Cryptocurrencies and civil fraud: old solutions for new problems

The pitfalls of cryptocurrencies have once again been laid bare, with the news that Canada’s largest cryptocurrency exchange, Quadriga, has applied for creditor protection having been brought to a standstill following the sudden death of its young founder, Gerald Cotton.

by Richard Clayman, Associate, Peters & Peters Solicitors LLP

An estimated £105 million of digital currency is currently ‘lost’, believed to have been managed by Cotton from an off-line, encrypted “cold wallet”, which is, for now, inaccessible to Quadriga’s customers.

This story serves as a reminder of how far digital currency has to go before it can be considered a viable alternative to fiat currency. Nonetheless, the rise in popularity of cryptocurrencies since the creation of Bitcoin in 2009 continues to present challenges for civil justice all over the world. Given the comparatively scant real-world use of cryptocurrencies, they have earned a reputation as the tender of the underworld; anonymous, instantaneous, decentralised and inadequately regulated, an ideal tool for illicit transactions on a massive scale, and a ready means of concealing and laundering the proceeds of fraud.

Despite these new challenges, the English civil courts are already well-equipped to assist victims of fraud in the crypto-sphere.

What problems do courts face when it comes to crypto-fraud?

Given the relatively recent arrival of fraud cases involving cryptocurrencies, there are no well-established practices or guiding principles on how such cases should be dealt with. By way of example, problems have been identified in the following areas:

• Uncertainty and irregularity — there is a degree of uncertainty about how cryptocurrencies should be treated as a matter of law. For example, in 2013 a Texas Court held that cryptocurrency could properly be regarded as a currency, while in 2017 a New York Court held that cryptocurrencies should be viewed as securities. In early 2018 Mark Carney, Governor of the Bank of England opined that, given their failings as currency, they could be better described as “crypto-assets”. In November 2018, the Vice-President of the European Commission asked the European Parliament to consider whether cryptocurrencies should be regarded as financial instruments for the purpose of financial regulation. There has even been debate in the English courts as to whether cryptocurrencies can be regarded as property at all, given that they are, in essence, just strings of electronic information — and if they are “mere information”, should they instead be classed as intellectual property? As sterile as such debates may seem, they have important repercussions for victims when it comes to the enforcement of judgments: should a victim seek a writ of possession against the defendant? If so, over what exactly? The cryptocurrency itself, the wallet or the private key? What about the appointment of a receiver over the crypto-asset? Or perhaps a third-party debt order against the crypto-exchange?
• Deciding which jurisdiction — should the victim bring a claim where the fraudster’s wallet is based? Or where the private key to that wallet is located? Or where the exchange, or the relevant issuing or receiving nodes, are located? Many cryptocurrencies in circulation today are designed to preserve the anonymity of their users, making them extremely difficult, if not impossible, to trace into the hands of an actual person. How can a victim even bring a claim for recovery in such circumstances?

So, how can the civil courts help?

In general, civil courts have some important advantages over criminal courts: powerful orders can be obtained very quickly, sometimes within hours, which may result in a quick resolution to the claim; the victim controls the process, deciding where to focus time and resources; and, whereas high costs have previously been viewed as an obstacle to bringing civil proceedings, alternative ways of funding litigation (such as third party funders or damages based agreements) are increasingly available to claimants, enabling them to obtain swift and effective justice.

In a typical scenario, a fraudster might use misappropriated assets to acquire cryptocurrency, then transfer that currency to various different wallets under their control. Unlike traditional currency, there are usually no ‘middlemen’ such as banks or clearing houses that might be in a position to block onward transit. What can be done?

• The ‘nuclear weapon’ of the English civil courts is the worldwide freezing order. Traditionally, such orders would be served on the ‘middlemen’ who would lock-down funds until they could be recovered (or the order discharged). In the case of crypto-assets, such orders may remain decisive if the fraudster’s wallet is controlled by a ‘middleman’, e.g. an exchange. If not, as is more likely, there may still be hope for victims in light of the recent case of CMOC v Persons Unknown, in which the English High Court went to creative lengths to thwart modern fraudsters. Although not a cryptocurrency case, the Court granted a worldwide freezing order against “persons unknown”, so that the defendants were identified only by reference to the fraudulent transactions complained of. Importantly, the Court also granted a blanket order for service of the freezing injunction out of the jurisdiction by electronic means. In the context of cryptocurrency, where each transaction is identifiable in the blockchain, a freezing order might be served directly and verifiably upon a wallet holder by reference to transactions in the blockchain. Should the wallet holder then breach the freezing order, they would be in contempt of court, and liable to imprisonment should they return to the jurisdiction.
• A further tool in the arsenal of the English court is the ability to grant disclosure orders. A defendant within the jurisdiction could be required to give immediate disclosure of all cryptocurrencies they own, their wallet addresses, and relevant passwords controlling them. The Court may even allow independent lawyers to change those passwords to lock-out the fraudster pending the outcome of proceedings. Even where a defendant is not in the jurisdiction, third parties, such as exchanges or wallet providers, within the jurisdiction can be ordered to disclose such details as they may hold in relation to particular customers. Finally, the CMOC case also demonstrated the ability of the Court to order disclosure against third parties located outside the jurisdiction, where those parties hold information pertaining to property and assets that might be subject to a worldwide freezing order. Such tools are bound to be increasingly useful to victims of fraud, especially as law makers across the globe bring exchanges and wallet providers under greater regulatory control, requiring them to hold extensive ‘KYC’ (Know Your Customer) information about their customers.
• The English court also has the power to grant delivery up orders, requiring defendants and third parties to deliver up specified information (for example, a private key or a password), and even more invasive search orders, allowing claimants to search for and remove property such as electronic devices, flash drives and mobile phones, and then to allow software to be run on those devices to “crack” password-protected files so that they can be reviewed.

All of these orders can be obtained, in the right circumstances, on a “without notice” basis, meaning the defendant or third party will not be tipped off about the impending order until it is served on them. Once served, if the defendant or third party fails to comply, they risk imprisonment for up to 2 years for contempt of court.

Old civil courts ready for new crypto challenges

While governments and regulators worldwide are only beginning to wake up to the reality of crypto-assets, the English civil courts are poised to apply their time-worn powers to the new challenges posed by tech-savvy fraudsters. As cases involving crypto-assets become more common place, no doubt principles will crystallise, but for now victims of fraud are far from helpless in the English civil courts.