The faster the journey, the deeper the risks – Is the rollercoaster crypto train hitting the buffers and what are the Implications for insolvency practitioners?

Friday 19th August, 2022

Until recently, the trajectory of the crypto world has been very largely upward (albeit with some significant volatility in asset values). That has now changed with a large number of industry participants collapsing and scathing media comment accompanying investor losses and concerns. Insolvency practitioners will increasingly see crypto issues and cases coming their way. After touching on the current state of the market, this article examines English legal jurisprudence on cryptoassets and considers the equipment which IPs will need to have in their toolbox to be able effectively to manage a crypto collapse on their watch.

In recent times, the business news has been full of negative crypto headlines. Where once, not really very long ago, it was all headline grabbing tales of the latest crypto currency to arrive on the scene amidst meteoric investment potential, now one cannot escape sorry tales of eye-watering value losses, platform and other intermediary collapses and burgeoning scandals facing investors (often involving allegations of fraud and other wrongdoing). At the larger end of things, the recent collapse of Celsius Network, a huge US crypto lender, into formal bankruptcy has been called cryptocurrency’s “Lehman moment”. Indeed, Coindesk recently said:

“Celsius is the third major crypto company to file for bankruptcy within the past two weeks as plummeting crypto prices buffeted by inflationary pressures and volatile market conditions cause consumer confidence in the industry to nosedive.” [1]

So, against this confused backdrop of mixed messages, where do we really stand now?

Digital assets – including cryptocurrencies and NFTs (non-fungible tokens) – have been with us for a while now. Alongside, the blockchain and many other digital technologies, there is widespread acceptance, if not outright enthusiasm, among many elements of the investment and business community for these technology driven developments.

Despite this, the downside risks associated with investing or otherwise participating in the crypto world remain vexed and a matter of extensive, and sometimes fierce, debate and regulatory concern. There has been considerably less real regard paid to the consequences of an ultimate failure of a crypto player, that is where a formal insolvency procedure ensues.

This article examines some of the technical and practical consequences arising when a cryptocurrency fails or when other forms of crypto business (such as a crypto exchange) collapse. The analysis will consider the strict legal position from an English insolvency law perspective as it is continuing to develop and then look at some of the key potential practical implications of a crypto implosion, particularly for an insolvency practitioner tasked with applying and managing an established insolvency process in the context of novel digital assets and an unfamiliar technological infrastructure.

Does English Law Recognise Cryptoassets?

A fundamental question for English law concerns the legal status of cryptoassets and, following on from this, whether such assets qualify as “property” for the purposes of English law. After all, cryptoassets are generally created to be a digital store of value, whether in the format of coins (stable or otherwise), tokens (security or utility) or NFTs (or one of the sub-categories of any of them) and the owners of the same value want to be able to protect it and deal and transfer it as and when they wish from time to time.

In the context of an insolvency process, one of the core responsibilities of an insolvency practitioner (“IP”) is the identification, collection and safeguarding, pending collection, of the debtor’s assets and “property”, following which the same will be realised to best effect in the interests of creditors. “Property” is defined in very broad terms in the Insolvency Act 1986 (the “IA 86”) to include “money, goods, things in action, land and every description of property wherever situate and also obligations and every description of interest, whether present or future or vested or contingent, arising out of or incidental to, property”[2]. In fact, such is the breadth of this definition that it is actually hard to imagine many assets or things which fail to come within its scope. The current edition of Sealy & Milman[3] speculates as follows on the point: “Presumably this definition is wide enough to include cryptocurrencies (such as bitcoin) and trading items like carbon credits.”

Fortunately, no further speculation should now be necessary. The UK jurisdiction Taskforce issued its Legal Statement on cryptoassets and smart contracts in November 2019 (the “UKJT Statement”). This remains the single most authoritative statement as regards the status of cryptoassets as a matter under English law, not least because of its eminent authors, consultees and respondees to the consultation. The core conclusion for present purposes reached in the UKJT Statement was that, not only were cryptoassets property at common law, but that “we have no doubt that they can be property for the purposes of the Insolvency Act”.[4]

Apparently drawing heavily on the expert analysis in the UKJT Statement, that conclusion has been reinforced in several cases which have come before the English courts since 2019, not least in AA v Persons Unknown[5] and Wang v Darby, as well as in cases seeking proprietary reliefs in the form of injunctions or orders for delivery up (such as Osbourne v Persons Unknown)[6]. Support has also come from decided cases in other common law jurisdictions which themselves refer back to the common law definition of property in English jurisprudence of the 1960s[7].

There are a couple of follow on points of importance in this regard. Firstly, the UKJT Statement also determined that cryptoassets could become subject to security (in the form of a legal mortgage or equitable charge) under English law, but not pursuant to a pledge or lien (given that both of these rely on physical (or at least constructive) possession which is not possible with virtual assets).[8] Secondly, with the acceptance that cryptoassets are property comes the much-debated possibility that they could and, in some cases, have been subject to the concept of a trust.[9] Thirdly, it seems fairly well established that the relevant jurisdiction applicable to a cryptoasset will be the location of the asset holder rather the location of the server on which the asset may be held or registered.

Whilst it seems attractive, and perhaps even reasonable, to conclude that these questions have now been settled beyond doubt (at least in this country), some words of caution should be heeded. Most of the few decided cases arise from interim hearings which are often convened on an urgent basis and where the presiding judge has, by necessity, an incomplete set of facts and documentation (and, significantly, no assistance from experts). Meanwhile, decisions from other jurisdictions will only have persuasive effect here in the UK. That said, the foundation of most of these decisions will have been an ambition to protect and / or seek to recover cryptoassets wrongly taken from their rightful owners, and so it would be a surprising set of facts indeed that would potentially have the effect of reversing the course which the courts (based on the thrust of the UKJT Statement) have set.

To bring things up to date, the Law Commission has recently published its proposals to reform the law applicable to digital assets.[10] Their market consultation seeks to get to the heart of the challenges established English jurisprudence faces with these new technologies. The Law Commission’s proposals include explicitly recognising a new, distinct category of personal property which recognises the unique features of digital assets (the proposed name for the same being “data objects”) and clarifying the law around ownership and control of digital assets and how the same may be transferred and deals transacted. Hot on the heels of that Law Commission consultation comes a consultation from UKJT on “the issuance and transfer of digital securities under English private law”. [11] Whilst the focus of this consultation is a consideration of how English law can support the issuance of debt and equity securities on blockchain and DLT systems, the results of the consultation will also likely add to the debate on how English law should treat digital assets more generally. Lastly, other organs of the state (in the form of the FCA, HM Treasury and HMRC) are also known to be considering cryptoasset questions from a regulatory and taxation perspective respectively.

Practical Considerations for IPs

Against the flux of the backdrop outlined above, life for IPs is not straightforward!

Mention was made above of the central role of an IP, namely to identify, secure and safeguard, and finally realise the assets and property of an insolvent debtor for the benefit of the debtor’s creditors. With only some small variations around the edges, these core ambitions are common to the main formal insolvency processes in the UK (and regardless of whether the debtor is corporate or an individual).

In a crypto context, an IP will face a variety of potentially tricky hurdles to these established objectives. Established approaches and processes may well be helpful, but new thinking and strategies are likely to be required to reflect the novelty and potentially unique characteristics of the underlying assets.

Identification of the Cryptoasset

As a day one starting point, this is potentially a major headache for the IP. Not only can you not “see” a cryptoasset or find it on an easily searched public register, it will typically be held in a virtual wallet which may be “hot” or “cold” (such as on a discrete hard drive or a USB stick or mobile phone) or “stored” on a centralised crypto exchange. Having said that, the fact that cryptocurrencies are built upon blockchain infrastructure should actually make the tracing exercise easier than with “conventional” fiat (or paper) currency. This is because blockchain technology involves transparent and immutable records of transactions which are discoverable to anybody who looks which should enable all links in a chain of transaction and the ultimate owner to be identified. The key will be in knowing how and where to look and the best possible avenues and techniques to use.

There is a growing field of dedicated expertise, in the form of crypro tracing specialists, who may need to be instructed by IPs to ensure that they achieve this critical first step of asset identification and tracing. Organisations like Chainalysis[12] offer deep identification, investigation, transaction monitoring and other related cyber services which may be an important first step or vital element of the investigation services team.

Standing by will be some traditional resources. The IA 86 provides a set of broad, sweeping investigatory powers available to an IP, not least a duty in a corporate insolvency scenario to co-operate with the IP which can be enforced by sanctions including a fine or ultimately even imprisonment.[13] The core duty (in section 236 of the IA 86) is for any person, including directors, whom the court thinks capable of giving information concerning the promotion, formation, business, dealings, affairs or property of a company to provide information or documentation in their possession or control. There are less extensive investigation, but still broad, powers to compel co-operation by a bankrupt individual (although these do not apply to third parties).[14] Notwithstanding the breadth of this, the mere identification of cryptoassets may be a path beset by obstacles which have not previously been encountered with other asset classes, even other intangible assets like intellectual property.

Taking Control

Having identified a cryptoasset, the next task facing an IP will be to secure and safeguard the same. This is very much a business as usual step for an IP, but brings with it additional questions and hurdles, not least around a potential lack of true understanding of the asset and the technical environment and infrastructure in which it may be held. Suffice to say, there is a growing body of third party expertise which can be tapped where the same is neither available to the corporate debtor itself or within the internal forensics or technology teams of the IP’s own firm.

Most important will be the need to obtain access to “self-custody” wallets where investors hold their own devices which can only be accessed by private keys only known to them (in contrast to holdings held on exchanges or in funds). Without knowing what these private keys are, an IP will not only be powerless to stop the debtor (or those connected with or employed by the debtor) from accessing or disposing of the assets, but will also be unable to transfer the same as part of any realisation strategy. The fragility of such small and portable wallets is illustrated by a number of cases where investors have mislaid their hard drives or USB sticks (or forgotten unlocking passwords) which hold their private keys with potentially catastrophic losses involved.[15]

Some related considerations will include:

  • considering any available means to control an asset which is subject to particular volatility
  • seeking appropriate insurance cover, if available (and financially viable), to manage and protect the assets
  • preparing and implementing an overarching strategy concerning the assets which addresses not only taking control of them (notably applying to court for orders requiring the debtor – and potentially connected parties or employees – to hand over the private key information and the computer drives which store the electronic wallets), but all of the steps necessary through to final realisation for the benefit of creditors, and
  • as a core part of the strategy, involving overseas experts and lawyers to address any applicable jurisdictional elements, such as involving a platform or exchange operating or held in another country.

Crypto Exchanges and Platforms

The basic processes outlined above may prove to be somewhat more straightforward where the collapse involves not an individual or corporate holder of cryptoassets, but rather an exchange on which they’re traded. Some of the highest profile failures in the crypto space have involved failed exchanges, such as Luna, a $40 billion crypto asset associated with TerraUSD, a $16 billion stablecoin intended to have parity with the dollar, and Singapore-based Three Arrows Capital. Most recently, Celsius and Voyager Discovery have collapsed after facing what amounted to the equivalent of a “run on the bank” from investors seeking to reclaim their asset holdings from the platform. Just like the interconnectedness of the modern banking world, the huge potential for contagion in the crypto space saw the collapse of Voyager Digital which was triggered by Three Arrows Capital defaulting on a $660 million loan from Voyager.

Given that there are estimated to be some 600 crypto exchanges operating around the world on a largely unregulated basis, which not only encourages imprudent behaviour but also tends to leaves them with vulnerabilities to hackers and fraudsters[16], the prospect of other potential exchange collapses is obvious.

Although not (or barely) regulated, the practical obstacles an IP might face with a failed exchange are potentially less difficult to deal with. This is because experiences gained from dealing with the insolvency of banks or other financial services players should be helpful. Considerations here will include ensuring that the most important employees (and / or consultants) are identified and retained on the payroll to ensure that there is continuity of the infrastructure systems, ensuring there is full technical knowledge of the robustness (or otherwise) of those systems and to assist with developing and then implementing the IP’s strategies for the insolvency process. This will include gaining insights into how investors’ assets have been held and, in particular, whether there are full records to identify the same and whether they have been commingled or remain segregated. Those familiar with financial services collapses will recognise these types of focus and concern.

Realisation of Cryptoassets

Having identified and then secured cryptoassets owned by the debtor or in which it has some right, title or interest, the next question is how the same can or should be realised. Almost as, or perhaps more, importantly, however, is the question of when they should be realised. There is perhaps no other class of assets which is subject to such dramatic and unpredictable swings in value as cryptocurrencies. Undoubtedly, expert valuation input will be required to help to assess the likely trajectory of values and, hence, whether there is any particularly urgent need to implement a stop loss strategy to avert the adverse effects of any particular volatility (or, possibly even, to secure any asset gains which might be achievable) and, longer term, to identify what will be the most opportune point at which to sell. The volatility inherent in cryptoassets will likely make an IP nervous, this being where criticism is most likely if a sale or other steps are thought to have been effected or taken too slowly – or too rapidly.

Identification of Creditors

The usual corollary to the realisation of assets is the need to understand who the creditors will be. There is no difference in principle with a crypto insolvency, but, again, there may be particular issues to address. For self-held wallets, identifying the beneficial owners may be more straightforward but, in the case of an exchange, understanding how the asset value is held by the exchange will be critical. There might be a trust argument (assuming that trusts are conceptually recognised[17]) and, if so, the beneficial owner is likely to have enhanced legal rights compared with a situation where the holder simply has a contractual and non-proprietary claim against the exchange for “their” claim (and will only then rank as an unsecured creditor). However, even in a trust type situation where there has been some segregation by the exchange, concepts of asset pooling and tracing will be potentially relevant and be likely to impact the final creditor analysis. This will necessitate sophisticated and careful legal analysis against a background where the claims and values concerned could well lead to litigation. Again, those IPs with experience of bank or financial firm insolvencies will be familiar with these sorts of considerations.

Lastly, as a crypto insolvency is likely to involve significant numbers of claimants and creditors, the IP will need to ensure that they have appropriate resources available and systems set up to handle the welter of correspondence and multitude of claims likely to ensue (such as a claim portal and FAQs). Whilst not regulated and without investor protection (compared with a collapsed bank or building society[18]), it is likely that the FCA may nevertheless take some interest in the insolvency process given the likely profile of the collapse, so there may be some regulatory scrutiny in any case.

Brett Israel
Partner and Head of Business Restructuring
Marriott Harrison LLP

Citations

[1] Coindesk, 15 July 2022

[2] Section 436.

[3] “Annotated Guide to the Insolvency Legislation 2022,” 25th edition at page 663.

[4] Paragraph 109.

[5] [2020] 4 WLR 35

[6] [2021] EWHC 3054 (Comm) and [2022] EWHC 1021 (Comm)

[7] For example, see in Singapore B2C2 v Quoine Pte Ltd [2019] SGHC(I) 03 and the appeal [2020] SGCA(I) 02, and in New Zealand Ruscoe & Moore v Cryptopia Limited (in Liquidation) [2020] NZHC 728

[8] Paragraph 103.

[9] See, for example, Wang v Darby and Andoro Trading Corp & Anor v Dolfin Financial (UK) Ltd & Ors [2021] EWHC 1578 (Comm)

[10] 28 July 2022: https://www.lawcom.gov.uk/law-commission-proposes-reforms-for-digital-assets-including-crypto-tokens-and-nfts/

[11] Legal Statement on Digital Securities: Public Consultation, 3 August 2022

[12] https://www.chainalysis.com

[13] Sections 234 to 236 of the IA 86.

[14] See, for instance, sections 312 and 333 of the IA 86.

[15] See, for instance: https://www.cnbc.com/2021/01/15/uk-man-makes-last-ditch-effort-to-recover-lost-bitcoin-hard-drive.html

[16] Notable victims of hacking have been investors in Coincheck (with losses to the tune of $530 million in 2018), KuCoin ($275 million in 2018) and Bitmart ($200 million in 2021).

[17] For instance, in the Cryptopia exchange collapse in New Zealand, the New Zealand High Court held that cryptocurrencies were “property” under NZ law and that, on the facts, the exchange held cryptocurrencies on trust for its account holders.

[18] The Financial Services Compensation Scheme: https://www.fscs.org.uk/what-we-cover/banks-building-societies/

Articles by Brett Israel