Unclaimed Property Laws And Virtual Currency Custodians: Part Two

We examine how unclaimed virtual currencies, airdrops, and hard forks can implicate unclaimed property laws. In addition, we explore the unresolved issue of how one might escheat virtual currencies to state agencies. For an introduction to unclaimed property law, see Unclaimed Property Laws And Virtual Currency Custodians: Part One.

 Josh Garcia,

 Jenny Leung

wishingwell

Companies that take possession of a consumer’s virtual currencies (“Custodians”) must grapple with the unclaimed property law (“UPL”) of each state of their consumers’ residence. Most states have adopted a version of the Uniform Unclaimed Property Act (1981 or 1995), (“UUPA”), yet only a handful have adopted the latest revisions in the 2016 UUPA that explicitly cover virtual currency. States that have not defined virtual currency in their UPL could decide to place virtual currency in the catch-all category of intangible property, and the rules of escheatment that attach would be those that attach to intangibles. Ignoring state UPLs puts companies at risk of fines, interest payments, and class action lawsuits.[1] Novel methods of holding and distributing virtual currencies – such as airdrops and hard forks – present unique issues under state UPLs.

Key Provisions of State Law

UPLs require a “holder” to report and transfer unclaimed property to the state after a certain number of years of inactivity (generally three to five years). A “holder” is typically a “person obligated to hold for the account of, or to deliver or pay to, the owner, property subject to” the state’s UPL.[2] A “person” is “an individual, estate, business association, public corporation, government or governmental subdivision, agency, or instrumentality, or other legal entity”[3] and can include Custodians such as virtual currency exchanges, custodians, hosted wallet operators, crypto to fiat payment service providers, rewards platforms, lending and staking service providers, and any other business that controls the private keys on behalf of the owner.

Who is the Holder?

One major challenge is identifying the “holder” of unclaimed property in the context of virtual currencies. For example, an owner may deposit their virtual currency with an exchange, but the exchange may also contract with a custodian that takes custody of the private keys. While the exchange has the legal relationship and obligation to hold the virtual currency on behalf of the owner, the custodian ultimately holds the private key and has possession and control over the virtual currency. A question arises as to who the state might deem ultimately “obligated to hold for the account of” the consumer. The contract terms between the exchange and the custodian may not match a state’s interpretation of who is obligated to the consumer. Further, the exchange and custodian may operate in two different states with conflicting UPLs, which may muddle the issue further.

If a state has enacted the 2016 version of the UUPA, there is some clarity: the party with the “direct legal obligation” to the owner is the holder.[4]

Multi-signature Wallets

A multi-signature (“Multisig”) is a type of digital signature that requires multiple private keys to transact. Some service providers offer Multisig wallets, where the service provider and at least one owner will each hold a private key. In a typical two-party Multisig relationship, both the service provider and owner must sign a transaction in order for the transaction to occur on the blockchain (as opposed to book entry). This function provides an extra layer of security, as no individual may unilaterally make transfers without the other private key holder(s).

It is unclear whether providers of Multisig services are “holders” for the purposes of state UPLs. Where an owner has not interacted with the Multisig service provider for years, and the Multisig service provider is unable to contact the owner, the private key held by the Multisig service provider may be rendered effectively useless. Even if the Multisig service provider was a holder at the time the virtual currency was handed over, it is unclear whether a Multisig service provider remains a holder once the owner effectively abandons the virtual currency at issue. A Multisig service provider would technically be unable to unilaterally transfer unclaimed virtual currencies to a state or liquidate them into fiat currency.

Airdrops and Hard Forks

Airdrops involve the distribution of a newly created virtual currency to numerous wallet addresses that already contain a certain amount of virtual currency. A hard fork is a rule change in the network’s protocol, usually resulting in a permanent divergence in the blockchain and the emergence of a new virtual currency. In the event of an airdrop or a hard fork, Custodians may suddenly find themselves in a position where they have exclusive possession and control over airdropped and forked virtual currencies (the “New VC”) in addition to the virtual currency they were originally holding on behalf of the owners. A question arises: are Custodians considered “holders” of the New VC?

Again we turn to the definition of “holder,” and its definition that it includes a person obligated to hold for the account of, or to deliver or pay to, the owner, property subject to this [act].” If a Custodian is not obligated to hold New VC on behalf of the owners, they may not be holders of the New VC.

The issue may be resolved by looking to a theory known as the derivative rights doctrine,[5] which states a state’s power to take custody of unclaimed property cannot exceed the rights of the owner. This suggests that if an owner never had rights to airdropped funds, neither should the state, and a Custodian holding that property may not violate UPLs by retaining the property.

Yet the exact obligations and expectations that flow to the Custodian ultimately depend on the facts specific to the relationship between the owner and Custodian. There is no cookie cutter answer to the question of whether Custodians are always “holders” of New VC.

Further, a Custodian may act in such a way to give rise to obligations regarding the New VC, such as announcing it will hold New VC on behalf of its customers even though it has no obligation to do so,[6] or that it will be distributing New VC to the customer.[7] Custodians should be aware that such announcements may risk the unintentional creation of a “holder” relationship under state UPLs.

“Decentralized Finance” Services and UPLs

Some developers intentionally build applications that aim to provide what is known as “decentralized finance” or “DeFi” services. Such services claim, crucially, that customers taking advantage of their platforms for financial gain do not give custody of their funds to a centralized third party. Rather, often customers engaging on these platforms will transfer funds from one network address – one that the user knows the private key for – to another network address – one that nobody knows the private key for or has control over.[8] The user can often reclaim the funds through a range of mechanisms, but questions arise regarding: (1) who the “holder” may be and (2) whether a “holder” even exist when funds are locked in a network address designed to rest outside the control of any centralized third party. States have yet to provide guidance on this issue and, as such, it is uncertain how state UPLs will apply to effectively abandoned virtual currency that has been committed to ownerless smart contracts on DeFi platforms.

DeFi providers may have the ability to alter certain features of the mechanism locking customer virtual currencies through an admin key[9] or ownership and/or control of governance tokens, but it is unclear whether the ability to change the underlying infrastructure would cause such providers to rise to the level of “holder” status.

Escheatment

Once a Custodian has determined they have obligations to escheat unclaimed property to a state, a pragmatic question of process emerges. Currently, no states have indicated they will take delivery of abandoned virtual currency. On the contrary, a number of states such as Illinois[10] and New York[11] have introduced bills that would require holders to liquidate the unclaimed virtual currency by a certain date, and to send the proceeds of the sale to the state. Nevada has updated its Reporting Manual acknowledging the Nevada Treasurer does not have the capability to receive virtual currency in its native form and requiring holders to liquidate and remit the unclaimed virtual currency to them.[12]

For states silent on virtual currencies, it is not clear whether unclaimed virtual currencies are reportable under the state’s UPL, what the process for transferring the unclaimed virtual currency is, and whether holders are required to liquidate the virtual currency prior to transferring to the states. This grey area may give rise to claims of wrongful or negligent escheatment where a Custodian liquidates virtual currency, the value of such virtual currencies increases post-liquidation, and an owner claims economic harm arose from the Custodian’s liquidation.[13]

Conclusion

Application of UPLs to Custodians comes with a range of questions that do not have simple answers. Some states may find themselves grappling with decades-old laws that make compliance difficult for Custodians. States should provide certainty to Custodians regarding their escheatment requirements in the various scenarios regarding virtual currency. The laws in many states, as they stand, do not provide adequate guidance for applications of blockchain technology currently in daily use. As a result, Custodians may be left deciding whether to (a) liquidate virtual currencies and be exposed to lawsuits from owners; or (b) hold virtual currencies and risk significant fines and interest payments from state authorities.

[1] See Unclaimed Property Laws And Virtual Currency Custodians: Part One.

[2] Uniform Law Commission, Revised Uniform Unclaimed Property Act (2016), https://www.uniformlaws.org/HigherLogic/System/DownloadDocumentFile.ashx?DocumentFileKey=2b59cc67-dc0e-262b-db15-8189cbe6e0ec&forceDialog=0 (“2016 Act”).

[3] While it may seem that a developer or DAO is not a “person” as defined, it is still possible that the developer or DAO may be an unincorporated association depending on state law, and therefore fall under “business association”.

[4] See 2016 Act at 22 (“Where one party has a direct legal obligation to the owner of the property, and another party has possession of funds associated with the property and an obligation to hold it for the account of, or to pay or deliver it to, the owner solely by virtue of a contractual relationship with the party who is directly obligated to the owner, but who has not assumed direct liability to the owner, it is the party who is directly obligated to the owner who is the holder for purposes of the act.”).

[5] See e.g., In re New York, 138 F. Supp. 661, 666 (S.D.N.Y. 1956). The American Bar Association and the Holder’s Coalition have argued that the derivatives rights doctrine has been recognized by the Supreme Court in Delaware v. New York, 507 U.S. 490, 503 (1991). Despite these arguments, the 2016 Act does not codify the principle.

[6] See e.g., David Farmer, Update on Bitcoin Cash (Aug. 3, 2017), https://blog.coinbase.com/update-on-bitcoin-cash-8a67a7e8dbdf (“Over the last several days, we’ve examined all of the relevant issues and have decided to work on adding support for bitcoin cash for Coinbase customers. … In the meantime, customer bitcoin cash will remain safely stored on Coinbase.”).

[7] See e.g., The Coinbase Blog, OmiseGO (OMG) is launching on Coinbase Pro (May 14, 2020), https://blog.coinbase.com/omisego-omg-is-launching-on-coinbase-pro-46849dc228ce (“If you held an ETH balance greater than 0.1 on Coinbase Consumer or Pro (then Coinbase or GDAX) on July 7, 2017 at 4:36 PM UTC in 2017, you’ll receive OMG from Coinbase.”).

[8] See e.g., Andy Peterson, No Escape: Augur Burns Key to Network ‘Killswitch’ (July 25, 2018), https://www.ccn.com/no-escape-augur-burns-key-to-network-killswitch/; and William Foxley, Developers of Ethereum Privacy Tool Tornado Cash Smash Their Keys (May 18, 2020), https://www.coindesk.com/developers-of-ethereum-privacy-tool-tornado-cash-smash-their-keys.

[9] See e.g., Openzepplin Security, Compound Audit (Aug. 23, 2019), https://blog.openzeppelin.com/compound-audit/ (“The CToken administrator can call the _reduceReserves function to withdraw some of the reserves.”).

[10] See H.B. 4573, 101st General Assembly (Ill. 2020) (“Illinois Bill”).

[11] See A.B. 8314, 242nd Leg. Sess. (N.Y. 2019).

[12] See Office of Nevada State Treasurer Zach Conine, Unclaimed Property Division, Holder Reporting Manual (2020), http://www.nevadatreasurer.gov/uploadedFiles/treasurer.nv.gov/content/Unclaimed_Property/Forms/Holder/Holder_Reporting_Manual.pdf.

[13] See also, Illinois Bill § 15-603(i) (clarifying that “The owner shall not have recourse against the holder or the administrator to recover any gain in value that occurs after the liquidation of the virtual currency under this subsection.”).

Footnotes