Bob Benjy, Esq.
The Increasingly Complex World of Collections Law in the World of Cryptocurrency
Updated: Oct 28, 2020
Collections has always been a cat and mouse game. The creditor (cat) chases the debtor (mouse) in hopes of taking a big, juicy bite (i.e., recovering on some or all of the debt). Sometimes the mouse will run into the proverbial bankruptcy hole in the wall, thereby frustrating the cat. Other times, the cat nabs the mouse (or a portion thereof) after which the chase either ends or continues. This is an age old game and the rules have not changed much in recent history; until now. Enter cryptocurrency (Crypto). (For purposes of this article, we will focus our attention to the undisputed, reigning king of all Crypto: Bitcoin. That said, most of the matters discussed herein will apply equally to other forms of Crypto, including but not limited to Ethereum, Bitcoin Cash, Litecoin, Ripple, Monero, Zcash, etc.)
The purpose of this article is to highlight the not so obvious fact that Bitcoin, which currently has a market capitalization of $112,841,174,380 (yes, you read that right; no, it's not a typo), has made the post-judgment collections business infinitely more complex and challenging. Without overcomplicating things, this article will try to explain why Bitcoin is a very powerful tool for debtors to place their assets outside the reach of creditors and the complex challenges collections attorneys will face from here on end in attempting to collect on large debts and judgments. The old way of doing things are going to become increasingly obsolete starting now and seriously deficient within two to four years from the publication of this article. Let's explore why.
A. Defining Bitcoin.
While the IRS, SEC and other governmental agencies here and abroad may disagree - Crypto is, at its core, currency. Yes, it has features akin to securities, barter agreements, IOUs, negotiable instruments, assets, etc. No, it is not tangible like FIAT currency. No, you cannot presently hold Crypto in an FDIC insured deposit account. Nevertheless, fundamentally speaking, Crypto is a powerful new form of digital money. It can be used to purchase products and services anywhere on the globe without the involvement of any traditional financial institution and on a peer-to-peer (direct) basis. No wire fees. No required Suspicious Activity Reports. No direct oversight. No direct ability for governmental interference and limited ability for governmental tracking and tracing (for now, anyway).
B. Obtaining Bitcoin.
So how does this new animal work? There are several ways to obtain Bitcoin. One way, which is a little shady and a lot uncomfortable, is to personally meet with sellers in a public space (perhaps a coffee shop) and hand off physical FIAT cash simultaneously with a digital transfer of Bitcoin from their private "wallet" to yours. The benefit of this arrangement is that there is no third-party intermediary involved, making it more difficult to trace the transaction and potentially providing both the seller and buyer with increased anonymity. The downsides are probably self-explanatory. When purchasing in this peer-to-peer manner, the purchaser will almost always have the seller transfer the Bitcoin directly into a Cold Wallet (defined and discussed below) which is under the purchaser's control. The transaction can be verified relatively quickly and the parties can part ways with piece of mind.
Another way to obtain Bitcoin, and perhaps the most popular and reliable way of doing so, is to purchase it from a third-party via an online clearing house or exchange. Examples include Gemini and Coinbase. Exchanges connect buyers and sellers and set the going price (through supply and demand forces) and take a chunk of the action as their fee. The downside? Exchanges, including Coinbase, are becoming increasing regulated and some have agreed to disclose transaction details to governmental authorities. While this is a good thing from a security and taxation perspective, it is less desirable from a privacy and anonymity perspective. In addition, one of the great features of Bitcoin is the ability to keep the transaction peer-to-peer and outside the prying eyes and claws of the government - a feature that is severely undermined (or more accurately, thermo-nuked) when purchasing Bitcoin on an exchange. The worst side effect of this sort of transaction is that the incoming Bitcoin (i.e., what you just paid for with FIAT) is often stored on your private "CRYPTO-wallet" on the exchange's server (Exchange Wallet) - making is susceptible to hacking and theft. On the plus side, you don't need to fear for your life and limb when engaging in this variety of purchase and sale transaction.
C. Secure Bitcoin Storage.
1. The Cold Wallet Approach.
Wise Bitcoin owners will purchase on the exchange and then promptly after receipt of the Bitcoin in the Exchange Wallet will transfer the Bitcoin to a physical hardware wallet in their possession (Cold Wallet). The Cold Wallet is "cold" because it is often not connected to the internet. It is, effectively, a USB device that you plug into your personal computer. The Cold Wallet has its own public key, which you disclose to third parties that wish to transfer Bitcoin to you; and also has its own private key (which you keep secret and which is necessary for transferring Bitcoin from you to third-parties' public key addresses). Because the Cold Wallet is not plugged into the internet very often, it is considered more secure than the Exchange Wallet which is always on the internet and, therefore, susceptible to attack and theft. Most importantly for purposes of this article, the Cold Wallet is encrypted with a password (hopefully a strong one that the owner has committed to memory).
If the password/pin to the Cold Wallet is lost, some (not all) Cold Wallets will allow recovery via a "seed," which may consist of a series of random words that must be entered in a very specific order before the Bitcoin contents of the Cold Wallet become again available for use. If, on the other hand, the owner of the Cold Wallet forgets both the password and the seed, he or she will be in a world of pain: the Bitcoin will be forever lost to the entire world (i.e., permanently unavailable to all).
Note that some Cold Wallets will also allow for multi-layers of password protection before one can access and transfer contents stored thereon (i.e., a numerical PIN or password, coupled with a passphrase and backed up with a back-door comprised of multi-word seeds that must be regurgitated in a specific sequence (to be used in lieu of the PIN and but still requiring the passphrase, if the user has elected to add a passphrase - which is an election)).
2. The Third-Party Vault.
Notwithstanding what was just discussed about the preference to avoid third-party intermediaries, sometimes purchasers of Bitcoin are uncomfortable directly holding the Crypto. They fear that they may lose the Cold Wallet or forget the PIN/password, misplace the passphrase and/or lose the seed. The are rightfully concerned that the Bitcoin could be forever lost if they are not sufficiently vigilant. Enter the third-party private "vault" (TP Vault).
Third-party vaults are the digital equivalent to a bank safe-deposit box where one stores physical cash (however shady or inappropriate that may be). One of the most well-known such third-party vaults is Xapo. Described by Wall Street Journal as the "Fort Knox for Bitcoin," Xapo physically stores Bitcoin on behalf of owners utilizing "deep cold storage, dynamic wallet address[es] and multi-signature authorization technologies." According to Wikipedia: "The Xapo Vault consists of physical servers located around the globe that the company says is protected by biometric scanner access, 24-7 video surveillance, and armed guards. The servers are in undisclosed locations underground ... including in a bunker, which was constructed in 1947 and is claimed to be a secret headquarters of the Swiss army during the Cold War." Per Wikipedia, Xapo, Inc. - the entity with which U.S. residents would transact business - is a Delaware corporation and a wholly owned subsidiary of Xapo Holding Limited (Cayman Islands) with its principal place of business in Palo Alto, California.
D. Impact on Collections Efforts.
By now you're undoubtedly starting to notice that post-judgment collection efforts (and pre-judgment levy of writ of attachment, bankruptcy liquidation, etc.) in this sort of an environment is a challenging proposition. This is especially the case in the Cold Wallet and TP Vault arenas and potentially a little less challenging in the Exchange Wallet Scenario.
The California Code of Civil Procedure (Code) does not provide any clear methodology to levy either a pre-judgment writ of attachment (a court-imposed lien) on Bitcoin, or any Crypto for that matter; with the same holding true vis-a-vis levying a post-judgment writ of execution (a necessary precursor in order to involuntarily take the Crypto and apply it to the money judgment entered in the judgment creditor's favor). This gets a little hyper-technical and is outside the scope of this article but is an important issue. To summarize, the Code is not clear on how the pre-judgment writ or attachment and/or post-judgment writ of execution could properly usurp dominion and control over the underlying asset: Crypto. Without a proper levy of the subject writ, the asset is not subject to the control of the sheriff, levying officer or the court and, arguably, no lien will attach, defeating the cat's intent.
Bear in mind that the asset in question is, for all intents and purposes, and intangible form of currency residing in cyberspace. It is not the physical wallet itself, which can theoretically be levied upon under the Code; rather it is the cryptographically protected information residing on or in the wallet itself. Levying a writ on the wallet itself does absolutely nothing to satiate the cat's hunger for mouse meat because unless and until the private key to the wallet and/or the wallet's PIN/password (and/or passphrase and/or seed), the physical wallet itself is useless (i.e., the cat is unable transfer the Crypto from the wallet into the cat's own wallet).
So hungry cat roadblock number one is that California law has a lot of catching up to do in its statutory law for methods of levy specifically designed to deal with Crypto-specific complexities. Even setting aside the nerdy issue of inadequate and outdated methods of levy, the second serious hungry cat roadblock is what the cat should do with the wallet if the cat does not have the correct private key and/or PIN/password and/or passphrase and/or seed (collectively, Authentication Code).
Collections lawyers may argue that since the matter is under the auspices of a court of law, the court may force the debtor or judgment debtor to disclose the Authentication Code, perhaps in the context of a post-judgment Order to Appear for Examination (which is something akin to an informal deposition where the judgment debtor is forced to answer questions about assets -- including location thereof -- under oath and on the record) (ORAP). Stated otherwise, courts have the inherent power to coerce judgment debtors to disclose important information, under threat of contempt citation, which could result in monetary sanctions and/or temporary incarceration in extreme circumstances. All that is good and well, but the practical reality is that most courts will not hold a person (even a judgment debtor) in contempt if the person can convincingly argue that he or she has forgotten the information being requested. (It would be damaging to a sitting judge's reputation to incarcerate judgment debtors, for instance, for merely "forgetting" the Authentication Code. This is even more the case when one recognizes that Authentication Codes are often complex strings of characters and symbols, which are easily susceptible to misplacement and/or lack of recall.) So practically speaking, the tools available to coerce disclosure of Authentication Codes are way less than adequate.
The matter is potentially even more complicated where the Bitcoin is stored in a TP Vault. Why? TP Vaults are often physically located in a foreign jurisdiction, the location of which is often kept a secret from the public for security purposes. Xapo's website, for instance, does not readily disclose the location of its vaults and even suggests that Xapo has vaults spread out in various jurisdictions around the globe. While it is true that Xapo itself is a Delaware corporation arguably doing business in California and, therefore, could risk exposing itself to liability if it fails to cooperate with proper levy maneuvers by the hungry kitty, the larger truth is that Xapo would be very disincentivized to cooperate with cats. Xapo is a security and storage company; a "swiss bank" for the 21st century; a bastion of freedom and independence, so to speak. It would make much more sense for Xapo to hire powerful counsel to fight off legal attacks in "small" collections cases than to roll over and cooperate by zapping the Bitcoin from their servers to the cat's belly. Realistically speaking, Xapo would be well-advised to fight hard and take the case up on appeal, at great expense to the hungry cat and his or her counsel. Xapo would argue that they should not be forced to hand over the Bitcoin to anyone, including a levying officer, because of jurisdictional issues and also because the Bitcoin resides on Xapo's hardware, not the hardware of the judgment debtor. Xapos will also argue that it should only have to comply if and when the hungry kitty provides an Authentication Code, not before. We all know how this cha cha is played, and we can expect TP Vaults to fight hard to avoid having to comply with judgments.
E. Summary and Conclusion.
The world is changing, fast. Technological advancements in the Crypto arena will make it a lot easier for debtors to hide assets or place them outside the reach of legitimate creditors and judgment debtors. Legal professionals practicing in this arena must start adapting and asking the right questions at ORAPs and in written post-judgment discovery so that the attorney can better evaluate the likelihood of recovery and the expense associated with getting there.
In the coming years, California law will need to develop substantially to empower (and even encourage) courts and judges to coerce relevant disclosure relating to Crypto assets. Also, the Code will need to be updated to more specifically identify procedures and protocols for levying on Crypto assets.