The Silk Road and MtGox: Lessons in Law for Bitcoin

Privacy Internet Digest Notes
pic01By: Chris Crawford and Joshua Vittor This article assumes a base level of knowledge about Bitcoin, bitcoin (BTC), blockchain technology, the Silk Road seizure, and the collapse of MtGox. For a helpful summary of how this technology works, see the first portion of this articlewritten by Matthew Ly of the Journal of Law and Technology. Bitcoin, and crypto-currency more generally, has risen in the five years since its launch from an academic exercise to what is today a multi-billion dollar system of transacting wealth. Its signature technology is the blockchain, a nearly incorruptible public ledger that replaces many functions traditionally left to trusted intermediaries, such as transaction verification. These trusted intermediaries, like banks and wire transmitters, are highly regulated under our current legal system. The threat of government enforcement or private litigation is meant to ensure that they operate fairly and legally and to provide relief for victims when the intermediaries breach those victims’ trusts. Bitcoin enthusiasts, however, emphasize that trusted intermediaries often do not operate fairly or legally (e.g. they run off with the money), and that the legal system’s reactive nature is an insufficient deterrent against malpractice and wrongdoing. Blockchain technology, some claim, has the potential to ensure proper transactions in a way that the traditional legal system has never been capable of. With blockchains, so the argument goes, there will be no need for a legal system (including government regulations) to guarantee the success of a transaction because there will be no need for trusted intermediaries to complete a transaction. However, two recent events in this technology’s short history suggest that the legal system will continue to play a large part in its development. First, the federal shutdown of online drug bazaar Silk Road, and subsequent seizure of BTC worth upwards of $100 million by U.S. Marshals, offers a glimpse at how Bitcoin will be forced to interact with traditional tools of law enforcement, such as the asset forfeiture program. Crypto-currency’s ever-evolving ability to allow trustless and decentralized transactions may create investigative problems for criminal authorities, but, as history suggests, it appears that the legal system will easily adapt to this new technology in order to prosecute and suppress criminal activity. Second, the collapse of the bitcoin exchange MtGox highlights crypto-currency users’ continued dependency on traditional proceedings like bankruptcy and class actions to settle disputes and obtain relief. Unlike the Silk Road, MtGox was ostensibly performing a legal activity that Bitcoin was designed to perform—facilitating the transaction of funds securely over the internet. The exchange’s failure to properly do so has called into question Bitcoin’s ability to ensure transactions without the traditional legal system’s deterrent and relief-granting power. Notably, however, MtGox’s implosion may have spurred a new wave of crypto-currency innovation (“Bitcoin 2.0”) that just may realize some of the technology’s promised abilities. Silk Road Forfeiture For two and a half years, a booming online marketplace called Silk Road made the transacting of illegal drugs (among other things) as easy as a click of the mouse.  Dubbed “the Amazon.com of illegal drugs,” Silk Road produced millions of dollars in revenue.  Its secret was simple: ensuring the anonymity of its buyers and sellers.  It did so primarily through the use of Tor, software that renders its users anonymous on the Internet and therefore virtually untraceable.  In order to even find Silk Road, one had to be using Tor. In addition to Tor, however, Silk Road took advantage of another burgeoning source of online anonymity: Bitcoin.  All transactions on Silk Road were conducted via Bitcoin. In order to purchase goods on Silk Road, users had to transfer bitcoins from their personal wallets to Silk Road accounts. The bitcoins of a prospective buyer were then held in escrow until the buyer confirmed the legitimacy of the purchased good, at which point they were transferred to the seller’s Silk Road wallet. Despite its best efforts, however, even the highly anonymous Silk Road was compromised in October 2013 when the site was shut down by the U.S. Government. Its alleged founder, the so-called “Dread Pirate Roberts,” was arrested by the FBI in the form of a 29 year-old named Ross Ulbricht. The most noteworthy aspect of the Silk Road crackdown—at least for the purposes of this article—is the intersection between the Bitcoin housed on the site, valued at tens of millions of U.S. dollars, and a key crime-fighting tool: the federal asset forfeiture program. As soon as the United States seized Silk Road, it also, by virtue of technological fiat (and, apparently, some clumsiness on the part of Ulbricht), seized the bitcoins housed therein. This included Ulbricht’s staggering personal bitcoin supply (about 150,000 BTC), accumulated through the healthy commission Silk Road took from all sales, as well as all of the bitcoins held by its many users or housed in the aforementioned escrow accounts (about 30,000 BTC).  This meant that if a drug-seeking Silk Road user tried accessing the site after the shutdown, he would, to his likely dismay, be redirected to an FBI-generated shutdown notice. In addition, all of the bitcoins he may have stored on Silk Road would also be gone, seized by the government as part of efforts to forfeit all of the bitcoins held in Silk Road accounts.[1] A short discussion of the federal asset forfeiture program will illuminate the importance of the Silk Road seizure. Asset forfeiture exists as a tool of law enforcement and criminal sentencing with the basic goal of “taking the profit out of crime.” Any property obtained through criminal means is, with very limited exceptions, subject to forfeiture so long as the government can prove the property’s traceability to the illegal activity. A bank robber, for example, would not be able to reap the benefits of his crime after he serves his time—such ill-gotten proceeds would likely be forfeited to the federal government. The government must file a forfeiture proceeding, separate from the criminal charge, in order to permanently secure the property. Procedurally, the government has two distinct options. It can file a criminal forfeiture case against a specific defendant, in which the seized property is attributable to that defendant. Such proceedings are tied directly to the criminal charges against the defendant, and the government must obtain a conviction in order to prevail on its forfeiture claim. Alternatively, the government can file a civil forfeiture claim, which is essentially a case against the property itself. As codified by the Civil Asset Forfeiture Reform Act of 2000 (CAFRA), 18 U.S.C. 983, the government can  forfeit property even without proving that its previous “owner” ever committed a crime, so long as it can prove that there is a “substantial connection” between the property and the criminal activity.[2] Sarah Stillman’s New Yorker piece takes a hard look at the tricky implications of civil asset forfeiture; the Institute for Justice also released a report decrying the civil practice. Essentially, the presumption of innocence provided to criminal defendants is unavailable to the property in forfeiture proceedings. As Larry McIntyre explains, tracking down each of the individual Silk Road users whose bitcoins were seized by the FBI would prove costly and time consuming. Civil forfeiture provided the government with a means through which they didn’t have to do so. The United States successfully convinced a federal judge that the Silk Road bitcoins are traceable to criminal activity, simply through the bitcoins’ presence on a site associated with the transacting of illegal goods. Without convicting Ulbricht (or anyone else) of a crime, the roughly $28 million worth of bitcoins held by Silk Road users was forfeited to the United States on January 15, 2014.[3] The Bitcoin community lionizes the technology for the anonymity and untraceability it provides to its users. But the Silk Road episode highlights civil asset forfeiture, and its relatively low standard of proof, as an effective tool U.S. law enforcement can use to target bitcoins that have been tainted by criminal activity. So what will money launderers and drug traffickers, eager to avail themselves of Bitcoin’s appealing anonymity, take away from the Silk Road experience? One answer may be that Ulbricht was just clumsy: Ulbricht agreed to be interviewed by Forbes, under the guise of the Dread Pirate Roberts, in the summer of 2013, revealing enough of himself to law enforcement to pierce Silk Road’s veil. A more interesting answer, and one with implications that strike at the very heart of the Bitcoin movement, is that Bitcoin isn’t actually anonymous or untraceable after all. Bitcoin might make it harder for law enforcement to track the flow of tainted money, but it doesn’t make it impossible.  Law enforcement likely had the ability to track down the individual Silk Road users, but civil forfeiture proved significantly cheaper and more efficient. As Michael Neilsen suggests, the claim that Bitcoin can be used anonymously—the claim that drove the very formation of Silk Road and other marketplaces that specialize in illegal goods—is a myth. “The block chain is public,” Neilsen argues, and “although Bitcoin addresses aren’t immediately associated with real-world identities, computer scientists have made a great deal of progress figuring out how to de-anonymize ‘anonymous’ social networks. The block chain is a marvelous target for these techniques.” Bitcoin’s apparent vulnerability to seizure and asset forfeiture appears to marginalize its most appealing assets: its perceived anonymity and untraceability. If FBI agents can trace the flow of the Silk Road bitcoins—or, simpler still, exploit civil forfeiture to make such tracing unnecessary—proponents of Bitcoin (particularly those who seek to use Bitcoin to facilitate criminal activity) will be forced to adjust accordingly. It is possible that Bitcoin users will find new ways to disguise the use of their Bitcoins (for instance, though the use of “laundry” services like Bitlaundry, and “tumblers” and alternative forms of crypto-currency like Darkcoin). But it is equally likely that the Bitcoin community will have to come to terms with the reality of their community’s limitations and its inevitable clash with traditional legal structures. By virtue of the blockchain, the backbone of the Bitcoin ecosystem, Bitcoin may never be as anonymous or untraceable as it purports to be. Ironically, as Neilsen aptly suggests, Bitcoin is “perhaps the most open and transparent financial instrument the world has ever seen.” The Silk Road episode stands as evidence that existing legal structures such as asset forfeiture currently have the power to contain Bitcoin. As the U.S. Marshalls auction off the bitcoins from the Silk Road forfeiture, we are left to question whether this newfangled crypto-currency is any different, from a legal perspective, from an old fashioned pile of cash. MtGox Collapse Before its dramatic collapse in early 2014, MtGox was the largest place on the web to exchange bitcoin (BTC) for fiat currency such as U.S. dollars. At its peak, the exchange handled millions of dollars worth of bitcoin-to-fiat transactions a day, just like a traditional “forex” trading platform. Understanding how the exchange worked is critical to understanding what went wrong. Bitcoin transactions are irreversible. Once BTC is sent from one public key address to another (by the sender signing the transaction with a private key), those funds cannot be retrieved unless the recipient manually sends the funds back (using their own private key). This feature of Bitcoin is normally considered the core of its almost-totally secure transaction system, but MtGox’s exchange system circumvented this security feature for the sake of convenience and speed. MtGox account holders would send their BTC over to the exchange, who would then hold the funds in its own public key accounts (this arrangement, called a web wallet, is the same as that used by Silk Road, above). That meant that MtGox had the private keys, and the only thing keeping MtGox from misappropriating the funds was, ironically, the deterrence of legal action on the basis of contract law or criminal law. This arrangement was considered “the worst of both worlds” because it combined the irreversibility of BTC transactions (once you sent your BTC to MtGox, only MtGox could ever send it back to you) with none of the highly-developed regulatory protections of the traditional financial services system. Indeed, even though users “owned” the BTC they had sent to their MtGox wallets, their claim to ownership was secured only by a simple contract—the user agreement. With the disappearance of more than $400 million worth of bitcoin from MtGox, and its subsequent collapse, many Bitcoin users are left with no option other than to trust the traditional legal system for relief. American and Japanese criminal authorities have opened investigations, private class action lawsuits have sprung up to establish legal claims against MtGox and its affiliates, and MtGox itself has turned to the bankruptcy system to safeguard the company’s remaining value (although there doesn’t seem to be much left). As with the Silk Road debacle, the need for the traditional legal system to resolve disputes and handle controversies remains present in the case of MtGox. Take, for instance, the efforts of MtGox's former customers to retrieve their funds, or to at least establish a claim to any future MtGox funds. Litigants filed class action lawsuits against MtGox in the United States and in Canada almost immediately after its collapse, and these suits seek to represent those who were unable to extract their balances of BTC or fiat before the exchange completely seized up. Whether the collapse was precipitated by hacking or mismanagement, its effect on customers is the same: they are unable to retrieve their funds. These lawsuits have named several defendants, including MtGox as a corporate entity, Mark Karpeles as its CEO, and Gonzague Gay-Bouchery as its Chief Marketing Officer, as well as Mizuho Bank, the entity that handled MtGox’s wire transmissions. Just as with any other financial malfeasance, litigants are suing everybody in sight, with a particular eye for defendants that can actually pay large judgments (like Mizuho). Mizuho had been trying to shut down MtGox’s account for months before the collapse, and now that it is potentially liable for the exchange’s errors, other banks who deal with Bitcoin businesses are proceeding cautiously (with ever-increasing legal compliance fees being passed on to Bitcoin users). Meanwhile, the class action litigants are pursuing their claims aggressively. The U.S.-based class action plaintiffs have reached an agreement with an investor group called Sunlot Holdings that proposes to apportion 16.5% of the equity value in MtGox for sale to fund the creditors’ claims against the company. MtGox will have equity value, they argue, because Sunlot would restart it under new management. The plan is to buy MtGox for 1 BTC and to legally pursue claims against Mark Karpeles personally (with the help of his former right-hand man, Gonzague Gay-Bouchery, who has also settled with the group). While many former MtGox customers are wary of Sunlot, few other plans have gained as much legal traction[4] However, the success of this plan or any other depends on yet another element of the traditional legal system—bankruptcy. MtGox had originally tried to avoid liquidation by filing in Japan for a reorganization proceeding called “Civil Rehabilitation,” which would have allowed it to continue functioning as it was, with Mark Karpeles being retained as the CEO. This was apparently highly optimistic on Mr. Karpeles’s part. Shortly after its request, the Japanese court denied MtGox’s application and instead directed it to a bankruptcy proceeding in which a custodian, Mr. Nobuaki Kobayashi, would liquidate the firm to make claimants whole. Pursuant to MtGox’s Chapter 15 bankruptcy filing in the U.S., a judge in Dallas has ruled that Mr. Kobayashi has the authority to oversee the settlement of claims and the liquidation of assets in the U.S. as well. This process may take several years. The extent to which Bitcoin’s largest currency exchange and its customers have become embroiled in legal actions is clear evidence that the traditional legal system will continue to dominate dispute resolution for Bitcoin users. Just as the Silk Road case demonstrates that already-existing legal tools like asset forfeiture can be adapted to Bitcoin’s supposedly cutting-edge usage, the MtGox case shows that bankruptcy and class actions are easily applied to Bitcoin-denominated business disputes. However, perhaps diverging from the Silk Road, MtGox’s function (exchanging currencies) can theoretically be performed without the need for private civil lawsuits and bankruptcy proceedings. MtGox’s vast and expensive failure may be a harbinger of new crypto-currency applications that do indeed function without the traditional legal system. A new exchange called Coinport, marketing itself as “extremely transparent,” represents one novel response to the collapse of MtGox. Since all Bitcoin transactions are recorded on the system’s public ledger, this exchange has delineated exactly which public addresses on the blockchain it controls—allowing anybody to perform real-time audits of the company’s balances to ensure it actually possesses the funds it otherwise claims to have in its customers’ wallets. From the perspective of some technologists in the “Bitcoin 2.0” community, however, these proposals do not fulfill the technology’s promised ability to create truly trustless transactions without the need for a legal system to provide deterrence and material recourse. To actually fulfill this promise, Bitcoin transactions must be executed between two parties—the seller and the buyer—without trusting an intermediary, such as an exchange like MtGox or even Coinport. To this end, some developers are moving forward with systems based on so-called Ricardian contracts (“smart contracts”) and multi-signature cryptography. One application of these technologies would be a peer-to-peer exchange. Much like BitTorrent, the technology through which millions of people around the world share movies and music without the use of a centralized system like iTunes, a peer-to-peer exchange would allow a buyer (of, say, bitcoin) to find a seller (who will accept, say, U.S. Dollars) and for their transaction to be executed using only their private keys. Although a discussion of this topic could easily occupy another Digest article, it is worth noting that the ghost of the traditional legal system is present even in these theoretically trustless exchanges. In order to accomplish the above-described peer-to-peer transaction, developers are creating systems (based on a theoretical framework known as “polycentric law”) that depend on for-hire notaries and even arbitrators, in case of a dispute. This seems ironic: to achieve a trustless transaction, which presumably eliminates the need for the intermediary legal system, one must depend on a different legal system. To put it mildly, this aspect of next-generation Bitcoin applications remains unsettled. Conclusion There is little doubt that Bitcoin and the multitude of progeny crypto-currency platforms it spawned have the potential to fundamentally change our conception of money. All signs point to it becoming increasingly accessible and popular—brick and mortar retailers have started allowing the use of Bitcoin at their stores, allowing consumers to transact with Bitcoin in the “real” world in addition to online. In order to continue its challenge to our traditional system of financial transactions, however, it must contend with and react to our traditional legal structures. Either that, or it must evolve beyond them. The Silk Road and MtGox episodes are early suggestions that crypto-currency technology will not be able to circumvent the traditional legal system entirely. As Bitcoin grows in prevalence, so does the law’s interest in being able to reach it.


[1] Larry McIntyre’s note on “cyber-takings” has a nice recap of the Silk Road crackdown.
[2] There is an “innocent owner” defense to civil forfeiture, where an individual can claim innocent ownership to property. The burden is on the innocent owners to prove that their stake in the property is unconnected to the underlying criminal activity.
[3] Because Ulbricht claimed an ownership interest in his personal bitcoin stash, the forfeiture proceeding with respect to those bitcoins remains pending. Ulbricht has pled not guilty to the charges against him, claiming even that he is not the Dread Pirate Roberts as is alleged. No individual owners claimed ownership interests in the roughly 30,000 BTC seized from Silk Road user wallets, which is why the civil forfeiture for those bitcoins has gone through.
[4]Sunlot’s plan was granted preliminary approval by a bankruptcy court in Illinois on March 8, 2014.