By Michael Bahar, Greg Kaufman and Kristen Bertch
As cryptocurrencies and other digital assets grow in popularity and value, they continue to test the limits of existing laws. One of the emerging—and increasingly urgent—questions that courts continue to face is how to effectively freeze cryptocurrencies so that defendants in litigation cannot move or dispose of disputed cryptocurrency or other digital assets. As the US Securities and Exchange Commission (SEC) has warned, there is often “difficulty” in freezing or securing investor funds that are held in a digital asset. Digital assets are generally held in the form of software wallets, which are encrypted. Unlike money or securities held in a bank or brokerage account, digital assets are often not held by a third-party custodian.
There have been multiple cases in which courts and regulators, using Fed. R. Civ. P. 65, have granted a motion for a temporary restraining order to freeze cryptocurrencies. However, this typically raises the challenge of how to actually enforce a freeze when the asset is 100 percent digital, is often designed to be anonymously held, and is part of a de-centralized distributed ledger that may not involve a regulated custodian.
One enforcement method proving increasingly effective—especially as regulations evolve to increase transparency over digital asset transactions in the US and other global jurisdictions—is to freeze assets as they pass through digital asset exchanges, which are the online platforms that exchange cryptocurrency and other digital assets into fiat currency or other digital assets.
If, however, the asset owner does not use a regulated exchange that serves as a custodian, often the only remaining recourse is to attempt to get the necessary information from the asset owner, either through the owner’s cooperation or some other means, or to go after any underlying tangible assets, depending on the nature of the digital asset.
Without knowing the owner of an account or knowing the owner’s so-called “private key,” effectively freezing digital assets can be very difficult. For example, in the PlexCorps case, a cross-border action alleging fraud, the SEC lamented its inability to discover, let alone freeze, all of the defendant’s cryptocurrency assets. While the court ordered the Quebec-based defendant to produce its fund information, the defendant withheld information on certain cryptocurrency assets. The SEC’s January 5, 2018 letter to the court distilled the core challenge: although Defendants were “bound” by the court’s orders that those funds not be dissipated, “there exists no central authority (like with respect to Defendants’ bank accounts) on which the Commission may serve freeze orders for cryptocurrencies.”
But, looking to exchanges can provide hope. Cryptocurrency exchanges are where many people go to exchange digital assets for other digital assets, swap digital assets for cash (still required to buy most goods and services), or to purchase digital assets using fiat currency. If you know the account holder or the account as well as the exchange, you may be able to enforce a freeze.
Most exchanges hold the private keys for customers, and many regulated exchanges maintain “know-your-customer” records that connect defendants to their accounts. Cases such as Brian Paige v. Bitconnect International PLC et al. and FTC v. Thomas Dluca demonstrate this tactic. In these cases, the plaintiffs knew the relevant exchange. In order to enforce the freeze without the defendant’s advance knowledge, they went to the exchanges to get the wallet addresses, transfer information and other information to identify past transactions and freeze future transactions.
This tactic can also be used in circumstances like those in White v. Doe, in which bad actors acquired a victim’s cryptocurrency through fraud, but the victim did not know the identity of the fraudster. Here the victim was able to use the address that the cryptocurrency was sent to in order to track down the fraudster. For cryptocurrencies such as bitcoin, the address at which a person received the cryptocurrency acts as a pseudonym. Every transaction on the blockchain is public, and people transact using their addresses as their identities. As a result, anyone can look at the blockchain and track every transaction associated with an address, including linking it to other addresses.
In White v. Doe, after the plaintiff Elizabeth White fell victim to a cryptocurrency fraud, she was able to use the fraudster’s wallet address to trace his transactions through multiple exchanges until it landed in the exchange, Bittrex, a Delaware-registered company. Her attorneys were able to file a complaint using the fictitious name John Doe and ask Bittrex to freeze the account. Bittrex agreed to freeze Doe’s account, but refused to release the name associated with the account until White acquired a subpoena. In the end, Bittrex helped identify the fraudster, and White recovered her cryptocurrency. This was the first case involving cryptocurrencies in which a private plaintiff obtained a judgement for fraud and successfully executed the judgment against the cryptocurrency.
In the United Kingdom, the challenges are similar. Recently, the English criminal court took the view that certain cryptocurrency is “realisable property” for the purposes of the Proceeds of Crime Act. In R v. Teresko, the criminal court gave the police an order permitting them to convert bitcoin into sterling. However, what enabled them to actually seize the cryptocurrency was that the police had found a piece of paper containing a bitcoin recovery phrase (i.e., a list of words which store all the information needed to recover a bitcoin wallet).
Of course, this tactic requires compliant exchanges, and exchanges which keep records and act as a custodian. The US-based exchanges generally keep—or should keep—such records because they are classified as money transmitters for federal regulatory purposes. The Financial Crimes Enforcement Network (FinCEN) recently released an interpretation of the relevant laws and regulations for cryptocurrency exchanges, in which it said that “an exchange that sells ICO [(initial coin offering)] coins or tokens, or exchanges them for other virtual currency, fiat currency, or other value that substitutes for currency, would typically also be a money transmitter.” To the extent an exchange is considered a money transmitter by FinCEN under federal law, it is subject to the federal Bank Secrecy Act (BSA). This is extremely important for the purposes of enforcing a freeze on cryptocurrencies because the BSA requires money transmitters to collect information about their customers and share that information with FinCEN. Such information should allow plaintiffs to identify the accounts associated with the allegedly illegal activity of a defendant.
Thus far, FinCEN’s enforcement of the money transmitter requirements for digital asset exchanges has been limited; however many states have explicitly included cryptocurrency-related businesses in their state money transmitter acts, increasing the pressure on these exchanges to maintain the records necessary to enforce a cryptocurrency freeze. FinCEN has only brought enforcement actions against two cryptocurrency businesses, Ripple Labs and BTC-e, for not complying with the BSA. However, for some digital asset exchanges, failing to keep sufficient records may result in a state action. States such as Connecticut and North Carolina consider businesses that transmit or trade virtual currencies to be money transmitters under state law, thereby requiring exchanges to maintain certain information including a general ledger containing information on their assets, liabilities and accounts.
Digital asset exchanges that have obtained a New York virtual currency license are also required by the New York Department of Financial Services (DFS) to maintain the records necessary to enforce a cryptocurrency freeze. New York’s requirements for obtaining and maintaining a virtual currency license include anti-money laundering, anti-fraud, consumer protection and cybersecurity requirements as well as record keeping requirements that would enable an asset freeze.
This enforcement problem can become more difficult when digital assets are held in overseas jurisdictions that lack strict regulation, as the SEC discussed during the PlexCorps case. SEC Chairman Jay Clayton, in a December 11, 2017 statement, warned investors that where “markets span national borders and . . . significant trading may occur on systems and platforms outside the United States . . . risks can be amplified, including the risk that market regulators, such as the SEC, may not be able to effectively pursue bad actors or recover funds.”
While Japan, for example, has put in place very strict obligations on its cryptocurrency exchanges, other countries have very lax record-keeping regulations. India, for instance, does not currently regulate cryptocurrency exchanges. Similarly, Costa Rica does not have laws governing the use or exchange of digital assets, as noted by the Central Bank of Costa Rica when it released a statement explaining that it does not in any way regulate or supervise cryptocurrencies.
On the other hand, a new European Union (EU) regulation which recently came into effect requires “virtual currency” exchanges to comply with anti-money laundering rules, better ensuring that all EU exchanges will have the information necessary to identify the parties involved in any of their transactions. The new anti-money laundering regulation, known as 5AMLD, requires exchanges to both report suspicious transaction activity and run identification and verification checks on their customers. 5AMLD entered into force in July 2018, and EU member states have until January 2020 to pass implementing legislation. While this date is after Britain is set to leave the European Union, the UK is expected to implement the directive.
If the defendants do not keep their digital assets with a third-party custodian, such as an exchange, the plaintiff typically has to seek the private key from the defendant in order to freeze the cryptocurrency, which can be difficult, but is not without precedent.
United States v. 50.44 Bitcoins is one example of a case in which law enforcement officials were able to acquire the private key from the owner of the cryptocurrency account. In this case, when agents, as a result of a larger investigation, arrived at the personal residence of Amanda and Thomas Callahan, Amanda Callahan admitted that she and her husband acted as money exchangers for websites, including marketplaces like the Silk Road, which was known to be involved in illegal activities. She then voluntarily transferred the bitcoin in question to the agents. The magistrate judge then ordered the Attorney General to take custody of the 50.44 bitcoin being held by the agents.
Absent a cooperative—or even a known—defendant, however, the challenges of enforcing a digital asset freeze may prove insurmountable, unless, as in the UK’s R v Teresko case discussed above, authorities are otherwise able to find the necessary information.
Since different types of digital assets work differently, there may be other opportunities to effectuate a freeze when less “traditional” forms are used. For example, a recent paper classified digital assets into three groups:
Freezing digital assets effectively is challenging, but looking to a third party such as a digital asset exchange can prove effective, especially as more jurisdictions increase regulatory oversight of them. Absent the ability to go after an exchange, however, it may still be possible to enforce a freeze, but it will require some degree of cooperation by the owner, some other means of finding the necessary information, or looking to an underlying tangible asset.
Michael Bahar, a litigation partner in the Washington DC office, is the co-lead of Eversheds Sutherland’s global cybersecurity and data privacy practice and a member of the firm’s Litigation practice.
Greg Kaufman, partner in the Washington DC office, defends clients in government investigations, enforcement and litigation matters, with particular experience in energy and commodities enforcement matters.
Kristen Bertch, staff attorney in the Washington DC office, counsels clients on a broad range of cybersecurity and data privacy matters, financial services, corporate governance and transactional matters, including initial public offerings and capital raising efforts.
Copyright © 2018 The Bureau of National Affairs, Inc. All Rights Reserved.
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