Enforcement Issues and Strategies in Crypto-Related Fraud and Asset Recovery Disputes

I.   Introduction

Since 2022, we have witnessed a series of unexpected events that have shaken the highly volatile crypto industry, including the collapse of FTX Trading Ltd, bankruptcy of cryptocurrency lender Celsius Network LLC, and litigation commenced by the United States Securities and Exchange Commission against various cryptocurrency exchanges. A Forbes report in mid-August 2022 warned of potential Bitcoin, Ethereum, XRP and Crypto price chaos.[1]

The number of crypto-related fraud and asset recovery disputes is also on a constant rise. It was reported that crypto crime hit a record US$20 billion in 2022, and that this sum does not include “off-chain” crimes such as fraudulent accounting by crypto firms.[2]

It is no wonder that we have seen more instances of courts (in Singapore and other jurisdictions) tackling legal issues relating to cryptoassets and granting injunctions and orders over cryptoassets. In Singapore, the General Division of the Singapore High Court (“High Court”) in ByBit Fintech Ltd v Ho Kai Xin and ors [2023] SGHC 199 (“Bybit”) recently held that cryptoassets are property in the eyes of the law, such that a wrongdoer can be found to be holding the cryptoassets on constructive trust for a claimant.

While successfully obtaining such injunctions and/or orders are important milestones for any claimant in a crypto-related dispute, it is only half the battle won in terms of asset recovery. The practical question for any claimant would often be this: are such injunctions and/or orders effective and can they be realistically enforced?

We discuss below various issues and strategies that claimants should consider (often from the get-go) to tackle common but sticky obstacles faced in enforcement of injunctions and orders relating to cryptoassets, including:

1. Who can a claimant seek relief against in a crypto fraud dispute, other than the unknown fraudster?
2. How can a claimant enforce an order against a cryptoasset which he may not have access to?
3. What happens when the cryptoasset in question has been sold by the fraudster to a third party?

II.   Parties whom a claimant can seek relief against in a crypto fraud dispute

The defendant in crypto fraud disputes is often unknown. A claimant would typically attempt to seek information from crypto exchanges to identify these fraudsters. Disclosure orders can be sought: (a) in support of injunctions (such as freezing or interim injunctions); (b) against non-parties to request documents to assist with a tracing claim where there is a prima facie case of fraud (ie, “Bankers Trust orders”); or (c) against non-parties who have become “mixed-up” in wrongdoing to provide information (i.e. “Norwich Pharmacal orders”).

In the UK, the English High Court has permitted “Bankers Trust orders” to be served out of jurisdiction in exceptional circumstances and has taken the view that doing so would not infringe the sovereignty of a foreign jurisdiction. This is because, in a crypto fraud dispute, the claimant usually would not know where the relevant documents are located. The English High Court explained that it “would be impractical and contrary to the interests of justice to require a victim of fraud to make speculative applications in different jurisdictions to seek to locate the relevant exchange company and then to seek disclosure, probably in aid of foreign proceedings”. Instead, any concerns about national laws can be dealt with by ordering that no respondent is required to do anything contrary to local laws.[3]

Nonetheless, such fraudsters may remain evasive. They may have provided inaccurate information to the crypto exchanges. Some may have deliberately chosen to create accounts with crypto exchanges that are known to be uncooperative in giving effect to court orders. Therefore, enforcing interim or final orders obtained against such fraudsters is a continuing challenge.

Claimants would therefore likely have to consider whether there are other parties they can seek relief from instead.

III.   Misrepresentation by known persons, celebrities and/or influencers

In cases where known persons, celebrities or influencers (“Influencers”) were engaged by crypto firms to market and endorse certain crypto investments that turned out later to be fraudulent, it may be possible for a claimant to look towards these Influencers for relief on the basis that there was fraudulent and/or negligent misrepresentation. For both claims, the claimant must show that:

1. A false representation of fact had been made;
2. The claimant had acted upon the false statement; and
3. The claimant suffered damage.

For a claim in fraudulent misrepresentation, the claimant would additionally have to show that the representation was made intending it to be acted upon by the claimant and with knowledge that it was false, or at least without any genuine belief that it was true. For a claim in negligent misrepresentation, the claimant would have to show instead that the representor owed the claimant a duty to take reasonable care in making the representation and the representor breached that duty.[4]

Whether a false representation has been made by an Influencer depends on the Influencer’s actions. In recent scams, it came to light that certain Influencers were gifted cryptoassets which were the subject of the crypto investment that they actively promoted on social media as financially viable. When the price of the crypto investment spiked, they (along with others who started the investment scheme) “dumped” the cryptoassets and deleted all posts related to the crypto investment. In such cases, the Influencers could be said to have made false representations concerning the financial viability of the crypto investment with the intention that their followers rely on those statements and invest in the cryptoassets.

On the other hand, if all the Influencer did was to lend a face to advertisements without making any substantive statements as to the financial viability of the crypto investment, this alone (even if the Influencer had received compensation for the endorsement) may not, as the US courts have found, be sufficient to give rise to a claim in fraudulent and/or negligent misrepresentation as it has been noted that customers should not rely on celebrity endorsements to make financial decisions.[5]

Claimants should therefore keep records of all communications and representations made to them. Given the ease with which social media posts and messages can be altered after the fact, it is critical to keep such records contemporaneously and ensure that the timestamps of the posts / messages are visible. Crypto transactions are recorded on the blockchain, and are relatively easy to trace. If it can be shown that the Influencers were promoting crypto investments while concurrently selling their own assets after having driven up the prices of their investments, this might bolster a misrepresentation claim.

IV.   Claims against crypto exchanges on the basis that they hold stolen cryptoassets on trust

As mentioned above, the Singapore High Court recently found in ByBit that cryptoassets are property, such that a wrongdoer can be found to be holding them on constructive trust for a claimant.

In that case, an employee of an external payroll company engaged by ByBit Fintech Ltd (“ByBit”), a crypto exchange, had wrongfully transferred, among other things, 4,209.720 USDT to four crypto addresses controlled by the employee. The High Court found that the wrongdoer employee held the USDT on institutional constructive trust for ByBit, and that institutional constructive trust arose by operation of the law as a result of unconscionability[6] (such as fraud and profiting from a breach of fiduciary duty).[7]

In the UK, claimants have attempted to apply similar arguments, not against the wrongdoer, but against crypto exchanges.

In Piroozzadeh v Persons Unknown and ors [2023] EWHC 1024 (Ch) (“Piroozzadeh”), a claimant traced stolen USDT to wallets in accounts registered with Binance. The claimant then obtained a without notice interim injunction against Binance on the basis that it held the stolen USDT on constructive trust for the claimant. Binance succeeded in having the without notice order set aside on the basis that the claimant failed to comply with its duty of full and frank disclosure:

1. The claimant omitted to inform the court that Binance could raise the defence that it was a bona fide purchaser of the transferred asset (as it was not involved in the fraud); and
2. The claimant failed to inform the court that Binance’s practice was to transfer all cryptoassets it received into a pool. In other words, Binance mixed its customer’s assets. The lack of segregation made tracing “essentially futile and close to impossible and possibly impossible exercise”.[8] The claimant was aware of this as Binance had raised this in its defence in separate but similar proceedings that the claimant had copies of.[9]

While Binance succeeded in setting aside the without notice interim injunction, this does not mean that a claim in constructive trust against a crypto exchange is bound to fail.

Whether such a claim would succeed depends on the extent to which the crypto exchange was involved in the wrongdoing and how the cryptoassets are held by the crypto exchange. There have been more instances of crypto exchanges collapsing as a result of fraud. In such cases, it may be possible for claimants to contend that the wrongdoing on the part of the crypto exchange gives rise to an institutional constructive trust in the claimant’s favour.

Conversely, if the crypto exchange was not involved in any wrongdoing, it might be able to raise the defence that it was a bona fide purchaser of the deposited asset (as in Piroozzadeh). We discuss this defence in the last section below.

V.   Blockchain developers may owe fiduciary / tortious duties to claimants

Each type of cryptoasset is created and issued within its own network. There are decentralised networks without any central network owner (like Bitcoin) and centralised networks where there is a central network owner.

In Tulip Trading Limited (A Seychelles Company) v Bitcoin Association For BSV & Ors [2023] EWCA Civ 83 (“Tulip”), the English Court of Appeal thought it arguable that cryptoasset software developers owe fiduciary and tortious duties to owners of cryptoassets utilising their network. This was a preliminary determination and the matter would be decided at trial.

In that case, the private keys to US$4 billion worth of Bitcoin were lost in an apparent hack. The claimant contended that the 16 named software developers controlled and ran four Bitcoin networks and were able to secure the stolen Bitcoin by moving them to another address that the claimant could control. Unsurprisingly, the software developers contended that the Bitcoin networks were decentralised and “part of a very large, and shifting, group of contributors without an organisation or structure”. Further, any change proposed would be ineffective as the miners would refuse to run it, and a disagreement would result in a “fork” (ie, the creation of additional networks).[10] The court stated that this would be an issue to be resolved at trial.[11]

Here, the software developers were able to contest the claimant’s argument that such duties existed by relying on the fact that the Bitcoin networks are decentralised and that they would not be able to implement the change requested by the claimant. However, where the cryptoasset network in question is centralised (i.e. where there is only one software developer controlling the entire network), it would be more likely than not that such duties would arise. As the English Court of Appeal noted, “developers are people who it is clearly arguable have undertaken a role which at least bears some relationship to the interests of other people” and, in a cryptocurrency situation, have authority given to them by their control of access to the source code, and are “in effect making decisions on behalf of all the participants in the relevant” network. These features are common to fiduciary duties.[12]

VI.   How a claimant can enforce an order against cryptoassets he does not have access to

The transfer of and access to cryptoassets are controlled by a set of digital keys and addresses. While anyone is able to transfer cryptoassets to any public address, the recipient must have a unique private key to access the received cryptoassets. Private keys can be kept in custodial wallets (e.g., with a crypto exchange) or in non-custodial wallets (where one stores one’s own private keys). Both types of wallets can be hot (connected to the internet) or cold (not connected to the internet).

As transfers of cryptoassets are recorded on the public blockchain ledger, it is possible to trace the last known location of the cryptoassets and whether they reside at an address associated with a custodial wallet (with a crypto exchange) or a non-custodial wallet.

Where the defendant or the third party (or crypto exchange) in possession of the wallet is known, and a court order has been made over the cryptoassets which require keys to access, the private keys can be obtained through discovery procedures, i.e., the claimant can seek disclosure of the private keys from the defendant or the third party (or crypto exchange) during enforcement. This mode of enforcement would be largely analogous to traditional enforcement of orders against moneys held by a bank or financial institution. Claimants need to be aware that the third party / crypto exchange might not cooperate, and that they may have to adopt other strategies to pressure the platforms to voluntarily comply with such court orders.

It becomes exponentially challenging where the cryptoasset is associated with keys kept in a cold wallet in the possession of an unknown party. However, not all is lost. Cryptoassets are valuable only if they are transferred or exchanged to cash, and such transactions would be recorded on the public blockchain ledger and traceable. It would nevertheless require more time and effort to monitor the movement of such cryptoassets.

VII.   What happens if the fraudster has sold the cryptoassets to a third party?

Where the fraudster has sold the cryptoassets to a third party, the key question is whether the third party was involved in the fraud (in which case, the claimant would likely have the same claims against that third party as against the original fraudster) or whether the third party was a bona fide purchaser.

Under common law, a bona fide purchaser for value of a property without notice of existing prior claims to the title would take good title to the property, even if the property was fraudulently obtained by the seller. While decentralised cryptoassets are recorded on the public blockchain ledger where due diligence can be easily conducted, it is almost impossible for a bona fide purchaser to check whether the cryptoasset in question is stolen property; the ledger does not distinguish between legitimate and fraudulent transactions.

A claimant should therefore consider tracing the assets as quickly as possible before commencing proceedings to obtain as much information as possible and seek an interim injunction at an early stage to freeze the assets to prevent further movement and to reduce the risks of onwards sale to a bona fide purchaser. Such an injunction can seek to restrain further sale or dealings with the cryptoasset in question.

That was the case in Janesh s/o Rajkumar v Unknown Person (“CHEFPIERRE”) [2022] SGHC 264, where the Singapore High Court granted a proprietary injunction prohibiting an unknown person defendant who went by the pseudonym “chefpierre.eth”, from “in any way dealing with the Bored Ape NFT” until after trial. In that case, the Bored Ape non-fungible token (“NFT”) was listed for sale on OpenSea (a marketplace based in the US); upon issue of the injunction, OpenSea cooperated and froze the NFT’s sale in around May 2022. There are two noteworthy points:

1. Claimants must be prepared from the get-go that not all third-party platforms may be as cooperative. They may have to take additional formal actions in the countries where these platforms are based to enforce such injunctions, or adopt other strategies to pressure the platforms to voluntarily comply with such orders.
2. Even if the marketplace on which the NFT is listed for sale does comply with the injunction, claimants need to be aware that the defendant may turn to other online marketplaces to list that NFT for sale. It would be important that the injunction obtained from the court is sufficiently broad in scope to cover such a scenario.

 

AUTHOR INFORMATION

Wendy Lin is the Deputy Head of the Commercial & Corporate Disputes Practice, and a Partner in the International Arbitration Practice at WongPartnership LLP.
Email: wendy.lin@wongpartnership.com

Leow Jiamin is a Partner in the Commercial & Corporate Disputes Practice at WongPartnership LLP.
Email:  jiamin.leow@wongpartnership.com

 

REFERENCES

[1] “Greatest Rug Pull Ever” – “Shocking” Fed Warning Heralds Bitcoin, Ethereum, XRP And Crypto Price Chaos”, Forbes (16 August 2023) <https://www.forbes.com/sites/digital-assets/2023/08/16/greatest-rug-pull-ever-shocking-fed-warning-heralds-bitcoin-ethereum-xrp-and-crypto-price-chaos/?sh=44c9abb43f9e>.

[2] “Crypto crime hits record $20 bln in 2022, report says”, Reuters (13 January 2023) <https://www.reuters.com/business/finance/crypto-crime-hits-record-20-bln-2022-report-says-2023-01-12/>.

[3] LMN v Bitflyer Holdings Inc and ors [2022] EWHC 2954 (Comm) at [35-[37].

[4] Tritech Water Technologies Pte Ltd and ors v Duan Wei and ors [2023] SGHC 23 at [48]-[49].

[5] In Re Ethereummax Investor Litigation, Case No 2-22-cv-00163 (6 December 2022) (US District Court, Central District of California). However, note that the proceedings are still ongoing as the complaint filed in that case was subsequently substantively amended <https://www.courtlistener.com/docket/61802418/in-re-ethereummax-investor-litigation/>.

[6] Philip Antony Jeyaretnam and anor v Kulandaivelu Malayaperumal and ors [2020] 3 SLR 738 at [11].

[7] Zaiton bte Adom v Nafsiah bte Wagiman and ors [2023] 3 SLR 533 at [104].

[8] Piroozzadeh at [8].

[9] Piroozzadeh at [29], [38]-[39].

[10] Tulip at [33].

[11] Tulip at [91].

[12] Tulip at [70]-[76].