As ‘Crypto Winter’ Drives Insolvency and Fraud, Lawyers Find New Ways of Tracking

The fall of cryptocurrency prices over the course of 2022 has already pushed major industry players to bankruptcy. Late last month, crypto-mining data center operator Compute North filed for bankruptcy, following the July bankruptcies of crypto lender Celsius, crypto brokerage Voyager Digital, and crypto hedge fund Three Arrows Capital.

As the prolonged “crypto winter” approaches $1 trillion in losses this year, restructuring lawyers and their colleagues at financial and blockchain analytics firms predicted a rise in fraud and insolvency at a recent virtual roundtable hosted by litigation funder Burford Capital. (The American Lawyer reviewed an advance copy of the transcript.)

Litigation finance will step up to meet the demand for counsel among insolvent companies and victims of digital assets fraud, some participants said. Meanwhile, the other parties involved in global crypto investigations and bankruptcies—courts, exchanges, and blockchain analysts—are finding innovative ways to help clients track and reclaim assets known for anonymity.

More Crypto Insolvency and Fraud on the Horizon

Most in the industry believe cryptocurrency and digital assets prices are unlikely to rebound in the near future, tightening the squeeze felt by crypto exchanges, lenders, brokers and others involved in digital assets. Market headwinds include rising interest rates, falling disposable incomes, recent moves by the SEC and DOJ to ramp up digital assets-related investigations and prosecutions, and the crash of “stablecoins” Luna and Terra.

Similar to the impact of subprime mortgages on the finance industry in 2008, the Terra crash could take out more firms in the crypto industry, said Kroll Singapore restructuring and disputes managing director Rose Kehoe.

“What I didn’t realize when Terra first collapsed was that a lot of exchanges had large reserves of Terra,” Kehoe said. “From that moment in time, there has been a contagion effect across the digital assets market, with many platforms facing financial difficulties. The market is not yet stabilized and there’s a lot of counterparty risk for borrowing lending platforms.”

Fraud also tends to rise in times of hardship, said Richard Beard and Emma Thompson, respectively managing director of restructuring and director in contentious insolvency at global management consulting firm Alvarez & Marsal. “There could be more contentious insolvencies and cases where crypto features as an asset class as investors have attempted to diversity their investment portfolio throughout the pandemic and more generally over recent years as crypto has become more widely understood as an investment opportunity,” Beard and Thompson said.

Litigation Finance May Aid Creditors Recovery Efforts

Asked how an increase in available litigation finance capital and products such as monetization would help companies and insolvency practitioners recover value for creditors, participants Thompson and Beard said third-party funding would allow businesses to pursue costly restructurings and cross-border investigations.

James Drury, director at Interpath Advisory in the British Virgin Islands, said he’s already seeing an uptick in interest from litigation funders regarding crypto and digital assets. “We have already started to see increased interest by funders in this space—whether that is buying claims in some of the larger bankruptcy or liquidation processes or an interest and desire to support investigators and insolvency practitioners fund actions against perpetrators of fraud,” Drury said.

Blockchain data analytics are also helping ease the perceived risk of funding litigation involving crypto assets, said Danielle Haston, head of global asset management at blockchain data platform Chainalysis.

“Thanks to the transparency and immutability of the blockchain, and the power of blockchain analysis tools like Chainalysis Reactor, which allow investigators to trace funds despite the use of obfuscation techniques such as the use of mixers and chain hopping, litigation funders and insurers should find that financial investigations involving crypto are often quicker and easier,” said Haston, adding that the evidence of funds flows is often better-preserved in blockchain than in typical financial investigations.

International Courts and Exchanges Help Fraud Victims

Courts in Canada, Singapore, New Zealand and the British Virgin Islands already consider digital assets as property, a designation that aids fraud victims by facilitating international cooperation, said Haston. “Having certainty over the classification of digital assets means that claimants can better predict what remedies will be available to them,” she said.

The U.K. judiciary is also becoming more familiar with crypto fraud cases, Thompson and Beard said, opening up more legal avenues for fraud victims. Rebecca Belgrave, partner in the dispute resolution department of law firm Mishcon de Reya in London, added that British courts’ recent willingness to grant proprietary and freezing orders against “persons unknown” helps victims freeze assets before the identities of defendants are determined.

Crypto exchanges are often amenable to cooperating with investigations before court orders, Drury said of his experience: “The reality is that exchanges are making a significant enough amount of money from custody and transaction fees that they don’t need or want fraudulent activity being on/off ramped through them.”