Cryptocurrency is coming and we are not ready. There is reportedly a real estate development project being constructed in Dubai (The Aston Plaza) in which a portion of the available units will be sold in Bitcoin transactions. It is not inconceivable that a construction project could be constructed using Bitcoin as the method of payment. Should this occur, how would you litigate payment issues under your current states laws related to construction related payments and liens?
What Are Blockchain, Cryptocurrency, and Bitcoin?
Blockchain is a virtual currency that uses nearly uncrackable encryption to validate transactions for each crypto coin. Further security is gained through using a distributed ledger where information for each blockchain is spread among many different parties. This further complicates any crack as it would require successfully hacking those parties too. Various cryptocurrencies are secured with blockchain and possibly a distributed ledger to give confidence in transactions without any governmental backing.
The most notable cryptocurrency is Bitcoin, but it is still not legal tender in any jurisdiction. Bitcoin can act as a substitute for government currency if all the parties consent. Instead of being backed by a country, crypto currency is guaranteed by the strength and confidence in the underlying algorithm. Bitcoin can be exchanged for US Dollars, Euros and other real and crypto currencies. Bitcoin has been in the news quite a bit lately with its dramatic swings in value reported much like a stock price. While it would be very unusual to see a transaction backed with a share of stock, Bitcoin is different. Some major retailers are accepting Bitcoin. There is undeniable trend toward more Bitcoin transactions.
Bitcoin’s value can fluctuate wildly. Accepting a payment in Bitcoin may be attractive to someone who is willing to take the risk that the value increases in the short term, or someone who can pay their subcontractors or suppliers with other sources of cash and hold the Bitcoin as an investment. If the value of Bitcoin drops after the one party receives it and before they convert it to legal tender for paying their subcontractors and suppliers, we can foresee a whole host of issues complicating the legal framework and subsequent litigation of a payment claim.
The IRS treats a Bitcoin transaction the same as a property transaction. For valuation purposes, the taxpayer receiving the virtual currency is deemed to have received the fair market value of the property on the day it was received. Virtual currency transactions are subject to the reporting of gains and losses like other property transactions. If we presume that the states will apply a similar approach to valuing virtual currencies like Bitcoin in a construction transaction, we should anticipate interpretative challenges to construction payment related claims. Legal tender doesn’t create a taxable event every time it changes hands.
The Problem with Construction-Related Payment Laws
Let’s look at a few construction payment related statutes that will undoubtedly cause construction attorneys some difficulty in litigating and uncertainty in evaluating their clients position. For the sake of simplicity this article looks at Texas laws, but rest assured there are similar concepts throughout the United States.
The Texas Construction Trust Fund Act (Tex. Prop. Code § 162) creates a trust on the construction payments made by a project owner to a contractor. Those funds are supposed to be paid down to those providing labor and materials on the project. In fact, under Texas law, these payments are not even considered part of a bankruptcy estate of the contractor holding them. What happens if the contractor receives a payment in Bitcoin at a value of $50,000 (which is calculated on the day the contractor receives it) and it subsequently devalues before the contractor is able to convert it such that the contractor suffers a loss of $10,000? For construction trust fund purposes, will the contractor be responsible under the trust fund act for the loss in value during that time? If the contractor is holding the funds in trust, is there some heightened obligation to protect the value (i.e. cash in immediately before any value is lost) or is it permissible to hold on to the float for a few days to try to take advantage of an increasing value trend? Perhaps the analysis changes if the contractor negotiates payment in Bitcoin.
Under the Texas Mechanic’s and Materialmen’s Lien Statute (Tex. Prop. Code § 53), an owner is required to hold 10 percent retainage from the prime contractor and then an amount sufficient to satisfy any pre-lien notices it receives from unpaid subcontractors and suppliers (fund trapping). Using Bitcoin complicates the evaluation of whether the owner has properly withheld retainage and the amount of trapped funds to hold. Subcontractors share pro rata in these two pools of money if the total amount of claims exceed the retainage and trapped funds pool. If Bitcoin is valued as of the date it is received, and the owner receives $500,000 in Bitcoin for a construction transaction, then $50,000 in Bitcoin value is set aside from the beginning of the project to serve as retainage as calculated on the date of receipt. What happens if the value of virtual currency drops in half by the time there is a lien claim litigated and the parties have to evaluate whether the owner properly withheld retainage and the value of what has been retained? If the owner sets aside $50,000 worth of Bitcoin value on the day a notice is received does that adequately trap funds? How much is trapped? If $50,000 is held as trapped funds or retainage, and the value increases, will lien claimants have some equitable claim to the increase in value or can the owner spend some of it without incurring liability? How will litigants deal with the potentially changing value?
Pay When Paid
Under Texas law, as in many jurisdictions, pay when paid clauses (not pay if paid clauses) permit a party, usually the prime contractor, a reasonable period of time to wait for a payment from another party, usually the Owner, before it has to make payment to a lower tiered subcontractor or supplier. If the value of Bitcoin is increasing on a hot market, or if the value of Bitcoin rapidly decreased (and caused a funding shortfall on the project) and that value is increasing can that be a factor used to determine whether a reasonable period of time to wait for payment has passed? What if the value never recovers?
These provisions clearly have not been adapted for a Bitcoin marketplace. How does a construction lawyer predict how the law will evolve and counsel a prudent approach as Bitcoin, or other forms of cryptocurrency become accepted as payment in our industry? How does the construction litigator confidently advise a client as to the merits of a payment dispute and available relief in such a situation? The work on the solution needs to start now; the problems are just over the horizon.
Thomas D. Franklin and Brian R. Gaudet are partner and counsel respectively at Kilpatrick Townsend & Stockton LLP.
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