UNITED KINGDOM: An Introduction to Crypto-Asset Disputes

Crypto Asset Disputes 

Crypto asset disputes within the UK present a multifaceted challenge, encompassing issues of regulation, contractual disagreements, fraud, and security concerns. These assets offer new opportunities and challenges for clients and the accounting, insolvency/restructuring and legal professions. Companies and investors in the fast-growing crypto sector face inevitable risks and they need to review their standard contractual terms regularly to make sure they address the specific issues that may arise with crypto assets and the industry in general. They also need to customise their terms to prevent or simplify potential crypto disputes.

Crypto assets are digital representations of value or contractual rights that use cryptography and distributed ledger technology (DLT) to enable peer-to-peer transactions without intermediaries. Crypto assets can take various forms, such as cryptocurrencies, stablecoins, utility tokens, security tokens, and e-money tokens.

This overview delves into the landscape of crypto asset disputes in the UK, exploring legal frameworks, notable cases, and the evolving state of the market:

First Steps 

One crucial first step is to include clear clauses in contracts that specify the applicable law and the dispute resolution method. Otherwise, the lack of a central authority for crypto assets may make it difficult to determine the proper forum for the claim. For the remainder of this article, we have assumed that contracts are governed by English law and subject to the jurisdiction of the English courts.

Legal Framework & Horizon Scanning 

The legal landscape of crypto disputes has evolved rapidly in the UK in the past five years since the first cases involving digital assets came before the courts. The courts have faced the challenge of adapting new technology to the existing legal framework. The Law Commission concluded recently that the common law is generally well equipped to deal with crypto-related disputes, and that no legislative reform is necessary at this stage, however many are sceptical about this and in contrast the courts have had to show creativity and agility in applying old laws to new situations and have had to quickly address key concepts in this area. For example, the Law Commission determined that certain established legal frameworks (eg bailment) would not apply to crypto assets, existing common legal could be developed to incorporate crypto assets by the simple expedient of saying that if an arrangement regarding a crypto assets has the “look and feel” of a concept recognised under existing common law, then it may be treated in the same way. This demonstrates the willingness of the judiciary to modernise this area of the law and to establish England and Wales as a leading jurisdiction for resolving disputes involving digital assets, although, of course, without statute (or a determination by the highest court in the land), common law is subject to change and judgments can be regarded as fact and circumstance specific.

There have been a number of legal and regulatory developments, however.

Under the Financial Services and Markets Act 2023, the FCA has been given discretion to bring some crypto assets (and activities relating to them) within the existing regulatory perimeter and HM Treasury has been able to launch the first “digital sandbox” (which will permit firms to operate under existing rules and regulations to provide innovative crypto asset-related products and services even if the rules and regulations do not, on their face, cover those products and services).

The UK FCA’s new rules for crypto asset promotion are an example of further change. In a sector that has been largely unregulated and dominated by new and fast-growing companies operating across borders, regulatory changes may trigger disputes.

The English courts have also taken a proactive approach in adjusting procedural tools (such as serving proceedings by NFT) and issuing orders that account for the specificities of digital assets. Moreover, the legal system has been actively involved in consultations, reports, and legal thinking in this area since 2018.

The primary focus of the English courts in the crypto world was initially centred on smart contracts and blockchain payments as innovative methods of conducting cross-border business, where the courts have predominantly dealt with fraud cases. Where the claims presented have overwhelmingly involved internet-generated frauds, featuring increasingly sophisticated and deceptive schemes that promise rapid and substantial gains for participants.

The challenges posed by cryptocurrency frauds are severe and can have life-changing implications for many victims. The defendants, otherwise known as fraudsters or hackers are drawn to such schemes due to the favourable investment environment, which provides a readily available market of victims, coupled with the potential for enormous gains by stealing bitcoins purchased using victims' fiat currency, especially in a robustly growing market. When these wrongdoers are “Persons Unknown” who are unlikely to pay back the claimants, claimants may try to involve big players in the crypto sector – with deep pockets – in the disputes, either as a source of information or as a source of liability and funds.

In general, English law mandates the service of legal documents on defendants located outside the jurisdiction in compliance with local laws. However, exceptions exist, and English procedural rules allow for alternative means of service when deemed appropriate. Many countries globally have adhered to the Hague Service Convention, and deviating from the convention's prescribed service methods for a specific country would conflict with convention rights.

To address this, English case law stipulates that a court should authorise service outside the convention's requirements only in exceptional cases, and in non-convention situations, when there is a compelling reason to do so. Regarding Person Unknown defendants, there is typically no practical way to serve proceedings other than through alternative means. Since the court is unaware of whether the defendant is located in a Hague Convention state or not, English courts have demonstrated willingness to permit service through various alternative channels. This often includes email, using the email addresses associated with the fraud, as well as service on the Exchange administering wallets utilised by the fraudsters. Additionally, service through NFT to wallets linked with the defendants has also been accepted in such circumstances.

Recovering lost funds presents substantial procedural and jurisdictional hurdles, consistently manifesting common themes across cases. In the midst of this acute distress, victims grapple with the task of securing legal representation to navigate a technically and legally intricate environment. Typically, victims domiciled or residing in England, or those who have suffered losses in England, confront the necessity of obtaining information disclosure orders against wallet administrators. They also seek worldwide freezing and/or proprietary freezing orders against unidentified fraudsters likely situated in offshore jurisdictions. These fraudsters, identifiable only by their email addresses used in carrying out the fraud, present challenges of identification and jurisdiction.

The modus operandi of most of these frauds follows a familiar pattern. Perpetrators advertise enticing investment opportunities through social media or online platforms. Victims, making contact via email or phone, are persuaded to purchase cryptocurrency using their fiat currency savings or loans. They then grant access to the relevant wallets, providing the private key or access to their PC, ostensibly allowing legitimate investment services. The purpose of this access is often to utilise the victim's crypto assets for activities such as arbitrage trading or transferring cryptocurrency among different individuals to generate artificial gains. Fraudulent schemes frequently involve the creation of fake trading account statements indicating substantial profits. Discovery of the fraud occurs when victims attempt to regain control of their assets, encountering excuses, demands for additional payments, and ultimately, unresponsiveness from the fraudsters. Additional claims have encompassed efforts to retrieve ransoms paid in cryptocurrency for malware removal, the recovery of cryptocurrency invested in non-existent investment schemes, and the retrieval of bitcoin unlawfully taken through fraudulently acquired login credentials.

The courts have demonstrated that they are well prepared to handle claims involving crypto based on their treatment of cases so far. Although the jurisdiction of the court hinges on the lawful service of originating process to a defendant. For example, if a defendant is situated outside England and Wales, the court attains jurisdiction only when the claimant secures permission from the English court to serve proceedings on the defendant, regardless of their location.

Another practical concern pertains to the location of a crypto asset, particularly in the context of extra territorial claims against alleged fraudsters. This becomes crucial because the jurisdictional gateways relevant to a proprietary claim typically focus on events within the jurisdiction or property situated within it. Moreover, the location of the property subject to the claim often determines the applicable governing law, significantly impacting the choice of whether to initiate the claim in England and Wales. Initially, courts generally regarded crypto assets as situated where the owner is domiciled. However, this approach has recently evolved, now being tested with reference to the owner's residence.

There is an increase in cases that involve cryptocurrencies or other digital assets between banks, as well as cases that involve one or more crypto-related companies, even if not directly related to the dispute. This trend is likely to continue.

Shoosmiths’Key crypto case tracker highlights some of the new legislation that will have an effect on clients, which include:

• Jones v Persons Unknown, where the court granted summary judgment for the claimant who claimed that Huobi, a Seychelles-based crypto exchange, controlled the wallet where the stolen Bitcoin was transferred, no-one had a better claim to the Bitcoin than the claimant, and so Huobi held the Bitcoin on trust for the claimant. The court ordered the wrongdoers and the exchange to return the Bitcoin.

• AA v Persons Unknown, where Crypto assets are defined as property at common law for the first time following the granting of a proprietary injunction over Bitcoin traced to Bitfinex, paid originally to hackers as a ransom.

• Piroozzadeh v Persons Unknown, where the court doubted that merely receiving funds from a previous wrongdoing – without more involvement by the exchange – would make the exchange a trustee. The issue will be further examined in the trial of D’Aloia v Persons Unknown, which is likely to take place in 2024.

• Tulip v Van der Laan, where the Court of Appeal determined that there was a compelling argument suggesting that the claimant, despite being a Seychelles registered company, was resident in the jurisdiction due to England being the location of its central management and control. Consequently, the property in question (Bitcoin) was deemed to be situated in England. Holding significance for jurisdictional purposes in England, particularly because the gateway for constructive trusteeship pertains to acts or events occurring within England and Wales or those governed by the laws of England and Wales.

• Osbourne v. Persons Unknown, similar approach taken to Tulip v Van der Laan, above.

Some things never change 

Of course, there are some high profile disputes and insolvencies (such as the risk of poor corporate governance and outright fraud that led to Three Arrows’ and FTX’s collapse) which require no specific legislative or common law changes: these instances involved good, old-fashioned malfeasance.

Further challenges 

While it is relatively easy to identify the “mind and management” of entities such as Three Arrows and FTX, smart contracts and new quasi-legal constructs such as Decentralised Autonomous Organisations (or DAOs) present a unique challenge to law and disputes.

Who is in charge of (and therefore culpable for) the acts and omissions of a DAO, a concept (a) not recognised by any jurisdiction and (b) by its supposed very nature with no “mind and management”? Who would therefore be held liable for the acts and omissions of a DAO? In the United States, a court held recently that the nearest equivalent to a DAO was an unlimited partnership. The members of bZx DAO therefore were jointly and severally liable for its debts and obligations. Sometimes, common law’s flexibility to apply existing rules to innovative concepts can lead to an outcome no one who designed a DAO could have anticipated.

Further, who is liable for a smart contract (or blockchain/DLT) if it operates in a way which causes a loss? Typically, the protocols for these contracts and blockchains will be opensource. Against whom would a person who suffered loss as a result of a smart contract being poorly coded seek redress?

Current Economic Conditions 

Globally, the accelerating adoption of blockchain/distributed ledger technologies and crypto assets by established market participants and new entrants alike is changing the world around us. In parallel, the rapid technological and commercial advancements in this emergent space are giving rise to novel issues ranging from the nature of proprietary and security rights in crypto assets, tracing of and enforcement against crypto assets, the legal status of new forms of organisations, potential liabilities of intermediaries, developers and programmers, and conflicts of laws.

The United Kingdom itself has witnessed a rapid rise in the popularity and adoption of cryptocurrencies and other crypto assets. Given the rapid growth in the industry in recent years, and the relative novelty of some of the issues that have arisen, disputes in this area tend to have significant direct and indirect consequences. Decisions in even some of the smaller cases by value can have outsized consequences for the wider industry and are therefore often heavily fought.

The sector has also faced significant volatility and uncertainty, as the prices of crypto assets fluctuate rapidly and unpredictably, influenced by various factors, such as supply and demand, technological innovation, regulatory developments, cyberattacks, and market sentiment. This is where we can expect to see more claims arising from the insolvency or bankruptcy of crypto companies, or from the poor performance of companies in the sector.

These may include disputes over investments, corporate transactions, and joint ventures, where an investor or a fund may want to exit a bad investment, or disputes over the valuation of collateral, which may be in the form of crypto assets. As with any new financial innovation, we also expect to see claims against bad actors who exploit that innovation, such as by ‘rug pulls’, where developers promote crypto asset projects and disappear with investors’ money without delivering the project.

Level of Activity, Trends, and Developments 

Despite the risks and challenges, the sector also offers significant opportunities and benefits for clients and the legal profession, such as:

• Competition and choice: Crypto assets may increase the competition and choice in the financial market, by challenging the dominance of incumbent players and offering alternative or complementary solutions to the existing ones.

• Inclusion and empowerment: Crypto assets may increase the financial inclusion and empowerment of individuals and businesses, by providing access to alternative sources of funding, payment, and investment, especially for the unbanked or underbanked populations. Crypto assets may also foster the participation and collaboration of diverse and distributed stakeholders, by creating peer-to-peer networks and communities that are governed by consensus and incentives.

• Innovation and efficiency: Crypto assets enable new and innovative ways of creating, transferring, and storing value, without relying on intermediaries or central authorities. Crypto assets may also enhance the efficiency, transparency, and resilience of the financial system, by reducing transaction costs, processing times, and operational risks. Crypto assets may also enable new business models, products, and services, such as decentralised applications, smart contracts, and decentralised finance (DeFi).

As new crypto assets are created and new platforms are launched, new use cases are explored and the universe of firms involved in the crypto asset sector expands (including traditional businesses which would not regard themselves as being in the “crypto asset business” and fintech firms which are in the value chain). Some of the current trends and developments in the sector include:

• Central bank digital currencies (CBDCs): CBDCs are a form of digital money issued by central banks, which may use DLT or other technologies to enable the digital representation and transfer of central bank liabilities. CBDCs are intended to complement or replace the existing forms of money, such as cash and bank deposits, and to enhance the efficiency, security, and inclusiveness of the monetary system. CBDCs have attracted significant attention and interest from central banks and policymakers globally, as they may have profound implications for the monetary policy, financial stability, and payment system. According to a 2021 survey, 86% of central banks are actively researching CBDCs, 60% are experimenting with CBDCs, and 14% are deploying pilot projects. Some of the countries that have launched or are planning to launch CBDCs include China, Bahamas, and Sweden.

• Non-fungible tokens (NFTs): NFTs are a type of crypto assets that represent unique and indivisible digital assets, such as art, music, games, collectibles, or identity. NFTs use DLT to verify the ownership, provenance, and authenticity of the digital assets, and to enable their creation, transfer, and monetisation. NFTs have emerged as a new and exciting phenomenon in the market, as they enable the digitalisation and democratisation of the creative economy, and create new opportunities and challenges for artists, creators, and consumers. According to a report, the total sales volume of NFTs reached USD10.7 billion in the third quarter of 2021, up from USD1.3 billion in the second quarter of 2021. Some of the popular platforms and projects for NFTs include OpenSea, CryptoPunks, Axie Infinity, and NBA Top Shot.

• Stablecoins: These are a type of crypto assets that aim to maintain a stable value by being pegged or backed by another asset, such as fiat currency, commodity, or another crypto asset. Stablecoins are designed to address the volatility and scalability issues of other crypto assets, such as Bitcoin and Ethereum, and to facilitate the use of crypto assets for everyday transactions and payments. Stablecoins have gained popularity and adoption in recent years, as they offer the benefits of both crypto assets and fiat currencies, such as speed, security, transparency, and stability. According to an annual report, the global stablecoin market capitalisation reached USD130 billion in October 2021, up from USD37 billion in January 2021. Some of the prominent stablecoins in the market include Tether, USD Coin, Binance USD, and Dai.

Conclusion 

According to a recent report, the global crypto assets market capitalisation reached USD2.6 trillion in May 2021, up from USD193 billion in January 2020. The number of crypto assets users also increased from 35 million in 2018 to 221 million in June 2021. The UK is one of the leading markets for crypto assets, with an estimated 10% of UK adults owning some form of crypto assets, according to a survey by the FCA. The UK also hosts a vibrant and diverse crypto assets ecosystem, comprising of various actors, such as exchanges, custodians, brokers, payment providers, lending platforms, asset managers, and advisory firms.

In other words, the UK has no choice but to adapt its laws in order to thrive (or at the very least compete on the global stage).

Courts will persist in refining common law principles to address the challenges presented by a predominantly unregulated economic sector. Ongoing challenges will revolve around safeguarding those in need of protection, unless the sector collectively commits to developing systems capable of functioning seamlessly across borders, facilitating swift and cost-effective enforcement. It is conceivable that a universally accepted arbitral system may emerge, accessible for third parties seeking information or other orders against exchanges. This system could be embedded in an internationally recognised set of terms to which all sector participants are willing to adhere. It appears that relying solely on national regulation might not offer a comprehensive solution to these complexities.