Cryptoassets and Insolvency

Cryptoassets have been around for more than a decade, however they only became popular in late 2017 when the price of Bitcoin (BTC) almost reached $20,000.

Since this phenomenon, a plethora of different cryptoassets have emerged into the newly formed markets, causing uncertainty and panic amongst some business and investors.

A cryptoasset (or cryptocurrency) is a code or piece of software that utilises blockchain technology. The fact that it utilises blockchain technology is what separates cryptoassets from any other type of digital currency.

One type of typical digital currency would be that found in smartphone games. In these games, users can purchase in-game currency for their FIAT currency. Usually once purchased, these currencies are not able to be converted back to FIAT, nor traded or exchanged. In addition, this type of digital currency can be edited, much like a version of a Word document; the entity controlling the game can simply create more of the in-game currency.

In comparison, the way in which blockchain code is written and the software that overlays it means that an entry on the blockchain ledger cannot be copied or edited. This has the effect that the cryptocurrency cannot be copied, giving it an intrinsic value as there will only ever be a specific number of each type of cryptoasset.

Different cryptoassets are distributed, maintained and limited in their production in variety of ways, but for the purpose of this article, I will focus on BTC.

What are the characteristics of a BTC?

Firstly, the code in which the BTC is created and distributed is hosted on the BTC blockchain, which is publicly distributed. This means everyone that has a computer has the ability to download and run the BTC blockchain code and become part of the BTC blockchain. While the program is running, the program attempts to solve complex computer programs and if a “node” is successful in this endeavour, the owner of the computer, the node and the fundamental wallet, is rewarded several BTC.

The blockchain ledger that records all transactions is distributed wholly on all nodes of the blockchain; this gives everyone access to the ledger and all the transactions conducted within it.

If someone has their node/wallet, with a ledger entry of 1 BTC, they own 1 BTC. The person with 1 BTC in their wallet can then send their BTC to another wallet by quoting a different wallet’s public address or key. A public key looks something like this:

“5Kb8kLf9zgWQnogidDA76MzPL6TsZZY36hWXMssSzNydYXYB9KF”

 When a transfer occurs, all the blocks in the blockchain must verify that transaction. Once verified, an entry in the ledger is created which is present in every node on the blockchain and is viewable by the public. This is an important factor as it means you can view every single BTC transaction. However, it is almost impossible to trace a public key like above, to an individual.

This is an example of how BTC, a publicly distributed “payment” or “exchange” coin works.

J P Morgan for example are developing their own private cryptoasset which is proposed to be used to increase efficiency of transfers of wealth within the company. These transactions will be controlled by JP Morgan and not available for public viewing, as the blockchain will be privatised.

Cryptoassets and insolvency

When a company or individual (collectively the “Insolvent Party”) becomes insolvent, they may be in possession of cryptoassets. In this instance there are several factors to consider before a creditor pursues an Insolvent Party.

Possession 

 A creditor will want to have confidence that an Insolvent Party has assets that can be liquidated in order to meet the debt and that any assets the Insolvent Party may have are not dissipated. In this circumstance the creditor may want to take a charge over any property or ask the Insolvent Party to disclose the assets they are in possession of.

If the Insolvent Party discloses ownership of cryptoassets, it is important to obtain the following further information:
where is the cryptoasset stored? Is it in cold storage, on a computer wallet, or held by an exchange or third party;

  1. what the public key of the wallet is;
  2. how many cryptoassets are owned; and
  3. what the cryptoasset actually is.

This information can help the creditor track the value of the cryptoassets held by the Insolvent Party, enable them to track any dissipation, provide enough detail to trace cryptoassets and to help source evidence supporting an application to the court.

If the Insolvent Party claims they do not own any cryptoasset and there is little evidence that would lead one to believe they do, it would be quite difficult to determine if they do or do not own any. One avenue that could be pursued is an application to the court for third party disclosure order against a third party wallet provider, in hope they would have a wallet in the Insolvent Party’s name; this application will likely fail unless substantial evidence can be shown that the exchange would even have a wallet for a specific Insolvent Party.

If however, the Insolvent Party has disclosed that the cryptoassets are held with a particular wallet provider, this will be helpful as it means a creditor could apply for a third party disclosure order and to obtain further information that may not have been disclosed, such as a public key.

If the Insolvent Party has disclosed their public key, a cryptoasset tracing company can trace and view the cryptoasset holdings of a particular wallet, which can be monitored continually. If cryptoassets are dissipated from that wallet, a trace can easily be conducted to determine where they have been transferred to.

Value

 Once a creditor knows that an Insolvent Party has (for example) 100 BTC, the creditor can determine the public value of the cryptoasset on one of several exchanges. There is a price disparity between all exchanges, however the price remains largely similar.

However, if the Insolvent Party has 100 “XYZ” (a made-up cryptoasset for the purpose of this writing), this cryptoasset may not be liquid as the demand for it is low or it may not be publicly traded. In these circumstances, I would think about disregarding these cryptoassets as security as the chance of liquidating them is very low, unless a genuine private buyer can be found.

It is important to note that some exchanges may quote a price for a certain cryptoasset, however, they may only be able to sell a very small percentage of the cryptoasset for that price and not be able to sell the rest at all.

Protection

 Once determined if an Insolvent Party is in possession of cryptoassets of value, a creditor will want to make sure that those assets are not dissipated; one way in which this can be achieved is by way of a freezing order.

A freezing order is an order made by the courts to a party, ordering them not to deal with specified assets in a specified way; an application to the courts must be made in order for the courts to grant one.

It is important to note that an application for a freezing order will require the applicant to prove that there is a real chance that the specific assets they seek to be frozen are likely to be dissipated.

Generally speaking, assets can either be held and controlled by an individual, or held by a third party on behalf of the individual.

If a creditor is successful in their application for a freezing order over the liquid cash of an Insolvent Party; they can correspond with the bank holding assets on behalf of the Insolvent Party and request that the accounts are frozen. As the bank will not want to disobey the order, they will likely comply, and the Insolvent Party will find it very difficult to dissipate those assets.

If however, a freezing order is sought on a car in the possession of the Insolvent Party, there is very little from stopping that party from dissipating the car.

Nevertheless, it is important to note that breaching a court order can lead to a custodial sentence and therefore providing incentive not to disobey it.

These two circumstances can be applied to cryptoassets. If a third-party wallet provider or exchange holds the cryptoassets on behalf of the Insolvent Party, then a freezing order will likely be effective. If however they are held on the Insolvent Party’s own wallet, subject to breaching the order, they could dissipate the assets.

 

Thomas Hulme, is a Cryptoasset specialist at internationally-focused London law firm, Mackrell Turner Garrett

 

 

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