Cryptoassets and Insolvency - Clues for Cayman from Other Jurisdictions
11 April 2019
With the Cayman Islands already the leading jurisdiction for the formation of international investment and financial structures, it comes as no surprise that it has achieved pre-eminence in the establishment of companies undertaking initial coin offerings (ICOs) and security token offerings (STOs), as well as funds investing in cryptocurrencies.
What the Cayman Islands courts have yet to encounter, but surely will and must, is litigation or a liquidation proceeding in which Blockchain technology, cryptocurrency or other cryptoassets play a part or, more likely, a starring role. Cayman Islands litigators and insolvency practitioners therefore have limited time in which to acquaint themselves with the legal nuances of these (relatively) new creations, however there is an ever-increasing number of cases from other jurisdictions around the world from which they can achieve an understanding of the likely contentious areas which will arise and how the Cayman courts, laws and jurisprudence may deal with them.
Reviewed below are a couple of instructive cases. Many of the well-known cases involve cryptocurrency exchanges, rather than companies investing in cryptocurrency or conducting ICOs or STOs. Though the latter entities are those with which the Cayman Islands are familiar, the below cases are relevant to the general cryptocurrency litigation landscape, as they all provide some insight into how courts around the globe are grappling with these new legal issues.
It has been over 5 years since Mt. Gox, at one time the world’s leading Bitcoin exchange and handler of over 70% of the world’s Bitcoin, collapsed as a result of the theft of 850,000 Bitcoins, 750,000 belonging to its clients. It was placed into bankruptcy by the Japanese courts in April 2014, with a lawyer being appointed as the bankruptcy trustee. As will be the case with almost any largescale piece of litigation involving cryptocurrency, there was a cross-border element to the proceedings, with the bankruptcy trustee seeking Chapter 15 recognition in the US and similar relief in Canada.
One interesting aspect of the Japanese bankruptcy was that the unsecured creditors, being those who used the exchange to store and barter with their fiat and cryptocurrency, had to value their non-monetary claims as at the date that the entity went into bankruptcy, being April 2014. This led to unsecured creditor claims being valued at US$400M, a figure influenced by the market’s then (rightly held, of course) fears over the security of Bitcoin.
The value of Bitcoin would skyrocket in late 2017 (at which time Mt. Gox was still in bankruptcy) and at which point the trustee managed to track down and liquidate enough Bitcoin to pay out the $400M owed to the unsecured creditors - that figure being based on the April 2014 value of Bitcoin. Aside from earning the trustee the nickname the “Tokyo Whale” for his actions supposedly being responsible for a collapse in the price of Bitcoin, this also paved the way for a potentially unsatisfactory and unjust scenario. The bankruptcy estate now held Bitcoin at a value of one billion dollars and unsecured creditors had, according to a strict interpretation of Japanese bankruptcy laws, been paid in full. That left all remaining assets to potentially be returned to shareholders of Mt Gox, which in essence were those parties who were and are still alleged to have played roles in its plight.
A creditor therefore filed for Mt. Gox to be placed into a process called a civil rehabilitation, through which Mt. Gox was pulled from bankruptcy and unsecured creditors, having to file new claims, now stand a chance at being compensated in accordance with the current value of Bitcoin. This serves to highlight the volatile nature of the value of Bitcoin, an issue with which a liquidator of a Cayman fund invested in cryptocurrency may have to wrestle when ascertaining the optimum time at which to liquidate a fund’s assets for the benefit of the estate.
Another question arising out of the Mt. Gox case is whether the Bitcoin could be designated as “property” and if so, precisely what kind of “property”. Shortly after Mt. Gox was placed into bankruptcy, an investor sued for the return of its Bitcoin on the grounds that the Bitcoin which it had deposited into the exchange was its property and should be segregated from the Mt. Gox estate.
The judge ruled that Bitcoin could not be an “object of ownership” because it was not a tangible thing and could not be “exclusively controlled”. Although the decision is not binding, let alone a persuasive authority for Cayman courts, there are other reasons why it should not cause undue concern for Cayman practitioners. Firstly, it was a decision rendered in a jurisdiction governed by a civil code, strictly adhered to, which left the court little room for manoeuver. Secondly, a judgment handed down in the Singapore International Court on 14 March 2019 (reviewed below) and which would be persuasive to a Cayman court, should allay any residual fears. However, should an insolvency practitioner find itself appointed over a Cayman fund which used a Japanese exchange, then the Mt. Gox case will of course be pertinent.
Quoine PTE Limited
This was a case where a client of Quoine, B2C2, used algorithmic software to trade Ethereum for Bitcoin. The trades were effected by Quoine’s automated software on the exchange. However, as discovered the next day, they had been effected at a rate which was incorrect and vastly in favour of B2C2. The trades were reversed by a Quoine employee the next day. Central to B2C2’s argument that Quoine held the Ethereum on trust for B2C2 was the assertion that a cryptocurrency is “property”.
The Singapore court was not presented with any argument against cryptocurrency being “property”, but perhaps recognizing that was not the only question which needed answering, it measured the nature of cryptocurrencies against the now-classic dicta of the House of Lords decision in National Provincial Bank v Ainsworth and found that they met all the required criteria of property which is capable of granting rights to the owner; they are definable, identifiable by third parties, capable in their nature of assumption by third parties and have some degree of permanence or stability. Therefore, the judge found that they could be held on trust, a fundamental characteristic of a “chose in action”, that is, an intangible property right which can only be enforced by way of court action, not by taking possession of the property (the latter being a “chose in possession”).
Assuming other common law courts follow the Singapore decision above, it seems the criteria for cryptocurrency and other cryptoassets to be recognized as “property” is clear. Exactly what type of property right should be granted to cryptocurrencies and other cryptoassets is still uncertain. A designation will at some stage need to be made, given that it will affect the remedies available to those who claim ownership. Cryptocurrency is capable (it seems no two cryptocurrencies are the same) of possessing many of the attributes of a chose in possession; they can be transferred, they can be stored in such a way that they may be lost, and they can be possessed by their transferal into a digital “cold” or “hot” wallet. Yet a cryptocurrency is obviously not a tangible thing. It has attributes of a chose in action, however with cryptocurrency of the likes of Bitcoin, it does not give rise to any rights against others. The only recognised (thus far) choses in action which do not come with a specific obligor counterparty are created by statute, for example copyright.
The fact that cryptocurrency seems to straddle the extant categories of property rights has led some in the legal community, including the UK Financial Markets Law Committee, to anticipate the need for a new category of property being recognized – a “virtual chose in possession”.
Lessons Learned So Far
The uncertainty surrounding legal status is as much an issue for tokens issued as part of an ICO or an STO as it is for cryptocurrencies. However, tokens issued pursuant to an ICO or STO do stand a greater chance of being categorized as a chose in action, given that they are more likely to grant rights and have an obligor counterparty. Much will depend on the content of the “white paper” of the ICO/STO, being the equivalent of a prospectus, issued to interested investors, and to that extent, those looking to design a token as part of an ICO or STO may wish to characterize their tokens to resemble a chose in action, or they may wish for their tokens to have no rights, uses or attributes.
Another factor will be the type of token issued. “Utility tokens” permit the holder to use the products or services offered by the company to which the investor pays its money in exchange for the token. An “investment token” gives the holder a share in the company profits.
So Where Are We?
The use of tokens and cryptocurrencies such as Bitcoin is showing no sign of losing momentum. As at the date of writing, Bitcoin has just experienced a price resurgence and is back to late 2018 value. Recognition of cryptocurrency as “property” is a solid start to its acceptance as a valid asset class, however for those involved in insolvency and restructuring, there is a decent distance between where we are and where we need to be before lawyers and practitioners can approach with confidence the issues which these assets are bound to raise.
Quadriga CX, formerly Canada’s largest cryptocurrency exchange, has been ordered by the Nova Scotia Supreme Court to file for formal bankruptcy proceedings in the next few days. This follows the sudden death in December 2018 of Gerald Cotten, its CEO and the only person with access to a cold wallet that holds all of the clients’ cryptocurrency (approx. US$196 million worth). It will be interesting for those in common law jurisdictions to watch how this plays out.