One of the key questions in the restructuring and insolvency proceedings of bankrupt crypto-asset exchange, FTX, is whether investors will get back assets deposited by them with the exchange. This is a hotly debated topic, with different Courts taking different positions on the matter. For instance, New Zealand and Singapore courts, under certain conditions, recognise cryptoassets as property held in trust by service providers, hence safeguarding them from being part of the insolvent firm's estate. On the contrary, a US court ruled in favor of crypto-asset service provider owning the assets, given specific clauses in the service provider’s terms of use.
In India, the issue is murky due to differing contractual terms among cryptoasset service providers, generating uncertainty for investors amidst insolvency proceedings. A proposed solution to the uncertainty entails adopting a more predictable legal framework inspired by the UNIDROIT's Principles on Digital Assets and Private Law, urging a clear distinction that digital assets held in trust by service providers are not part of the insolvent entity's estate. This approach necessitates amending India's Insolvency and Bankruptcy Code, 2016, to incorporate these guidelines, aiming to balance investor protection with the innovation in crypto-financial services.
Michael Lewis’s latest book “Going Infinite”, published on October 03, 2023, traces the rise and fall of Sam-Bankman-Fried’s FTX empire. Lewis is a renowned author and financial journalists, known for his books and articles on financial markets, including the Big Short and Moneyball. His most recent book delves into the behind-the-scenes events at FTX, a popular global crypto-asset exchange that went bankrupt in 2022 after a run on its deposits and is currently undergoing restructuring under US law.[1] A key question surrounding the restructuring and insolvency process is whether cryptoassets deposited by investors with FTX will be returned to them. This blog post explores how this question has been dealt with in other insolvency proceedings involving crypto-asset service providers and suggests measures the Indian Government can bolster to secure investor deposits.
The treatment of investor assets during insolvency proceedings is one of the foremost legal challenges insolvency courts must grapple with.[2] If investor assets, typically held by a cryptoasset service provider, are considered the property of the investor and held in trust by the service provider, then such assets will not form part of the insolvent firm’s estate. This means that liquidators cannot lay valid claims to such assets during insolvency. Conversely, where investor assets are considered the insolvent firm’s property, liquidators will have a valid claim, possibly resulting in investors losing their money.[3]
In deciding such cases, courts in different jurisdictions have relied on the contractual terms agreed to by the user and the cryptoasset service providers. The New Zealand High Court addressed this question in the liquidation proceedings for cryptoasset exchange Cryptopia. It interpreted the company’s Terms of Use to mean that user assets are held in trust by the service provider and cannot, therefore, form part of the firm’s liquidation estate.[4] Notably, Cryptopia's terms of service specifically included trust-related provisions and its internal financial accounts also showed that it asserted no ownership over the user’s assets.[5]
Courts in Singapore have also accepted that cryptoassets can be considered property of investors held in trust by the cryptoasset service provider, based on the terms of the underlying contract. However, what terms and conditions are sufficient to indicate the creation of a trust remains unclear. For instance, in Quoine Pte Ltd. Vs. B2C2 Ltd., the Court of Appeal held that a trust had not been created as the terms of usage did not contain specific trust-related clauses, as was the case in Cryptopia’s insolvency.[6] The Court also held that the mere fact that investors’ cryptoasset were held separately from those of the service provider was not sufficient to indicate an intention to create a trust. In a more recent judgment, the Singapore High Court held that cryptoasset were held in trust by the service provider but did not clarify how it ascertained the intention to create a trust between two parties.[7]
The scenario in the United States is less favorable to investors. In a recent case, a New York Bankruptcy Court ruled that the investor assets deposited with Celsius Network, a crypto lending company, were owned by the company and not the investors.[8] As such, the investor deposits in this case form part of Celsius’s estate and its liquidators can lay a valid claim to them during insolvency proceedings. The case involved assets pledged to Celsius’ “Earn” program, which allowed users to earn yield on assets deposited with the lending company. The Terms of Use specified that, in exchange for earning yield, users transferred all rights underlying the cryptoassets to Celsius and that Celsius could lend, hypothecate, and mortgage the funds.[9] The user-depositors argued that the Terms of Use were ambiguous and constituted unconscionable “clickwrap” agreements that could not be enforced.[10] The Court opted for a strictly contractual approach and decided in favour of Celsius based on the Terms of Use.
The US and New Zealand cases highlight that relying on contractual terms to determine the ownership of investor cryptoassets held by an insolvent service provider could lead to markedly different outcomes, leading to uncertainty for investors surrounding insolvency proceedings. Indeed, this is likely to be the case in India, where cryptoasset service providers’ contractual terms vary significantly. For instance, CoinSwitch Kuber, a leading cryptoasset exchange, specifically states that investor assets are held by it in trust.[11] In an insolvency proceeding, such assets will not be considered a part of the insolvent firm’s estate as they continue to be owned by the investors. However, other providers’ terms of usage provide clarity on the matter. Mudrex’s Terms of Service, for example, do not specifically state whether investor assets are held in trust or if ownership rights pass to the service provider when assets are deposited.[12]
Instead, a more predictable regime for determining ownership over investor assets is required to safeguard investors without unduly restraining domestic crypto-asset exchange service providers from developing new and innovative crypto-based financial services in India. The International Institute for The Unification of Private Law (UNIDROIT) also favors such a predictable and investor-friendly approach. Its Principles on Digital Assets and Private Law advise member nations to adapt their insolvency frameworks to ensure that assets held by a custodian on behalf of its clients do not form part of its estate during insolvency.[13] Instead, it requires insolvency and resolution professionals to take necessary steps to ensure that user assets kept with the crypto asset custodian can be returned to their control.
Incorporating the UNIDROIT’s recommendations in India would require guidelines to be issued under the Insolvency and Bankruptcy Code, 2016. The guidelines must clarify that digital assets are property capable of being subject to ownership and that investor assets in the custody of a crypto-asset service provider are held in trust on behalf of the investors. Recognising investor assets as property held in trust would remove them from the insolvent firm’s estate in accordance with the explanation to s. 18(1) of the Code, which specifically states that assets owned by a third party in possession of the corporate debtor held under trust are not owned by the insolvent entity. Additionally, the guidelines should also require the interim resolution professional to ensure that control over investor assets is returned to them expeditiously during insolvency proceedings u/s 18 of the Code.
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[1] https://restructuring.ra.kroll.com/FTX/
[3] Ibid.
[4] https://www.courtsofnz.govt.nz/assets/cases/2023/2023-NZHC-2490.pdf
[6] https://www.sicc.gov.sg/media/case-summaries/quoine-pte-ltd-v-b2c2-ltd-case-summary
[7] https://www.elitigation.sg/gd/s/2023_SGHC_199
[8] https://www.nysb.uscourts.gov/content/re-22-10964-mg-celsius-network-llc-11
[9] https://cases.stretto.com/public/x191/11749/PLEADINGS/1174901042380000000067.pdf
[11] https://coinswitch.co/terms-of-use#