Uncover the latest insights from the London International Disputes Week, where global legal professionals explored international dispute resolution and crypto regulation. This captivating article dives into key legislative developments, intense regulatory competition, and intriguing cases that shed light on digital assets and crypto exchange accountability. Stay informed and engaged, whether you’re a lawyer, blockchain expert, or simply curious.

Last week in London, legal professionals from around the globe convened for the London International Disputes Week (LIDW), an event that serves as a platform to delve into the latest legal issues concerning international dispute resolution, including crypto regulation in different jurisdictions and challenges that stakeholders face when crypto exchanges are going into insolvency.

This article is designed as a long read and is expected to captivate both lawyers and blockchain experts, as well as those who were unable to attend the LIDW events dedicated to crypto due to scheduling constraints.

We present a comprehensive overview of the key legislative milestones in the field, drawing comparisons between the United States, the United Kingdom and the European Union. We will analyse the intense competition witnessed between two prominent US government agencies, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), which brought an unprecedented level of enforcement actions throughout 2022. Additionally, this article will closely examine recent and noteworthy cases that shed light on the nature of digital assets under common law jurisdictions as well as clarify the possible gateways of holding the crypto exchange liable in case of insolvency or hack.

UNITED KINGDOM: CRYPTO HUB OR NOT?

In April 2022, the UK government announced that it intends to make the UK a global crypto-asset technology hub.

UK Prime Minister Rishi Sunak said:

“It’s my ambition to make the UK a global hub for crypto asset technology and the measures we’ve outlined will help to ensure firms can invest, innovate and scale up in this country.”

On 17 May 2023, the Treasury Committee, in their report, stated that:

“Unbacked crypto-assets have no intrinsic value, and their price volatility exposes consumers to the potential for substantial gains or losses, while serving no useful social purpose. These characteristics more closely resemble gambling than a financial service. We are concerned that regulating retail trading and investment activity in unbacked crypto-assets as a financial service will create a ‘halo’ effect that leads consumers to believe that this activity is safer than it is, or protected when it is not. We therefore strongly recommend that the Government regulates retail trading and investment activity in unbacked crypto-assets as gambling rather than as a financial service, consistent with its stated principle of ‘same risk, same regulatory outcome’.”

This report undermines everything that was already achieved in crypto regulation as it challenges the notion that crypto-assets should be treated as financial instruments, subject to the corresponding regulatory framework.

Another issue that arises from the statement “unbacked crypto should be regulated as gambling” is that winnings from gambling are generally tax-free in the UK. The report does not explicitly discuss any potential effects on the established taxation framework for crypto-assets, thereby raising doubts about the ongoing validity of HM Revenue & Customs’ position.

Nevertheless, in February 2023, in its consultation paper, HM Treasury stated that it is not going to create a new bespoke regime for digital assets. HM Treasury expressly said that it will not regulate digital assets themselves but will regulate activities related to digital assets. Therefore, it can be concluded that the UK has a conservative approach and tries to put digital assets into the existing regulatory perimeter.

UNITED STATES: REGULATION THROUGH ENFORCEMENT ACTIONS

Currently, there is no specific federal regulation in the United States. Meanwhile, US agencies such as the SEC and CFTC and others took the initiative into their own hands. Similarly to the UK, US agencies believe that crypto-assets are subject to current regulation. In other words, digital assets that have characteristics of securities and satisfy the Howey Test must be subject to SEC’s jurisdiction and Securities laws. Digital assets that have characteristics of commodities (e.g., virtual currencies, as was stated in the CFTC v. McDonnell case) are subject to CFTC’s jurisdiction and Commodity Exchange Act (CEA).

However, as opposed to the UK, it is seen that the US approach is to regulate through enforcement action. According to last year’s statement, SEC’s Crypto Assets and Cyber Unit “has brought more than 80 enforcement actions related to crypto asset offerings and platforms”. CFTC definitely keeps up with the SEC. On March 27, 2023, CFTC filed a civil enforcement action charging Changpeng Zhao (co-founder and CEO of Binance) and three entities that operate the Binance platform with numerous violations of the CEA and CFTC regulations.

EUROPEAN UNION: THE FUTURE IS PRESENT

16 May 2023 has great significance for European crypto regulation. The EU Council adopted two critical sets of rules: Regulation on Markets in Crypto-Assets (MiCA) and the new Anti-Money Laundering (AML) Regulation.

“I am very pleased that today we are delivering on our promise to start regulating the crypto-assets sector. Recent events have confirmed the urgent need for imposing rules which will better protect Europeans who have invested in these assets, and prevent the misuse of crypto industry for the purposes of money laundering and financing of terrorism”. — Elisabeth Svantesson, Minister for Finance of Sweden

As MiCA is well known in the crypto sector and will come into force in late 2024, let’s look into new AML rules.

“Crypto asset service providers will be obliged to collect and make accessible certain information about the sender and beneficiary of the transfers of crypto assets they operate, regardless of the amount of crypto assets being transacted.” — EU Council press release

It will enable better monitoring and detection of any potentially illicit activities, allowing for prompt intervention.

MiCA and new AML rules make “the future present”, — said one of the LIDW speakers. It is difficult to argue with them as, up to the current moment, the EU is considered to be the pioneer in crypto regulation.

ASSETS TRACING: WHO OWNS THE ASSETS

The most crucial step is to understand your relationship with a crypto exchange. Exchange’s terms and conditions determine how it holds your assets and whether your assets are ‘yours’.

If you draw a parallel with a bank, funds deposited in your current bank account do not constitute “your” money. They become the bank’s money, and you are owed a debt by the bank. With crypto exchanges, the situation is more challenging.

Most crypto exchanges claim that they act as custodians of a customer’s digital assets. The term “custodian”, however, lacks a precise legal definition in the law of England and Wales, particularly in the context of intangible assets. Some crypto exchanges, while claiming to act as custodians, often state in their Terms of Service that customers retain legal and beneficial ownership of the assets. Some exchanges do not touch upon this matter at all. Other crypto exchanges give their customers a beneficial right to an asset while retaining the legal title for themselves, thereby creating a trust over the assets in favour of the customer.

The only known case in the common law jurisdiction that extensively examined an exchange’s terms and conditions is David Ian Ruscoe and Malcolm Russell Moore v Cryptopia Ltd (in liquidation) [2020]. In its decision, the New Zealand High Court held that the exchange acted as both custodian and trustee.

In the recent decision on Jones v Persons Unknown [2022], the UK High Court held that a crypto wallet provider was the constructive trustee of stolen funds.

A constructive trust is an equitable remedy imposed by a court to prevent the unjust enrichment of one person at the expense of another as the result of wrongful conduct, such as fraud or breach of fiduciary duty, such as when a third party receives trust property with knowledge of a breach of trust. For instance, a constructive trust may arise where a person holds funds that they know have been paid to them by mistake, or they have obtained by means of fraud.

In the above-mentioned case, the Court stated that Huobi was a constructive trustee of Mr Jones’s Bitcoin as Huobi controlled the wallet holding the stolen Bitcoin and there was no evidence that Huobi had “any proprietary interest in respect of the claimant’s Bitcoin, which would override the claimant’s beneficial interest in that Bitcoin”.

Why does it matter, would you ask? The defendants, usually the victims of fraud that results in exchange insolvency, are not interested in whether the cryptocurrency is property or not or whether the crypto exchange is a trustee or not. What matters to them is what remedies they have.

If a crypto exchange holds funds on constructive trust for a customer that was defrauded, it gives the claimant a direct avenue to seek action against the exchange for breach of trust should they fail to comply with their duties as trustees.

The right to sue a trustee for breach of trust is a personal claim, i.e., the trustee is personally liable to make good the loss to the trust. However, where trust property can be identified in the hands of a trustee, the beneficiaries may make a proprietary claim to the property. Thanks to blockchain that makes all transactions transparent, it is possible to identify where all assets were transferred.

When a crypto exchange enters insolvency, those digital assets that are subject to proprietary claims will not form a part of the exchange’s estate; therefore, a creditor has an opportunity to make a full recovery rather than having to prove themselves as an unsecured creditor and wait for a payment that usually less than 50% of the asset or even nothing at all. Further, if the value of the trust property or its proceeds has increased, a proprietary claim enables the beneficiaries to claim the increase.

In addition, if a third party has become involved in a breach of trust, the beneficiaries may be able to bring a personal or proprietary action against the third party. When a crypto exchange claims that it has become insolvent due to the assets “disappearing”, the third party is most likely to be involved. If a third party received money or property traceable to a breach of trust with knowledge of the breach, they will be treated as if they were a trustee.

Whether it is possible for crypto-assets to be held in constructive trust was also examined in the UK High Court D’Aloia v Persons Unknown & Others [2022] decision. Yet, another interesting issue that arose in this case, is that it establishes a threshold for the court to grant the interim freezing injunction. The claimant needs to have a good arguable case that crypto-assets could be held on constructive trust instead of determining that the exchange was, in fact, a constructive trustee on the balance of probabilities (the higher standard used in all civil cases).

It is anticipated that future court decisions will offer more specific guidance on the circumstances under which an exchange can be held liable as a constructive trustee. However, the precedent set by the Jones and D’Aloia cases currently serves as a helpful tool for those seeking to recover misappropriated crypto-assets.

QUINCECARE DUTY AS A POTENTIAL GATEWAY TO MAKE CRYPTO EXCHANGE LIABLE

“Quincecare duty provides that a banker must refrain from executing a customer’s order if the banker is ‘put on enquiry’ that it has reasonable grounds to believe that the order is an attempt to defraud the customer” as stated in the Barclays Bank v Quincecare Ltd [1992] case and confirmed in the UK High Court JP Morgan Chase Bank NA v Federal Republic of Nigeria [2019] decision.

Quincecare duty remained dormant for several decades. However, recently it was attempted to extend the duty’s application to Bitcoin software developers, as evidenced in the Court of Appeal decision on Tulip Trading Ltd v Bitcoin Association for BSV [2022] case.

In this intriguing case, the self-proclaimed ‘inventor’ of Bitcoin aimed to hold specific Bitcoin software developers responsible for a fraudulent hacking incident by unknown parties that resulted in significant cryptocurrency losses. The claim argued that developers of digital cryptocurrency networks have a duty of care towards owners who have lost their private keys, requiring assistance in regaining control of their assets. The claimant further asserted that these software developers could be equated with financial institutions as they retained control of the network, even in the absence of a contractual relationship with the end Bitcoin owner.

In High Court, the claim was unsuccessful as there was no relevant contract between a banker and a customer, and “the duty is owed only to the bank’s customer and not to any wider class”. However, the Court of Appeal recently overturned the initial decision, acknowledging the possibility of a novel fiduciary duty owed by network developers to Bitcoin software users.

“The developers of a given network are a sufficiently well-defined group to be capable of being subject to fiduciary duties. Viewed objectively, the developers have undertaken a role which involves making discretionary decisions and exercising power for and on behalf of other people in relation to property owned by those other people. That property has been entrusted to the care of the developers. The developers, therefore, are fiduciaries.” — stated in the Tulip case.

While the Quincecare issue is not expected to be reopened in this case, given the absence of a contract between developers and end users, the potential development of law to include such a protective duty at common law aligns with the rationale behind the Quincecare duty.

Also, the UK High Court decision of Hamblin v World First [2020] opened a gateway for scams victims to potentially make a claim directly against the payment service provider. The claim can be based on the grounds that the payment service provider made payment either without authorisation and/or in breach of Quincecare duty.

Consequently, there is an opportunity for the expansion of Quincecare duty into the crypto world. Cryptocurrency exchanges that hold digital assets on behalf of customers may face claims if they fail to adequately safeguard against fraudulent asset release or engage in deceitful activities concerning underlying digital assets. While the Quincecare duty has predominantly been invoked in relation to banks, its underlying principles indicate its potential relevance to other financial institutions, intermediaries, and cryptocurrency service providers that undertake the custody or transfer of assets or provide payment services.

CASE LAW UNVEILED: FASCINATING DISCOVERIES

AA v Persons Unknown Re: Bitcoin [2019]: The UK High Court defined crypto-assets as property at common law for the first time.

Ion Science LTD v Persons Unknown [2020]: The UK High Court held that the “lex situs”, or location of crypto-assets, is the place where the owner is domiciled.

D’Aloia v Persons Unknown & Others [2022]: For the first time UK High Court allowed the service of proceedings via non-fungible token (NFT).

Sarcuni v bZx DAO (2022): US case stating that persons who run and or vote a decentralised autonomous organisation (DAO) may be held jointly and severally liable for any losses caused to other members of the organisation, despite a lack of corporate structure.

CONCLUSION

The London International Disputes Week 2023 shed light on the current state of crypto regulation and its challenges in different jurisdictions. The UK takes slow steps towards regulating crypto-assets, while the US focuses on enforcement actions against crypto businesses through its agencies. The European Union stands as a pioneer in crypto regulation with the adoption of MiCA and new Anti-Money Laundering rules. Case law developments highlight the importance of understanding ownership, tracing assets, and potential liability of crypto exchanges, with the Quincecare duty and constructive trusts emerging as potential gateways for making crypto exchanges liable.

This article was written by Liza Lobuteva of Digital & Analogue Partners. Visit dna.partners to learn more about our team and the services.

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