An appellate decision from a provincial high court in northeastern China may help to shed some additional light on the Chinese government’s regulation of virtual currency exchanges in China, the anti-money laundering (AML) and know-your-customer (KYC) expectations placed on these exchanges, and the liability that might accrue to exchanges in the event of criminal activity involving virtual currencies.
The Lekuda (OKCOIN trading platform) case was initially filed in the civil division of the intermediate court of the municipality of Suihua (绥化) in northeastern China, Heilongjiang Province. Coincidentally, China’s northeastern region is also known for Bitcoin mining. In China, there are three types of litigation (三类诉讼), each with their own set of procedural rules and jurisprudence, and the Lekuda case filed in Suihua was styled as a tort case, a type of civil litigation. While characterized and classified as a civil tort case, the case also implicates certain criminal and administrative issues at its periphery.
The decision that was recently made publicly available was the July 2016 decision of the second instance court (an appellate decision). The underlying Suihua intermediate court decision has not yet been made publicly available, but may eventually become so. That said, from the appellate decision, we can learn the basic facts.
According to the findings of fact recorded in the appellate decision, the plaintiff in the underlying matter, a Chinese company named Huachen, claimed that criminals had defrauded it of RMB 12,000,000 (just under USD $2M), and then laundered a portion of that money (RMB 2,000,000) by buying Bitcoin on a virtual currency exchange – an OKCOIN trading platform – and cashing it out through underground banks in Macau. The court reported that the criminals had purchased two sets of identification documents and related debit cards on the Chinese black market and then used them to set up an OKCOIN account. The first instance court found that Lekuda had not followed its own AML/KYC practice and although it had flagged the transaction as suspicious, it allowed the transaction to proceed only upon reviewing a photocopy of an identification card, and did not insist on reviewing a photo of the identification card and a photo of the customer holding that particular identification card to further verify that particular customer’s identity.
The alleged victim of the criminal scam, Huachen, sued Lekuda for civil damages. Huachen alleged that Lekuda was civilly responsible for that portion of the defrauded funds which had been transferred from the OKCOIN trading platform and which had been spent by the criminals, damages amounting to RMB 1,568,923 (approximately USD $235,000). The lower court held Lekuda liable for 80% of those damages and Lekuda appealed to the Heilongjiang High Court.
Before discussing the appellate court’s decision, it’s important to understand a bit about the background concerning the regulation of Bitcoin exchanges in China.
Regulation of Bitcoin Exchanges
Considering the popularity of Bitcoin as virtual currency, in 2013-2014, the People’s Bank of China (PBOC), the authority charged with regulating non-financial institutions providing payment services, enhanced Bitcoin regulation. On December 3, 2013, the PBOC, together with the Ministry of Industry and Information Technology, the China Banking Regulatory Commission, the China Securities Regulatory Commission, and the China Insurance Regulatory Commission, jointly issued the Notice on Guarding against the Risks of Bitcoin (<关于防范比特币风险的通知>) (Joint Notice). The Joint Notice barred financial and payment institutions from trading in Bitcoin, required all Bitcoin trading exchanges websites to be registered with relevant telecommunications administrations, and required trading exchanges to establish and implement internal AML compliance measures.
Subsequently, in early 2014, PBOC reportedly required financial banks and third-party virtual currency payment providers including Alipay, which at that time accounted for approximately half of all online transactions involving virtual currencies in China, to stop providing clearing services for Bitcoin. In or around April 2014, several financial banks and Alipay issued official announcements declaring they would not provide service in any form concerning Bitcoin trading. In May 2014, five major Chinese Bitcoin trading exchanges including OKCoin issued a joint declaration promising that they would comply with the regulatory requirements and fulfil their (AML) duties.
Separately, PBOC also issued the Administrative Measures for Payment Services Provided by Non-Financial Institutions (《非金融机构支付服务管理办法》) which required non-financial institutions like virtual currency exchanges to obtain a Payment Business Permit. PBOC also recently promulgated the Administrative Measures for Online Payment Business of Non-bank Payment Institutions (《非银行支付机构网络支付业务管理办法》), which went into effect on July 1, 2016. The new Administrative Measures for Online Payment Business further strengthens regulation for online payment services by laying out mechanisms for client and operation management, emphasizing real-identity requirements when online payment accounts are opened.
The Appellate Court Decision
Against this backdrop, the appellate court found that Lekuda operated without a Payment Business Permit and was in violation of the requirements specified in Administrative Measures for Payment Services Provided by Non-Financial Institutions. It also found that Lekuda did not operate consistent with the Joint Notice’s directive on KYC and AML compliance measures, specifically by failing to duly enforce the requirements of real ID registration and reporting of suspicious transactions. While the lower court had determined that Lekuda operated beyond its registered scope of business by setting up a OKCOIN (Bitcoin) trading platform, the appellate court did not address this issue. But the appellate court found that Lekuda was tortious per se by being in violation of the relevant regulations and that as such they were a cause of the consequences for certain losses of Huachen which could not be recovered. As such, under something like a negligence per se theory, the appellate court held Lekuda liable for 40% of the non-recoverable loss allegedly suffered by Huachen, which amounted to RMB 627,569 (approximately USD $94,000).
From the appellate court decision, it appears the case only implicated the OKCoin.cn domain (apparently owned by Lekuda), and did not stretch to OKCoin.com, a global Bitcoin exchange. Moreover, OKCOIN, in a post on Reddit, maintains that it has strengthened its AML/KYC practices in the time since the original decision was reached. While it’s not yet clear whether PBOC will take additional AML measures against Bitcoin-related companies in China, the new appellate decision places China-based Bitcoin trading exchanges on notice to comply with various registration and compliance requirements under the existing regulatory framework.