Crypto – Is It Still ‘Buyer Beware’?

Not a day goes by without there being a discussion on corporate Zoom calls or in the press about cryptocurrencies. For better or worse, these blockchain-based systems have caught the public imagination in a way that feels not dissimilar to the UK property boom of the late 1990s and early 2000s.

Views on politics and capitalism are more divisive now than they have ever been and cryptocurrencies (crypto) are sometimes viewed as a means of circumventing traditional banking systems. For instance, if you want to transact in US dollars, it has to be done via one of the intermediary banks in New York. This makes your transfers traceable. Previously, some felt crypto was an untraceable alternative, unaware of how the blockchain operated. They felt it was a way to transact anonymously. But crypto exchanges are now sharing their KYC information with tax and law enforcement authorities in certain jurisdictions. In fact, this is becoming an increasing tool in litigators’ armoury, as noted by the recent guilty plea in the US by a crypto firm which evaded taxes^[i].

The fascination with cryptocurrency is perhaps still best illustrated by Bitcoin, the best-known from around 6,000 cryptocurrencies in operation today. In 2010, you could have purchased a single Bitcoin for around 10 US cents. While the value of the asset is extremely volatile, in October 2021 that same Bitcoin hit an all-time high of circa US$66,000 before falling back to sub-$60,000 just days later. To put Bitcoin’s meteoric rise into context, purchasing just US$10 dollars of Bitcoin 11 years ago would now make you a millionaire, with your US$10 investment worth US$6,600,000 at Bitcoin's all-time high. Meanwhile, in November the cryptocurrency market soared to an all-time high, reaching a market cap of US$3 trillion. No wonder that more and more investors, both institutional and retail, are jumping on the bandwagon of every new initial coin offering.

Crypto is no longer just an anti-establishment asset, however. Digital currencies are racing at an almost unforeseen pace towards becoming mainstream assets. In their wake are a diverse and vast number of other digital assets. Even social media giants such as Facebook have got in on the act with the recent launch of its Novi digital wallet (albeit without a long-promised Diem cryptocurrency which was supposed to be a cornerstone of the enterprise), to 200,000 users in the USA and Guatemala, designed to benefit from the lucrative remittances market.

Such are the opportunities presented by digital assets, the UK government is investigating its own “Britcoin” option (not to be confused with the delisted Britcoin that exchanges dropped in 2019). The attractions of government-backed digital currencies are obvious. With the push to a cashless society, a digital currency would make tax evasion harder than when dealing with cash. It would also allow any government to follow the historic movement of payment through exchanges.

Ironically, digital currencies could become the most secure means of government monitoring and, importantly, a means of proper tax revenue collection from citizens and corporations^[ii] and could go hand-in-hand with the new minimum global corporation tax recently agreed by almost 140 countries.

Done correctly, it is not hard to imagine information being shared electronically between nations in real-time rather than specific requests being required. This example goes a step further from merely accepting an existing digital currency as legal tender, as El Salvador has done recently with Bitcoin. Any government will want to learn from El Salvador’s lessons, following street protests and the country’s digital Bitcoin wallet Chivo removing a pricing feature that allowed users to make rapid profits on trades^[iii].

With government backing, there is no reason why ‘cash’ will not become a relic of the past and we will all be using traceable digital currencies. Either way, the growth of Bitcoin and other currencies suggests crypto is here to stay. What will be key for longer term success – and building investor confidence – is preventing wild swings in value. If retailers accept crypto for purchases, they can't face the risk of a sudden collapse in value that, if sustained for several months, could lead to a slew of insolvencies in small and medium enterprises.

The Basel Committee on Banking Supervision has recently said that it is deciding how much capital banks should be required to maintain if they hold Bitcoin and other crypto-assets.

It plans to hold banks that have exposure to volatile cryptocurrencies to stricter capital requirements than other asset classes. The group has proposed that lenders should hold the equivalent amount of capital to their exposure to crypto-assets.

It is also important to remember that converting crypto into fiat, depending on the jurisdiction, may lead to a capital gains liability or similar taxation issues. In the UK, the revenue service HMRC is focusing some of its energy on investigating crypto asset realisation gains. It was recently reported that “nudge letters” would be issued to those that were suspected of holding cryptocurrencies^[iv]. This follows on from HMRC, as well as the IRS in the USA seeking information about crypto asset holders from exchange providers. In the US, there have even been calls for capital gains taxes to be levied on unrealised gains.

As with every asset, there are those who will utilise crypto for nefarious purposes. With asset recovery being central to our firm's work, we have no doubt that we will see an increase in fraud surrounding digital assets. The key in these situations is to move quickly to trace and prevent further movement of the assets.

One fraud involving a supposed cryptocurrency – OneCoin – was dramatically exposed in the excellent BBC podcast series by Jamie Bartlett, The Missing Cryptoqueen. This fraud had all the hallmarks of an old fashioned Ponzi scheme packaged for the digital world, simply replacing “crypto” for certificates of deposit or share certificates. Many were drawn in by the supposed fabulous returns promised by OneCoin’s founder, Ruja Ignatova. US authorities estimate some US$4 billion was taken in from people around the globe. Some may call out investors’ greed here or their naivety but many who lost their money – in a scheme which was aggressively promoted – could only afford small sums. Similar to pyramid schemes of the past, crypto fraud often preys on the most vulnerable in society. The mania surrounding some crypto offerings certainly seems to have echoes of historic ‘bubbles’ such as Tuilipmania, the South Sea Company bubble, and the Mississippi Company land fraud.

Then there are those who wish to use crypto in order to launder their ill-gotten gains. What better place to store untaxed or illegally-earned funds than a crypto wallet? Depending on who you believe, some consider cryptocurrencies to be a significant means of transferring terrorist funding^[v]. We are increasingly seeing signs that cryptocurrencies form part of fraudsters’ toolsets in dispensing large sums of ill-gotten gains. However, if this asset class price continues to increase, which many predict it will, it may be good news for creditors who may be able to make a greater-than-otherwise recovery.

Regardless of the reasons for purchasing crypto, it’s essential to make sure not to lose the seed phrase or private key if they are stored on a hardware wallet.^[vi]  Alternatively, if you store your crypto on an exchange, you run the risk of it being stolen or lost.^[vii]

Like most offshore jurisdictions, the BVI’s tax neutral position makes it inviting for those considering initial coin offerings of cryptocurrencies, tokens or other blockchain assets. It is also home to Tether, the world’s largest stable coin. For this reason we expect the jurisdiction (along with other onshore/offshore jurisdictions such as Cayman, Delaware and Luxembourg) to see more litigation related to this area in the future as creditors investigate what assets might be held by insolvent estates or which were transferred shortly before liquidation. As you would expect, the courts have taken a practical approach to this problem, looking at the location of the owner or exchange.

Digital asset judgments will remain a continually developing area of law, with a plethora of first instance decisions that are likely to be reviewed carefully by the appellate courts in the future. In England and Wales, as well as the BVI, it is now accepted (if there was ever any doubt) that crypto assets form part of the insolvent estate.

In Philip Smith and Jason Kardachi as Joint Liquidators of Torque Group Holdings Limited (In Liquidation) v Torque Group Holdings Limited (In Liquidation) BVIHC(COM) 0031/2021 the issue of an insolvent trading platform (Torque) came before the BVI courts. Torque held a number of different cryptocurrencies. What was interesting about the case was how neatly the issues before the court were resolved.  Essentially the digital assets were held in two different types of accounts – assets in “User Trading Wallets” were deemed to be assets of the company against which creditors would need to file claims, whereas assets in “User Personal Wallets” were not as legal and beneficial ownership never passed to the platform and would be released back to the owner.

A further interesting part of this judgment was the definition of a “cryptoasset”:

“A cryptoasset is ultimately defined by reference to the rules of the system in which it exists. Functionally, it is typically represented by a pair of data parameters, one public (in that it is disclosed to all participants in the system or to the world at large) and one private. The public parameter contains or references encoded information about the asset, such as its ownership, value and transaction history. The private parameter—the private key—permits transfers or other dealings in the cryptoasset to be cryptographically authenticated by digital signature. Knowledge of the private key confers practical control over the asset; it should therefore be kept secret by the holder. More complex cryptoassets may operate with multiple private keys (multisig), with control of the asset shared or divided between the holders.”

Speaking with people about the case, it has become apparent that some crypto investors consider creditors may not have agreed with one of the liquidator’s proposals: to convert the cryptoassets into US dollars (the other being Tether) in order to avoid the price volatility. This will be an ongoing issue: a liquidator’s duty is to gather, protect and realise assets for creditors. But if those creditors do not want to be pulled out of the market, liquidators will need to seek urgent instructions from creditors’ committees and seek the approval of the court to protect themselves should the value of the assets plummet prior to distribution. The Torque case was relatively straightforward: however, not all cases will be easy to follow and, when you remove the unique nuances of digital assets, the cases face the same fraud hurdles as more traditional asset tracing matters.

KYC (know-your-customer) is another issue here, as it is for all industries. Exchanges generally only require KYC on the deposit and withdrawal of fiat currencies. However, those seeking to hide or launder funds may use pseudonyms or nominees and approach less-well- regulated exchanges in a similar way to those who incorporate in certain jurisdictions where KYC is not as vigorous as in places such as the BVI. Once digital assets have been acquired, they can be exchanged for other digital assets without further KYC on more secure or well-known exchanges. This can allow persons to transfer assets many times into different forms (referred to as using a “mixer”) before using a less-well-regulated exchange to turn the assets back into a fiat currency.

An alternative would be to acquire the digital asset using pseudonyms or nominees (or, via a hack, to steal them from an exchange) and store the asset on a hardware wallet (perhaps after using a mixer). The assets or tokens are consequently held off an exchange and are unenforceable until they become active again. If the fraudster were to wait several years before seeking to spend or convert the funds, it is questionable whether the authorities would be alerted due to the passage of time. This is no different to other stolen or hidden assets such as high value artwork or cars^[viii].

This problem of identifying the person(s) behind a hack or fraud has been highlighted by “persons unknown” orders in the UK, which illustrates the courts’ flexibility. In Ion Science Ltd v Persons Unknown and others^[ix], the High Court granted a proprietary injunction, a worldwide freezing order and disclosure orders against persons unknown and, to assist the discovery, a Bankers Trust Order against entities connected with the exchanges. This decision was in addition to the earlier case of AA v Persons Unknown, whereby the court confirmed Bitcoin constituted property. When considering jurisdiction, the courts appear to be taking a flexible approach, willing to accept jurisdiction if the event before them has taken place in part in the jurisdiction e.g., passed through an exchange in the jurisdiction.

What we are learning is that digital assets are here to stay and, in many respects, they are no different to other assets from an asset tracing perspective. Given the speed at which crypto fraud can happen, the advice is similar to all frauds. It is important to get into touch with the relevant professionals as soon as possible, so that steps can be taken to inform the exchanges and request any identified accounts be frozen while confirmative court orders are sought. The longer the digital assets are at large, the less likely a recovery will be made.

More generally, while there are those who are still dubious about cryptocurrencies, there is growing evidence to point to their increasingly widespread acceptance, including by institutional investors. Governments are investigating their own digital currencies, too. It is likely that crypto will continue its push into the mainstream.

However, all new digital offerings (or current fledgling offerings) must be treated, like all new investment opportunities, with caution. People may need to resist the temptation of investing due to the fear of missing out on the next Bitcoin or Ethereum without conducting due diligence. The phrase “do your own research” has never been more apt.

Footnotes:

^[i] https://news.bitcoin.com/crypto-firm-owners-plead-guilty-to-tax-evasion-face-up-to-5-years-in-prison/

^[ii] https://www.reuters.com/business/finance/uk-launches-taskforce-potential-bank-england-digital-currency-sunak-2021-04-19/

^[iii] https://www.bloomberg.com/news/articles/2021-10-25/el-salvador-s-bitcoin-speculators-are-stifled-in-chivo-crackdown

^[iv] https://international-adviser.com/hmrc-sends-nudge-letters-to-crypto-investors-over-unpaid-tax/

^[v] https://www.bbc.co.uk/news/uk-england-leicestershire-58439085

^[vi] https://www.bbc.co.uk/news/technology-55645408

^[vii] https://en.wikipedia.org/wiki/Quadriga_Fintech_Solutions

^[viii] https://www.autocar.co.uk/car-news/industry-news/missing-bond-car-%C2%A318m-aston-martin-db5-reportedly-found

^[ix] https://www.rahmanravelli.co.uk/articles/cryptocurrency-fraud-a-significant-judgement/

Shaun Reardon-John
Shaun has particular expertise in cross-border insolvencies, fraud, asset recovery and commercial dispute resolution. He recently acted on behalf of the joint liquidators in relation to two cross-border insolvencies that involved international investigations where investors lost in excess $50 million. Shaun also worked as part of a team in relation to an international Ponzi scheme involving a failed financial institution. In addition, Shaun has commercial arbitration experience involving two corporate parties regarding a breach of contract. He has also been instructed in relation to the enforcement of arbitration awards. Shaun studied at Cardiff University before training with the National Health Service and qualifying as a solicitor in England and Wales in 2008. Upon qualifying, he then moved to Eversheds where he gained a wealth of experience with fraud and commercial litigation. In 2012, he relocated to the British Virgin Islands where he worked for Martin Kenney & Co (MKS) until April 2019, when he returned to the UK. In August 2019 Shaun became a consultant solicitor for MKS from his base in England, where he continues to work for his clients on offshore commercial litigation.