Defining digital assets in insolvency proceedings

In turn, we are now beginning to see the implications of digital assets gradually being integrated into traditional financial systems.

Today, we briefly explore some issues relating to digital assets in the context of insolvency law.

Digital assets hold unique characteristics such as anonymity and decentralisation, which complicate their relationship with the legal system.

Likewise, digital assets do not fit neatly within traditional legal understandings of property. Are they money, security or some other form of an asset?

Digital assets are neither physically possessed nor do they constitute a chose in action (an enforceable right of ownership, eg, a money debt).

Ultimately, digital assets’ characteristics will impact their treatment in any insolvency proceeding.

An answer regarding whether cryptocurrencies are a “security” is pending in the US.

In 2020, the US Securities and Exchange Commission commenced legal proceedings against Ripple Labs Inc for raising funds through the sale of digital assets known as XRP. The SEC is seeking to establish XRP as a security. The outcome in this case is much anticipated.

The High Court in England has already grappled with the issue of characterising digital assets in a 2019 case called AA v Persons Unknown. AA was an English insurer of a Canadian insurance company.

In October 2019, the insurance company’s computer systems were hacked and encrypted, rendering its data inaccessible without the hacker’s password-protected software.

The hackers demanded $1.2 million in bitcoin — eventually haggled down to $950,000 — to provide the password; at the time, $950,000 was equivalent to BTC109.25.

AA paid the ransom within 48 hours and the data was decrypted. It took five days to decrypt 20 servers and ten days to decrypt 1,000 desktop computers.

AA engaged the services of specialist blockchain investigators to track the ransom payment on the blockchain, which is effectively a public register of every transaction in a given digital asset.

The investigators located 96 of the 109.25 bitcoins at blockchain addresses held by a digital assets exchange, which was named as a defendant in a claim for recovery of the digital assets.

The court considered the first and perhaps fundamental question in the claim to be whether bitcoins “are property at all”. If not, a claim for their possession would be bound to fail.

The court recognised that this “produces a difficulty because English law traditionally views property as being of only two kinds, choses in possession and choses in action”.

Demonstrating the flexibility of the common law, the court found that bitcoin was property, relying on the four indicia of property at common law, namely that bitcoin is definable; identifiable; capable of being assumed by third parties; and has a degree of permanence.

Nevertheless, jurisdictions and governments globally will not be able to arrive to a “one size fits all” decision regarding cryptocurrencies.

As digital assets are increasingly likely to be seen as assets in insolvency proceedings, creditors ought to demand that debtors disclose any digital assets, given these possess a market value.

Once debtors are compelled to disclose such holdings, the next phase of insolvency proceedings is enforcement. While there is strong precedent for the recognition of cryptocurrency as property, logistical enforcement issues remain.

Ownership of a digital asset is defined by public and private “keys”.

The public key is similar to an account number — this is what anyone can use to transfer cryptocurrencies to.

The private key is held by the owner of the cryptocurrency and is used for access and control.

In insolvency proceedings, a liquidator must obtain the private key before the digital assets can be considered acquired.

Digital assets are intangible; it is likely an uncooperative debtor may need to be coerced by the court to provide the private key to access the crypto wallet.

As there is no known public registry that discloses security interests over digital assets, it is the responsibility of the debtor to inform all parties involved that a security interest exists.

Finally, the volatile nature of digital assets may impact the insolvency process. For example, at the outset of insolvency proceedings, creditors may be in a strong position should the value of the cryptocurrency be high. However, values may easily reverse before proceedings end.

There has been a global rise in the number of insolvency proceedings involving digital assets. The current regulatory and legislative frameworks around the world must evolve to address all issues associated with such assets.

The courts, regulators and legislators will continue to play a crucial role in the future of digital assets, particularly in insolvency proceedings.

For its part, the Bermuda Monetary Authority is consulting on new digital asset business cyber-risk management rules and codes of practice.