The Legal Challenges of Recovering Lost Cryptocurrency

Aug 26, 2022 | Blog

As long as the concept of personal property has existed, bad actors have been attempting to steal it. It therefore comes as no real surprise that when “new” types of assets are created, new threats also emerge. Such has been the case with the explosive growth of the cryptocurrency market.

A report by data platform Chainalysis estimates that $14 billion worth of cryptocurrency was received by illicit addresses in 2021, with the majority of this cryptocurrency coming from stolen funds and scams. While the increase in crypto crime (up 79% from 2020) is relatively small compared to that of the overall growth of the crypto market (up 567% from 2020), crypto crime poses a particular problem to individual investors because of the limited legal options for reclaiming lost funds.

Cryptocurrency does not have the same legal protections that traditional payment methods and fiat currency do. And while cryptocurrency’s decentralized nature is what in large part makes it appealing to many investors, this also means that there is no single authority or standard set of procedures that can be used to mediate disputes, pursue hackers and scammers, help retrieve losses, or handle instances of insolvency.

Additionally, the regulatory framework for cryptocurrency is still in the process of being created. As such, the legal status of many crypto tokens and crypto exchanges is still being debated and is often viewed differently by investors, exchanges, token creators, and various governmental organizations. For example, crypto tokens held in domestic exchanges are considered property—specifically, capital assets—by the IRS for tax purposes. Profits from crypto trading are therefore taxed as capital gains. However, for cryptocurrency held in foreign exchanges, it remains unclear and unspecified whether investors must report this under IRS Form 8938 (Statement of Specified Foreign Financial Assets) and/or to the Financial Crimes Enforcement Network through a Foreign Bank Account Report (FBAR).

Another debate exists regarding crypto tokens’ status as either securities or commodities. While certain tokens such as Bitcoin and Ether are considered commodities by the Commodity Futures Trading Commission, the Securities and Exchange Commission is making the case that many (if not most) other crypto tokens function as securities vis-à-vis the Howey test and are therefore subject to the rules of the Securities Act of 1933.

Beyond the issues of neatly labelling crypto assets, cryptocurrency exchanges may contend that they have no obligation to assist investors with investigating theft or reclaiming lost funds. This particularly arises when an exchange is located in a foreign country with little to no crypto regulation. Even in situations where an exchange or government might be willing to help, the completely digital nature of cryptocurrency and the seeming lack of physical nexus can create jurisdictional issues. For example, if an American investor holds cryptocurrency in an online exchange based in Japan but is hacked by an anonymous account based in Brazil, one can see how determining jurisdiction can be murky.

Some countries are working to cut through this murkiness and provide crypto investors with greater legal recourse to pursue stolen funds. England and Wales, in an effort to create a crypto-friendly landscape, are considering changes that would confer certain legal personal property rights onto crypto assets. On July 28, 2022, the Law Commission of England and Wales published a consultation paper recommending that the countries create a new category for digital assets under the umbrella of personal property law. Personal property law in these two countries currently consists of two categories: “things in possession” (e.g., gold or diamonds) and “things in action” (e.g., shares in a company). While crypto tokens are already largely considered to have proprietary rights in England and Wales, the Law Commission recommends creating a third category called “data objects” that would include crypto tokens as a subset.

This change would take into account the unique features of digital assets and extend greater protections to individuals who own them. The paper suggests that the existing legal frameworks for various causes of action and legal remedies should be available for crypto tokens. Among others, these would include damages for breach of contract; tracing; unjust enrichment and restitution; proprietary injunctions; freezing orders; relief against “persons unknown”; and enforcement of judgements.

Whether other countries, including the U.S., will follow in the footsteps of England and Wales in providing additional legal recourse for crypto theft remains to be seen.

If you have any further questions regarding cryptocurrency and property rights, please contact Michael Ward.