In the week of November 7th, 2022, the digital asset ecosystem experienced an unprecedented level of market instability, as billions of dollars of value seemingly disappeared from FTX.com (“FTX”), an industry goliath, overnight. By the end of the week, a series of shocking revelations culminated in FTX itself and approximately 130 affiliated entities filing for bankruptcy. Earlier that year, FTX had been valued at $40 billion and was endorsed by celebrities and institutional investors alike, and its founder was coined “the next Warren Buffett” by Time magazine. The sudden collapse and disappearance of billions of dollars of value left many wondering whether users who had assets stored on FTX would be entitled to recovery of any of those assets, and more generally, how other users can protect themselves in the future when choosing to store their digital assets on these platforms.
Spurred by the former question, the discussion within this article will focus on the latter by considering whether a user’s relationship with companies offering digital asset related services (known as “Crypto Asset Service Providers” or “CASPs” in some jurisdictions) can be characterized as a “trust relationship.” This determination dictates whether, in the event of a bankruptcy, the user’s assets will be held outside of the bankrupt estate and protected from creditors, or whether the user will lose any special entitlement to the return of those specific assets and be treated as an unsecured creditor of the estate. In the interest of providing potential clarity to readers, this article will also highlight certain terms and provisions that may be included in the contractual documents that commonly govern the relationship between the CASP and the user.
Whether the relationship between users and CASPs can be established as a legal ‘trust’ is also an important consideration in restoring consumer confidence in an emerging industry that has the potential to offer numerous benefits. While the concept of a purely digitalized financial market and currency may seem like a drastic departure from traditional financial methods (or, as coined by crypto enthusiasts, “TradFi”), perhaps it shouldn’t. Rather, it may be argued that the birth and evolution of the digital asset ecosystem is another step in a transition away from traditional financial methods that has transpired over the past thirty years. This transition has arisen in the pursuit of new potentials and advantages not offered by TradFi, such as the ability to definitively trace digital assets and determine their ownership history and provenance. However, for these advantages to truly outweigh the uncertainty accompanying this transition, it must first be shown that these features can actually be realized for broader stakeholder benefit. The establishment of a trust relationship may help to significantly mitigate, if not eradicate, this uncertainty.
As the reader continues through this article, bear these thoughts in mind, with consideration of how the concepts outlined herein can provide benefits to everyone, from the CASPs all the way down to the end users. The reader should further note that the statements contained herein are intended to be purely commentative and do not provide any legal advice, opinions, or positions on any past or future scenarios.
Issues of Discussion
The considerations of this article are outlined within the context of an insolvency proceeding, and they are cumulative and twofold: (1) can the relationship between the user and the platform be structured as a trust, being among settlor, trustee, and beneficiary, whereby legal/beneficial title to the digital assets remains with the user; and, if the prior question can be answered in the affirmative, (2) in the event that a CASP enters into bankruptcy or insolvency proceedings, can the user preserve their unencumbered right to “their” digital assets? Therefore, the overarching question posited by this article is whether users retain title to digital assets that they have stored on these platforms. Put simply: who actually owns the digital assets sent by users to CASPs?
Upon bankruptcy, claims against the filing party (i.e., the “debtor”) are ranked according to a priority scheme established by the governing statute of the debtor’s jurisdiction. Typically, funds held by the debtor, including those provided by another party, are considered to constitute assets of the estate of the bankrupt debtor for distribution, regardless of whether the other party had any intention to become a creditor of the debtor. In this capacity, the “unintentional creditor” is deemed to be an unsecured creditor, usually ranking lower in priority in the distribution scheme behind secured creditors and certain specified parties, among others. This consequence often leaves the “unintentional creditor” with only a remote prospect of receiving some or all of their funds back.
However, there are certain exceptions to the above mechanism, including the “trust exception,” which provides that property held by the debtor in trust for any other person will not be divisible among the creditors, and the beneficiary of the trust will be able to recover the property held in trust for them. Under this concept, the law recognizes that the assets/funds/property held by the debtor never belonged to the debtor, were never intended for the debtor, and thus never constituted part of the estate of the bankrupt debtor. In other words, if this exception can be established on the facts, the party that provided the digital assets is able to avoid becoming a creditor of the debtor and is often entitled to the full recovery of the assets that the debtor held on their behalf.
Establishing a Trust
For a party to establish that the subject property was “trust property,” it must be capable of proving that a valid trust was in existence at the date of bankruptcy. A trust may be established through several methods, including (i) by “express trust,” whereby the settlor of the trust, by express intention, takes formal steps to have the trust constituted; (ii) by “constructive trust,” whereby a trust arises by operation of law in response to a series of events; or (iii) by “resulting trust,” where the trust is imposed as an equitable remedy when the ruling court believes it is an appropriate and equitable outcome in the circumstances.
As the latter two forms may only be imposed by a court post hoc and are highly dependent on specific context, this article will solely focus on express trusts. The reader should note, however, that this demarcation does not represent the authors’ opinion that the imposition of a constructive or resulting trust may or may not be applicable in the context of a CASP insolvency.
For a valid express trust to be established, three certainties must be present: (i) certainty of intent, specifically whether it can be said that the settlor clearly intended to create a trust; (ii) certainty of subject matter, which requires that the trust property be substantially identifiable; and (iii) certainty of objects, which requires clear and definitive identification of the beneficiaries of the trust. Allcertainties must be present to establish a trust (or, at the very least, a court must be able to infer their presence to some discernable degree). The scope of the following analysis considers the former two certainties in further detail, with certainty of objects being assumed in most circumstances.
(b) Certainty of Intent
For certainty of intent to be satisfied, there must be a clearly evidenced intention that the parties sought to create a trust, and the wording of the document(s) utilized to constitute the trust must indicate that the transferee is to take the property in the capacity of a trustee. However, merely including the words “in trust” or “as trustee for” in such documents is neither solely instructive nor imperative in satisfying this certainty requirement. Nor is it required that the intention be explicitly expressed; intent may be implied based on a variety of contextual factors, including the preexisting relationship between the parties and certain commercial realities.
Courts have demonstrated a reluctance to impose a trust where its imposition would not “fit” within the context and relationship of the parties. For example, courts have typically concluded that the relationships of debtor/creditor and trustee/beneficiary are not ordinarily co-extensive; it is often either one or the other. Similarly, transfers described as a “debt” obligation may be inconsistent with rendering a relationship of trustee-beneficiary.
The concept of commingling assets further clouds a determination of whether the requisite degree of certainty is present. Where the trustee has mixed the “trust assets” with non-trust assets, it may be inferred that the settlor never truly intended their assets to be held in trust at all. From a commercial realities perspective, assuming the presence of a trust were to be argued, the very capability of a trustee to commingle, and any actual commingling, could give rise to several difficulties in administering the trust. The Supreme Court of Canada recently commented on this factor, noting that the presence of commingling is ordinarily evidence of a debt obligation rather than a trust obligation and is suggestive that the relationship is not one of a trustee and settlor. However, the ability of a trustee to commingle trust assets with non-trust assets is not dispositive on this prong of certainty. As established, courts will take a holistic approach in their analysis as to whether a trust exists, with no singular factor being a sufficient condition.
(c) Certainty of Subject Matter
Certainty of subject matter requires that the assets forming the trust property be ascertained, or at least be ascertainable, at the time that the trust was created. Additional specificity from case law provides that (i) the trust property be fixed or specified in the trust instrument, or (ii) there be a sufficiently clear method or formula for identifying the trust property.
As with intent, the presence of commingling also creates difficulty in establishing the requisite level of certainty of subject matter, as it impairs the ability of parties to ascertain which assets are trust property transferred to the would-be trust by the settlor. However, while commingling may create practical difficulties in identifying trust assets, commingling alone does not per se destroy the trust. If trust property is initially ascertained or ascertainable, the property may yet remain traceable where it has been converted into other forms or mixed with other funds.
For the purposes of this article and its discussion of whether digital assets stored on CASPs can be formulated as trust assets, the analysis of this prong of certainty takes on additional nuance. As alluded to, the novel blockchain technology upon which digital assets are based may provide stakeholders with, in some cases, arguably superior avenues for tracing and ascertainment in comparison to TradFi counterparts.