers that we're talking about for the

company, are those numbers related to those as assets, are those turned over to MarksNelson for their review and then

84 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 ultimate addition to the company's tax return? A. Well, in this case we're talking about the individual's

tax return. Q. Yeah. So -- I'm sorry. To go back to -- to go back to

MarksNelson and the company, and not the individual, but you would expect that the company would turn over any information related to -- to those assets to MarksNelson for inclusion on the company tax return and the financials? A. Yes. The car existed during 2012. I know that The

MarksNelson received that information regarding the car. house was purchased in December of 2012. There was no --

there was no tax activity attributed to the house for the three weeks it was owned in 2012. For 2013 I am personally

doing the value of the car and the value of renting the home, both of those will be added to Mr. Vleisides's W-2. Q. Okay. The final thing I want to touch -- well, actually, But the -- so Butterfly Labs has

one more thing beyond that.

grown tremendously in terms of its -- its gross revenue from 2013 -- I'm sorry, from 2012 to 2013; correct? A. Q. Yes. And we talked about the applicability of this particular What are

computer hardware beyond just mining applications.

some other uses of this hardware beyond just -- just Bitcoin? A. So we -- the company was approached several months ago by

a major significant credit card company about the possibility

85 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 of using that hardware in validating credit card transactions as either authentic or fraudulent. That company is currently

conducting testing using 12 of the company's suitcase-sized machines, much large -- about eight times more powerful than this one. So they're running a test on that, and if that

turns out, what my understanding, as of last week, is their testing is going well. That would -- if they decide to adopt

this technology for validating all of their credit card transactions, which I would say given the size of this company would be 10s of millions if not hundreds of millions of transactions a year, we would be looking at a multimillion dollar order from them and the opportunity to then take that product to other credit card companies as a whole new -- a whole new market for this technology. Q. A. Q. For authenticating credit card transactions? Correct. And on the preorder for testing purposes, how many

machines did they order? A. Q. A. Q. A. They ordered 12 machines. And at a cost of how much per machine? Twenty -- about 20,000 per machine. So that's a fairly substantial order for testing purposes? It is. Now, I -- to be clear, because this is such a

potentially large new market for us, we have loaned them those machines. They are to test with them and return those

86 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 machines. Q. Okay. So this was not recorded as a sale. But they were built and processed here in Kansas

City with the idea that there could be some potential future business with that credit card company? A. Q. Yes. Okay. That's right. Let's talk about any online retailers that -- that We've talked

are interested at all in -- in this product. about Butterfly Labs' own website.

Are you aware of any other

commercial -- larger commercial interest or consumer interest in this product beyond just the website for Butterfly Labs? A. Yes. There -- the first week of January there's an

annual -- there's an annual trade show in Las Vegas, the Consumer Electronics Show, CES. It's -- it's the consumer

electronics trade show for the year. Butterfly had a booth at CES this year. I was not And

there, but, you know, appropriate company people were. apparently there was a lot of buzz around Bitcoin, and Butterfly attracted a fair amount of attention. We had

inquiries after -- or during and after CES from at least three well-known retail chains, Micro Center, TigerDirect and Fry's Electronics. We have since engaged TigerDirect as a customer.

So we are supplying them with our hardware to advertise on their website and sell to their customers. And we have a

meeting with Micro Center, I believe this week, and the Fry's Electronics will come behind that. So there is a new retail

87 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 reseller channel. Q. So the market is expanding beyond just the -- the

consumers that -- that wanted product, now you are able to compete and supply larger commercial retailers with the product as well? A. Q. That's the direction we're headed in, yes. Okay. The final thing I want to talk about is the -- the I believe there were

issue of the lawsuits that were raised. -- there were two that was raised.

One was in Johnson County And I want

and one was filed in the District Court of Kansas.

to ask you, to your knowledge, is the company handling these lawsuits? I mean, were they aware of them before they just

came up today in -- in testimony? A. Q. The company is responding to those lawsuits. Okay. And who do they have engaged as a firm that is

working on those lawsuits? A. Polsinelli, who serves as external counsel for the

company. Q. Okay. So Polsinelli is actively engaged with handling

those lawsuits? A. Q. Actively engaged. Okay. And you also have played an active role in, I

guess, handling those lawsuits too? A. Q. I have. Okay. And to highlight a point that was made earlier, but

88 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 BY MS. MAHONEY: Q. So just on this lawsuit thing, there was a default Honor. THE COURT: Thank you, Mr. Naseem. neither of those lawsuits personally names any company individuals as -- as the basis for it is the company itself that is being sued? A. Q. A. Q. BF Labs, Inc. is the only named defendant in the suit. Okay. In both suits; correct? Correct.

In each suit. Okay.

MR. NASEEM:

I have no further questions, Your

Ms. Mahoney? CROSS-EXAMINATION

judgment; right? A. Q. A. There was. So that's -- that's not an active involvement; is it? That Pols -- so there is default judgment. And Polsinelli Because

has filed a -- let me think about this for a minute.

not being an attorney I have to think about the difference between the two. One has a default judgment in place, the Polsinelli is filing

other has filed for a default judgment.

an opposition to the request for default judgment in the Meissner case. On the Lolli case, Polsinelli is actively

involved in settlement negotiations.

89 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. Okay. Now, you talked about how somebody should And this car was Was that

characterize personal use of company assets.

bought in, you know, May or thereabouts of 2012.

characterized as personal income to Mr. Vleisides on his 2012 tax return? A. On -- so the -- the proper way, yes, it was. Although it

was not handled the preferred way from a tax reporting standpoint. It should have been reported as part of his W-2 The way that the former

income as additional wages.

controller handled it is that she used a 1099 miscellaneous form, which is a self-employment form. So they reported the value of what Mr. Vleisides received and he reported it on his return. It was reported as

self employment income, not as wages from the company. Q. And has the company as assets that it has bought to

improve its profitability bought houses for other employees? A. Q. It has not bought houses for any other employee. Okay. You said that you had asked Polsinelli to draft When did you ask

notes to document the shareholder loans. them to do that? A. Q. About a week ago, probably. Okay.

And you understand that Ms. Pierce asked for that

information in September of 2013 when you came in? A. Q. I'm not aware of that. Okay. And so in both circumstances, of the house and the

90 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 loan, it was customers' money that went to Mr. Vleisides buying his house that he lives in, and to loan him and other shareholders money; right? A. Because of this prepaid model?

It was certainly money that customers deposited, you know, I'm not entirely

with the company to purchase their products.

sure at which point legal entitlement to the money passes from the customer to the -- to the company. But the -- the money

that any company uses, if it's not borrowed or put in by investors comes from its customers. from the customers. Q. A. And you called it also advance pay? I -- advances of salary, draws, payroll draws early on. In this case it all came

By the end of 2012 what they had done is in the beginning as each draw was made it was added to the amount of the loan. the end of the year it was deducted from the loan and moved over into salaries and wages. So by the end of 2012 no part At

of the loan reflected the wages part of what had been advanced to Mr. Vleisides. Q. Well, it kind of sounds like what happened, from your

description, was that these shareholders were using company credit cards and making personal purchases and then they just turned into loans? A. They were turned into loans at some point? The company --

To some extent I would say that's correct.

the company credit cards were used for both personal and business purposes, and the personal portion was shown as an

91 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 advance that would be -- need to be repaid by the shareholder. Q. Now, should people who have company credit cards use them

for personal expenses? A. Q. They should not. All right. And so does that continue on, do you know,

by -- by Mr. Vleisides? A. Q. I -- I will say that it probably has continued. All right. Are there other employees, in particular

Mr. Vleisides' mother, who has a company credit card that makes personal purchases on? A. There are other company emp -- there are other company

employees who -- you know, the only one I've looked at closely is Mr. Vleisides because of this issue. There are other I do not

company employees who have company credit cards.

know whether Mr. Vleisides' mother has a company credit card. Q. Did you prepare the 2012 financial statements or tax

returns? A. I reviewed the 2012 tax returns that were prepared by And I did not produce or review, other than for

MarksNelson.

informational purposes, the 2012 financial statements. Q. So having worked for this company for only approximately

four months, you have not prepared any financial statements or tax returns for -- for anybody involved here? A. So I've prepared -- prepared. MarksNelson is contracted

to do the external accounting.

Because the company lost its

92 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 of 2013. controller they turned to an outside firm to do the -- the reporting. MarksNelson produced reports for the first quarter I reviewed those in detail. 2012 they, I believe,

were prepared by the company, and then MarksNelson reviewed those. I also reviewed them, but I did not have a hand in And as far as Mr. Vleisides' personal tax

preparing them.

return, I did not have a hand in preparing that. Q. A. Q. A. Are you familiar with bank accounts of the company? Generally, yes. How many bank accounts do they have at BMO? Two that I'm completely aware of. I'm not -- I don't

think there are others after -- beyond that. Q. A. How many employees have use of the company credit card? There were formerly American Express cards, now we use There are either five or six outstanding

Diners Club cards. cards. Q.

And who checks on whether the -- those people use them for

personal expenses? A. We have a staff accountant who processes the charges and

makes the first cut at determining whether something looks like business or personal, and then I review it after that. Q. The Monarch BPU was said to begin shipping at the end of Has that happened?

2013. A.

No.

93 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. And finally, the shareholder loans were represented to be How is that accounted for?

based on future profitability.

Isn't future profitability pretty speculative? A. So in the -- nothing that I have seen in the company's The notes from the

records says it's future profitability.

prior controller didn't refer to what they were anticipating. In a pre-sales type of model, if you know that you're selling something for a thousand dollars and it's going to cost you $300 to create it and a hundred dollars to advertise it and another $100 for the people to put it together, you can expect that you have about $500 of profitability built in there. However, the way you account for it is all of that is deferred into the future from a -- from a generally accepted accounting principles' point of view you look at a completed transaction. So the fact that I'd received your

order and your money, but I haven't delivered to you, I don't have any sales revenue in that period. revenue until I deliver your product. I don't have any sales And at that point I do

have sales revenue, I record the cost, and the profitability of the actual realization of the profit. So if I collect all of this money in 2012 and I don't deliver until 2013, 2012 reflects nothing other than the cash and a liability to deliver the product. 2013 will show

all of the revenue and all of the cost and all of the profitability, but no cash in flow.

94 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 BY THE COURT: Q. You testified earlier -- I want to make sure I understand I thought you said they have manufactured Q. A. Q. And these were made in 2012; is that right? The loans were in 2012 and in 2013. All right. And 2012 was when there were a lot of shipping

problems and basically all liabilities for this company? A. For this product, yes. They had an earlier version -- an

earlier generation of product that did ship in 2012. Q. And, in fact, the company reported losses on both the

financial statement and tax return? A. That's correct. MS. MAHONEY: THE COURT: No further.

I have a couple questions that will give One moment,

you a chance to -- to follow-up, if you need to. please. EXAMINATION

this, Mr. Bourne.

and shipped all the products in the backlog and they now have 60 employees. It was in the context of your discussion of

they went to 110 employees to 60 and you made the statement, I thought, that they have now manufactured and shipped all the products within the backlog. that right? A. You did with the exception of three to five orders, which I mean, they total $2500 in those orders have not Is that -- is that -- did I get

haven't.

95 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 been done. Q. Oh, okay. So -- and that's part of your -- your work with

PayPal is they shouldn't have any -- there shouldn't be millions of dollars with PayPal; right? A. Q. A. Q. That's right. But there is; right? There still is $3 million in PayPal. Okay. One moment, please. Now, you also described -- you One way is

testified that there's two ways is PayPal works.

going to the company website, and -- and when you decide to pay for a product you press the PayPal button, I guess. said the other way is that PayPal escrows this amount. remember talking about that? A. I -- I do, although that's not a separate method of That's what happens to the funds after you elect to You Do you

payment.

push that button. Q. That's my -- that's my question. So it's not like

Butterfly Labs went to PayPal and says, hey, we would like to select this alternative way where you escrow the money and it's a pre -- it's a prearranged agreement. This escrow is --

I understand maybe that's how PayPal makes money off the interest of this to some degree, but it's usually not an escrow -- it's an involuntary escrow of sorts it looks like in this case because I'm sure Butterfly Labs wanted their money, but there was a lot of problems related to that; right?

96 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. A. Yes, sir. Sure. -- what I had said earlier. We've ended up refunding If I go back to --

about eight percent of the actual purchases. Q. Sure. But I guess my question is, this isn't some

prearranged agreement between Butterfly Labs and PayPal that they'd escrow this money, this was a default procedure that PayPal had in place to protect themselves and the consumer; is that fair? A. Q. Yes, sir. So basically there's really one way. I don't want to But

argue with you because I fuss at lawyers for argument.

isn't there really one way how PayPal's intended to work and it's where you press the button and you pay them and you get your stuff; right? The default is if you don't get your stuff

and you complain, PayPal freezes it and that becomes an escrow if it doesn't -- everything else doesn't work out correctly; is that a fair way to characterize that? A. Out of -- out of a hundred percent of the orders that

PayPal receives in, they're going to -- they're going to hold back 10 to 15 percent of the money as a reserve against expected refund requests. Q. A. Okay. That's typical. That would be the normal way to do it.

As the volume of complaints rises, and the financial exposure

97 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 grows, more and more moneys flowing through, PayPal, in its own defense and protecting consumer, I'm not sure whether I would say arbitrarily but certainly unilaterally decided 10 to 15 percent holdback is not enough. hundred percent. Q. A. Q. So -We're going to hold a

And given the backlog, that's not unreasonable; right? I -I mean, I don't want to put words in your mouth. Don't --

you don't have -- if that -A. Well, Your Honor, as -- from an auditor's point of view,

you look at historical claims and you say, typically five to twenty percent goes bad. Up to that number is reasonable, and

beyond that, from an auditor's point of view, you're overreserved. Well, my position as a CFO is to say to PayPal,

you guys have been and remain overreserved. Q. So when you report liabilities, you do -- you do -- I know

that there are a number of, like we talked about, there's the methods we've used to report income tax, corporate income tax, there's also different methodologies we use to calculate assets and liabilities to get some sense of the financial well-being of the company. But when you look at liabilities,

under the generally accepted accounting practices or principles, this -- this money that you have, this is reported as liabilities; is it not? Or this money that PayPal has,

because you owe -- you owe something here; right?

98 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Yes. That's right. Every dollar that comes in as cash is That

initially posted to an account called prepaid sales.

prepaid sales account shows up under the heading liabilities for the company. Q. What do you call lawsuits that are pending, pending

lawsuits, how do you report that? A. You don't report that until there's a reasonably

quantifiable and -- it has to be a likely loss and the loss has to be quantifiable. Q. A. Q. Okay. -- you would put it on as an expense and a liability. And but you didn't really prepare these financial And at that point --

documents because you just came late to the game, so to speak; is that fair? A. Q. Yes, sir. So you didn't really have to quantify or calculate

pursuant to these generally accepted accounting principles the liabilities related to this PayPal issue; is that fair? A. No. The PayPal issue is very straightforward. It -- the

way it was accounted for was the proper way to account for it. Q. But you didn't do any of the financial reporting in that

regard? A. Q. I did not. Now, it would seem to me that this idea of undocumented

loans or advances is probably the worse way -- it gives

99 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 accountants nightmares is what keeps you guys up at night; is that fair to say? A. Q. Yes, sir. Okay. And that's why you when you got there, you said, We've got to document this.

hey, we've got to fix this.

We've got to put this in writing because this -- it's scrutiny from courts and the IRS and everybody else and investors, everybody else involved; right? A. I probably didn't say that as soon as I got there, but I -- I

once I became aware that this is an issue, then yes. will say this is not atypical.

It is typical that this

situation, because it's a privately held company. Q. There are many inherent problems with this practice,

though? A. Q. Yes, there are. All right. One moment, please. So what accounts -- what

liabilities does Butterfly Labs have at present would you say? A. Q. We have -- in terms of dollar amount or type? Types. Types. Any -- any rough -- and, you know, rough

estimates related, if you could, please. A. Sure. Again, we have not been able to accumulate all the But, in general, the

numbers for the 2013 reports yet.

largest liability that the company has remains for preorders now, not of that version of the product, but the next version of the product. So we've received moneys from customers,

100 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 BY MR. NASEEM: Q. Mr. Bourne, I want to follow-up again on the PayPal issue. have. preorders for the next iterration of these products. That's

the largest liabilities on the books if we had our financial statements current. And we probably, at this point, I'd say

that liability would be north of $10 million. Q. Okay. And -- and, basically, what I got from your

testimony, you may have said this, this applicable federal rate that -- that where corporations loan money to shareholders or to principals in the corporation, this is not uncommon in the corporate world; is that -- is that right or is it uncommon? A. In the private held small company world, shareholder loans The same rate would be used if there was a It has to be an interest Loans between Small company loans

are very common.

loan between two family members.

bearing loan and the AFR is what's used. related parties typically would use AFR. to shareholders are extremely common. THE COURT: Mr. Naseem? MR. NASEEM: Thank you, Judge. Very good.

That's all the questions I

REDIRECT EXAMINATION

Even though there were problems that had arisen with -- with this money that was in escrow, did Butterfly Labs seek to terminate the relationship with -- with PayPal?

101 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 A. Q. No. Not at all.

And, in fact, would it be fair to say that they worked

extra hard to make sure that PayPal and the customers were -were satisfied according to the terms that -- that PayPal had set? A. Q. We did. Okay. And as a result of those efforts, you were able to

clear out the backlog and reduce the amount of reserve that PayPal ultimately held; correct? A. Q. So far we've gotten $8 million out of the 11 back. Okay. And would it be fair to say that -- that Butterfly

Labs would like to continue to do business with PayPal? A. Q. Yes. Okay. We would. So even though you didn't have a chance to

negotiate the terms on the front side as to what the escrow would look like, the terms were at least acceptable enough to you that you would continue to do business with them? A. Q. Yes. I mean, the fact that they keep a larger reserve, I

understand, we've talked about that. A. I have asked them what -- what under the terms of service

that they have with us gives them the right to retain the -the level of reserve that they have. answer to that question. Q. But those negotiations are typical in the type of business I have not gotten an

102 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 arrangement with someone that is -A. It's a fairly one sided relationship. They're huge and

we're not. Q. A. Q. Fair enough. So we take the terms that they dictate. Okay. We talked about this Monarch BPU that has not yet What is the Monarch BPU? It's more in

shipped. A.

It's the next generation of this product.

the form of a card, about the size of your hand, that would -it's kind of a plug and play type of component if you're building computer hardware. So it's a more powerful version

of -- of this that will be coming out soon. Q. Okay. And, you know, as far as where things are on the

process of getting that out the door, what -- where do things stand, if you know? A. The -- all of these products are based on this chip that I The -- the chip that's in this is The chip in the new one is a 28 It's the more is

was describing before.

called a 65 nanometer chip. nanometer chip. law.

Everything's shrinking.

So you have to design the chip, and then you have to get

a firm that builds chips to actually build some prototypes that you can test and see if they function the way that you want them to. This process is multiple. I mean, it's many

months from design to initial manufacturing to testing to full production.

103 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Where we are in it today is that the prototype chips have been delivered to the lab that will do the testing on those chips. So the testing process should take until, well, At that point

the end of this week or maybe into next week.

we'll know if the chip's functional as they designed, if they live up to the engineering specifications. modifications will be made, if necessary. At that point You have to

reprototype and then you go into production assuming the reprototype works correctly. Q. And similar to what we talked about before, is Butterfly

Labs keeping its customers apprised of its progress in that regard? A. Yes. I think, you know, we had a newsletter that was just

recently released to anyone who's ordered from us before advising them of the status of the current product. Q. Okay. So, in other words, they're not hiding from the

product, that they are trying to address it actively? A. Q. Yes. Okay. Let's go back and talk about the credit card Is it fair to

statements that are reviewed by the company.

say that there is a process by which credit cards, either by the owners or by employees, is -- is reviewed? A. There -- there's more of a process now than there was And there's not enough of a process now to give me a

before.

hundred percent comfort that we are where we should be.

104 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 We're -- we're migrating from a very immature, loosely managed company to a more mature professionally managed company. Q. And I guess the larger point there is have you encountered

any resistance of any kind from either the employees or the ownership about moving to a tighter more structured company? A. Q. No. Okay. And as it relates to loans, when we use that term,

and if there is something that is determined to be a personal expense and gets put into this other bucket, personal expense bucket, is the expectation that that would have to be paid back at some point to the company? A. Q. Yes. Okay. Absolutely. So it's not like the company is just giving away

all its money to the extent that you can determine whether something is a legitimate business expense or a personal expense. The personal expense is accounted for as well and

then must ultimately be paid back to the company? A. It's neither all of its money nor is it being given away It's being accumulated in an account that is -- it I have another client who does exactly It is

at all.

says loans receivable.

the same thing and it's called shareholder advance. being accumulated in a bucket.

The intent, given my review of

the former controller's emails, was that this would be paid back out of eventual dividends. Now the dividends are dependent on profitability.

105 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 BY MS. MAHONEY: But the idea was in the future we'll have profits. paid out of dividends. It's to be

So the implication is that they were In March of 2013 By that time

expecting to be profitable in the future.

could they know that they have been profitable?

they had received enough orders to where I think there would be a pretty good indication that that's what they believed. Q. And to some extent, I mean, when you engage in -- in

business, and especially something as advanced as this, I mean, some of the calculations that are done by the company, some of it is -- I mean, there is some speculation about what future profitability may be, what the future demand may be, all those types of things go into the business decisions that get made? A. Yes. And the longer you're in business the more history

you have to base those projections off of so the more reliable they become. So at an early stage it's -- to some extent,

it's seat of the pants. Q. A. But like you say, it's not uncommon? No. MR. NASEEM: questions, Your Honor. THE COURT: Ms. Mahoney? Just one. Okay. Thank you. No further

MS. MAHONEY:

RECROSS EXAMINATION

106 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Q. Judge Kays asked you about the liabilities that they had

and you said the largest was the preorders? A. Q. A. Q. Yes. And those are nonrefundable payments by customers? That's right. And so when customers complain that they have not gotten

their product, and they say, I was told all sales are final or that this was nonrefundable, those customers are right; aren't they? A. Yes. Those are the terms that are on the website. MS. MAHONEY: THE COURT: Okay. That's all I have.

Thank you.

Mr. Naseem, any other evidence you'd like to present, sir? MR. NASEEM: THE COURT: MR. NASEEM: THE COURT: other evidence? MS. MAHONEY: THE COURT: No, Your Honor. That concludes the evidence. Let's see. Get my No, Your Honor. All right. Thank you, sir.

I'll retrieve that. Yes. So does the government have any

Okay.

Let me tell you what I think. notes here.

Mr. Vleisides, here's your problem.

You are on

supervised release for fraud.

So any time we get concerns

that, A, you're not completely forthcoming with all the

107 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 bad. that. information that we think you should be; and B, we've got $11 million in escrow that's being held based upon customer complaints, you have a huge problem. As far as the evidence, I -- I -- based on the evidence I've heard at this point in time, I am going to find that you are in violation of your probation in this way -- or your supervised release, in that you did fail pursuant to the special conditions of probation and supervised release, you did fail to advise or seek permission from your probation officer to apply for any loan or open any line of credit without prior approval. any question about that. That's clear. I don't think there's

Whether or not we call it an advance It lacked the transparency

or a loan, you took money out.

that we expect based upon your conditions of supervis -supervised release. will make a finding. The other stuff is pretty close. It smells really So on that particular issue, the Court

And but I am not going to make a particular finding on Yes, sir. MR. NASEEM: THE COURT: MR. NASEEM: THE COURT: Judge, can I be heard? No. No. I'm sorry. We're done with evidence and So that's the No. I'm sorry. Maybe I can --

I'm -- I'm going to rule here on this.

particular issue that you're stuck with today.

108 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 that. Now, my job first is to calculate the guidelines. This is a -- you are still a criminal history category I. guideline range is 3 to 9 months. The supervised release The

range is custody and supervised release may not total more than three years. At this time, what is your recommendation? MS. MAHONEY: continued supervision? THE COURT: supervision. MS. MAHONEY: THE COURT: disposition, sir? MR. NASEEM: Can I make final argument as to whether Right. Twenty-four months of continued Twenty-four months, Your Honor, of

Now, Mr. Naseem, you may be heard as to

it's appropriate to even place him on supervised -- or continued supervised release? THE COURT: MR. NASEEM: Sure. Okay. Sure. Thank you, Judge. I think it

would be helpful to kind of break this down into two different categories. One is, did a violation actually occur? Did

Mr. Vleisides -THE COURT: MR. NASEEM: THE COURT: And I've already said it did. Okay. In your appellate brief you may argue

But I'm really done hearing argument about that part

109 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 right now. MR. NASEEM: Okay. Well, then, let me turn then to

the time that's been imposed and whether it's actually then appropriate. THE COURT: MR. NASEEM: Yes, sir. Okay. I think what you see here, Your

Honor, is -- is Mr. Vleisides being actually very transparent with Ms. Pierce about what was going on with him and his company. We have email exchanges that occur between the two. The FBI gets to come out to

There are numerous phone calls.

Butterfly Labs and talk to him and tour his facility. Ms. Pierce testified that she went out there multiple times. He has in person discussions with her. She

was allowed to any form that she requested he -- he was giving her. So he was compliant, I think, in every way that would be And to the

possible with the terms that were put before him.

extent that Ms. Pierce did not understand what was happening, I don't know that Mr. Vleisides would have been a mind reader to know given the open lines of communication that she did not understand something. If there was a question that she had

about something, he would expect that she would ask him, like she had on so many other occasions. Now, all these factors I think are proof positive that he was doing what was necessary on supervised release. And given where --

110 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 growing. THE COURT: MR. NASEEM: THE COURT: MR. NASEEM: THE COURT: you, I guess. So you are going to argue for. No, no, no. It sounds like you're arguing with -I'm going to transition, Your Honor. You can do, but it's not going to help

You can -I'm going to transition to whether that

MR. NASEEM:

-- that term is appropriate. But clearly then Butterfly Labs is developing and Mr. Vleisides has -- has been an active part of that

growth, and we heard the term mouthpiece I think may be used negatively. But I think he is more of a champion in that

regard for building this business, trying to rebuild his life. And if we put him on 24 months of supervised release, the opportunities that were available to -- to Butterfly Labs to move this -- this venture forward, this venture that rivals some of the top tech companies in San Francisco. We are doing

business here in the midwest that San Francisco and the east coast is doing. If we put him on supervised release for 24 months, we prohibit some of those opportunities. He is prevented from

-- from traveling as freely as he could, maybe some other investment opportunities that would arise he may not be allowed to participate in. Maybe other companies have certain

requirements about who they will do business with, and if he

111 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 the door. THE COURT: MR. NASEEM: Yes, sir. Yes, sir. But that's 110 families that is listed as an owner and has 24 months of supervised release, those kinds of conditions may prohibit the growth, the future growth of Butterfly Labs, which we've heard has been tremendous. In a time when there was economic downturn this company was putting about 110 people to work. people. That's a lot of I don't

That's a lot of families that are being fed.

think we should limit the potential of Butterfly Labs by imposing this additional condition of release of 24 months. THE COURT: I have 110 -- 110 employees the company

peaked at is what I was thinking. MR. NASEEM: THE COURT: MR. NASEEM: THE COURT: MR. NASEEM: Yes. Did you just say 2500? No, no. Okay. And 60 after getting the production out 110 at its peak.

are -- that are relying upon Butterfly Labs to -- to remain viable, to go forward. heard. I think it's a good company, as you've

And as you have seen they have put the right Mr. Bourne has

leadership in place in the form of Mr. Bourne. come in and made significant changes. resistant to that.

He has not been

Mr. Vleisides has not been resistant to

112 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 that at all. And I think if we impose 24 months of

supervision on him, we are -- we are making him take a step back. He has done all that he has done, having been -- I'm not telling the Court anything the Court doesn't know. But

the odds of success after you have been convicted of a white collar fraud and building up a company that now does revenue in the millions again, it really defies a lot of the odds. And so what he has done, along with the other ownership group, has been really tremendous, Your Honor. And his -- it's a

benefit to all of Kansas City to have a company like that in its midst. If we prevent him from being able to travel and to -- to do the things that are necessary to move the company forward, we -- we take a chance that we cripple Butterfly Labs in some way. I would suggest, Your Honor, that six months of additional supervision could be necessary, to the extent that we have questions that have been raised here about what has the company been doing, I think we've answered those today. And if Ms. Pierce does not understand what is going on, or if the government doesn't, then we can answer those questions as easily as we did before in a six-month period. An additional

two years of supervision is not necessary to figure out what the answer to these questions are.

113 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 You've got a CFO who is well versed now in just his four months about what the company's up to and can help address any questions that -- that Ms. Pierce may have. If

the concern is truly that she did not understand what the company was doing, I think we have that figured out, even in the show cause hearing. But to the extent she needs some more And it doesn't have to be in a

answers, he can provide those. two-year time period.

Because sometimes, Your Honor, what

happens is that the amount of time that you have stretches to fit the time given. So if we say we have two years to try to But if we say six And

figure out, that's what it will take.

months then we can try to figure it out in six months.

this company has been actively working to try to put all this stuff together. And so I think we could reasonably expect that with six months of additional supervised release we can get all the answers to the questions that the probation office needs. THE COURT: MR. NASEEM: THE COURT: Thank you. Thank you. Would your client like to be heard? He

doesn't have to, but if he'd like to speak he may stand where he's at. MR. NASEEM: that he wants to say. THE COURT: Okay. You did a good job, Mr. Naseem. I don't know that there's anything more

114 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 did. I don't think he needs to add anything to it, but he has a right and I want to make sure he understands that right. MR. NASEEM: THE COURT: Thank you, Your Honor. All right. I like what your attorneys But let me make

I think they did a good job for you.

sure my findings are clear here. misunderstood a thing.

I don't think Ms. Pierce

I think Ms. Pierce was crystal clear. I think

I think Mr. Vleisides was crystal clear.

Mr. Vleisides failed to give all the information that was required of him. That's the basis of this violation.

In fact, Ms. Pierce, I'm going to direct you to add any additional or suggest any additional conditions you think that will help better monitor this unique business enterprise, which Mr. Vleisides is involved in. I'll expect you, and I'll

impose those most likely if I find them to be appropriate. And I'll expect Mr. Vleisides to respect those and demean himself to the supervision of Ms. Pierce of this court. Now, there is a stench coming from Butterfly Labs. It's a strong smell. It's not enough to send you to prison

today, because, to be quite honest with you, if it was, we'd be talking about 24 months in prison. it's too close. It's not -- I think

I think Mr. Bourne did a very good job of But if I

testifying, and it assisted your defense greatly.

find out that there is this fraud word involved in this part, you know, Mr. Vleisides, as we say here at the courthouse, you

115 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 need to get your toothbrush and get your things in order, because fraud will not be tolerated, you understand that? So

I would work very hard to make these consumers happy consumers who you've dealt with. Now, I do believe that a continued term of supervised release is important. So we're not going to lock

you up today based on this al -- violation. Today it is pursuant to the Sentencing Reform Act of 1984, it is the judgment and sentence of this Court, based upon his violation of supervised release, that Sonny C. Vleisides is hereby placed on supervised release for an additional term of two years. While on supervised release the

defendant shall comply with all the conditions previously imposed in the original judgment dated September 15th, 2010. Further, the defendant shall abide by the following addition -- additional conditions. The defendant shall submit

his person, his property, house, residence, office, vehicle, papers, computer, other electronic communication or data, storage devices or media and effects to a search at any time conducted by a U.S. probation officer at a reasonable time in a reasonable manner, based upon reasonable suspicion of contraband or evidence of a violation of a condition of release. Failure to submit to a search may be grounds for revocation. The defendant shall warn any other residents that

116 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 his premises may be subject to searches pursuant to this condition. The defendant shall file a personal and business tax returns as required by law and provide the probation officer with copies of all tax documents as directed by the probation officer. As I said earlier, Ms. Pierce is going to make some proposed suggestions to the Court related to how we can better supervise you, Mr. Vleisides, and make sure that we have transparence in that supervision. Your job is to make sure

that she understands everything, and this -- this business about her not understanding, I don't buy it. communicate, create transparencies. Your job is to

Any loan, especially

$64,000 or whatever it is, is something she needs to know about before it's made, no matter -- I know you're calling it -- we're calling it an advance today, but I find it's a loan, so we're clear on that part as well. You have 14 days to appeal this decision. I hope this is successful for you, Mr. Vleisides. I'm -- I'm pulling for you. I hope Butterfly Labs is a But there's a smell,

legitimate company that enjoys success. and that's what I'm addressing today.

Ms. Mahoney, what did I leave out? MS. MAHONEY: THE COURT: Nothing, Your Honor. Thank you.

All right.

Mr. Naseem, anything else?

117 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 /s/Regina A. McBride, RDR, CRR REGINA A. MCBRIDE, RDR, CRR Official Court Reporter March 5, 2014 DATE MR. NASEEM: THE COURT: Mr. Vleisides. No, Your Honor. All right. Thank you.

Good luck to you,

That will conclude this case.

(Proceedings concluded at 12:09 p.m.) C E R T I F I C A T E I CERTIFY THAT THE FOREGOING IS A CORRECT TRANSCRIPT FROM THE RECORD OF PROCEEDINGS IN THE ABOVE-ENTITLED MATTER.

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