Crypto: issues for solicitors and their PI insurers

31 May 2023. Published by Simy Khanna, Partner and Harriet Keltie, Senior Associate

We explore the types of work lawyers are doing in this area, the risks this work may give rise to and issues for solicitors and their PI insurers to consider.

What are cryptocurrencies and how do they work?  

Cryptocurrencies have existed since 2009, when the Bitcoin blockchain was launched. Since then, the space has grown at an extraordinary rate. As of March 2023, around 23,000 cryptocurrencies exist, with many having different use cases and unique selling points. 

Given the speed at which the space is growing, the world is grappling with what exactly cryptocurrencies are – are they currencies, assets, or investments?  Most important for solicitors, how, if at all, can they truly be regulated?  

What is Bitcoin?

The best starting point for understanding this landscape is the most well known cryptocurrency: Bitcoin. At the time of writing, Bitcoin has a market cap of c. $541 billion – just under half of the entire market cap for all cryptocurrencies.

After the fallout of the 2007/8 economic crash, Satoshi Nakamoto (the still unknown founder(s) of Bitcoin), published a white paper called Bitcoin: A Peer-to-Peer Electronic Cash System, in 2008. Nakamoto's goal was simple: to enable online payments that could be sent directly from one party to another, without having to rely on a third party financial institution (for example, a bank).  

The White Paper sets out how the Bitcoin protocol would operate, how it would remain independent and how it would remain secure.  On 3 January 2009, the first Bitcoin was created, or mined.  

However, Bitcoin needs somewhere to exist, and this is where the blockchain comes in.

What is the blockchain?

Bitcoin exists on its own blockchain which, in its simplest form, is a transparent ledger that anyone can access. Accordingly, the blockchain makes it possible for anyone to review any historical Bitcoin transaction. The blockchain is updated and maintained simultaneously across thousands of computers (known as 'nodes'). Whilst nodes operate individually, they all work to validate, broadcast, process and store BTC transactions. 

Because the ledger is spread across multiple nodes, it is decentralised. As a result, Bitcoin does not exist in just one jurisdiction. In principle, its decentralised nature means this system is robust, free of censorship and resistant to state/organisational intervention and geopolitical conflict. Its greatest advocates have argued that due to its freedom from state/organisational control, it is resistant to inflation. This is because Nakamoto ensured that only 21 million bitcoins will ever exist. The last bitcoin is due to be mined in c.2140. In comparison, "fiat" currencies, such as the US Dollar continue to feel the effects of inflation. Commentators allege that the US dollar has lost 96% of its buying power since the inception of the Federal Reserve in 1913. This is in large part caused by governments continuing to use quantitative easing. In 2020 alone 40% of all US Dollars in circulation were "printed".  

How does the blockchain work?

The nodes referenced earlier continuously update the register of transactions on the blockchain.  The ability to send bitcoin continues so long as the nodes keep up to date records.  Rather than recording and agreeing on the order of every individual transaction, the nodes record transactions in clusters, called 'blocks'.  Blocks are created far less frequently than transactions, and one block can contain hundreds of transactions.  

Instead of having to agree on the order of individual transactions, which could allow for a "double spend" scenario, the nodes need only to agree on the order of blocks.  Once transactions are bundled with others into a valid block, the block is passed amongst the network and verified (confirmed).  When the next block is verified by the nodes, the first block has two confirmations, and so on.  As the blocks are layered on top of one another, they are chained together by cryptographic hashes – hence: blockchain.  

How do you access and use Bitcoin?

Acquisition of Bitcoin is easy. The most popular way to buy it is through an exchange, where you can purchase Bitcoin with a standard bank transfer.  You simply send money to your account on the exchange before then purchasing Bitcoin.  

When users buy Bitcoin from an exchange, they are assigned a public key which they can share with anyone. This key acts as an address (akin to a banking sort code and account number) and allows for anyone with knowledge of it to send Bitcoin to it.

This key also acts as the user's identity on the blockchain – it is this key that is recorded on the blockchain as receiving or sending bitcoins. Therefore, the more this key is shared, the less anonymous the user becomes.  There is, however, nothing stopping anyone from having as many addresses (or "wallets") as they want. 

In addition to a public key, participants are also given a private key. This key is specific to just your Bitcoin "wallet". A private key gives you the ability to prove that you are the owner of the Bitcoin in your possession. It can take many forms; for example a QR code or a mnemonic phrase. When a wallet is set up for the first time, the user is given its private key which will never be shown again.  Should that user ever be "locked out" of their wallet, access can be re-granted by the user repeating their private key.  Losing the private key is likely to mean that re-establishing access to funds is impossible - and some have lost millions as a result. 

What about the volatility of cryptocurrency? 

Anyone who has paid even vague attention to the cryptocurrency market will be aware that the market is volatile.  Since reaching an all time high of $69,000 per Bitcoin in November 2021, its price has now crashed as low as c.$15,500. This crash has wide reaching consequences, not just for investors, but for those employed within the space. 

What does all this have to do with lawyers? 

On 11 January 2022, the Master of the Rolls, Sir Geoffrey Vos stated that "every lawyer will require familiarity with the blockchain, smart legal contracts and cryptoassets".  He (and others) predict that cryptoassets and blockchian becoming mainstream is imminent.  Commercial and technological developments over the past two years – accelerated by Covid – have given rise to huge growth in the use of both cryptoassets and blockchain.  The legal sector is not immune from these advancements and, in fact, is heavily involved already.  The President of the Law Society anticipates that we will see further increase in law-tech adoption across the profession in the coming years.  New regulations and legislation are being introduced to catch up and keep pace.  

At the same time, lawyers are increasingly working with technological specialists and taking on the role of project managers.  This technology is increasingly forming part of main retainers – all of which means that not only do solicitors need to quickly get up to speed with how these technologies operate, but also how they impact the way in which legal services are carried out.  

What is the current UK legislation and regulation position?

The UK currently has no specific legislation governing cryptocurrency, so the way in which it is treated by the law has been developed through case law alone.  Case law has so far established (among other things): 

That cryptocurrencies constitute property under English Law (AA v Persons Unknown [2019] EWHC 3556)

That the governing law of a cryptoasset is the place where the owner is domiciled (Ion Science Ltd & Ors v Persons Unknown & Ors (Unreported));  

That cryptoassets can be held on trust (Zi Wang v Darby [2021] EWHC 3054); and 

That alternative service of proceedings may be granted by 'airdropping' NFTs into a crypto wallet.  In D'Aloia v (1) Persons Unknown (2) Binance Holdings Limited and others1 , the Court granted an order for alternative service in this way when the Claimant fell victim to a crypto scan.  

In addition, there is presently no specific regulatory regime for cryptoassets in the UK, other than that since January 2020 crypto-asset exchange and wallet providers fall into the scope of anti-money laundering regulations and must be registered with the FCA.  However, the FCA does not regulate most cryptoassets, so the FSCS will not protect investors if exchanges go out of business.   

In January 2022, the FCA published a consultation paper on strengthening financial promotion rules for high risk investments, including cryptoassets.  The trigger for this consultation was research revealing a lack of understanding on the part of crypto consumers regarding the potential risks, rendering them susceptible to losses.  For example, 45% of new investors said they did not view 'losing money' as a potential risk of investing, and 69% of people aged 18 – 40 who had purchased cryptoassets wrongly believed they are regulated by the FCA.  The FCA's official advice is that consumers should "be prepared to lose all [their] money" if they invest in crypto.    

The Treasury, along with the FCA, has recently consulted on cryptoassets and the government has tasked the Law Commission with making recommendations for reform to ensure that the law deals adequately with cryptoassets whilst also fostering its growth and benefits.  On 21 November 2022, the deputy governor for financial stability at the Bank of England, Sir Jon Cunliffe, said that the very recent collapse of FTX highlighted the "urgent need" to regulate the cryptocurrency sector.  It is clear, therefore, that this area is going to be subject to significant change. 

What type of work are solicitors already doing in this space – where cryptocurrencies are the focus of the retainer?

Corporate and commercial

Corporate and commercial lawyers are working with suppliers and customers of blockchain technologies and cryptoassets, advising on issues such as: contracts, compliance, regulatory and competition issues.  There may be IP considerations – does the client need to consider licences, copyrights, patents, trademarks and data security?  Clients are likely to need input from tax specialists. 

It is easy to see how this type of work, much like a standard corporate transaction, can involve services across a corporate law firm.  

Disputes

Lawyers will be advising on disputes where cryptoassets have been misappropriated and clients are seeking their recovery, possibly because of wrongful acts.  Lawyers are also advising on title and trademark disputes involving cryptoassets.  

Cryptoassets have been the subject of freezing injunctions, worldwide freezing orders and a banker's trust disclosure order (Walker and Danisz v Persons Unknown).  In the context of litigation, the Court even considered whether Bitcoin could stand as security for a defendant's costs: in Tulip Trading Ltd v Bitcoin Association, the court decided against this due to the volatility of Bitcoin.  

Contracts

Smart contracts are essentially programs stored on a blockchain.  They are digital contracts that are automatically generated, executed and enforced when pre-determined conditions are met.   The main benefit of a smart contract is that it enables contractual performance to occur without the need for human intervention.  They tend to be used in standard transactions using run of the mill documents. 

Lawyers are likely to be involved in the creation of smart contracts from both a legal and technical perspective.  They will need to think about the legal aspects of the contract but also whether its digitisation and the coding used gives effect to the agreed terms of the contract.

What about legal work where crypto/blockchain is incidental to the retainer?

As well as lawyers being directly involved in the crypto/blockchain sphere, there is no doubt that cryptoassets are affecting, or will affect the more traditional types of legal service.  

Real Estate

Solicitors have to find a way to deal with clients who approach them wishing to turn their cryptoassets into properties.  Given the concern about links between cryptoassets and organised crime, solicitors need to be extremely careful.  

The Proceeds of Crime Act 2002 relates to the recovery and confiscation of proceeds made from criminal activities – it applies to the professional advisers involved in the transactions relating to this property, not just the cryptoasset owner.   

In addition to the risks, however, it is also worth considering the opportunities that blockchain may provide for the real estate industry, such as marketing properties across multiple locations simultaneously, allowing transactions to take place through the blockchain using smart contracts or revolutionising centralised land registries. 

We anticipate that borrowers who hold significant digital assets are likely to push for them to be considered by lenders as part of the credit process when assessing whether to lend.  

Solicitors will want to be fully on top of these changes. 

Divorce

Cryptoassets are treated as property by the Courts and can therefore be divided, transferred or sold within divorce and ancillary relief proceedings, just as with any other asset. 

Within the context of divorce proceedings, spouses must give full and frank financial disclosure of all their assets and liabilities, which includes cryptoassets.  Lawyers will need to not only fully understand the assets, but also review their value.  This is particularly important (and potentially particularly difficult) given the volatile nature of the value of cryptoassets.

Issues for divorce solicitors to consider include: 

a failure to disclose cryptoassets may result in a spouse being penalised by the Family Court for committing a material non-disclosure; 

a party ordered to transfer cryptoassets may be forced to offset its value against another asset if they fail to do so; 

tracing cryptoassets is potentially difficult (and could be all but impossible).  The crypto-sphere markets itself partly on its increased security and anonymity and there is no central register of ownership on which solicitors can conduct checks. 

Solicitors may have to consider instructing specialists to uncover and trace cryptoassets.  In addition, special injunctions may need to be considered.  Where should orders relating to cryptoassets be served?  Potentially on the crypto exchange(s), in addition to the asset owner, and there could be numerous exchanges to serve.  

Divorce solicitors work within a system relying on full (and honest) disclosure.  It is not hard to see that the increased ability to conceal assets that crypto provides may cause problems for solicitors in this sector.  

The volatile nature of cryptocurrency causes additional issues.  How should valuation be tackled?  An asset's value could change significantly from the disclosure of a spouse's Form E by the time settlement is achieved, or a hearing held.  What happens if the value of cryptoassets change significantly once settlement is agreed?  It is likely that expert evidence may be required to provide a long-term appraisal of the value.  

A rapidly shifting asset price will also not assist solicitors when it comes to conducting a cost-benefit analysis of instructing experts.  If an expert tracer is required, this may easily be justified if the asset's value is high but should this crash (which can happen very suddenly), solicitors could wind up incurring costs tracing or valuing an asset that are greater than the asset is ultimately work.  Clients are unlikely to thank solicitors for incurring cost on this basis.  As the use of cryptoassets grows, there could be a lot for solicitors advising in this space to grapple with.  

Private client

Private client lawyers should be asking clients at the outset to establish the extent of their estate held as cryptoassets.  Where cryptotoassets are involved, there are potential problems: 

The executors may not have any knowledge of the asset and even if they do, they may not be able to get hold of the keys.

On the other hand, if the keys are part of a will, once a grant of probate has been issued, a will becomes a public document, and so in that event, there is a risk that the keys become publicly available. 

What are these assets worth, and how can solicitors best establish their value?

Given their volatility, cryptoassets can be problematic to manage. 

Tax

There are numerous issues for a tax lawyer to consider.  HMRC has assessed that:

Cryptoassets are liable to CGT upon disposal.

Cryptoassets received from employers give rise to an income tax and national insurance liability.  

Cryptoassets form part of a deceased's estate and so there will be inheritance tax considerations.

Gifts within families have the same tax consequences as transfers of any other property. 

There will be potentially tricky jurisdiction issues for tax lawyers to consider. 

Cryptoassets and ESG

The popularity of cryptoassets has grown extremely quickly.  At the same time, increasing focus has been placed on its potential impact from an ESG perspective.  Investor interest in ESG continues to grow and, as a result, businesses, financial institutions and insurers find themselves facing previously unseen levels of scrutiny in terms of their ESG credentials.   

ESG is an enormous subject and discussing ESG and cryptoassets could easily encompass several articles, but we will touch briefly on each area. 

Environment

Environmental concerns have been raised relating to the amount of energy used in mining cryptocurrencies and the consequent emissions, particularly Bitcoin.  Mining a single Bitcoin uses the same amount of energy as one US household uses in 9 years.  Bitcoin currently consumes more electricity than the entire country of Argentina and emits roughly the same amount of carbon dioxide into the atmosphere every year as Greece.  

However, there is a growing trend towards using renewable energy and today, nearly 40% of cryptocurrency mining is powered by renewable energy.  Some investors now seek sustainably mined Bitcoins, which are more costly but are less likely to carry ESG and reputational risks.

Social considerations

Cryptocurrencies are, in theory, widely accessible; all consumers need to access the market (beyond the investment sum) is a connection to the internet.  Investors can transfer value all over the world via a network that is independent, not centrally run or subject to state interference (and its supporters argue it has an inherent value as a result of this feature alone).  However, the available anonymity could enable market manipulation and encourage or support financial crime.  To combat this, a range of 'know your customer' solutions are developing.

Governance

As touched on above, Bitcoin is decentralised, it is not run by a central body, organisation or group.  In theory, it is governed communally by its users.  If someone wished to make a substantial change to its system (such as changing from a proof-of-work to a proof-of-stake model, which may make it more environmentally sustainable), they would need to submit a BIP (a Bitcoin Improvement Proposal) to the Bitcoin community (though there appears to be no formal place to do so).  A BIP is passed and incorporated into the Bitcoin protocol if it is 'upvoted' by at least 95% of the mining community.  Whilst this does, in theory, allow democratic governance, the lack of a formal place to garner support for a BIP and the extremely high threshold for effecting change must surely make changes unlikely.   

ESG conclusion

Businesses cannot escape the impact of ESG and solicitors are no different.  If law firms are handling cryptoassets, or advising on them, it is worth thinking about whether this is likely to have an impact on their ESG credentials (not least because their insurers might want to know about it).

Risks for solicitors and their insurers 

Insurance

Solicitors' policies indemnify their insureds against civil liability to the extent that it arises from 'private legal practice'.  Private legal practice is the provision of services in private practice as a solicitor and the work described in this article will undoubtedly fall within this (rather vague) definition.  

The world of cryptoassets and blockchain is a new world and it is constantly developing and evolving.  There is currently light regulation, but that is likely to change.  This market is taking off and is also going to expand.  The UK is actively embracing digital technologies.  

With that level of rapid change and huge expansion of this market, lawyers who are advising on these issues in such an evolving landscape are potentially at risk of liability claims if they get it wrong, or where they do not keep pace with the developments.   There may be a lack of understanding and knowledge here – all of which means that claims may be more likely to arise.  

The other issue, somewhat unique to cryptoassets, is that with such rapid fluctuation in their value, it will be difficult for law firms to get a steer on the value of any claim against them.  This could have a knock-on impact in assessing risk, which will impact reserving claims.  This also has wider implications for pricing, premiums and reinsurance. 

Examples of potential claims solicitors may face 

Regulatory and tax - lawyers advising in this space need to ensure that they keep up to date with rapid changes.  It is not difficult to imagine that claims are likely to arise as a result of the advice being wrong.

Divorce and wills - clients may look to blame their solicitor if there have been difficulties getting hold of all the disclosure / information on assets.  These assets can be very hard to track and private keys, once lost, are unlikely to be recovered.

Commercial disputes - solicitors may need to act quickly to instruct experts to trace cryptoassets and to consider what applications to Court may need to be made to freeze them. Claims may arise where solicitors have failed to take such steps, or failed to do so promptly. 

Smart contracts - lawyers may be exposed where something goes wrong with the smart contract.  

Cryptoassets are increasingly being used as a vehicle for money-laundering.  If this area means clients themselves are more susceptible to fraud – they are going to look to someone to blame.  Solicitors can be an easy target if they fail to carry out proper due diligence and checks.  

How can law firms deal with these emerging risks? 

Law firms should start with the basics; thinking carefully about what work they may already be doing with cryptoassets.  How much consideration have they given to which practice areas are starting to have involvement, or are likely to become involved in the near future?  

Law firms should carefully think about what expertise they have already, and what further learning or training needs they have.  In addition, law firms should think carefully about whether they are consulting on this subject (who might be delivering any necessary training?) or outsourcing to experts or specialists.  Do those external bodies have the right expertise, and do they have their own professional indemnity insurance? 

Law firms must think carefully about what checks and due diligence they are doing on the source of funds where cryptoassets are involved.  This should obviously be carefully documented.  

Whilst this is the case when any legal work is carried out, it is especially vital for law firms to carefully define the scope of their retainer (in writing) when involved with cryptoassets/blockchain.  Solicitors must identify which aspect of any transaction they are advising on and which aspects are for other advisers to deal with.  A failure to clearly set this out can lead to an expectation that a solicitor has been engaged to provide advice on broader business matters.  Solicitors must be careful to consider the purpose for which the advice is sought, and given, and how this fits into the entire transaction.  The notion of 'scope creep' and the finding in MBS v Grant Thornton2  are especially relevant here. 

Conclusion

There can be no doubt that the world of crypto and blockchain is growing fast.  In addition to the risks and challenges, there are considerable opportunities for solicitors in this sphere.  The UK legal system is well placed to become to the go-to jurisdiction for crypto dispute resolution thanks, in part, to the High Court's repeatedly pragmatic and commercial approach to crypto fraud cases and guidance from the judiciary.  

With cryptoassets becoming more and more accessible to the average person, it is hard to see a world in which solicitors will not be expected to advise on areas touched by cryptoassets in the future.  For now, the questions remain, how will the sector keep up, and when will meaningful regulation roll out?

[1] [2022] EWHC 1723 (Ch)
[2] Manchester Building Society v Grant Thornton UK LLP [2021] UKSC 20

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