The churn in the digital assets industry, evidenced by the dramatic change in the fortunes of investors in digital assets such as Filecoin, EOS, DYDX, LooksRare, among others, and recently in FTX following its high-profile bankruptcy, has provided further basis for increased legal and regulatory scrutiny.
Suffice to say, this year has been a challenging one for the crypto industry and has brought key issues regarding digital asset tracing and enforcement to the fore.
Most legal systems have faced issues in characterising and ascribing rights and obligations to digital assets.Globally, laws and regulations have struggled to keep pace with innovation in the digital assets space.
From securities trading to restructuring and insolvency, most legal systems have faced issues in characterising and ascribing rights and obligations to digital assets. This is most acutely felt in the tracing and enforcement of digital assets.
In this article, we explore the key challenges and opportunities in the tracing and enforcement of digital assets, with a focus on English law and practice.
What is a digital asset?
A digital asset is any investment represented digitally or electronically. This includes crypto assets and tokens. For the purposes of this article, we assume that digital assets are capable of attracting personal property rights and are therefore valuable in the context of enforcing a judgment or award in respect of it.
English law recognises two categories of property: things in action and things in possession. The former relates to rights that can only be enforced by legal action. The latter relates to rights attaching to tangible property that is capable of physical possession.
For example, the car which a person owns is a thing in possession whereas a debt owed to them is a thing in action. However, having regard to the distinguishing features of certainty, exclusivity, control and assignability that apply to the existing categories, digital assets do not fall neatly into them.
It is not inconceivable for digital assets to go missing because of an investment scam or other fraudulent activity.Therefore, the Law Commission is currently reviewing the recognition and protection of digital assets in England and Wales. In a recent consultation paper, the commission recommended the creation of a third category of property: data objects.
To be a data object, a thing will need to: (a) be composed of data represented in an electronic medium, including in the form of computer code, electronic, digital or analogue signals; (b) exist independently of persons and the legal system; and (c) be “rivalrous” (its use by one person inhibits its use by others).
Ultimately, the characterisation of a digital asset in a legal system affects the rights and obligations that attach to it, and this in turn informs the tracing and enforcement options available to investors.
Why is digital asset tracing needed?
According to the Law Commission, the purpose of tracing is to enable a person to locate and identify their digital asset (or its proceeds or substitute) “through a series or chain of transactions, with the overarching aim of establishing a proprietary claim” against that digital asset.
It is not inconceivable for digital assets to go missing because of an investment scam (such as in the case of OneCoin) or other fraudulent activity. While this could result from textbook fraudulent misappropriation, bad actors continue to use increasingly sophisticated methods to defraud investors of their digital assets.
Like money laundering, scamsters may use layering transactions to obfuscate fund flows and evade financial surveillance. Layering crypto transactions can be done through multiple transfers to intermediate addresses and third-party services (such as dark pools, online casinos, and P2P exchanges), which makes the transfer and dissipation of digital assets quicker.
With the highly technical and fast-paced nature of the digital assets industry, the ability to trace these assets quickly and accurately is of paramount importance.Similarly, the origin and destination of funds can also be obscured using techniques such as coin swaps, cross-chain bridges, mixing services and chain-hopping. Perpetrators may also use privacy coins to evade oversight.
While digital assets can exist independently of the legal system (for instance, on a blockchain), it is not always possible to locate these assets without expert guidance due to the information asymmetry inherent in the digital asset trading system. The cross-border nature of digital asset trading adds another layer of complexity to the tracing process.
With the highly technical and fast-paced nature of the digital assets industry, the ability to trace these assets quickly and accurately is of paramount importance when seeking to establish what has happened to them and to protect an investor’s rights.
Tools for digital asset tracing and enforcement
While laws and regulations continue to play catch-up with the rapid advancements in the digital assets industry, there are some traditional tools under English law that can be repurposed for digital asset tracing and enforcement.
Information is key in any asset tracing and enforcement exercise. In this regard, disclosure orders play a vital role in addressing the significant information asymmetry between claimants and bad actors.
Worldwide freezing orders can nonetheless be useful to limit the risk of cross-border dissipation.Therefore, in addition to seeking disclosure from the defendants later on in the proceedings, claimants can supplement their knowledge of the wrongdoing by applying to the court for disclosure from various third parties caught up in the wrongdoing (for example, online casinos, P2P exchanges, banks), such as under the Bankers Trust or Norwich Pharmacal jurisdictions.
Such applications for disclosure can even be made before the wrongdoer has been notified of the claim. In this regard, English courts are making an increasingly creative variety of orders that permit claimants to notify defendants about the claim through unconventional means such as through social media or a non-fungible token on the blockchain (see the case of D'Aloia v Persons Unknown & Others).
Freezing orders, which are prohibitory in nature, aim to prevent the dissipation of assets by defendants (whereby they make their assets disappear in whole or in part) in anticipation of enforcing a judgment against them.
The English courts recently ordered a worldwide freezing order in a cryptocurrency fraud claim in the case of Fetch.ai Ltd and Another v Persons Unknown & Others.
While the digital assets industry continues to innovate at a rapid pace, its legal problems mirror the issues faced by traditional financial products.While freezing orders attach to the defendant and not the digital asset itself, worldwide freezing orders can nonetheless be useful to limit the risk of cross-border dissipation because they severely limit the defendant’s ability to transfer, and make use of, the digital asset or the proceeds of a sale globally.
Proprietary injunctions, which operate to freeze the property specified in the court order, are also useful to prohibit defendants from dealing with or disposing of the precise digital assets in respect of which the claimant asserts a claim.
In 2019, the English courts granted a proprietary injunction in AA v Persons Unknown and others held that cryptocurrencies are capable of being subject to proprietary injunctions.
Conventional enforcement methods such as the appointment of receivers, third-party debt orders, charging orders, and attachment of earnings continue to remain useful tools.
For example, in the digital assets context, parties have successfully obtained third-party debt orders from the English courts in an initial coin offering fraud case (Ion Science Ltd v Persons Unknown & Others).
Old wine in a new bottle?
Indeed, while the digital assets industry continues to innovate at a rapid pace, its legal problems, such as fraud and risk of dissipation of assets, mirror the issues faced by traditional financial products. Unlike conventional products however, there are information asymmetries inherent in the digital assets trading system owing in part to the limited regulatory oversight thus far.
Wrongdoers can take advantage of this information vacuum to defraud investors and rapidly transfer assets away from enforcing jurisdictions.
While the English courts await the lawmakers’ characterisation of digital assets, they are likely to continue to apply a combination of rights and remedies.The Law Commission recognises the difficulty of legal intervention in digital assets. While the English courts await the lawmakers’ characterisation of digital assets, they are likely to continue to apply a combination of rights and remedies currently available to investors.
This approach raises difficult questions and tests the limits of the adaptation of legal norms to emerging technology. For instance, it is unclear if the right to clawback the digital asset and to unravel transactions applies to insolvency procedures for digital asset entities such as crypto exchanges.
While the law continues to develop through legislative reform and judicial precedent, it is critical for parties to seek advice from experienced legal counsel and specialist digital asset tracing agencies at an early stage to minimise loss and maximise their chances of recovery.
Prateek Swaika is a partner and solicitor advocate and Sagar Gupta is an associate at Boies Schiller Flexner (UK)
