Recovering Crypto Assets in Insolvency

With the cost-of-living crisis and a possible recession facing the UK economy, it is not surprising that government statistics show insolvencies are rising significantly, with a substantial increase on pre-pandemic levels, and up to 80% higher than the previous 12-month period.

An emerging trend within insolvencies is the recovery of crypto assets, whether the businesses are within the crypto sector, or whether it is any other entity holding value in cryptocurrencies.

It is now widely accepted that cryptocurrency falls within the broad definition of Property and therefore, crypto assets can, and are, being recovered in formal insolvency procedures, in both this jurisdiction and across the globe.

There have been a number of recent cases where it has been established that a cryptocurrency is deemed to be a recoverable asset within the insolvent estate and that if it can be traced, and secured (usually through court procedure), then it can be recovered on behalf of the creditors.

Crypto asset recovery process

With the market crash in crypto assets, the slump in digital currency and billions of pounds lost, 2022 has led to the worst wave of financial disasters across the industry and a massive confidence shake-up. This period has been dubbed the “crypto winter”.  Major causalities of 2022 include some of the biggest names in the sector, such as Three Arrows Capital (3AC), FTX (the second largest exchange and said to be the world’s largest fraud of all time), Celsius Network, Terra Network, Voyager Digital and BlockFi. In addition, just before the New Year, Core Scientific, the world’s largest crypto mining company, collapsed and announced bankruptcy in the US.

Once in bankruptcy or liquidation, the legal process will determine the priority of the creditors and the valuation of the assets. The recovery action can be long and complex with the focus not only on realising remaining crypto assets but investigating former officeholders and potentially bringing claims for monetary compensation. Despite the turmoil that the crypto sector currently faces, cryptocurrencies are here to stay, and Insolvency Practitioners (IPs) will need to tackle some difficult practical recovery steps with digital assets.

Cross-border insolvency laws provide robust and effective legal regimes for tracing and recovering crypto assets that have been transferred across borders.

The likelihood of recovery of crypto assets could be higher than in traditional insolvencies, as the developing case law means it’s now possible to pursue crypto exchanges for defrauded sums, rather than having to locate a fraudster and trace the assets.

Issues for Insolvency Practitioners

Cryptocurrencies do, however, give rise to a number of novel issues for IPs, including how to access details of the wallet addresses, private keys and withdrawing into fiat (if indeed that is necessary for the purpose of returning assets/funds to creditors).

If a creditor of a cryptocurrency business, such as an exchange, goes into liquidation, the creditor will need to determine whether that asset belonged to them (i.e. the asset should be returned outside of the liquidation process) of whether the asset is held on their behalf (i.e. they therefore fall as a creditor, and will rank last as unsecured creditors, and need to rely upon the IP for recovery).

The importance of IPs identifying how, and by whom, the digital asset is held cannot be overstated. If the crypto assets are held by or in the name of a custodian, for example, which could be an exchange, the beneficial/equitable interest in the asset may remain with the depositor, and therefore belong to the depositors. In such circumstances these assets could be separated from the general pool of assets that will be divided up among the pool of creditors.

A key issue for IPs will be the priority of distribution between various creditors and to determine the rights and interests of various creditor groups. Both creditors and IPs should undertake a detailed analysis of any applicable service terms and conditions and also seek to establish whether or not in practice actions were taken that were consistent with those terms.

Whilst the price of many crypto assets have significantly declined since late 2021, many still contain substantial value. On appointment of IPs, they must quickly work with directors and officers of the company and any service providers in the liquidation and ascertain if there are any digital assets and their whereabouts. There is always a risk of dissipation of assets and that risk is even greater with crypto assets that can be easily transferred. IPs must:

• identify and secure crypto assets and should work with the individuals holding the private encryption keys to the associated cryptocurrency wallets.
• move digital assets held on private addresses (not, for example, service/exchange-controlled accounts to addresses, that the Liquidators control the private keys to. In failing to do so, IPs risk that others may know the private keys to addresses thereby enabling them to move the funds without their knowledge and potentially opening themselves up to a future claim.

One of the key attractions for those holding crypto assets is the ability to buy and sell them quickly. The timing of such transactions before the liquidation is crucial and an IP will investigate if any of those transactions are “voidable” and, if so, an IP can take steps to seek a return of those assets.

The Insolvency Act 1986 provides the IP with a wide armoury of potential enforcement tools which are frequently deployed in tandem with actions commenced in the civil commercial court. For example, transactions which have been entered into with the intention of defrauding creditors, or whether or not any transactions can be deemed to have been at an undervalue, are very difficult to establish in this volatile and ever-changing climate. IPs must always fully consider their “targets” against whom potential recovery action is to be. It could be serving directors, past directors, shareholders, connected parties or third parties.

What IPs must consider

IPs must carefully consider:

• The jurisdiction clauses within any terms and conditions, and the domicile of the “owner” of the crypto assets.
• The potential jurisdictional disputes or parallel proceedings which may give rise to conflicting judgments.
• How to manage recovery in a volatile market.
• How to reduce market exposure while securing the best price they can for the assets they are liquidating.

Inevitably certain recoveries will be more straightforward than others. For example, where IPs have the keys it will be easier to realise value more quickly; however, recoveries will become more difficult where assets are more illiquid, perhaps held by third parties, and complex tracing action is required.

Cooperation between office holders, IPs and creditors is essential if the IP is going to be able to ascertain whether or not detailed investigations and recovery actions are to be undertaken.

Like all insolvencies, IPs require capital to fund any action, and their appetite to proceed will be largely driven by the perceived chances of recovery and identification of suitable “targets” from whom recovery can be made. Third-party funders exist to finance such activities but rightly require a good assessment of the merits of such actions and the chances of recoveries being made. It is essential therefore that IPs and all stakeholders associated with the liquidation obtain prompt legal assistance so that all available options can be explored and the appropriate action to maximise their returns can be deployed.

If you have concerns about retrieving crypto assets when going through an insolvency, please contact Louise Abbott and Matthew Hennessy-Gibbs.