Cryptocurrencies, and decentralized finance more broadly, have been attracting an increasing number of investors seeking alternatives to traditional fiat money.
The digital finance industry has experienced massive growth but markets remain largely unregulated and the industry continues to weather short-term volatility, as evidenced by the most recent downturn which erased $2 trillion in value in a matter of months. The unpredictability of cryptocurrency markets inevitably precipitates crypto-related lawsuits, fraud, and judgment debtor evasion.
Bad debtors who don’t want to pay may choose to store their liquid assets as digital assets as a way of putting them beyond the reach of creditors and stymieing any potential recovery. This is a common mechanism for hiding assets following a successful judgment or award. After pursuing a costly, time-consuming dispute, the last thing a claimant wants is to commit even more resources to chasing a defendant who refuses to pay a judgment after being defeated at trial.
Contending with a recalcitrant debtor or sophisticated fraudster who is hiding wealth in digital currencies may seem like a dead end. However, while digital assets cannot be seized in the same way that physical assets can, they may still be recoverable with expert help. Finding a path to recovery requires expertise, investment and creative problem-solving. Funded asset recovery can enable clients and law firms to recover judgments and awards, without adding cost and risk to corporate balance sheets.
Understanding an unregulated, dynamic market
The digital asset market comprises not only cryptocurrencies, such as Bitcoin and Ethereum, but other types of assets—including non-fungible tokens (NFTs), whose rapid and widespread adoption has catapulted into the mainstream. By way of example, the volume of trading on OpenSea, the largest NFT marketplace, reportedly grew from $28 million in 2020 to $14.4 billion in 2021.
Although NFTs are by far the most high-profile digital assets, they represent only one category of a fast-growing market that is already challenging legal notions surrounding ownership, value and jurisdiction within the context of Web 3.0.
Digital assets are becoming increasingly popular in the commercial world, too. Institutional investors and big banks are vying for first-mover advantage. JP Morgan has unveiled its JPM Coin, designed to allow payments using blockchain technology, while Goldman Sachs recently issued its first-ever Bitcoin-backed loan. As adoption grows, so will the sophistication of institutional crypto financial products.
Cryptoassets are typically difficult to recover against. They often rely on encrypted, decentralized ledgers to record all transactions securely. Despite the pseudonymous nature of blockchain, there is a good deal of transparency baked in that should, in principle, make cryptocurrency transactions relatively easy to trace. Enforcement, however, has been historically difficult for several key reasons.
Domestic laws do not apply
Some of the largest crypto exchanges in the world are corporate nomads that move with the prevailing regulatory wind, almost emulating the decentralized nature of the assets in exchange. This opaqueness and everywhere-and-nowhere approach to corporate structuring poses jurisdictional challenges for those seeking disclosure and damages.
As a result, legal avenues to relief are being tested constantly. In England and Wales, for example,there is growing use of Norwich Pharmacal court orders against crypto exchanges.
Decentralized exchanges also make it hard to establish jurisdiction and determine applicable protection laws for investors. For instance, a US federal judge recently dismissed a New York class action suit against Cayman Islands-registered Binance on the grounds that it was not a domestic exchange, and as such, that domestic securities laws did not apply.
Ownership is difficult to prove
The absence of regulatory oversight in most jurisdictions means the identity of cryptocurrency wallet owners—the holders of the funds—can be difficult to determine. Ownership can be further obfuscated by the use of cryptocurrency mixers, which combine (CoinJoin) different streams of potentially identifiable cryptocurrency, thus complicating any tracing exercise.
Most notably, the Ethereum mixer Tornado Cash was recently sanctioned by Office of Foreign Assets Control for its role in laundering half a billion dollars in stolen funds. Recent analysis suggests that close to one third of the $7.6m that has mixed in the tornado cash since its inception in August 2019is tied to illicit parties, such as hackers.
Digital assets are hard to classify legally
Courts, tribunals and regulatory bodies are still determining how to enforce judgments against digital assets. Although the courts are beginning to define cryptocurrencies and how they are to be dealt with, regulators face similar challenges around classification.
For example, if Ripple’s cryptocurrency XRP is classified as a security, as the Securities and Exchange Commission (SEC) contends, Ripple should be registered under the Securities Act and make disclosures accordingly. However, Ripple has been arguing that XRP is a commodity, which means it would eventually come under the jurisdiction of the Commodities and Futures Trade Commission (CFTC).
Despite the reliability and traceability of the ledgers, cryptocurrency is not a physical asset that can be seized in the traditional sense. It cannot be confiscated in the way that land, machinery, buildings, tools, vehicles or other forms of material economic resources, can.
Digital assets are hard to value
Because the value of cryptocurrency is dependent on an often-volatile market, courts have had difficulty ascertaining how to value cryptocurrency. The recent decision in Tulip Trading Ltd v Bitcoin Association illustrated this point perfectly. In that case, the court found that security for costs could not be satisfied by a party providing cryptocurrency, as its high volatility could result in any security being effectively valueless. The recent economic downturn has added further weight to the volatility argument.
For all these reasons, it helps to work with a team of judgment enforcement specialists to source and recover crypto assets. Although enforcing against digital assets can be difficult, an expert asset recovery team can incorporate digital assets into an overall enforcement strategy to lead to new third parties, offshore accounts, previously undisclosed bank accounts and domains outside of the jurisdiction.
Cases bring clarity over judgment creditors’ position
Several recent developments have had implications for asset recovery practitioners and judgment debtors regarding cryptocurrencies, decentralized finance and digital assets. In a series of recent cases, courts in multiple jurisdictions moved step by step toward the recognition of cryptocurrency as property.
In 2020, the High Court of England and Wales in AA v Persons Unknown endorsed analysis claiming that cryptocurrencies are a form of property capable of being the subject of a proprietary injunction. Following this precedent, the British Virgin Islands in Joint Liquidators of Torque Group Holdings Limited (In Liquidation) v Torque Group Holdings Limited (In Liquidation) similarly held that cryptocurrency assets were property for the purposes of liquidation under the BVI Insolvency Act 2003.
Similar decisions have been made in various other common law jurisdictions, including New Zealand, Australia, Singapore and the US, and more, recently China. These decisions mean that individuals and businesses may be able to obtain an injunction to freeze cryptoassets in common law jurisdictions and that orders may also be made for relevant exchange to identify the account holders.
In the UK, the Law Commission recently provided guidance on this issue by proposing that digital assets be considered a separate category in English property law, which may bolster claimants’ powers of recourse. In another significant milestone, in 2021, English courts were asked to consider the lex situs–law of the state where assets are located–of cryptoassets. In Fetch.AI Ltd & Anor v Persons Unknown Category A & Ors, the court reconfirmed the findings in Ion Science Ltd v Persons Unknown that, as property, cryptoassets were situated where the owner is domiciled.
This was a welcome confirmation of an emerging point of law, particularly given the potential form is appropriated cryptocurrency to be rapidly dissipated across a myriad of jurisdictions. The development also relieved claimants of the burden associated with tracing where cryptoassets are being held, particularly if the assets have been shuffled around.
The US and UK courts have taken a remarkably robust approach when dealing with digital assets other than cryptocurrencies, such as NFTs. Over the past year, both courts granted orders permitting service of court proceedings via token transfers on the blockchain, embracing technology in circumstances where claimants are pursuing unknown defendants. In Osbourne v Persons Unknown, the court ruled that NFTs were to be treated as property as a matter of English law.
In addition, all these developments have shown that the courts are increasingly willing to assist victims of crypto fraud. There are also signs that this inclination may soon be enacted into legislation. In September, the Economic Crime and Corporate Transparency Bill was introduced to parliament in the UK, aiming to amend the Proceeds of Crime Act to support law enforcement efforts to recover digital assets. The same week, the White House released the first ever federal digital assets framework, setting out how government authorities should adopt and regulate cryptoasset technology.
Enforcement expertise is key
Despite the widespread adoption of digital assets, we are yet to witness a huge uptake among recalcitrant debtors hiding substantial amounts of their wealth. This is because cryptocurrencies are inherently risky, prices fluctuate daily, and protocols collapse without warning. In light of this, traditional stores of wealth seem to remain preferable for the time being–even for bad actors.
But as uptake and acceptance continue to increase, we can expect a corresponding rise in crypto fraud and the use of digital assets as a way to hide funds and evade international sanctions. While enforcing judgments in the digital asset space comes with its own challenges, the help of experts in asset recovery will be precious to creditors looking to recover lost funds.
This article was originally published in IFLR here.