The capital structures of companies in the 21st century will be starkly different from those of the last century. Once driven by hard assets, such as real estate, natural resources and machinery, modern businesses become highly dependent and valued on the basis of intangible assets – contracts, intellectual property and goodwill. Recent years have seen a rapid development of new technologies allowing for the creation of novel types of intangible assets with their own value and characteristics. There is hardly anyone these days who has not heard about Bitcoin or cryptocurrencies in general. Once thought to be a tool to avoid third party intermediaries (read banks) in financial transactions, crypto assets turned into an investment tool, characterised by price volatility, hyped private and public interest, as well as uncertainty regarding its legal status.
Bitcoin as the world’s first decentralised digital currency has become possible thanks to the blockchain technology – publicly distributed, shared and immutable digital ledger. Anonymity and irreversibility of transactions on blockchain have made it attractive for users. It is estimated that cryptocurrency market capitalization will hit USD 1 trillion in 2018. A lot will however depend on public perceptions (read trust) and government reaction. The latter so far has been rather mixed. Among rising fears of the technology being used in illicit activities (money laundering, extortion, financing of terrorism, etc.) and weak investor protection, state authorities struggle in finding a balanced solution. This becomes particularly difficult due to the lack of consensus on what cryptocurrencies actually are – securities, digital assets, currency, commodities or something else. But while regulatory and legislative bodies take their time to establish legal frameworks for the operation of the crypto market (tokens, coins, ICOs, crypto exchanges, etc.), courts have no such time and are faced with the need to resolve real disputes.
This is particularly so in the context of insolvency cases, in which several questions may arise. For instance, how to treat various types of digital assets belonging to the debtor, how to trace them in cases where the debtor refuses to disclose their existence, transfers them to third parties or simply refuses to provide access to the insolvency practitioner or court? And last, how to dispose of them and at what exchange rate, if any? Many of the indicated questions have been brought up in the recent bankruptcy case of Mr. Tsarkov, considered by the Commercial Court of Moscow (Russia) in March 2018, case No. A40-124668/17. In this case the insolvency practitioner (IP) filed a motion with the court asking to mandate the inclusion of the contents of the crypto wallet at www.blockchain.info (around 0,2 BTC amounting to approx. USD 2,300 as of the date of the judgment, 5 March 2018) allegedly owned by Mr. Tsarkov into the insolvency estate. In addition, the IP requested the key to the wallet to be handed over to him. The IP argued that Bitcoin was an asset, and since the primary purpose of the bankruptcy procedure was the sale of the debtors’ assets and value maximization to creditors, Bitcoin should fall under the insolvency estate. Mr. Tsarkov objected, claiming that current laws of Russia did not address relations involving cryptocurrency and that cryptocurrencies could not be an object of property (civil) rights.
Resolving the dispute and refusing to recognise Bitcoin as an asset for the purposes of insolvency law, the court essentially provided two arguments. Firstly, it noted that the legal nature of cryptocurrency is unclear and cannot by derived by analogy. Additionally (and for no particular reason), the court made references to various policy documents by the Central Bank of Russia, in which the latter stressed that digital coins are price volatile and can be used in high risk or shady transactions breaching anti-money laundering (AML) legislation. This argument seems rather unpersuasive to me. The court cannot simply walk away from adjudicating the issue because it finds it too difficult to understand. The fact that cryptocurrencies are not mentioned in law does not make them “outsiders” to the legal system – the objects of property rights are not exhaustively listed in Russian law and include “other assets” (Article 128 Russian Civil Code). Besides, in January 2018 the Russian Ministry of Finance proposed draft legislation defining ‘cryptocurrency’ as a digital financial asset existing in the distributed ledger of digital transactions. Exclusion of Bitcoins from the insolvency estate is detrimental to creditors’ rights as crypto assets have value and are relatively easy to dispose of, i.e. turn into liquid fiat currency.
Secondly, and more challenging for practical reasons, the court rightly pointed out that due to the anonymity inherent in the operation of (some) crypto wallets (e.g. registration at www.blockchain.info is free and only requires verification by email), the ownership over cryptocurrency in the wallet is hard to ascertain. Paradoxically, in the case at hand Mr. Tsarkov did not dispute the fact that the respective Bitcoins belonged to him – there was no disagreement about it. Nevertheless, the court was not persuaded. This of course was a strange decision. But let’s assume the debtor denied any connection to the said wallet or even its existence was hidden, for example its key ended up being in a decommissioned military bunker somewhere in Switzerland. In this scenario, it would be extremely difficult to link the debtor to a particular wallet. However, if there is sufficient evidence indicating that the wallet belongs to the debtor, he could be obliged to disclose its content (hand in the key) to the IP. Failure to do so may result in penalties (l'astreinte or another similar instrument) or denial of debt discharge upon closure of the bankruptcy proceedings. When dealing with the insolvency of a company refusing to cooperate with a court or IP, one can also consider resorting to the tool of director’s liability.
Whereas crypto wallets are hard nuts to crack, a different situation arises whenever cryptocurrency exchanges are involved. Unlike wallets storing data on Bitcoins or other cryptos, crypto exchanges allow customers to trade digital currencies for other assets, such as conventional fiat money, or different digital currencies. Therefore, most often such exchanges mandate more stringent customer identification, necessary to comply with the applicable KYC/AML standards. Under Japan’s so-called Virtual Currency Act, in force since 1 April 2017, crypto exchanges must comply with minimum capital requirements and implement advanced customer identification procedures. South Korea followed by banning anonymous cryptocurrency trading and obliging crypto investors to use real-name bank accounts. Even though European regulators are lagging behind, undoubtedly, they will soon follow their Eastern counterparts. The possibility to check the identity of traders on exchanges, whether at the request of a court or an IP, enhances transparency and simplifies digital asset tracking. However, the effectiveness of such measures may still be doubtful. First of all, by the time the court reacts, all coins owned by the debtor may be long siphoned from the exchange and become untraceable. And secondly, crypto exchanges may be located in jurisdictions which either do not cooperate with courts from other countries or do not prescribe full-fledged client identification measures.
While regulation of crypto assets is still in its embryonic stage, insolvency courts serve as a testing (‘battle’) ground, both in terms of defining cryptocurrencies’ legal status and finding practical ways of recovering and handling their value for the general benefit of creditors. In my previous blog I discussed the issue of decentralised autonomous organisations (DAOs) and jurisdictional challenges their failures lead to. Up next: Insolvency of crypto exchanges: international experience. Stay tuned.