Regulating the Wild West: Cryptocurrency and Non-Fungible Tokens

Since first launching in 2009, the cryptoasset market has exploded with an estimated value of more than $3tn at its peak in November 2021. This combines mainstream cryptocurrencies like Bitcoin, Ethereum and Tether with a growing market in Non-Fungible Tokens (NFT), amongst many other developments.

For those who don’t know:

• A cryptocurrency is an intangible digital currency where transactions are automatically verified and stored on a decentralised ledger, rather than being maintained by a third party, such as a bank or payment provider.
• An NFT is a digital asset, the ownership and prevenance of which is stored and recorded on a similar blockchain or decentralised ledger.

In both cases, a single transaction – either a sale or purchase of an NFT or a trade of cryptocurrency – appears as a link in the decentralised ledger, with a series of transactions, or links, forming a chain – hence the name blockchain.

Fresh off the heels of NFT NYC, a gathering of around 15,000 experts and crypto professionals in New York, interest continues to increase in what is a fast moving and developing industry.

It is not hard to see why the industry has also garnered the interest of insolvency professionals with:

• More than 200 cryptocurrencies currently trading with a market cap in excess of $100m – with Bitcoin leading the way with a market cap of over $400bn
• Over 2,000 cryptocurrencies failing since 2009, many of them linked to fraudulent business and investment activities
• Numerous noteworthy business failures and large scale frauds.

The recent collapse of TerraUSD has led to an exodus from the crypto market and a crash in the value of the majority of crypto assets, with some estimating that the market has reduced to $1tn, a loss of $2tn from the market peak in 2021.

This has led to growing calls for regulation, with Japan set to be the first country to create a clear regulatory framework for cryptocurrencies, and the UK and US likely to follow, with consultation ongoing.

With cryptoasset insolvencies only likely to rise in the coming years it is important for insolvency professionals to stay abreast of developments and the evolving legal and regulatory framework.

But where are we today?

Cryptoassets are property

After many years of uncertainty in relation to the ownership of cryptoassets and the extent to which they represent ‘property’, it is now clear that both Bitcoin and NFTs have been treated as “property” following High Court judgments seeking proprietary and injunctive relief associated with fraudulent activity.

Whilst the position is somewhat uncertain in relation to other cryptoassets, particularly as the market continues to evolve at pace, it is hoped that the High Court will adopt a similar wide approach.

As the UK Jurisdiction Task Force identified, the Insolvency Act 1986 (IA86) provides a significantly wider definition of “property” for the purposes of insolvency. This means that insolvency practitioners can operate from a position of strength and on the assumption that the cryptoassets form part of any insolvency estate.

Cryptocurrency as ‘currency’

While we can be quietly confident that cryptocurrency is ‘property’ in accordance with current guidance, more difficult questions arise as to whether cryptocurrency is ‘currency’ or a kind of ‘commodity’ with different jurisdiction taking different approaches. Notably:

• Pursuant to Skatteverket v David Hedqvist, the European Court of Justice determined that cryptocurrencies are ‘currencies’ for tax purposes
• Pursuant to HashFast Technologies, the US Federal Courts determined that cryptoassets should be treated as currency when determining value.

Although still in doubt, this does suggest a leaning towards a ‘currency’ status.

If that is the case, IA86 provides that claims denominated in “foreign currencies” will be converted to sterling at the exchange rate prevailing on the date on which the debtor entered insolvency proceedings.

Legislation is currently silent on claims relating to cryptoassets. Considering the volatility of cryptoasset markets, this issue alone has the potential to drastically affect the outcome for creditors with claims associated with cryptoassets.

It is likely that the position will need to be determined by Ips on a case-by-case basis to determine whether the insolvency process is best managed by realising the assets for distribution to creditors or, alternatively, as in the case of a special administration, to achieve the objective of protecting and returning client monies and client assets.

In those cases, the IP will need to have regard to:

• The nature of the insolvent entity and whether they are regulated by either the Prudential Regulatory Authority (PRA) or the Financial Conduct Authority (FCA)
• The extent to which they can control digital wallets, exchanges and other systems for the purposes of realising or transferring cryptoassets
• The extent to which cryptoassets and creditor interests are identifiable
• Where cryptoassets are being realised, how and when any assets or claims should be converted

Cryptoassets and tracing

In theory, the tracing and recovery of a cryptoasset is no different from other assets, in particular money transfers being traced electronically. If anything, the process is in fact simpler thanks to the technology underlying the blockchain, which creates a transparent and immutable record which cannot be altered or doctored.

This means that anyone can check the blockchain and trace the flow of cryptoassets, assuming they know how to read it and, more to the point, have the necessary specialist software.

In the majority of cases, any stolen cryptoassets will be held in one or more digital wallets. If you are fortunate, the company operating the wallet will hold documents for money laundering purposes helping to identify the perpetrators.

Even if this is not the case, the courts of England and Wales have already illustrated their ability to adapt to the technological challenges to ensure access to justice, with numerous cases ongoing against parties or persons unknown.

Recent Case Law Developments

D’Aloia v (1) Persons Unknown (2) Binance Holdings Limited and others

In D’Aloia v Persons Unknown, the High Court embraced blockchain technology and ordered that those proceedings could be served using an NFT on anonymous defendants linked to fraudulent activity, on the basis that they could not be identified.

Jones v (1) Persons Unknown (2) Huobi Global Limited (unreported, 29 June 2022)

In a case in which this firm acted, the High Court made a Prohibitory Injunction, Freezing Order and Bankers’ Trust Disclosure Order over a digital wallet containing $318mn of Bitcoin which was linked to theft and fraud.

Using specialist software, the theft was traced to a digital wallet operated by the Huobi exchange (headquartered in the Seychelles) which was prohibited from dealing with or distributing the Bitcoin, and was required under the terms of the order to disclose payment related information and the identity of the party who owned the wallet.

Ion Science Ltd v Persons Unknown (unreported, 21 December 2020) & Danisz v (1) Persons Unknown (2) Huobi Global Limited

Traditionally the courts have determined that the relevant governing law is the law of the place where the asset is located. Taking into consideration the virtual and moveable nature of cryptoassets, the courts have held and reaffirmed the position that the applicable law in such cases is law of the jurisdiction in which the person or entity which owns the asset is domiciled.

In a subsequent decision in the same proceedings in 2022 the court granted for the first time an interim third-party debt order in relation to cryptocurrency.

Cryptocurrency and cross-border

The nature of cryptoassets means that they may be impossible to deal with without their relevant account keys.

By way of an example, the Administrators and Liquidators of Dooga Ltd (trading as ‘Cubits’) reported throughout 2019 to 2021 that, although they had located the digital wallets containing the company’s cryptoassets and could verify transactions, they did not have the relevant account keys and could not therefore access or transfer the cryptoassets.

This may mean in similar circumstances that an IP will be unable to deal with any cryptoassets without cooperation from foreign domiciled individuals or entities, and that cooperation may or may not be forthcoming depending upon the parties and jurisdictions involved.

Key to any recovery effort is likely to be the extent to which foreign jurisdictions will render support or assistance to an IP based in the UK, where:

• A specific cryptoasset has been transferred across borders
• The nature of the blockchain is that it operates across all jurisdictions
• The parties to any dispute or legal proceeding are based in numerous different jurisdictions.

Although the courts of England and Wales have determined that cryptoassets are located where the person or entity which owns the asset is domiciled, it is likely that many other jurisdictions may determine that they also have jurisdiction taking into consideration other factors. IPs will therefore want to have regard to the other potential jurisdictions which might be relevant, and which might provide:

• Alternative enforcement options
• Assistance to a foreign registered officeholder

Existing cross-border insolvency laws already provide effective legal regimes for tracing and recovering assets across borders. This would include relevant cryptoassets.

The UNCITRAL Model Law (“Model Law”) in particular provides an IP, once proceeding are recognised, with a range of powers and remedies in countries where it has been enacted, which includes the US, Singapore and Dubai, amongst many others.

In many other jurisdictions where the Model Law has not been adopted, the courts regularly  render assistance to representatives of foreign insolvency proceedings – in particular commonwealth jurisdictions which follow English common law principles such as the Cayman Islands, British Virgin Islands and Hong Kong, who provide a range of proprietary and injunctive relief.

Conclusion

For those involved in cases involving cryptoassets, it is important to stay abreast of ongoing developments as the case law and guidance continues to grow.

Where crypto was once viewed as an asset often associated with fraud and other murky business practices, recent case law ably illustrates a growing range of enforcement options and strategies to assist an IP to fulfil their role to creditors.

There will be many more developments over the coming years and months as interest in the industry and market continues to grow, with the NFT London conference hitting our shores in November 2022.