Crypto-custodians insolvency proceedings: Clarifying the proprietary nature of crypto-assets
By Paúl Noboa-Velasco (San Francisco de Quito University)
The treatment of crypto-assets during the insolvency proceedings of crypto-assets exchange platforms is a question that remains unanswered. To begin with, it is uncertain if the holders of crypto-assets exercise proprietary rights over them. As a result, it is uncertain how the holders of said digital assets should be treated whenever the exchange that stores them becomes insolvent. Therefore, this post will analyze if crypto-assets should grant proprietary rights to their holders and, if so, if those assets should fall within the insolvency proceedings of the exchange platforms or if their owners, as the possible holders of proprietary rights, are entitled to exclude them from said proceedings.
Proprietary nature of crypto-assets
While some jurisdictions (such as Singapore) have conferred proprietary nature to crypto-assets, others (such as Japan) have refused to attribute said status. Concerning their legal nature, categorizing crypto-assets as the property of their holders could clarify their treatment during insolvency proceedings. Noteworthily, a distribution can only be made from the debtor company's assets in insolvency. Therefore, any assets owned by third parties will not fall within the company's insolvency proceedings and cannot be distributed among its creditors. In other words, if crypto-assets are considered property, their holders would be entitled to exclude them from the intermediary's pool of assets.
In contrast, if crypto-assets cannot be the object of property, their holders would only have contractual claims over them. Hence, they will have to participate in the pari passu distribution as unsecured creditors during the exchange platform's insolvency. Therefore, clarifying whether crypto-assets constitute property is relevant to determining how their holders shall be treated during the bankruptcy of a cryptocurrency exchange platform.
According to the UK Law Commission's report on digital assets, British law has traditionally recognized two categories of personal property: (1) things in possession which, broadly, are assets capable of possession (such as tangible goods), and (2) things in action, which are any personal property that can only be claimed or enforced through legal proceedings (such as shares in a company). Furthermore, according to the report, digital assets could not be categorized as property, either as things in possession, because they do not have a tangible existence, or as things in action, because they are not only enforceable through legal proceedings. As a result, the Commission proposed a third category of property to encompass the attributes and characteristics of digital assets. In contrast, a recent decision of the Singapore High Court, the ByBit Fintech case, has ruled that digital assets can be considered as things in action, confirming that crypto-assets constitute a form of property. This landmark case offers certainty that could influence how digital assets are treated during the insolvency proceedings of the intermediaries that take custody of them.
Furthermore, common law systems usually analyze four criteria to consider whether any right or interest shall be deemed as property. Following the Ainsworth case, "[property] must be definable, identifiable by third parties, capable in its nature of assumption by third parties and have some degree of permanence or stability." Gendall J, in the Cryptopia case, analyzed those considerations in relation to crypto-assets. Concerning the first condition, Gendall J argued that crypto-assets are identifiable with the encoded information allocated in the network, which is easily assigned to an account holder. The second condition, identification by third parties, requires that the owner shall have the right to control any asset and exclude others from said control. Gendall J argued that this requisite control over the crypto-assets is provided by the private key, which he likened to a PIN. Furthermore, Gendall J considered that cryptocurrencies are easily identifiable because the holders' public address appears as the last entry in the blockchain. Concerning the third criterion, capability of assumption by third parties, Cryptopia dictates that cryptocurrencies are continuously traded in an active market where the holders' rights are respected. Finally, cryptocurrencies meet the fourth criterion because blockchain, as an immutable technology, provides a system to ensure the necessary permanence and stability for crypto-assets. Therefore, based on the Ainsworth case, crypto-assets shall be considered property from a common law perspective. Further considerations ratify the proprietary nature of crypto-assets: (i) they are not mere information (because they cannot be easily duplicated and their transference requires a private key); and (ii) crypto-assets should be protected, from a public policy perspective, because they may allow legitimate commercial transactions.
In contrast, civil law jurisdictions usually divide property rights over material and immaterial goods. However, intangible goods have traditionally been associated: (i) with mere rights (either in rem or in persoman); and (ii) inventions and other creative ideas deemed as intellectual property. Therefore, it has been argued that civil law jurisdictions have been customarily reluctant to acknowledge a third type of property: intangible assets that are not deemed intellectual property. Nonetheless, the said traditional approach (derived from the Civil Codes enacted in the 19th century) has been modified by recent legislation in several civil law jurisdictions, which expressly concedes proprietary nature to intangible assets and, more narrowly, to crypto-assets. Furthermore, countries such as Ecuador, Colombia and Spain allow the transference of digital assets to a company's legal capital as a contribution in kind. Following that trend, articles 209 and 212 of the Ecuadorian Corporate Restructuring Bill (currently under legislative revision) recognize that crypto-assets shall be considered the property of any company facing restructuring or liquidation proceedings.
To sum up, the proprietary nature of crypto-assets in civil law jurisdictions, which usually adopt a narrower view of property than common law systems, will depend on the legal recognition of the said third category. However, conferring proprietary nature to crypto-assets is a growing trend in both jurisdictions, either by recent legislative amendments (in civil law jurisdictions) or by categorizing them as things in action or as a third type of property (in common law systems).
In both cases, conferring proprietary characteristics to digital assets will protect crypto-investors against the insolvency of crypto-custodians because those assets will be excluded from the pool of digital and non-digital assets available for other creditors. The Ecuadorian Corporate Restructuring Bill has adopted this approach, which ratifies that crypto-assets are deemed the property of any investor in the event of an insolvency proceeding.