There has been no shortage of high-profile insolvencies in the crypto market in recent months across a range of market participants and geographies. These include the US Chapter 11 and Bahamas provisional liquidation of FTX as well as the US Chapter 11 filings of BlockFi, Singapore-based crypto hedge fund ThreeArrows Capital, US-based lenders Celsius Network and Voyager Digital, US-based crypto mining data centre Compute North and German crypto bank Nuri. While the number of insolvencies poses questions about the risk management and governance of crypto businesses, below we address what it means legally and practically for users, lenders and other market participants when a crypto custodian falls into distress and even an insolvency process.
CRYPTOASSETS AS PROPERTY
Much ink has been spilled in the last few years on the question of whether the assets of a crypto business are capable of being treated as property. This, of course, is a key question for customers and creditors facing the prospect of a counterparty's insolvency. In short, the English law answer seems to be 'yes' – cryptoassets are property in the ordinary legal sense. AA v Persons Unknown and others  EWHC 3556 (Comm) (considered here) and Ion Science Ltd v Persons Unknown (unreported, 21 December 2020) (commented on here) held that cryptocurrencies are a form of property capable of being the subject of a proprietary injunction. This view has been extended to non-fungible tokens in Lavinia Deborah Osbourne v (1) Persons Unknown (2) Ozone  EWHC 1021 (Comm) (considered here). This analysis is relevant to the availability of proprietary tracing. Judge Pelling QC has expressed an opinion (albeit in the context of fraud claims) that this direction of travel is likely to continue. The UK Jurisdiction Taskforce (UKJT) has taken the view cryptoassets are property for the purposes of the Insolvency Act 1986 (IA 1986). As considered in further detail below, the Law Commission has also published a consultation on recognition of digital assets which considers issues around the legal categorisation of cryptoassets. However, some uncertainty remains pending substantive judicial determination or legislative reform on this issue.
JURISDICTION AND GOVERNING LAW
Jurisdiction is another key question in the context of cryptoassets, but particularly in the event of distress and insolvency. Establishing the jurisdiction of the English court in proprietary claims to cryptoassets held by insolvent businesses will likely require consideration of where those assets are located. The location can be difficult to determine given cryptoassets usually operate in a decentralised way, often with offshore structures and minimal local presence. They do not have a physical presence in the traditional sense, and transactions can involve servers and software operating in multiple jurisdictions. Challenges will likely arise in cross-border insolvencies where creditors across countries could seek to commence proceedings in different jurisdictions. These complex issues of cross-border insolvency and comity are yet to be explored fully in different jurisdictions and could potentially lead to scrambles for assets. These issues could also be of critical importance given the differences in legal and regulatory regimes in different jurisdictions. Recent English case law indicates it is the domicile or the residence of the person or company owning the coin or token which determines the location of the cryptoasset which is relevant to the court's jurisdiction and the applicable law. Again, there remains some uncertainty in relation to this analysis, not least as to what ownership means in the context of cryptoassets. The conflicts of law rules applicable in other jurisdictions may, of course, be different.
At least one exchange has publicly stated that creditors will only have an unsecured contractual claim in the event of an insolvency, meaning customers will be at risk."
CLAIMS INTO INSOLVENT CRYPTO ESTATES
The potential for theft and difficulties with tracing fraudsters are well known risks of dealing with cryptoassets and are fast becoming the subject of increased regulatory scrutiny. In the context of insolvency, a risk for investors is cryptoasset custodians not offering deposit protection if they do not have sufficient assets to meet their liabilities to their users. How losses are allocated would depend on the business' terms and conditions and their operation in practice. At least one exchange has publicly stated that creditors will only have an unsecured contractual claim in the event of an insolvency, meaning customers will be at risk. Other market participants may have arrangements in place which purport to back deposits in a way that allows unlimited withdrawals, even in insolvency, and gives protections to customers in an insolvency context. If a crypto custodian enters an insolvency proceeding, the allocation of losses will be dependent on the legal nature of the custody facility and the rights granted to users under it. If the facility is purely contractual, then users will have no proprietary rights of recourse to any specific cryptoasset retained by the insolvent estate but will instead rank as general unsecured creditors. However, where cryptoassets (or entitlements to them) are subject to a trust but held on an unallocated commingled basis for the benefit of multiple parties, there is uncertainty as to the correct approach to apportioning shortfall losses among such parties under English law. For pools subject to substantial volumes and high frequency of transactional activity, it has been argued courts should allocate losses among all affected participants on a proportionate (or pro rata) basis, particularly where the application of traditional tracing rules to determine the appropriate distribution of losses would be unduly complex. But, unless there has been an express affirmation of a pro rata apportionment of shortfall losses, there is the possibility certain creditors could seek to recover using traditional tracing rules adopting the rule in Clayton's case or a 'first in, first out' approach. From an English law perspective, we understand this has not yet been tested in the crypto context. In the event of a custodian insolvency, the Financial Services Compensation Scheme will not provide compensation because claims against crypto custodians would not fall within its remit (as noted by the Law Commission).
INSOLVENCY OFFICEHOLDERS' CONTROL OVER CRYPTOASSETS
Cryptoassets generally require private cryptographic keys to access the wallet the assets are stored in and transact with such assets. More complex arrangements may have multiple private keys such that several entities share control over the asset. To gain control over any cryptoassets in the insolvent estate, insolvency officeholders will need to access these keys, either through the insolvent business' co-operation or by initiating court proceedings. The UKJT has previously taken the view a private key is information (as opposed to property). An insolvency practitioner should therefore be able to apply to the court to summon relevant persons under section 236 of the IA 1986; although doing so formally would be time-consuming and could risk the dissipation of assets in the meantime. The court may require such persons to produce books, papers or other records (presumably including information regarding private keys) in their possession. If cryptoassets are property, then it should be possible for officeholders to demand delivery up of such property under section 234 of the IA 1986.
A significant issue in the insolvency of a large crypto exchange is likely the quantity of creditors with claims against the company: it has been reported the number of creditors of the FTX estate may surpass one million."
VALUE OF THE DEBT AND DISTRIBUTION OF PROCEEDS
Lenders advancing loans in cryptocurrency bear the risk of the fiat currency value of their debt fluctuating. For example, the US dollar value of a loan advanced in Bitcoin in November 2021 would have been significantly higher than at today's date and would likely fluctuate during the pendency of insolvency proceedings. What does that mean for the orderly resolution of insolvency proceedings? Insolvency practitioners and courts will have much to consider, including: the point in time the debt should be valued; how the entitlement should be distributed (ie, in cryptoassets or fiat currency); and how to distribute any excess and apportion any loss as a result of a decrease or increase in the fiat currency value of a debt. Again, these issues are yet to be handled by an English court. An interesting question would be whether the English court would follow in the footsteps of the High Court of the British Virgin Islands which, in a liquidation order for ThreeArrows Capital, held that the liquidators would be entitled to convert any cryptocurrencies into US dollars or into USD coin (USDC) or Tether (USDT) to safeguard the value of the company's assets from market volatility. It classified USDC and USDT as being cryptocurrencies pegged to the US dollar, which has caused debate. As has arisen in the context of the FTX bankruptcy, a significant administrative issue in the insolvency of a significant crypto exchange is likely to be the quantity of creditors with claims against the company: it has been reported the number of creditors of the FTX estate may surpass one million.
AVOIDANCE OF TRANSACTIONS
In certain cases, insolvency officeholders may seek to exercise their powers under the IA 1986 to unwind certain transactions in the run up to a company's insolvency. This includes those amounting to a preference, those made at an undervalue and those defrauding creditors, with a view to maximising the pool of assets available to creditors. Since cryptoasset transactions are not straightforward to trace and beneficiaries may remain anonymous, identifying these transactions may require insolvency officeholders to seek assistance from technical experts and obtain from the court injunctions against unknown beneficiaries or information orders against cryptocurrency custodians. There may also be practical difficulties with reversing transactions once they are permanently recorded on the blockchain. Such steps may not be practical in every circumstance given the time and expense involved.
TAKING SECURITY OVER CRYPTOASSETS?
When advancing finance, lenders may wish to take cryptoassets as collateral for the loan. The Law Commission has noted that creation of collateral by transfer of ownership, such as mortgages and charges, should work for cryptoassets as it does for other property. Against that, the Law Commission has expressed the view that cryptoassets may not be capable of being "possessed", but instead are subject to "control". This suggests possession-based arrangements such as pledges and contractual liens cannot be created for cryptoassets. These are not definitive legal statements, so some uncertainty remains in this analysis. As it stands, there is no tried-and-tested method of taking security over such assets as there is with other assets. This may give rise to some risk, particularly where cross-border issues arise.
UK LEGAL REFORM
In response to market distress, in May 2022, the UK Treasury introduced a consultation for law reform to manage the failure of systemic digital settlement asset (DSA) firms, including stablecoins. Stablecoins are cryptoassets whose value is pegged to other assets, with a view to maintaining price stability. The consultation recognises that there is uncertainty in respect of the regime that applies in case of failure of a DSA firm and proposes for this to be the Financial Market Infrastructure Special Administration Regime (FMI SAR) as opposed to the Payment and E-Money Special Administration Regime. It does so on the basis the Bank of England (BoE) rather than the Financial Conduct Authority should be the lead regulator in these instances, and the objective should be the continuity of operations of the DSA. The Treasury also proposes modifications to the FMI SAR as applicable to DSA firms, such as an additional objective covering the return or transfer of customer funds and private keys and empowering the BoE to direct administrators on which objective should take priority. The consultation closed on 2 August 2022 and public feedback is now being analysed. The Law Commission also published a consultation in July 2022 on recognition of digital assets in the law of England and Wales (our summary of the Law Commission's position is available here). Most significantly, the Law Commission has proposed the creation of a third category of personal property (beyond "things in possession" and "things in action") called "data objects". The proposal sets out three criteria for identifying a data object:
- - Be composed of data represented in an electronic medium, including in the form of computer code, electronic, digital or analogue signals.
- - Exist independently of persons and exist independently of the legal system.
- - Be rivalrous. This means something which cannot be used by others in an equivalent way simultaneously. However, this is not intended to mean that it is unique or non-fungible. Finding a way to make electronic data rivalrous, when it can otherwise be reproduced near-infinitely at close to zero marginal cost, is a key innovation of blockchain technology.
The Law Commission has also suggested reform to clarify what would happen if there was a trust over pooled assets in insolvency. It has proposed statutory reform modelled on the Investment Bank Special Administration Regulations 2011 – adopted in response to the Lehman Brothers International (Europe) insolvency – which provides for pro rata allocation of shortfall losses where assets are held in a pooled multi-client account. Legally, this would be on the basis that beneficial interests in commingled holdings are co-ownership rights under an equitable tenancy in common. The outcome of this consultation is awaited.
With continuing distress in the crypto sector, it seems highly likely that we will see further developments and clarifications of insolvency laws across jurisdictions. Market participants will be watching keenly to understand what this means for them.