Crypto Assets and Insolvency

The advent of crypto assets has disrupted conventional financial landscapes, introducing novel prospects as well as intricacies. One such intricacy is the phenomenon of insolvency within the cryptocurrency arena. As cryptocurrencies progressively gain popularity and usage, it is imperative to comprehend the potential implications of insolvency and bankruptcy on crypto assets and their holders. The recent judgment in the Bored Ape case has shed light on the status of non-fungible tokens (NFTs) as property and its implications for the future of crypto assets. This article offers a comprehensive examination of the current state of insolvency in the cryptocurrency world, including an in-depth analysis of the unique features of cryptocurrencies that may affect their treatment in insolvency proceedings. The article also provides a review of the existing legal frameworks and proposed solutions, providing a well-rounded understanding of the complexities of insolvency in the crypto arena.

By delving into the current state of affairs, this article aims to provide valuable insights for individuals and organizations operating in the rapidly evolving cryptocurrency field. Its goal is to bring clarity to the intricacies of insolvency in the crypto world and assist in informed decision-making within this dynamic and exciting landscape.

1. What are Crypto Assets in the context of the Bored Ape case?

In the latest judgment of the Singapore High Court¹, the Court looked into the question of whether the Bored Ape Yacht Club (BAYC), a unique collection of Bored Ape NFTs (i.e., digital collectibles constructed on the Ethereum blockchain), can produce proprietary rights that can be safeguarded by way of an injunction. The Court explained that crypto assets (including NFTs) are a network of entries or codes that are stored on a blockchain, and are merely considered as information. These intangible assets are incapable of being owned like chattels and, therefore, cannot be categorized as “things in possession.” They exist in a decentralized system wherein they derive their value from smart contracts and consensus. It is improbable that crypto assets can be perceived as a “thing in action”.

Since mere information does not qualify the criteria of being a “thing in possession” or a “thing in action”, more often than not, Courts in common law jurisdictions are hesitant to consider it as property. The Court went on to elucidate that the expression “thing in action” has, in the past, brought property of an intangible nature within its fold. However, there is ambiguity and a lack of direct authority to infer that crypto assets can fall within the ambit of “thing in action”. Thereafter, after considering legal precedents and commentaries on this matter, the Court took a broader view and noted that as per judgments examining the concept of property, information has been termed as a piece of knowledge that informs the reader.

The Court then touched upon the point of NFTs. It stated that information, concerning NFTs, is a string of information codes that dispenses information to the system wherein the control over the asset lies exclusively with the owner, along with its transferring rights. The Court has pointed out that information in terms of an NFT cannot be straight up dismissed as being part of the definition of property. The criteria laid down by the Court needs to be taken into consideration while assessing the inclusion of an NFT within the ambit of property.

1.1 What is a Non-fungible Token?

Non-fungible tokens are blockchain-based digital assets which have a unique identification code. These asset-backed tokens indicate the authenticity of the asset associated with it, along with its ownership. Fungibility, in economic terms, refers to the uniqueness of an asset i.e. whether it has the ability of being interchanged with something of the same value. In contrast to this, NFTs are assets that cannot be exchanged or replaced, and are, therefore, unique. 

NFTs have blown up in recent years. These unique digital assets, ranging from music to art are being bought and sold online like exotic Van Gogh masterpieces. The idea is to generate a kind of scarcity in the ocean of an infinite digital world. Just as there is always an original work of art in the real world that can be attributed to an owner, in the digital world, an NFT is a digital original that is unique and whose ownership can be determined.

Owing to their growing popularity and value across the globe, India too has seen a considerable rise in NFT trading, which has, in turn, resulted in legal challenges to the interplay between NFTs and the Insolvency and Bankruptcy Code, 2016.

1.2 Ainsworth Criteria: Whether Crypto Assets can be characterized as property or not?

In the Bored Ape NFTs judgment pronounced by the Singapore High Court, the Court called attention to the House of Lords’ matter of National Provincial Bank v. Ainsworth (hereinafter referred to as the Ainsworth criteria^[1]), wherein Lord Wilberforce opined that before “a right or an interest can be admitted into the category of property or a right affecting property, it must be definable, identifiable by third parties, capable in its nature of assumption by third parties, and have some degree of permanence or stability.” To put it in simple terms, in order for an interest or a right to pass the test of being classified as property, it is pertinent to ensure that the interest or right is unique in nature, is exclusive, transferable, and has permanency or some sense of stability. The Ainsworth criteria is widely used to determine whether Crypto Assets can be characterized as property or not.

With reference to an NFT, its identification code and metadata is what gives it its unique character, and therefore, it is capable of being defined. NFTs are stored in digital wallets which give access to these assets by assigning a private key specific to a particular address, thus authorizing the owner of the wallet to have exclusive control over the asset. The permanence of keeping NFTs in digital wallets is akin to keeping money in a physical wallet, and the owner can transfer control by transferring the private key. For the afore-stated reasons, the Court concluded that NFTs ticked all the boxes of the Ainsworth criteria, as a result of which the rights and interests in the NFTs ought to be protected by way of granting the proprietary injunction.

1.3 Is the decision laid down in the Bored Ape Case universal for all NFTs?

In an analysis of service terms of eight platforms dealing in NFTs,^[2] it was observed that the property rights of relevant assets are not encapsulated in the case of all NFTs. It can, therefore, be concluded that Crypto Assets (including NFTs) may or may not be characterized as property, depending on the contractual framework on which it is built. However, generally speaking, it has all the ingredients of a property.

2. Issues revolving around Non-Fungible Tokens

The legal status of NFTs in the United States is a subject of considerable intellectual discourse and ambiguity. Despite calls for regulation, no comprehensive framework has yet been established by the Securities and Exchange Commission (SEC). While some within the SEC have suggested that NFTs may fall under the category of “investment contracts”, and thus be subject to legal restrictions, a formal statement on the matter has yet to be issued.

The notion of “investment contract” is defined by the landmark ruling of the Supreme Court of the United States in SEC v. W. J. Howey Co.^[3] This ruling establishes that an investment contract arises when an individual invests money in a common enterprise, with the aim of generating profits through the actions of others. The question of whether the profits realized are a direct result of third-party efforts remains a matter of case-by-case evaluation.

NFTs are traded in cryptocurrency exchanges, and the biggest hindrance in their trading is the conundrum of their legal status. In Internet and Mobile Association of India v. Reserve Bank of India^[4] (IMAI Case), the Supreme Court struck down the Reserve Bank of India’s April 2018 circular which directed all the regulated entities to abstain from dealing in cryptocurrencies. The Court pointed out that the impugned circular was unreasonable, and therefore, violated Article 19(1)(g) of the Indian Constitution. Subsequently, since early 2021, the government has amended its approach towards cryptocurrencies and has reconsidered a blanket ban on them. This, along with amendments made by the Ministry of Corporate Affairs to the Companies Act requiring disclosure of crypto-assets and cryptocurrency transactions in company balance sheets, has greatly contributed to the growth of the cryptocurrency ecosystem in India.

Despite this growth, there remains a lack of regulation and identification surrounding crypto-assets in the country. This raises the question of how pre-existing statutes, such as the Insolvency and Bankruptcy Code of 2016, would apply in the event of an insolvency process involving crypto-assets.

There is still debate among scholars and industry experts on the classification of cryptocurrency under Indian law. While the Supreme Court in the IMAI case stated that cryptocurrency lacks legal tender and cannot be considered a currency, the government of India has recently clarified that gains from the transfer of cryptocurrency are taxable under the Income Tax Act of 1961, suggesting that it falls under the category of goods. This is further supported by the possibility of the government levying an 18% GST on foreign crypto exchanges for transactions with Indian citizens, as well as the analysis of how other jurisdictions, such as the USA and UK, treat cryptocurrencies like Bitcoin and Ethereum as commodities.

The Securities Contracts (Regulation) Act, 1956 (SCRA) in India categorizes a derivative as a financial instrument whose value is contingent upon the prices or index of prices of the underlying securities. If NFTs are deemed to fall within this definition, they are subject to the provisions of Section 18A of the SCRA, which stipulate that such contracts must be transacted on a stock exchange recognized by the Central Government. As a result, the platform where NFTs are traded would be obligated to pursue recognition as a stock exchange through a formal application process with the Central Government.

The classification of NFTs as either securities or contracts is a complex issue that depends on the specific attributes and promises embodied in each NFT. NFTs are often considered to be unique and non-fungible digital assets that serve as proof of ownership or authenticity of a certain asset or artwork. In this context, they can be viewed as contracts that transfer ownership rights in the underlying asset, similar to traditional contracts. However, if an NFT provides fractional ownership interest in a larger asset or if it promises returns on investment based on the performance of the underlying asset, it may be considered a security. This is due to the fact that such an NFT would confer an investment interest in the underlying asset and would therefore resemble a derivative financial instrument.

​​In this case, an NFT may be subjected to the jurisdiction of securities regulations, which are designed to protect investors from fraudulent or speculative investment products. It is important to note that the regulatory treatment of NFTs can vary from jurisdiction to jurisdiction, and the specific features and promises associated with each NFT must be meticulously evaluated in order to determine their regulatory status.

The regulatory treatment of NFTs can vary greatly depending on the specific attributes and promises associated with each NFT, and it is essential to conduct a comprehensive analysis of the underlying legal and regulatory framework in order to determine the proper classification of each NFT.

3. The Applicability of the Indian Insolvency and Bankruptcy Code (IBC) to Cryptocurrency

The advent of cryptocurrency has challenged the traditional financial system and raised questions about the regulatory framework for insolvency proceedings. The Indian Insolvency and Bankruptcy Code (IBC), 2016, is the legislative framework for Insolvency proceedings in India and governs the process of restructuring and liquidation of debtors. We will discuss the applicability of IBC to cryptocurrency and the challenges faced by Insolvency Professionals while handling restructuring processes involving cryptocurrency.

Classification of Cryptocurrency as Operational Debt:

As per Section 3(11) of the IBC, a debt could be financial or operational in nature. Section 5(21) of the IBC categorizes a debt involving cryptocurrency as an operational debt, as cryptocurrency can be considered “goods.” A corporate debtor is liable to pay if there is a default concerning an operational debt involving cryptocurrency.

The Role of Insolvency Professional:

Once the default is established by the Adjudicating Authority and a restructuring order has been passed, the creditor with the help of the appointed Insolvency Professional, can take control of the debtor’s property to resolve the default in payment. According to Section 3(27) of the IBC, property includes money, goods, land, or actionable claims, and since cryptocurrency falls under the category of goods, an Insolvency Professional can take control of the same while handling a restructuring process. Even if the cryptocurrency is placed in a private cryptocurrency wallet, the Insolvency Professional can take control of it.

Problems and Challenges:

• The lack of regulation and identification of cryptocurrency: creates several challenges for Insolvency Professionals while handling restructuring processes involving cryptocurrency. One such issue is the determination of the existence of cryptocurrency assets of the debtor. However, the recent amendments made to Schedule III of the Companies Act, 2013, require companies to disclose their cryptocurrency assets, making it easier for Insolvency Professionals to establish the existence and location of the assets.
• The valuation of crypto assets: that could result in full-blown legal battles where parties litigate the correct valuation using expert witnesses, evidence, and comparisons to comparable assets. But with digital assets being so volatile, and typically not tied to any external fixed prices or scales, the task of determining value is going to be much harder. Additionally, the bankruptcy proceedings under IBC have no specific provisions to conduct the valuation of the crypto assets.
• Hot and Cold Wallets: Another issue in the insolvency of crypto assets is that they are held offline on ‘cold wallets’, with no central authority or bank to send you a notice of appointment that can transfer or freeze crypto assets to your wallet. This differs from ‘hot wallets’ where crypto assets are typically held with an exchange, which an administrator, liquidator, or trustee could write to. What happens when the person holding the wallet forgets the key to their own wallet? Many crypto assets are held in decentralized wallets that no one can access because the key is forgotten and there is no way to reset it. It’s therefore crucial that the Insolvency Professional engages experts that can help secure and look to re-key crypto assets.^[5]
• Cooperation of the Custodial Cryptocurrency wallet: The Insolvency Professional also requires the full cooperation of the debtor to take control of its cryptocurrency assets, as they are usually stored in a private cryptocurrency wallet and can be accessed only by a private key. If the cryptocurrency assets of a debtor are stored in a custodial cryptocurrency wallet, the Insolvency Professional might face some inconvenience while segregating the debtor’s cryptocurrency assets from the assets of other customers of the custodial cryptocurrency wallet provider.
• Cross-border issue: The cryptocurrencies run on distributed ledger technology, and are not located in any one jurisdiction. The precedents set by insolvent crypto exchanges around the world have shown the need for office holders and trustees to seek enforcement orders for recovery in various jurisdictions. In the absence of consistent cross-border regulation, it’s also possible that multiple jurisdictions could have contradictory judgments. As an example, if security hasn’t been registered over crypto assets in England, it may be invalid under English law, but the Indian court might still recognize the security’s ^[6]
• Volatile nature of cryptocurrency: The volatile nature of cryptocurrency presents another challenge for Insolvency P Liquidating a large part of cryptocurrency assets in one go or in a short time can affect the price of the concerned cryptocurrency. In 2018, the Gox trustee^[7] converted a considerable segment of cryptocurrency assets into cash for distribution to creditors, which drove down the price of the concerned currency and was heavily criticized by the creditors.

Conclusion

In conclusion, the lack of proper identification and regulation of crypto assets presents considerable challenges for Insolvency Professionals globally, when navigating through the resolution process involving cryptocurrencies. While the government has attempted to establish regulations for the cryptocurrency market, these efforts have yet to produce tangible results.

As the use of cryptocurrencies continues to grow, the market will increasingly recognize the need for a clear and comprehensive legal framework for the insolvency of debtors dealing in  crypto assets. Therefore, it would be in the best interest of every stakeholder that the economies of the world develop a sound jurisprudence for dealing with such issues by means of meticulous deliberation and active participation of the legislature and judiciary. It is anticipated that the increasing prevalence of cases involving cryptocurrencies will bring about the necessary changes to the existing rules and regulations, Taking this into consideration, the major task is to balance the interplay between existing laws and the intricacies of crypto assets in order to develop a stable regulatory infrastructure for dealing with them.

Reference:

[1] 1965 AC 1175 at 1248.

[2] UK Jurisdiction Taskforce, “Legal statement on crypto assets and smart contracts” (November 2019), https://technation.io/lawtechukpanel/ (last visited Feb. 5, 2023)

[3] SEC v. Howey Co., 328 U.S. 293 (1946)

[4] Writ Petition (Civil) No.373 of 2018

[5] Grant Thornton, https://www.grantthornton.co.uk/insights/challenges-posed-by-cryptoassets-in-restructuring-and-insolvency-appointments/ (last visited Feb. 5, 2023)

[6] Ibid.

[7] Joanne Molinaro and  Susan Poll Klaessy, Crypto As Commodity, And The Bankruptcy Implications, Law360 (2018), https://www.foley.com/en/insights/publications/2018/10/crypto-as-commodity-and-the-bankruptcy-implication (last visited Feb. 5, 2023)

1. Janesh s/o Rajkumar v Unknown Person (“CHEFPIERRE”) [2022] SGHC 264[↩]