A collaboration between Interpath and Kobre & Kim. By Timothy de Swardt, James Drury and Merrick Ricardo Watson.
Against a backdrop of booming crypto interest and participation, we look into the difficulties involved in tracing and recovering misappropriated digital assets, and the tools now available to liquidators of insolvent companies to foil the fraudsters.
The article focuses on BVI companies: many crypto trading firms and exchanges are based in the BVI. The techniques and types of claims discussed, however, will have application in many other jurisdictions, particularly those with insolvency legislation broadly modelled on the UK Insolvency Act 1986.
Cryptocurrencies and digital assets
The resurgence in crypto in recent times has tracked vigorous growth in the entire digital assets industry. The difference this time, compared to the previous cycles in 2013 and 2017, has been the increasing participation of traditional financial institutions. Once viewed as radical and risky, increasing knowledge and understanding of cryptocurrencies has seen mainstream institutions, even sovereign governments, engaging with the market.
Unsurprisingly, this massive increase, along with immature and limited regulation and a surge of unsophisticated investors, has seen a corresponding rise in fraud. Even before the latest phase, we saw:
Asset tracing
All crypto transactions are publicly recorded on the blockchain. On the face of it, this should make tracing stolen crypto relatively easy. In reality though, finding out where stolen crypto’s gone – and to whom - is time-consuming and laborious, with success by no means assured, as increasingly sophisticated fraudsters employ a variety of tools and techniques to throw investigators off the scent.
First, to complicate tracing, fraudsters will often dissipate stolen assets numerous times through multiple wallets (cold and hot) and through ’mixers’ which convert one form of crypto asset into another. As discussed below, these ‘crypto to crypto’ transactions typically demand KYC from neither sender nor receiver[1]. Rules on tracing misappropriated property predated crypto, and have yet to adapt effectively to the new environment.
Common law tracing is not possible when stolen funds (here, digital assets) are sent through a mixed pool of funds – for example, a wallet with a positive crypto balance before the receipt of the stolen crypto.
Equitable tracing, while more flexible, still struggles with high frequency, low value dispersals through multiple mixers, largely because of the difficulties linking stolen crypto received with crypto then dispersed. Equitable tracing also typically requires the fraudster to have breached a fiduciary duty to the victim.
Second, anonymity is easy. Although there is transparency regarding transactions on the blockchain, the record will show only transaction hash, block confirmation, the sending public wallet address and the recipient wallet address. Even if the crypto can be traced to a particular wallet or, more likely, a series of wallets on different blockchains, those wallets will typically not be associated with any regulated exchange. Only when the fraudster wants to convert crypto gains to fiat currency does KYC have to be provided, since exchanges are obliged to comply with anti-money laundering regulations.
However, the specific regulations vary depending on where an exchange operates – and fraudsters wanting to turn their ill-gotten gains into fiat currency will obviously tend to use the least demanding exchanges, often also using fake identities and documents.
Hence the surge in claims against ’persons unknown’ (UK/BVI) or ’John Does’ (US) in cryptocurrency recovery cases, with courts adopting an increasingly flexible approach to suing defendants seeking to hide behind anonymity or fake identities. In England, at least, the courts have even allowed such claims to proceed to judgment: see for example CMOC Sales & Marketing Limited versus Persons Unknown. Such judgments enable enforcement against identifiable assets including those in a crypto trading account - even if their owner’s identity remains unknown.
“Unsurprisingly, this massive increase, along with immature and limited regulation and a surge of unsophisticated investors, has seen a corresponding rise in fraud.”
The power of insolvency
No company, as a rule, wants to become insolvent. But when a trading company has lost most or all of its crypto assets to a large-scale hack, it is an option that should be seriously considered. A company could enter into insolvent liquidation by, for example, a members’ special resolution or director’s application to appoint liquidators in the BVI under the BVI Insolvency Act 2003.
Insolvency can offer several benefits. First, liquidators’ powers of discovery and investigation exceed those of ordinary litigants. In the BVI, for example, liquidators may send requests for information to, or depose under oath, any person involved in the "promotion, formation, business, dealings, accounts, assets, liabilities or affairs" of an insolvent BVI company, with no prior need to file a legal claim. Filing a legal claim, quite apart from the risk and cost involved, is often difficult and time-consuming in the absence of an identifiable defendant (though not impossible, as we explain below). Liquidators can also obtain Chapter 15 recognition in the United States relatively easily, along with the broad subpoena power available under US law.
Second, liquidators have a number of clawback-type claims at their disposal which are not available to ordinary litigants. In particular, claims for transactions at undervalue (TAVs) are often a particularly valuable tool in crypto recovery. TAV claims are significantly more flexible than traditional asset recovery claims (such as constructive trusts, unjust enrichment, conversion, etc.) because under BVI legislation, once a TAV has been found, the court ’may make such order as it considers fit for restoring the position to what it would have been if the company had not entered into that transaction’. Moreover, the order may extend to the proceeds of the TAV, which suggest the stricter rules of common law and equitable tracing do not apply, and may also affect a person who is not the counterparty to the TAV itself. What’s more, in the BVI, such summary claims made on application rather than by claim form can reduce timescales from years to months.
The law on TAVs remains underdeveloped in the BVI, but there has been at least one successful TAV claim reported: one brought by Interpath, acting as liquidators in Ortland Equities Corporation (in liquidation) v Pitkin Group Limited. In that case, the BVI Court rejected arguments that the transaction was at fair value, and ordered the return of the assets that had been transferred at undervalue.
Despite these promising features of TAV claims, there are some important considerations to bear in mind under BVI legislation. First, a claim for a TAV must have been entered into during the vulnerability period: six months before the onset of insolvency for an unconnected person, or two years in the case of a connected person. Second, that TAV must itself have been at least a cause of cash-flow insolvency or have occurred at a time when the company was already cash-flow insolvent. (Balance sheet insolvency does not count for the purposes of a TAV.) Third, and perhaps most obviously, the company must be in insolvent liquidation, with day-to-day control of the company ceded to liquidators. The stakeholders of the company would want to ensure liquidators who are specialist asset recovery experts with specific experience in cryptocurrency recovery.
Interim remedies
In many instances it should be possible, in principle, for the liquidators to make an application seeking injunctive relief, either in the form of a proprietary injunction or a worldwide freezing injunction, to prevent offenders (even ones whose identities remain unknown) moving or dealing with misappropriated assets while steps are taken to identify them and recover the assets.
The case of AA v Persons Unknown in the High Court in England is particularly instructive. Not only did the claimant obtain a freezing injunction against ’persons unknown’ (itself a rare occurrence), but the court ruled that BTC could be considered ’property’ for the purposes of a freezing injunction. In reaching its conclusion, the court gave considerable weight to the recent UK Jurisdictional Task Force (the UKJT) Legal Statement on Cryptoassets and Smart Contracts, published in November 2019 (see update here).
The case has recently been followed in England in Fetch.ai Limited v Persons Unknown and in the BVI in Smith and Kardachi (in their capacity as joint liquidators of Torque Group Holdings in Liquidation) v Torque Group Holdings Limited.
The BVI courts are well versed in dealing with cases involving theft or fraud relating to more traditional forms of property, and are therefore well placed to help individual and institutional investors whose crypto assets have been stolen.
In applying the decision in AA v Persons Unknown, the BVI Commercial Court recently granted a freezing injunction together with related disclosure orders to an institutional investor that had invested money in the Quantum Group. Quantum’s operators reportedly started using new investor funds to pay out redemptions -a classic Ponzi scheme - resulting in investors losing their investment. A free standing injunction and disclosure orders against an exchange that operates via a BVI company was granted by the BVI Commercial Court, allowing the investor to successfully freeze the accounts and obtain KYC information which confirmed that the accounts were owned by the individuals behind Quantum.
In addition, in circumstances where crypto can be identified as being in a hot wallet and held by a custodian or exchange, liquidators can exercise their discovery powers against that exchange, or obtain court orders for disclosure (such as Norwich Pharmacal orders), enabling them to identify the defendants. Disclosure orders – AKA ‘Spartacus orders’ - can also be sought against the unknown bad actor directly, albeit their effectiveness relies on the bad actor’s reluctance to be in contempt of court, and consequent compliance.
It should be noted that even if the exchange is served with disclosure orders and/or Spartacus orders, there is no guarantee that they will act on them.
In the more sophisticated jurisdictions and regulated countries, better-known exchanges such as Kraken, Coinbase and Binance are likely to comply with court orders or requests, but fraudsters will almost certainly be looking to transfer misappropriated assets to more challenging jurisdictions, where enforcement and recognition are likely to be problematic. In such cases, it becomes a race to prevent assets being converted to fiat currency – a race made all the more challenging by the speed of transactions, which may ultimately render any order or judgment effectively null and void.
Conclusion
The use of cryptocurrencies to conceal the proceeds of fraud and fraudulent activity concerning or involving cryptocurrencies is on the rise and likely correlated to their increasing popularity, but with the right expertise recoveries are possible. Though insolvency is never a step to be taken lightly, it does significantly enhance the options available to victims, with at least the prospect of eventual recovery.
This article is not intended as legal advice nor a substitute thereof and no reliance may be placed on its contents.
[1] However, as from 19 October 2021, following regulatory pressure on the world’s largest crypto exchange, Binance implemented new KYC requirements which ensures all transactions - fiat to crypto and crypto to crypto - are supported with sufficient AML
