Block and tackle - unclaimed property and cryptocurrency

by Eversheds Sutherland (US) LLP
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Introduction

As promoters of cryptocurrencies and digital-asset exchanges face intense scrutiny from tax, securities and other financial services regulators, they will soon have to contend with unclaimed property (or escheat) laws in the United States. All fifty states and the District of Columbia have escheat laws on the books that require a “holder” of intangible assets to report and pay “abandoned” assets to the states after three to five years of inactivity on an account. This article explores how these laws could apply to cryptocurrency exchanges, hosted wallets, and other market participants, such as banks, broker-dealers and vendors, who are eager to gain a strategic foothold in this burgeoning market.

Since 2017, four states have enacted new escheat laws that specifically address cryptocurrency, and several other states are considering legislation in 2018. In addition, a recent class action lawsuit filed against Coinbase, a California cryptocurrency exchange, shows that the escheatment of cryptocurrencies is now the subject of litigation.

The cryptocurrency business is growing exponentially. It is estimated that one of the largest exchanges, bitFlyer, has a trading volume of $1.7 billion daily. While cryptocurrencies promise the ability to make financial transfers without an intermediary and without geographic limits, critics of cryptocurrencies express concern about the anonymity of the transactions and the obscurity of ownership of some exchanges.

Unclaimed Property

Unclaimed property laws give state governments the power to take custody of intangible property that is “presumed abandoned.” The specifics of unclaimed property laws vary by state, but they sweep broadly and apply to a wide range of intangible assets, including money, financial accounts and securities.  Most states’ statutes also have a catch-all provision that applies to “all other intangible property.” A company (the “holder”) that is in possession of property belonging to another (the “owner”) must report and remit that property to a state government in the name of the owner if the “dormancy period” for that property expires without the owner initiating some activity on the account (typically three to five years of inactivity, depending on state law and the type of asset).

State unclaimed property reporting requirements are rigorous, and states are increasingly moving to enforce unclaimed property laws aggressively by hiring private auditors that work on a contingency fee basis to audit companies and identify unclaimed property that has not been reported to the state. The audits are often contentious, and the assessments can be in the millions of dollars, particularly if a holder has evaded the law or not historically reported some kinds of property.

Unclaimed Property for Cryptocurrency

How unclaimed property laws apply to cryptocurrencies, often referred to as “virtual currency” by state regulators, has several perplexing aspects. In 2016, “virtual currency” was included as a specific property type in a new model law for unclaimed property—the 2016 Revised Uniform Unclaimed Property Act (2016 Uniform Act). Since 2017, four states—Illinois, Tennessee, Utah, and Kentucky—enacted legislation based on the model, specifically including a virtual currency provision. Even states without specific legislation, however, may take the position that virtual currencies are covered by the catchall provision for “intangible” personal property.

It is generally expected that states will attempt to bring cryptocurrencies within their unclaimed property laws, raising questions about how those laws will apply in practice. Since unclaimed property obligations apply to companies holding property belonging to another, cryptocurrency exchanges and online wallets will feel the most direct impact of the unclaimed property laws, so long as they have the ability to transfer cryptocurrencies to third parties on behalf of their customers. More conventional businesses like banks and mutual funds, that are looking to gain a strategic foothold in this market, will also feel the impact, as will employers who pay employees and companies that pay vendors in cryptocurrencies. If the owner of a cryptocurrency retains the sole ability to transfer the asset, however, there would be no way for a state government to assert the right to take custody based on the unclaimed property laws.

But how would the holder actually remit cryptocurrencies to the state? Because most states are not currently set up to receive cryptocurrencies, there are likely two options. Either the holder (or its agent) would need to liquidate the cryptocurrency before reporting, and then send cash to the states, or the state treasury departments will need to create their own cryptocurrency wallets or accounts to receive and hold cryptocurrencies. There is precedent for states accepting non-dollar financial assets, such as securities, which are escheated by transfer agents that transfer ownership of the shares to the state’s account. But it remains to be seen how states will address this issue for cryptocurrencies.

Either method could pose a potential risk to cryptocurrency and market participants if the owner’s assets are liquidated as a result of escheat and the owner misses out on value appreciation. Even if the states are set up to accept cryptocurrency directly from holders and transfer agents, many states liquidate non-dollar assets shortly after receipt of that property. When states receive unclaimed securities, for example, the property often is sold and converted to cash, which can result in an investor losing his or her position in the market. Liquidation practices that cause property owners to miss out on market gains have prompted lawsuits against companies for alleged “negligent escheat” and against several states for unlawful takings. Because the extreme volatility of some cryptocurrencies can result in massive appreciation over short time horizons, any liquidation of a cryptocurrency has the potential to expose the industry to unwanted risk.

The timing and scope of escheat laws as applied to cryptocurrencies are also unresolved. For most types of property, state laws require escheat after three to five years of inactivity, but this is by no means consistent. Here, questions arise as to what events trigger the required period of inactivity (or “dormancy period”), what counts as “inactivity,” and how long the dormancy period lasts. The answers to these questions may vary among the states, depending on how cryptocurrencies are categorized under those state laws. In states that have adopted the 2016 Uniform Act, cryptocurrencies are likely to be categorized as “virtual currencies” that are escheatable after a standard three to five year dormancy period. For states that have not adopted the 2016 Uniform Act, it is less clear how escheat laws will apply to cryptocurrencies what the applicable timing requirements for escheat will be.

One possibility is that different cryptocurrencies will be categorized differently based on the nature of each different asset. Recent guidance from the US Securities and Exchange Commission warns that it will treat many initial coin offerings (ICOs) as offerings of unregistered securities. Separately, a federal court recently ruled that cryptocurrencies are commodities and may be regulated by the Commodity Futures Trading Commission (CFTC). The varying dormancy triggers for securities and commodities among the states adds to the complexity of how to categorize cryptocurrencies for unclaimed property purposes.

Yet another potentially significant issue involves how escheat laws will be applied to foreign accounts. Some aggressive states assert the right to take custody over the assets of foreign customers of US financial institutions, a controversial position that could have worldwide implications for customers of US exchanges and wallets.

The litigation risks facing cryptocurrency businesses are not limited to negligent escheat, as demonstrated by a recent class action filing against Coinbase, a cryptocurrency exchange, in California. The plaintiffs in the lawsuit are seeking to recover all cryptocurrencies sent by email through Coinbase that were never claimed by the intended recipient, alleging that they never received the Bitcoin sent to them through Coinbase via email in 2013. The emails contained links prompting the recipients to create Coinbase accounts, through which they could claim the Bitcoin. However, the plaintiffs did not attempt to use the links to access their Bitcoin until 2018, by which time the links were no longer live. As a result, the plaintiffs claim that Coinbase has unlawfully retained the cryptocurrency. And plaintiffs allege that Coinbase has failed to comply with the California unclaimed property law, seeking an order to require Coinbase to report unclaimed cryptocurrency to the State of California if the coins cannot be delivered to the recipients. The plaintiffs argue that Coinbase’s alleged violation of the unclaimed property laws constitutes a claim under the California Unfair Competition Law (UCL) for “unlawful” business practices. This case appears to raise a question of first impression on whether a UCL claim can be based on an alleged violation of California’s unclaimed property statute.

Conclusion

As with other areas of cryptocurrency regulation, escheat laws are expected to develop rapidly, and many questions remain unanswered. As the total value of cryptocurrencies increases exponentially, states that rely on unclaimed property as a source of revenue will likely push for expanding the application of their escheat laws to capture cryptocurrencies, raising additional risks for cryptocurrency exchanges and other businesses participating in the cryptocurrency markets.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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