Closing The Loop

Welcome to the age of Bitcoin.  And Ether.  And Monero.  With roughly 970 cryptocurrencies currently circulating in the digital nethersphere, forms of payment that were once favored by cybercriminals and TOR network marketplaces have gone mainstream.  They’re not just trendy vehicles for investors, either; entrepreneurs are buying into cryptocurrencies to the point where they’re now shelving IPOs in favor of initial coin offerings, or ICOs.  Even landlords and property sellers are starting to accept rent and home purchases in various cryptocurrencies.

While society as a whole may not be ready to give up their USDs for BTCs, the rise of cryptocurrencies as purchase and investment options is creating a novel set of eDiscovery issues for attorneys to grapple with.  This is mostly due to the way these cryptocurrencies ensure anonymity during transactions without letting government regulation get in the way.  This will not only impact the way litigators specializing in cryptocurrency approach eDiscovery, but will also impact the types of ESI issues attorneys must soon consider in order to provide competent representation to clients.

How Cryptocurrencies Work

To truly appreciate the legal issues behind cryptocurrency transactions, it’s best to clarify how they operate—especially the more popular ones such as Bitcoin and Ethereum.  

Cryptocurrency transactions work off of peer-to-peer payment systems that allow buyers and sellers to directly and anonymously enter into transactions with each other.  

Unlike the average Benjamin-based exchange, which could involve government-regulated entities such as banks, credit agencies and investment brokers, cryptocurrency technology does not require centralized authorities. 

Perhaps the most famous system, blockchain, is used by Bitcoin, which currently reigns king as the most valuable cryptocurrency.  Blockchain, which was originally described in a whitepaper published by an anonymous author under the pseudonym Satoshi Nakamoto, is a decentralized digital ledger system.

The system relies on publicly available ledgers, distributed throughout the network, that track transactions and subsequent currency exchanges. Because the ledgers are widely distributed, and heavily encrypted, falsifying information is incredibly difficult—one cannot alter transactions when thousands of other ledgers would instantly identify the discrepancy. This is the difference between a "consensus system" and a centralized authority. 

Therefore, instead of having a single bank store and monitor account amounts, cryptocurrency ledgers fill this void by providing up-to-date information on accounts, which they display publicly while keeping user information anonymous.  This decentralized, anonymous approach to economic transactions is what makes cryptocurrencies such an intriguing option for investors and a growing number of consumers. Not only does it provide users with a transparent, public database of transactions, but also one that is operated out of numerous data centers instead of one, which prevents any likelihood of illicit tampering.  

Smart contracts, on the other hand, are the distinguishing feature of Bitcoin’s biggest rival, Ethereum.  Smart contract technology allows users to embed units of cryptocurrency with legal conditions and terms that automate payment when the proper conditions are met, without human intervention.  In other words, smart contracts turn ordinary units of cryptocurrency into contract enforcers, and can be used to dictate and automate payment installments and terms on everything from derivatives transactions to simple contracts—eliminating the need for specialists to wade through voluminous paperwork to come to the same conclusions.  The technology is capable of being used to automatically notarize documents, transfer title to property, and verify buyer and seller identities during a transaction.  The technology behind smart contracts has many high-profile backers, including J.P. Morgan, Microsoft, and Intel, and could soon transform the way people conduct sophisticated transactions and payouts.


Legal Issues for Tracking Cryptocurrency

Cryptocurrencies’ advantages as anonymous, deregulated peer-to-peer payment systems, however, can create a number of regulatory and legal issues, especially regarding evidence collection and eDiscovery.  Because of the way cryptocurrency systems protect the anonymity of their participants, they have become ideal vehicles for money laundering, tax fraud and illicit purchases.  

One sensitive eDiscovery issue brought about by cryptocurrency is how to identify cryptocurrency users.  The IRS, for example, is using the John Doe summons as a method of uncovering the identities of anonymous cryptocurrency users suspected of tax fraud.  These summonses, which are issued only upon receiving court approval, allow the IRS to investigate the tax liability of unidentified individual, or group of, taxpayers upon an initial finding of a tax compliance problem. They are often used to uncover anonymous tax shelter beneficiaries or owners of tax-exempt bonds.  

Although John Doe summonses are not supposed to be issued to conduct “fishing expeditions,” the way the IRS has been using them in relation to cryptocurrency transactions is spurring controversy.  One case is the IRS’s recent use of such a summons on cryptocurrency wallet and merchant provider Coinbase.  The government requested this summons to investigate records of all Coinbase users who transacted in virtual currencies within a specified three-year span, in an effort to determine whether any of them were involved in tax evasion.  

A federal court in the Northern District of California authorized service of the summons in December 2016, which covered roughly 500,000 of the service’s users.  Of these, approximately 90 percent traded less than $10,000 in cumulative cryptocurrency transactions.  In response, the House Ways & Means Committee issued a stern letter to the IRS commissioner stating that the agency was overstepping its bounds in requesting the summons in the absence of more formal IRS procedures and policymaking on how to best address cryptocurrencies.  In addition, one attorney has already filed a motion to intervene and quash the summons, arguing that it is overbroad and not grounded on justifiable suspicions of tax evasion activity.

Despite being centered on anonymous transactions, however, there are ways attorneys can work around anonymity issues and find discoverable cryptocurrency transaction evidence.  In a white paper, Michael Doran explains that one way litigators can find relevant evidence is by subpoenaing a hard drive image of the user’s cryptocurrency wallet—especially if the wallet uses an open-source framework such as Bitcoin-QT, which stores the entire user’s transaction history within the app.  If this is the case, a lawyer or investigator working from a hard drive image of the wallet could locate and extract files related to certain suspect transactions and cryptocurrency data activity.  

The wallets themselves are not the only devices lawyers could try retrieving. Any devices the user used to connect to Bitcoin’s network could contain important evidence in the devices’ volatile memory, or computer memory that’s stored while the devices is turned on. Other useful evidence can be found by examining the user’s transactions in the cryptocurrency’s public blockchain ledger or by subpoenaing the user’s encrypted cryptocurrency credentials, though government attorneys trying this strategy during a criminal case could face Fifth Amendment issues similar to those involving encrypted hard drives and passwords.  

The difficulties posed by cryptocurrencies don’t end there. When cryptocurrency evidence is obtained and identified, it could face problems regarding admissibility, for example. California attorney James Ching has explored the possibility that blockchain evidence could be inadmissible hearsay, falling outside of Federal Rule of Evidence 803’s exception for business records.

Such issues, of course, represent only a fraction of the potential legal issues at play with cryptocurrencies, where the anonymous nature of transactions can complicate matters for attorneys looking for evidence. Nonetheless, for all their potential benefits and in spite of possible drawbacks, cryptocurrencies are creating a new Wild West within today’s digital landscape, and it's one that lawyers and legislators must quickly come to terms with.

This post was authored by Eric Pesale, the founder of Write For Law, who writes regularly about eDiscovery, cybersecurity and other legal topics for law firms, publications, and companies. He is a graduate of New York Law School and the University of North Carolina at Chapel Hill, and recently passed the New York bar exam. Eric can be reached at [email protected] or on Twitter at @writeforlaw.

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