Crypto assets in corporate insolvency in Cyprus
Ioannis Sidiropoulos of Elias Neocleous & Co discusses the key issues for insolvency practitioners to consider when an estate includes crypto assets in Cyprus
Currency is a significant expression of state power in the public sphere. It determines the capacity of the state to project power through its external economic relationships and trade agreements. There is also an internal aspect where power is expressed through regulating the relations between private market players, including their credit arrangements, underpinned by a legal framework based on consistent principles.
Throughout modern history, credit systems have functioned based on traditional monetary rules that have followed the same patterns. In other words, the economics entailed by the use of currencies as a means of payment provided a level playing field for the unravelling of all economic relationships, both external and internal.
The utilisation of distributed ledger technology (DLT) in transactions and the advent of crypto assets are bringing about a revolutionary change in economic relations. Bitcoin, and crypto assets of similar monetary instrument architecture (cryptocurrencies) in general, may create some difficulties for central banks in applying monetary intervention as an economic policy tool.
Even the founders of the most prominent neoliberal economic model (Milton Friedman is the most distinguished theorist) put monetary control at the centre of their arguments, which has also been the case for all the hitherto established monetary theories.
In Cyprus, as in many other jurisdictions, cryptos are not recognised as legitimate currencies (yet). After all, under Article 10 of Regulation 98/974 EC, from January 1 2002, euro banknotes are the only ones with legal tender status in all EU member states, for the time being.
However, this is precisely the essence of the innovation crypto assets bring about; while not regulated yet (and, of course, not banned in our jurisdiction), they exist, they are used as a de facto means of payment, they are connected to the value of certain goods and services, and they represent some (albeit still quite volatile) value. For example, the University of Nicosia accepts payments in Bitcoin for its tuition fees.
The lack of explicit rules increases the profit margins but also the risks. This underlines the need for clarity in the traditional business settings these assets are now invading. As noted below, UK courts at least have already labelled crypto assets as property.
While all aspects are equally important, this article focuses on and provides some initial views about the distress/insolvency question. Increasing numbers of market players have started to try this kind of investment and some of them even provide security based on them. What would happen when a creditor has interests in an insolvent estate, including crypto assets? What would be the main points of concern, and how can insolvency practitioners address this problem in this misty and still under-regulated landscape?
The amount of uncertainty is still quite high. But (business) life goes on, no matter what. There are already economic relations being formulated involving many crypto assets, with no guarantee that some of them will not end up in distress situations.
DLT, including blockchain, is an innovative technology for the decentralised validation and distribution of information records, either privately or publicly, creating a repeated digital copy of data available at multiple locations. DLT and blockchain in particular is the underlying technology of crypto assets, which are created and exchanged in an encrypted form on a peer-to-peer network, i.e., electronic data is shared on a computer network and not on a server.
Transactions on the blockchain are recorded using algorithmic puzzles resolved by the participants in the blockchain framework (‘miners’), who receive a reward for their calculation and resolution efforts. Blockchain is effectively a record, contained in code recorded on the blockchain (a digital ledger), of a series of transactions recording the ‘creation’ and ‘transfer’ of transactional subjects.
Crypto assets in general are diverse but share at least a common characteristic, namely the fact that they utilise cryptography, particularly a cryptographic system of pairs of keys: the public keys are publicly known addresses and are used for identification. In contrast, private keys are not publicly known and are used for authentication and encryption, serving as proof of ownership of a crypto asset. These are known as decentralised finance (DeFi) arrangements.
There are several types of wallets for crypto assets/currency storage. One classification is between hot and cold wallets. Hot wallets are hosted by third parties such as online cryptocurrency exchanges. Cold wallets are not connected to the internet and may be held on a USB-like drive.
Additionally, there are software wallets, on the one hand, on computers or mobile phones, and hardware ones, which are devices specifically designed to store cryptocurrencies and which are supposed to shield from digital hacking, on the other. Understanding of these options becomes particularly important for insolvency practitioners (IPs) trying to determine the existence of such assets in an insolvent estate.
Crypto assets on the credit ground
The agony to define
Despite the above, crypto assets, particularly bitcoin, are becoming increasingly difficult to define in actual transactional terms. This is not surprising as there are no specialised laws at the EU level concerning crypto asset activities. The EU aspires to regulate crypto assets services under the EC’s proposed Regulation on Markets in Crypto Assets.
Considering crypto assets as property (as it will be explained further below), the concept of ownership will have to apply to them. A person who has acquired knowledge and control of a private key by some lawful means would generally be treated as the owner of the associated crypto asset, as would be the case with the lawful possession of a tangible asset.
Of course, ownership will also depend on the circumstances and on the rules of the relevant system, i.e. a person may hold the key on behalf of another, or as a custodian or intermediary, agency or trust rules being relevant in this regard; or a crypto asset may have multiple keys, so, ownership may be shared or separated between the holders.
As it stands currently, the actual parameters of ownership and control of crypto assets are legally undefined (a short analysis follows below), and valuation is also obscure. Cyprus plans to introduce national legislation on the matter soon (but it is not clear when exactly), having already drafted a relevant bill, which is going to provide particular guidance in terms of the property status of this kind of assets. CySEC has also provided some regulatory guidance, mainly about the registration of Crypto Asset Service Providers (CASPs).
Crypto assets of interest for this analysis are those that are a digital representation of value not issued or guaranteed by a central bank (thus, central bank digital currencies are not in the scope of this article) or a competent authority. They are not necessarily connected to a fiat currency, not attributed an official legal status of currency, but accepted by natural or legal persons as a means of exchange and which can be transferred, stored and traded electronically. They do not qualify for regulation under the Markets in Financial Instruments Directive or the Electronic Money Directive.
Crypto assets can be significantly productive investments if appropriately managed by well-informed investors. However, it is rational to expect that some entities will have to resort to various forms of reorganisations with or without the courts’ engagement and may not avoid corporate failure, finally. Like any other business, token issuers, funds or intermediaries servicing the crypto asset industry that have accumulated capital by these means may have to encounter pressing creditor claims, devaluation of assets, or various technical and/or regulatory adversities. In this regard, as is also the case in Cyprus, a receiver or another insolvency practitioner (IP) may be appointed in the context of disposing of creditor claims.
It is essential to clarify that there can be many kinds of risks that could cause the financial position of a crypto asset investor to weaken (and cause distress). Possible distress of crypto asset positions should not be attributed solely to the volatile nature of crypto asset/currency prices – something that can be offset, to some extent, by prudent leveraging of one’s investment portfolio.
The risks of crypto asset-related investments can be related to investors lured into unsuitable investments due to the lack of information, a trait of crypto asset positions. They can also result from technological challenges, such as coding errors in smart contracts, cyberattacks, fraudulent activities, double spending or other abusive opportunities. Other aspects include custody risks. For example, the possibility of theft of the hardware where the private keys are held cannot be excluded.
Moreover, there can be financial stability risks associated with systemic risks due to the broader use of crypto assets as a means of payment/exchange. CySEC has issued several warnings about these pitfalls. And of course in an underregulated environment, there are legal risks, which this article attempts to address.
Existing cryptocurrencies are not mutable. This means, among other things, that once they are transferred from one wallet to another, this process cannot be reversed, as can existing/traditional transactions. In this context it would be useful for the reader to imagine a classic insolvency scenario whereby the IP tries to reverse certain kinds of transactions, i.e., those during the suspect period.
A further challenge stemming from decentralisation is that control of cryptocurrency networks is not a matter of a single entity but distributed across numerous stakeholders across the network. So each network member maintains a copy of the ledger, and changes in the ledger need consensus on the proposed change by at least the majority of the participants in the network.
These difficulties will become more obvious with the greater use of smart contracts. This article will not discuss further this, automatic settlement, contractual analysis, as it is still early to draw even some first conclusions, in terms of distress. Clarification attempts, such as the quite recent ones by the International Swaps and Derivatives Association, are some first, particularly welcome, initiatives to shed light on this part of the discussion.
For the time being, when asking ourselves what constitutes a crypto asset from a legal point of view, we are trying to consider what kind of rights investors and creditors can base their claims on in a crypto asset-related insolvency, i.e., the legal status of the asset, of the claim, and how to make distributions. The above risks can cause problems. But they also call for a differentiated approach, which could even take the form of a new kind of property right.
International insolvency cases
In the case of Bitgrail in 2019 (Court of Florence Bankruptcy Docket Nos. 178/2018 and 205/2018 Decision No. 17/2019), crypto assets were labelled as property but were treated as mixed with the other assets by the custodian. This understanding provided only the option of a contractual claim to the custodian’s clients, which was also the result of the earlier 2015 Japanese case of Mt Gox (judgment of Tokyo District Court).
Again, in 2019, in the case of Cryptopia (Ruscoe v Cryptopia Ltd, NZHC 728) crypto assets were not considered separate from other assets. The judicial innovation here was an assumption that a trust had been created, with an associated proprietary interest in the assets held by Cryptopia for its clients.
In the 2020 Singapore case of B2C2 Ltd v Quoine Pte Ltd , a question was whether Quoine held the bitcoin in question on trust for B2C2. In its analysis, the Singapore Court of Appeal noted: “There may be much to commend the view that cryptocurrencies should be capable of assimilation into the general concepts of property. There are, however, difficult questions as to the type of property that is involved.” The Singapore Court of Appeal did not arrive at a firm conclusion because it found that there was no certainty of intention to create a trust.
In AA v Persons Unknown EWHC 3556, a 2020 case, the England and Wales High Court faced the question of whether bitcoin could be classified as property in terms of a proprietary injunction to recover stolen cryptocurrency as a result of a cyberattack. The court accepted that crypto assets could be treated as property, even if they do not meet the actual definition of the latter, and the labelling them as ‘a third type of property’ can be a good idea. Ultimately, the injunction was granted.
AA is a landmark case, and includes findings and admissions that will be the basis for future judicial, regulatory or general business deliberations. It followed the 2019 insight of the United Kingdom Jurisdictional Task Force (UKJT) according to which crypto assets possess all the characteristics of property and their intangibility ought not to disqualify them.
This was further confirmed in the 2021 Re Quadriga Fintech Solutions Corporation case, where the Canadian court held that the definition of property under Canada’s insolvency law accommodates cryptocurrencies.
In any case, it is becoming clear that the implications of crypto asset functions and their low dogmatic compatibility with the current theoretical structures will bring about the need for different characterisations.
The insolvency academic and business communities are familiar with the notion of (re)characterisation when addressing how different assets must be handled in the context of various settings of credit distress. Thus, crypto assets are expected to become a matter of asset-shielding and cherry-picking, presenting a major challenge for creditors and IPs in the near future.
Handling the problem
Assistance from AML framework
As mentioned above, there is still no dedicated legislation and case law on these matters in Cyprus, apart from the provisions of the law transposing the Anti-Money Laundering (AML) Directive into national law concerning crypto assets service providers. From an institutional point of view, the existence of AML rules in place can be crucial in crosschecking factors of financial mischief that may drive distress.
The guidance of the Financial Action Task Force was updated in October 2021 and is equally significant in terms of clarifying the concepts of control or sufficient influence over DeFi arrangements (i.e., who sets transactional parameters, holds an administrative key, retains access to the platforms, collects fees or realises profit), thus tackling the anonymity problem of the crypto-assets business. However, the mission of these frameworks is not to tackle matters of corporate debt distress.
Ascertaining the law governing the issues relevant to taking crypto asset-related security/collateral and the possible consequences of the insolvency of a system participant is still extremely difficult due to the sui generis nature of virtual assets held on a DLT system and also of the multiplicity of choice of law. While a definite answer is not desired to be provided on the latter issue here, before the courts do, as a starting point this could be determined based on the debtor’s centre of main interest (COMI) or where they are domiciled.
This would align the concerns here with the general deliberations of the COMI rules that apply in the case of insolvency (which only permit main insolvency proceedings to be brought in the EU member state in which the debtor has their centre of main interests). Of course there may be the possibility for secondary proceedings/requests for freezing orders in the jurisdictions of the servers of exchanges.
In the absence of specific judicial guidance, insolvency legislation will be applied based on the nature of the transaction the crypto assets relate with and accepting, for now, that crypto assets are a form of property.
Insolvency framework and IP strategy
Cyprus insolvency law includes an array of provisions that could be applicable. The first point of caution is that courts/IPs must make sure any hidden crypto assets do not distort the application of the insolvency tests of Section 212 of the Companies Law (Cap. 113), i.e., the reliability of the ‘inability to pay’ indicator so that they are sure there is no successful effort to initiate insolvency protection when it is not deserved. In general, Cyprus courts seem to have applied this test with rigorousness.
When a relevant procedure is initiated, IPs and the court have the right to receive information about the debtor’s property and this right could be applicable in the case of crypto assets. Examples are the following sections of Cap. 113, 224 (obligation of directors to provide information), 235 (access to liquidators accounts), 253 (inspection of corporate books by creditors), and 340 concerning special reports of the debtor company’s business addressed to the receiver/creditors, Section 231 about preserving the debtor’s property by a liquidator and Section 232 about making a debtor’s property available to the IP, in the case of a winding up order. Moreover, the correct assessment of crypto asset-related aspects in the insolvent estate will most probably affect the IPs’ fees and remuneration (Section 230).
Thus, determining swiftly and efficiently whether a company holds crypto assets and then undertaking initiatives to realise any crypto asset(s) held must be top IP priorities. Failure of the IP in this regard could expose them to liability, i.e. Sections 234 and 238 Cap. 113.
IPs could try to find large files indicating blockchain downloads, possible utilisation of cloud technology, (particularly by businesses that would typically need not to use it), large passwords, etc. They should also bear in mind that an insolvent entity could turn some of the assets of the insolvent estate into crypto assets and then dispose of them.
As in any other case, it is highly recommended that IPs, as per their legitimate powers, immediately seize control of the crypto assets (in particular the private keys). One way to achieve this is to transfer to a cold wallet designated for this task. Handling this kind of asset requires high technical expertise, so it would be advisable that IPs request the assistance of a trained and capable professional. Apart from the danger of hacking (relevant to the hot wallets), the IPs should also be vigilant about access to those wallets, which must only be granted to the authorised person(s), due to the obvious danger of asset dissipation, as seems to have happened in the case of Cryptopia.
Apart from the above-mentioned case of AA v Persons where an injunction was granted, in another case, of 2018, the Moscow Arbitration Court ordered a non-cooperative debtor to disclose the details of his cryptocurrency portfolio and decided that the latter should be included in the insolvency estate (decision of the 9th Appellate Court of Moscow, Case No. A40-124668/2017). The decision was based on the opinion that creditors should not be deprived of the value of the cryptocurrency unless that value was expressly excluded by law. The courts’ role could also be important in ordering the debtor to disclose whether there are third-party rights on the particular crypto assets.
Of course, due to the lack of regulatory clarity in the field, the lack of domestic case law, and the obscure nature of the crypto assets themselves, it is difficult to determine the level of judicial protection actually available to creditors seeking satisfaction for their claims. In Cyprus, there are judicial tools that can be of assistance in this regard, such as freezing orders (served to exchanges, in the absence of crypto asset accounts in the banks) to ensure that the insolvent estate does not dissipate.
The order must have a worldwide effect, as it will not always be apparent where the crypto assets are held. In the case of fraud, as this is defined in Section 36 of the Civil Wrongs Law, Cap. 148, any fraudulent preference transaction made or done by or against a company within six months before the commencement of its winding up may be invalidated (Section 301, Cap. 113). Transactions and asset tracing is facilitated by the nature of blockchain holding a record of past movements (although this will be a costly and energy consuming exercise).
Valuation and realisation
Regarding valuation (Section 251A, Cap. 113) and realisation of crypto assets, it is essential to remember that crypto asset/currency prices are highly volatile. Also, there is no single and agreed conversion rate in this market, as there is no interbank offer rate designated for crypto asset exchange operations. And indeed, recent experience has shown that the conversion rate can fluctuate a lot in short periods. This becomes even more important if the creditors specifically ask to receive fiat currencies.
To achieve the best price for a crypto asset, it would be advisable for the IP to do their own research about the market and the exchanges and particularly about anything relevant to the assets at hand, to compare them with similar ones, and get an idea of how these communities work. Placing the cryptocurrency into an auction can also be an option, as Section 233.2, Cap. 113 provides. In any case, it would be advisable for an IP to seek court validation of their efforts.
Towards legal certainty
Insolvency mechanisms have proved to be of crucial importance for countries’ social and economic integrity. No matter how revolutionary crypto assets are, governments seem to eventually find ways to accommodate their existence within the current frameworks, possibly exercising maximum institutional ingenuity but still trying to compromise with the existing structures that cannot and will not disappear overnight.
For example, a remaining problem not addressed in depth in the article is the priority of claims. This needs to be resolved in close connection with the actual proprietary nature the jurisdictions will confer on crypto assets. Turning to the starting point of the article, the whole discussion touches upon the coexistence of fiat and cryptocurrencies and the equilibrium of power this situation is between public and private players in the monetary stage.
The solid and adjusted function of insolvency-related mechanisms can contribute towards greater clarity in the market and thus increase appeal to investors. Eventually, the crypto asset community members themselves will realise (if they have not already) that, as is the case with any other community, some rules will be needed to protect from the occasional bad apple in the barrel.
Everything outlined in this article points towards the relevance of current knowledge. Each of the above matters deserves an extended paper presentation. That is, of course, not possible here, where a high-level analysis is provided. In general, courts, IPs, individuals and businesses should familiarise themselves with cryptocurrencies and DLTs, and be educated and adequately advised on the potential pitfalls when interacting with them.
States must undertake mild regulation to protect the market players but at the same time ensure that they do not cancel the advantages of crypto asset transactions. Only with some legal certainty will these systems gain more credibility from investors, enabling them to mature and attain growth.
As far as Cyprus is concerned, lawmakers seem to have received the message of the times.
Associate, Elias Neocleous & Co