Crypto View - November 2022

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Well... It has certainly been an eventful month in crypto, with FTX's fall from grace dominating headlines and being discussed widely by people not normally that interested in crypto. This has been the biggest event to rock the industry for years, certainly since the Mt. Gox hack of 2014, and the repercussions and wider contagion are only just beginning to be felt (there's an interesting Twitter thread comparing the two events).

However, things still keep moving. There have been two consultations launched in the UK - one on Decentralised Autonomous Organisations (DAOs) and another on Non-Fungible Tokens (NFTs) - and we take a look at these below. We also take a look at developments with MiCA this month. If you haven't yet, do listen to our thought-provoking webinar series on MiCA.

The big news: FTX

You will have struggled to miss what h a p p e n e d to FTX this month, but to recap - on 11 November, FTX and some of its affiliates filed for bankruptcy protection under Chapter 11 of the US Bankruptcy Code. It concluded a tumultuous period of just over a week that has had profound consequences for the crypto market. Issues began surfacing on 02 November, with CoinDesk publishing a leaked balance sheet of Alameda Research, a crypto trading firm linked to FTX which showed that it had a huge amount of FTT (FTX's native token) on its books. This led CZ of Binance to tweet that the exchange was going to liquidate roughly USD 2.1 billion of FTT - though he insisted this was not a move aimed to destabilise one of its closest competitors. This in turn caused a panic in the market, despite Sam Bankman-Fried, the (then) CEO of FTX, trying to reassure its users that the exchange had "enough to cover all client holdings," and that it doesn't "invest client assets."

 By 08 November it looked as though Binance might be buying FTX outright, with CZ saying that he had signed a non-binding letter of intent to acquire the exchange. While this looked to stabilise things, it took less than 24 hours for the non-binding nature of the letter to become painfully apparent. Following "corporate due diligence" Binance pulled out of the deal. 

What has come out since the bankruptcy filing has been shocking, with tales of huge personal loans being made to executives, a total lack of systems and controls, deficient record keeping and practically no corporate governance in place at the firm. Calls were soon being made across a number of jurisdictions for regulation to improved to stop such situations from happening again. While we would note that from initial reports it does seem that the issues were not necessarily down to a lack of regulation (rehypothecating customer assets without permission is not something that regulation would prevent), there are certainly strong arguments to bring the crypto industry more in line with traditional finance in a number of respects rather than, as some commentators suggested, letting the industry "crash and burn." Preventing exchanges from engaging in proprietary trading, and introducing minimum capital and prudential requirements seem two obvious suggestions. We would definitely agree that there is scope to bring in more robust regulation to protect investors and minimise the risk of such events happening again. It is notable that the bit of the FTX empire that was subject to regulation, namely LedgerX, is not part of the administration, and no customer funds went missing there, bolstering the "same risk, same regulation argument" also made by Sir Jon Cunliffe at the Bank of England. This was a point loudly made by the CFTC (but unfortunately it seems, not appreciated by the wider market). No doubt the crypto world will listen closely to CFTC Chairman, Rostan Behnam giving evidence before the U.S. Senate Committee on Agriculture, Nutrition, and Forestry today!

Many people - particularly those with exposure to FTX - will be questioning what happens next and whether assets will be returned to customers. We have prepared a number of resources to help navigate the situation:

1. a webinar with leading US law firm Seward & Kissel discussing the bankruptcy proceedings in the US and Bahamas and the likely next steps for affected customers, which can be accessed here.
2. a podcast on the English law position concerning FTX - accessed here, and
3. a podcast about the broader legal issues (and disputes) arising from transfers of digital assets (whether or not involving FTX) - accessed here.

 While much will depend on the progress of the US bankruptcy proceedings, some key considerations for those with exposure to FTX will be:

• Whether the exposure is in fiat or asset form;
• Which FTX entity is the contracting party;
• What the contract providers for in terms of ownership of custodied assets and governing law;
• Whether steps were taken to liquidate / withdraw assets in the run-up to the collapse of FTX and whether there is a risk of clawback; and
• Making a claim in the FTX bankruptcy.

We are actively monitoring the situation and helping clients to navigate its legal challenges, and if you want to discuss anything further please get in touch with Douglas Robinson or Tina Lockwood.

DAO consultation

On 16 November, the Law Commission issued another consultation, hot on the heels of its monster consultation on Digital Assets. The latest consultation is somewhat shorter, and is looking into the concept of DAOs. While it is published by the Law Commission, it is the Department for Business, Energy and Industrial Strategy (BEIS) that is sponsoring it. BEIS is the UK government department for responsible for company law, and the corporate forms within that legal framework. It forms part of the broader approach from the UK government to try to stay at the forefront of legal innovation. The aim is to consider how DAOs can structure their organisational arrangements under the law of England and Wales and will identify any areas in need of further consideration and potential law reform, which could be taken forward either by the Law Commission or the Government.

You may be familiar with DAOs as a common organisational structure found in decentralised finance (DeFi). As the consultation points out, there is no unified and accepted definition of what a DAO actually is, though it notes that they have been described as a way to organise people, a social-coordination technology that relies on blockchain-based smart contracts and incentives to facilitate individuals collaborating and taking actions with collective impact. One of the first questions of the consultation is to ask responders to consider how they understand each of the individual descriptors of a DAO, i.e. what does it mean to be "decentralised", what do people understand by "autonomous", and what is an "organisation" in the context of a DAO.

A key point of the consultation is to look at current corporate structures and assess the extent to which DAOs could fall within these. It considers unincorporated associations, general partnerships, a form of trust arrangement, and whether DAOs could be seen as an arrangement for joint ownership of assets. It also seeks views from respondents on their experiences of other jurisdictions other than England and Wales - and whether there may be other legislative approaches to legal forms that are more effective or attractive for use by DAOs than those that are currently possible in the UK.

 One interesting point raised is whether developers of open-source code for software protocols, blockchain protocols or smart contracts could or should owe of duties of care and/or fiduciary duties to users of those software protocols. As DAOs have decentralisation as one of their primary functions, there is a tension with the fact that someone should be responsible for any problems that may arise. It refers to the Tulip Trading v Bitcoin Association case where a Craig Wright company sued a number of developers claiming that they had a fiduciary and/or tortious duty to his company which had the effect that they should assist it in regaining control and use of its assets that had allegedly been stolen in a hack. On the pleaded facts and claims, it was held that the arguments in the case did not have a real, as opposed to a fanciful, prospect of success, though leave to appeal the decision has been granted.

 The Law Commission is seeking responses to the consultation by 25 January 2023.

Crypto Common Law

One of the points raised in the Law Commission's Digital Assets consultation was how to make the necessary changes to law - whether to push for legislative change or wait for developments in common law. We were involved with a lot of discussions with the Financial Markets Law Committee for its response, and we came down in favour of common law. There was concern that it may take time for the right cases to come through the courts, but it does seem that jurisprudence is developing in this area. We saw one case that was reported this month cover a lot of ground. In Jones v Persons Unknown and Others [2022] EWHC 2543 (Comm), a claim was made following a large scale cyber fraud which resulted in the victim transferring 89.61616088 Bitcoin (worth approximately £1.54m as at the date of judgment) to a fake crypto investment platform. The case was important as it is the first time that a judgment has confirmed that a crypto exchange can hold assets misappropriated from a fraud victim as constructive trustee (readers with good memories may recall that the D'Aloia Case had already shown courts saw that there was a good and arguable case for this, but Jones has confirmed it) and be ordered to deliver up those assets to the victim. Jones also included another instance of service by airdrop (again D'Aloia got there first), and interestingly it is reported that the indemnity costs awarded were ordered to be paid in Bitcoin - this is definitely a first if so!

NFT consultation

In addition to the Law Commission's consultation on DAOs, the Department for Culture Media and Sport (DCMS) is holding an inquiry into the operation, risks, and benefits of NFTs and the wider blockchain. There is no consultation paper or position put forward, but rather DCMS is inviting responses to four broad questions:

1. Is the UK's light-touch NFT regulation sufficient?
2. What are the potential harms to vulnerable people of NFT speculation?
3. Do blockchains offer security to British investors?
4. What are the potential benefits to individuals and society of NFT speculation?

NFTs are largely unregulated in the UK, generally seen as not falling within scope of "cryptoassets" for the purposes of AML legislation, though can fall within the regulated investments depending on their features. It is understood that this inquiry is a precursor to potential regulation being brought in with a Treasury review also being mooted. It does appear that there are a number of limbs to potential changes around cryptoassets and related infrastructure and we hope that the government ensures that these are joined up. There is a risk with HMT, the FCA, DCMS, and BEIS all looking at aspects of legislating and regulating the world of digital assets that there could be a lack of cohesion in the ultimate position.

Tax in Crypto

 Today, we have released our latest thought-leadership report, Crypto Compare, that looks at the tax treatment of transactions in cryptoassets across eight jurisdictions - France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Spain, and UK - addressing some of the main tax questions concerning cryptocurrencies, ICOs and NFTs. Please do get in touch with us if you would like to discuss this further at all.

This month in MiCA

 The big news on MiCA in November is that the date for the vote on the legislation has likely been pushed back to February 2023, which will mean further delays to it coming into force. The length and complexity of the text have been given as reasons for the delay. Luckily we have held a series of webinars to help you work through the complexity, with the final one in the series having been this week. You can listen back to all of the episodes here, and I have it on good authority that we will shortly be publishing a summary document of them all (you'll hear about it here first).