Can You Legally Protect a Bitcoin Transaction?

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A Bitcoin is a digital representation of value enabled by blockchain technology, which provides a decentralized ledger to publicly document and track Bitcoin transactions occurring across a peer-to-peer network. Although the blockchain's functionality as a public ledger provides efficiencies to transactions, the lack of a central authority creates a legal enigma. How can an entity protect itself when trading a value of Bitcoin on the blockchain with a value of anything else (e.g. U.S. dollars) when the blockchain only facilitates one half of the transaction?

The Bitcoin Transaction

The Bitcoin transaction involves a simple transfer of value between two parties. Each party is known to the other by a “public key” that allows its identity to remain anonymous. A “private key” held by the transferor enables it to initiate the transaction, which is then broadcast to the Bitcoin network for verification. “Miners” verify the transaction by solving complex equations in exchange for newly minted units of Bitcoin. Once verified, the transaction becomes another “block” in the Bitcoin blockchain.

There is no centralized authority, whether a bank, regulator, or otherwise, involved in a Bitcoin transaction. Therefore, unique problems arise when parties seek to exchange Bitcoin for USD. For example, if a buyer transfers a value of USD from its bank account to the seller, but the seller fails to deliver Bitcoin through the blockchain, the buyer has no recourse against the seller unless additional protections are put in place. There are some tools that can be implemented to try to mitigate this risk:

  • Use of an escrow. Buyers may mitigate risk associated with a Bitcoin transaction by initiating a multi-signature transaction. A multi-signature, or ‘multisig,’ transaction requires several keys to authorize transfer of Bitcoin to the buyer. In a “2 of 3” multisig transaction, two out of three available private keys, known the seller, buyer, and escrow agent, respectively, are needed to complete the transaction. Thus, if there is a dispute between buyer and seller (e.g. the buyer fails to hand over USD), the escrow agent can use its third private key to ensure the promised value of Bitcoin is paid to the buyer.
  • Contract. Parties to a transaction may consider adoption of an out-of-band (non-Bitcoin) contract to govern the exchange. Given that the parties to a Bitcoin contract are often in separate countries, the contract should include a clear and unequivocal choice-of-law clause specifying that U.S. law is to govern the transaction and that any dispute arising under the contract should be governed by the laws of a specified jurisdiction in the United States. Some states appear to be more progressive in granting legal status to cryptocurrency transactions, including Arizona,[1] Delaware,[2] and Vermont.[3]
  • Consider binding arbitration. In order to preserve anonymity, parties may agree by contract that disputes be resolved through binding arbitration that relies on U.S. law. As long as the parties to the transaction have signed it, any arbitration award in favor of the buyer can be enforced under the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards[4].
  • Understand how Bitcoin is classified. Some uncertainty exists as to how a Bitcoin transaction is regulated by federal agencies in the United States. Due to its unique characteristics, Bitcoin, and cryptocurrency in general, is conceptualized differently for various purposes:
  • The U.S. Internal Revenue Service has determined cryptocurrencies should be classified and treated as property for Federal tax purposes.[5] Thus, all Bitcoin payments are subject to reporting, and a Bitcoin owner must keep track of capital gains or losses associated with any given transaction.
  • On July 25, 2017, the U.S. Securities and Exchange Commission (“SEC”) issued guidance that Bitcoins may be classified as “investment contracts” under Article 8 of the Uniform Commercial Code, and therefore subject to Federal securities laws.[6] The facts-and-circumstances test set forth by the U.S. Supreme Court in SEC v. W.J. Howey Co., 326 U.S. 293 (1946) should be used on a case-by-case basis in order to determine whether a “token sale” using virtual currency falls within the ambit of an “investment contract.”
  • The Financial Crimes Enforcement Network (“FinCEN”) treats Bitcoin as currency for the purpose of enforcing anti-money laundering regulations, including the Bank Secrecy Act.[7]
  • Finally, the Commodity Futures Trading Commission (“CFTC”) asserted jurisdiction over Bitcoin transactions under the Commodity Exchange Act, thereby likening Bitcoin to traditional commodities such as gold or silver.[8] China, Japan, and Finland have also classified Bitcoins as commodities.

Recent Regulatory Developments

Because Bitcoins possess characteristics in common with property, securities, currency, and commodities, regulators have struggled to develop a consistent framework that governs Bitcoin transactions. Bitcoin owners should be cognizant of the interaction between Federal, state, and international regulations that apply to a particular Bitcoin transaction.

On July 25, 2017, the SEC addressed “token sales” in relation to its investigation of the Decentralized Autonomous Organization (“DAO”). A token sale is a capital-raising method that utilizes blockchain as an alternative to traditional forms of fundraising, such as obtaining venture capital investments. In its pronouncement, the SEC put to rest the idea that purchasers need not determine whether a token is classified as a security in the jurisdiction of sale, as long as it was not a security under the laws of the jurisdiction of its issuance. Rather, the SEC cautioned that Federal securities laws “apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”[9]

By contrast, on July 26, 2017, FinCEN assessed civil penalties against Russian company BTC-e and its owner in connection with virtual currency transactions that FinCEN held violated U.S. anti-money laundering laws.[10] This action marks the first time FinCEN has conducted an action against a foreign money transmitter doing business in the United States and further reiterates FinCEN’s commitment to classifying cryptocurrency as a “commodity.”

On the state level, in 2015, New York enacted legislation requiring digital currency companies to obtain a “BitLicense” in order to engage in cryptocurrency transactions in the state. The licensing program is administered by the New York Department of Financial Services (“NYDFS”) and may offer additional security to Bitcoin owners doing business with New York companies.

Bitcoin owners should also be aware of international laws applicable to a particular Bitcoin transaction. For example, China is the world’s largest Bitcoin trading market; however, its laws prohibit banks and employees from engaging in Bitcoin deals through financial institutions and further prohibit such institutions from servicing or doing business with the Bitcoin industry.

Conclusion

Structured appropriately and with all legal ramifications in mind, a Bitcoin transaction permits Bitcoin owners to conduct business efficiently and anonymously through a decentralized platform. However, Bitcoin owners should implement protections such as an out-of-band contract or secure storage solution to maintain control of their investments.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.

 

[1] See Arizona HB 2417, available at https://legiscan.com/AZ/text/HB2417/id/1497439.

[2] See “The Delaware Blockchain Initiative,” Marco A. Santori (June 10, 2016), available at https://global.delaware.gov/2016/06/10/the-delaware-blockchain-initiative-potential-amendements-to-the-delaware-general-corporation-law/.

[4] For a list of signatories to this treaty, see http://www.newyorkconvention.org/countries.

[5] See Notice 2014-21, available at http://www.irs.gov/pub/irs-drop/n-14-21.pdf (“General tax principles applicable to property transactions apply to transactions using virtual currency).

[6] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017), available at http://www.sec.gov/litigation/investreport/34-81207.pdf.

[7] See “Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies,” Guidance, Department of the Treasury Financial Crimes Enforcement Network, FIN-2013-G001, 18 (March 18, 2013), available at https://www.fincen.gov/sites/default/files/shared/FIN-2013-G001.pdf.

[8] See “CFTC Order bitcoin Options Trading Platform Operator and its CEO to Cease Illegally Offering Bitcoin Options and to Cease Operating a Facility for Trading or Processing of Swaps without Registering” (Sept. 17, 2016), available at http://www.cftc.gov/PressRoom/PressReleases/pr7231-15; In re Coinflip, Inc., C.F.T.C. Docket No. 15-29, 3 (Sep. 17, 2015), http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcoinfliprorder09172015.pdf.

[9] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017), available at http://www.sec.gov/litigation/investreport/34-81207.pdf.

[10] See “FinCEN Assessment of Civil Money Penalty in the Matter of BTC-E a/k/a/ Canton Business Corporation and Alexander Vinnik” (July 26, 2017), available at https://www.fincen.gov/sites/default/files/enforcement_action/2017-07-26/Assessment%20for%20BTCeVinnik%20FINAL%20SignDate%2007.26.17.pdf.

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