Cryptoasset Series - Part 4
Cryptoassets: Practical considerations in insolvency
The regulatory and legal framework for cryptoassets is still developing across both the UK and global markets. Whilst certain countries, and equally different organisations within each country, appear to be seeking to attract crypto businesses and advertising their jurisdiction as open to business, others appear more concerned with the potential customer harms that may arise. However, across all jurisdictions, regulation and legal frameworks are at early stage of their development and to some degree regulators appear to be sat in the stands whilst the business models and business uses of cryptoassets are tested in the real world.
As insolvency practitioners (“IPs”), we always see that no two businesses are the same and the issues encountered in one failure may differ significantly to those on another. Considering our extensive experience developed in working on some of the first financial insolvencies of their kind, such as Dunfermline Building Society being the first UK FS Special Administration, MF Global being the first Investment Bank Special Administration, Bank of Cyprus being the first EU Bank depositor bail in and most recently Viola Money being the first e-money Special Administration, we see some common practical issues as well as some novel issues that would be encountered when cryptoassets are held by the business that has failed.
In this article we review key practical challenges faced by insolvency practitioners when winding down crypto businesses, and in particular those businesses that hold cryptoassets on behalf of customers (e.g. brokers and exchanges).
IPs have a duty to safeguard the assets of the company and to distribute those to the creditors. Whilst cryptoasset transactions are typically open to the public gaze and therefore traceable (technology is evolving quickly to trace complex transaction web), the same does not apply to the wallets where the cryptoassets are stored. Many wallets are anonymised so identifying the true beneficial owner of an asset becomes more challenging. This is especially the case when some wallets are stored “off grid” such as USB sticks or other devices and there are no legal mechanisms to reveal the identity. If the wallet is stored with or via a standardised and domiciled crypto exchange then it is possible that identities of beneficial owners can be obtained via the courts.
So how do we identify intangible assets which may be of significant value, but simply held on a USB stick or on an employee’s phone? Knowing the questions to ask to both directors and staff, reviewing bank statements for large payments to crypto brokers/exchanges, seeking evidence of encryption keys, reviewing email and/or board minutes for crypto brokers/exchanges references and having a sceptical scrutiny in all your dealings with company staff can help when disclosure isn’t forthcoming.
Equally, IPs often rely on standard “task lists” and template documents to manage risks of running the insolvency. How many firms have gone through these template documents and updated them to include relevant questions regarding cryptoassets?
In the UK, if an IP requires more information, they are also able to use the powers set out in s.236 of the Insolvency Act 1986 to ask the court to summon a director or other relevant person to account for his dealings with the company, or produce any books, papers or other records in his possession or control, which could extend to disclosing their knowledge of cryptoassets owned by the company and/or the associated private encryption key.
Once identified, the cryptoassets need to be secured and stored whilst a strategy is developed – securing the assets is different to the officeholders’ normal strategies of changing the locks and listing the assets on the standard IPs’ insurance policy. Whilst specialist crypto advisers are available to support with this process, having forensic technology staff with the relevant experience is essential to ensure the cryptoassets are captured and secured at an early stage and specialist insurance policies may be required to cover the assets. Additional legal strategies may be required when technical expertise cannot reach those wallets stored offline.
To date the largest crypto business failures have mostly been those of crypto exchanges. For crypto exchanges, we have seen that maintaining the business’ IT infrastructure is critical. The exchange IT team is likely to be critical to safely recover these assets, albeit their utility is limited to the extent they continue to be available, co-operate and can be trusted. As we have experienced across insolvencies, being able to identify at an early stage which staff are critical, developing close working relationships with the staff and putting appropriate incentive programs in place maximises the chances of successful outcomes. However, having staff with the technical expertise within the officeholders’ team is also critical in order to be able to understand the risks, identify the key staff and oversee both the IT system maintenance, decommissioning and specialist projects (i.e. transfer or distribution of assets, claim portal etc) that are required in an insolvency.
Crypto businesses continue to rapidly develop their business models with ever changing novel products, not just the cryptocurrencies offered, but also derivatives or the latest trend (perhaps “yield-farming” and “staking”, in which customers seek to earn interest on their cryptoassets). Using and holding cryptoassets in this manner adds complexity for the officeholder when determining what assets are held by the Company and who are the customers that need to be notified of the appointment. Whilst CASS rules and annual CASS audit requirements in the UK have given a solid basis and a well-practised methodology for performing this analysis should an investment bank fail, there may be no such user knowledge or standard practise for performing reconciliations at crypto exchanges for an officeholder to rely upon. Equally, negotiating the close out of trades and the return of funds from third party exchanges is likely to create significant complexity with the rapid growth of these products.
For a crypto exchange, a key legal issue to resolve is likely to be who is the beneficial owner of the cryptoassets. Does the exchange hold cryptoassets on trust for the customer, or is the exchange the holder and the customer simply as a creditor claim? There are no standard terms and conditions for the sector to operate to, businesses have grown rapidly and may have amended the terms and conditions over time, particularly as business models and the technology offerings have evolved, and the position may differ between types of cryptoassets and whether the customer holds them in hot or cold wallets. This issue will have to be considered on a case-by-case basis and may not be clear, but the treatment can create significantly different outcomes for customers. If deemed a segregated asset, the normal practise will be for the cryptoassets to be returned to customers, albeit the officeholder will likely need to consider the pooling of cryptoassets and at what level (i.e. pool for all crypotassets vs each type of cryptoasset or as held at specific points in time). In comparison, if deemed non-segregated, the officeholder would look to liquidate the cryptoassets and distribute fiat currency to all creditors, both customers, trade and other creditors. On MF Global, we saw a large number of customers dispute whether their claim was a segregated or non-segregated claim.
Should the cryptoassets be treated as non-segregated assets, challenges may also arise from the conversion of claims into a single currency as at date of insolvency. The UK Insolvency Rules 2016 require that the IP converts all debts incurred or payable in a foreign currency into sterling at a single rate determined by the IP by reference to the exchange rates prevailing on the date of the relevant company's insolvency with reference to the Bank of England (“BoE”) spot exchange rate. There is no BoE equivalent for cryptocurrencies and therefore customers may dispute which exchange price to apply for cryptocurrency valuation purposes, particularly with less liquid cryptocurrencies or should there be significant price movement as a result of the insolvency event.
A number of failures of crypto exchanges have been as a result of cyber-criminals stealing cryptoassets, which are likely to create shortfall in certain pools. The IP would need to perform tracing activity to identify the cause of any shortfall. To the extent that the relevant assets can be located as being held incorrectly outside the pool, the IP may be obliged to transfer the assets back into the relevant trust pool. Through our work on MF Global, we obtained directions for the legal basis and calculation of shortfall claims where a user does not receive the return of their client assets in full and pursues a shortfall claim (unsecured creditor claim) against the house assets. A similar shortfall claim would be expected to arise here although parties may dispute the basis of its calculation (particularly if the house estate has significant funds).
For those customers where their cryptoassets are being held on a trust or segregated basis, it may come as a surprise to understand that in an insolvency, the Berkeley Applegate principle means that costs in handling and distributing those crypotassets are typically borne by the customers – agreeing the quantum of costs and how the payment is made (i.e. should customer pay their portion of costs to the officeholder, prior to having their cryptoassets distributed or would a portion of each customer’s crypotassets be liquidated and withheld by the officeholder) will be a challenge for the IP to consider.
Dealing with customers – crypto exchange
IPs will be required to comply with AML regulations – the reviewing and sample testing of the company’s policy and processes may provide sufficient comfort, or alternatively the officeholder may deem it necessary to re-perform the work. Concerns in this area may also make it difficult to achieve a bulk customer book transfer, an outcome that can often maximise value.
With a crypto exchange, dealing with customers is likely to be a significant workstream, particularly if there is a large volume of relatively unsophisticated retail individuals. With no FSCS protection, the timing of making payments to customers and levels of recovery are likely to be slower and lower. Developing plain English communications, potentially in various languages and with good FAQ, will likely reduce the number of queries and therefore costs in handling customer enquiries.
Equally the development of a claims portal or adoption (and adaption) of the customers own systems for the purpose of communicating with creditors to deal with a large volume of claims will be essential.
As ever, there will be non-responsive or inactive customers, and the necessary attempts and form to contact them will have to be considered, balancing cost versus fairness.
Many claims have been made about cryptoassets being the assets of choice for criminals due to the pseudonymity that they can offer. However, as the market value of cryptoassets has increased, the value of cryptoassets that are being traced and recovered is growing year on year.
IPs would need the cooperation and support of exchange platforms, specialist software that analysis the distributed ledger data and forensic experts to investigate crypto transactions. The tracing exercise may prove to be expensive in an insolvency as most exchanges operate in different jurisdictions and strategies such as mixing chain hopping and privacy coins can make recoveries more challenging. Given that the expenses of an insolvency rank above, for example, unsecured claims, it may be a difficult exercise to balance the benefit of this exercise for the wider body of creditors with the potential downside risks for them.
Reporting on the conduct of the directors of a company prior to its insolvency would also prove challenging. Crypto businesses are often decentralised organisations, governed by a body of rules as opposed to being managed by a small group of people. The open nature of the blockchain means that cryptoasset activities and governance are democratised and carried out by its user base rather than being carried out by the entity itself. As such, it may prove challenging to take action against the directors and seek remedies that may have added to the insolvent estate.
There is no special administration regime in the UK for crypto exchanges, therefore whereas other FS business failures can rely on an appropriate special administration regime, any officeholder appointed over a crypto business is likely to be required to obtain court orders to resolve many of the issues identified.
Whilst there are significant practical and legal challenges posed by cryptoassets, the experience of dealing with failures of brokerage businesses and other FS insolvencies will help to guide IPs when determining how to realise and distribute this asset class.
This article was first published in INSOL World Q2 2022 edition.