Crypto assets in insolvency - key features and points to consider

Crypto assets in insolvency - key features and points to consider

Assessing assets: whats digital?

The so-called crypto-winter and associated high profile insolvencies of major players such as FTX, Three Arrows Capital and Genesis may have dampened enthusiasm for this new asset class in some quarters. However, while volatility is likely to be an ongoing characteristic in the short and medium term, it is probably better to view recent events as a period of market correction rather than the "beginning of the end" of crypto assets.

The future for a new class of digital assets

Crystal-ball gazing can be dangerous, but it seems likely that the coming years will see growth in this market as further innovative technologies and uses for digital assets develop. Many countries around the world are anticipating big opportunities and are competing to position themselves at the forefront of the market, with Hong Kong, the UAE, Singapore and others all aiming to create crypto-friendly environments.

Greater regulation, in part aimed at stabilising the market, is also on the way, not least in the EU with the anticipated introduction of the Markets in Crypto-Assets Regulation this year. In this country, the Treasury is consulting on extending the existing regime under the Financial Services and Markets Act 2000 to cover certain digital asset services (see HMT publishes consultation paper and call for evidence on regulatory regime for cryptoassets, LNB News 01/02/2023 49). Whatever form it takes, it is only a matter of time before regulatory systems catch up and many of the bigger players in the crypto world, with an eye on brand recognition and reputation, welcome this development.

Alongside this, a number of countries are considering the introduction of central bank-backed digital currencies. The Bank of England recently launched a consultation on the introduction of what has, almost inevitably, been dubbed Britcoin. China has already got there and is trialling a digital Yuan. If these projects take off, digital currency ownership and use is likely to increase exponentially.

As well as this activity at the national level, we have a generation of tech natives coming into the workforce who live their entire lives online and are increasingly comfortable with digital asset technology and the concepts behind it. The idea that a non-fungible token (NFT) of a designer handbag in the Metaverse can cost more than the real-world equivalent is far less likely to shock them!

So, what does this mean for legal, insolvency and asset recovery professionals? In short, it means that this class of assets will increasingly feature in the work we do and we need to upskill so that we understand it and can respond accordingly.

In an insolvency context, insolvency practitioners (IPs) need to be aware that businesses and individuals will increasingly hold this class of assets which can be used to try to hide wealth. On that basis, we would expect to see them cropping up in the anticipated wave of insolvencies in the near future. Therefore, it is important that IPs quickly identify and realise such assets and failure to do so could materially impact the return to creditors and potentially expose an officeholder to a claim by creditors.

The developing legal landscape

There has been a steady stream of crypto-focused case law from the English courts in the last few years, and our common law system has been forced to adapt to new ways of doing business. While much of this case law derives from fraud cases, the principles established have wider application.

Perhaps the most fundamental development is that the courts appear now to treat digital assets as property. The leading case here is AA v Persons Unknown [2019] EWHC 3556 (Comm). This was an uncontested interim hearing rather than a fully contested trial so, in theory, the matter is not definitively decided. However, further interim judgements have followed the same approach, both in relation to crypto currency and NFTs, and there are few in the legal world who expect the courts to depart from this view. It is also worth noting that the Law Commission has consulted on introducing a third category of property into English law (alongside things in possession, such as a bag of gold, and things in action, such as shares or contractual rights) to cover digital assets, to be known as "data objects".

Therefore, the debate over whether digital assets can be property is all but concluded. In an insolvency context, any transfers of digital assets could constitute a transaction at an undervalue, preference or transaction defrauding creditors under sections 238, 239 and 423 of the Insolvency Act 1986 (IA 1986) respectively. Transfers of this category of assets will therefore need to be investigated in the same way as any other disposal by a company or individual in the lead up to entry into insolvency.

The next question is that if digital assets are property, where is that property located? The asset does not have any physical presence and only exists as code. This issue was considered in the matter of Ion Science v Persons Unknown (unreported) 21 December 2020 (Commercial Court). The case involved a claimant based in England, fraudsters who claimed to be based in Switzerland and Bitcoin that was held on an exchange that originally claimed to be based in San Francisco but later held itself out as a decentralised organisation with no HQ location. In considering whether it had jurisdiction to hear the matter, the court held that the location of the assets is the residence or domicile of the person who owns it. So, while the assets might be held in a wallet on an exchange based in another jurisdiction, the assets themselves, for the purposes of English law, will be deemed to be in England if the owner is here. In the context of an insolvent company, where an English company holding crypto assets enters insolvency, the assets will be deemed to be held in England too.

Identifying digital assets

So how can digital assets be identified? The key principle to consider as digital assets become an increasing feature of insolvencies is "no key, no coin". 

Digital assets are generally accessed through wallets and there are several ways that these can operate. They could be hot or cold wallets, which simply means wallets connected to the internet or stored offline, either on a computer or other hardware wallet devices. They could also either be personal wallets or wallets hosted on an exchange platform, the latter being popular as it enables easy purchase of digital assets using bank or credit cards and access to trading services. Wallets tend to be controlled via public or personal keys; public being the wallet address (which can be shared with others) and the private (which only the owner holds) providing access to the wallet contents.

These keys will usually just be a long string of letters and numbers. If the private key cannot be identified, there may be no means to access the assets, hence the maxim above. However, some of the exchange platforms operate slightly differently and funds may be recoverable if access details are lost. Understanding how the assets are held is therefore of central importance.

IPs will also need to be aware that these assets, or signs of them, can be found almost anywhere when examining the company’s or individual’s books and records. This could include correspondence, financial records (especially where transactions are linked to exchanges), internet search history, a piece of paper or even a QR code. IPs should be mindful of any random strings of letters and numbers identified within the books or records (or miscellaneous QR codes) which may help to identify digital assets. Understanding digital assets (including how they can be held and accessed) will be the key to successful recovery.

Recovering digital assets

Once the existence of assets has been identified, an officeholder will usually need to obtain the private key to access and transact with them. In lieu of company directors’ cooperation in providing this information, an officeholder will need to consider initiating court proceedings to obtain it.

Requests for details relating to the private key could form the basis of an application under IA 1986, ss 234 or 236 to summon relevant individuals to court. These types of application take time however and risk the assets being dissipated in the meantime. The first step is to make a request for assistance under IA 1986, s 234 (or in the case of company directors, IA 1986, s 235) for information regarding the private key.

Where director engagement is not forthcoming, a section 234 request could be made directly to the crypto exchange holding the relevant asset (and, if assistance is not provided, an application could follow under IA 1986, s 236). Some of the larger players have shown that they are willing to engage with professionals seeking to recover or protect assets. Others are still operating in something of a "wild west" environment and may be less helpful.

Once the officeholder has control of the assets, consideration should be given to securing them, using the different methods of wallet holding, as summarised above. While it might be convenient to use a third party custodian such as an exchange, an offline "cold" wallet will be far more secure in preventing unauthorised access. Where cryptocurrency is insured, the officeholder will also need to ensure that they have complied with any security requirements stipulated by the insurer.

Investigating transactions

Given that digital assets are (almost certainly) property, any transfers could constitute a transaction at an undervalue, preference or a transaction defrauding creditors. Helpfully, blockchain-based digital assets leave an indelible record of transactions and with the right tools, tracing is possible. However, this comes at a cost and speed is of the essence, given that assets can be scattered at a click of a button.

Other barriers to tracing can be leveraged by those trying to hide their activities. For instance, with some exchanges, assets will go off blockchain so, while it is possible to see them going in, it is not always possible to see where they go once they’re in the exchange. For the technically savvy, there are tools such as cross blockchain crypto bridges which move assets from one chain to another and mixers, which are specifically designed to obscure digital asset trails.

The best way to guard against this sort of activity is to act as quickly as possible and, where appropriate, to engage asset-tracing and legal specialists to try to stop the assets disappearing. Freezing orders against persons unknown, to prevent assets being moved, and disclosure orders requiring exchanges to reveal identities of those who control wallets, have become relatively commonplace in crypto fraud litigation. A common feature in many of these cases has been the speed with which the wronged party has dealt with the matter. However, there will be many other cases which did not come before the courts due to the delay in taking action.

A practical solution for officeholders is available through IA 1986, s 236 by requiring the relevant exchange or custodian to provide the necessary information to identify the beneficiary. Where an antecedent transaction can be established, the court has discretion to order different forms of relief other than requiring the original property be restored to the insolvent company. This could include the transferee accounting to the officeholder for the benefit received in traditional "fiat" currency.

Valuing and distributing digital assets

The cryptocurrency market is highly volatile, and officeholders have a lot to consider when it comes to valuation and distribution. Such considerations include if and when to convert the cryptocurrency to fiat currency, potential consultation with creditors regarding options for distribution, including the possibility of an in specie distribution (ie transfer of the actual digital asset) which can give rise to apportionment issues where different tokens are held (akin to the issues upon holding more traditional multi-currency deposits).

The above is particularly key where there is a significant amount of cryptocurrency and that IPs do not rush to convert, but take time to consider and consult with an experienced digital asset management agency as to how best to proceed. While officeholders are not traditionally under a duty to "wait out" the market to maximise value, given the volatility of crypto assets, timing the disposal or distribution carefully will ensure they act in the best interests of creditors and help to safeguard against criticism. It is important therefore that IPs document all such decisions.

The legal landscape is rapidly evolving to adapt to this new class of digital assets as their popularity continues to grow. IPs will need to familiarise themselves with the peculiarities associated with crypto assets considering their growing prevalence. Officeholders will need to take swift and decisive action to identify and safeguard any crypto-assets upon their appointment to prevent dissipation, and consider the particular portfolio of digital tokens held when distributing to preserve value for creditors.

This article first appeared on LexisPSL R&I and is republished with permission and can be accessed here

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