Trust The Tried And Tested When It Comes To Protecting Your Digital Assets
The contents of this Insight are generalised, and readers are urged to seek specific advice on matters and not rely solely on this text. © Vibha Vallabh, Ellora Private Office, May 2021
This article will not be discussing the merits or inferiority of cryptocurrency as an investment, but rather given the unique features of such an asset, how it can be managed from an asset protection and wealth succession perspective. The forward thinking and capability of virtual assets should be no different to its future safekeeping. It will therefore be assumed that the reader already possesses background knowledge on cryptocurrency and they are now seeking the same on how to protect it.
The Legal Nature of the Asset that Requires Protection
Whilst some countries have outright prevented the dealing of cryptocurrency, others have adopted it and provide formal recognition as to its legal classification.
Switzerland
Switzerland has not recognised cryptocurrency as property but by its Swiss Federal Council. However, as far back as 2014 has stated that virtual currencies are not legal tender but given their tradability, should be classified as an asset.1 Although it is not considered legal tender it does exhibit key features of money and therefore there is no reason not to treat exchange activity like exchange of foreign currency or money transmission from an anti-money laundering perspective, therefore requiring stricter due diligence which includes duty to verify the identity of the contracting party and establishing the identity of the beneficial owner, and duty to keep records of transactions carried out.2
Whilst there is no specific investor protection, there are some interesting banking options available for high-net-worth cryptocurrency owners.
New Zealand
The New Zealand case of Ruscoe v Cryptopia 3 not only defines the legal and proprietary status of cryptocurrency, but also provides comprehensive easy to read background information on the crypto world and is worth a read in full for this purpose alone.
In brief, Ruscoe v Cryptopia was a case where Cryptopia a New Zealand based cryptocurrency exchange was hacked whereby somewhere between nine and 14 percent of cryptocurrency with a value of NZD30 million was lost, and as a result its shareholders resolved by special resolution to place the company into liquidation. The liquidators made an application to the court seeking directions as to the legal status of the cryptocurrencies held by Cryptopia and whether they were held in trust by them as this would determine the outcome of the competing interests between the creditors and the account holders/investors. Both are important issues in determining the legal status and propriety interest if any of this ‘new’ asset and the likelihood of recovery from a cryptocurrency exchange where they were held in a soft wallet.
The legal nature of digital assets. Because of the ever-changing nature of such crypto assets and different systems in use, Justice Gendall sought to outline its features rather than provide an outright classification. Such features namely being intangibility; cryptographic authentication; use of a distributed transaction ledger; decentralisation; and ruled by consensus. He did describe the different crypto assets but for the current case before him he was concerned only whether the crypto asset itself (the native or on-chain asset) is property distinct from the asset it might represent. This was important because proprietary rights compared to personal rights could then be recognised against the whole world.
Equitable Interest. Was determinant upon how Cryptopia operated. For any account holder to claim propriety interest, if the relationship is not well defined by its terms and conditions a closer look is required of the services an exchange provides its customers. Whether any or all the digital assets are held on trust for any or all the account holders and whether by way of express, implied, resulting, constructive, Quistclose trust or otherwise.
Both matters were important, because if the crypto asset could be considered intangible personal property, only then could it be capable of forming the subject matter of a trust at common law thus protecting the accountholders rights against the creditor if it was found that the crypto exchange did hold such assets in such manner.
Findings Justice Gendall found that cryptocurrencies situated in Cryptopia’ s exchange were a species of intangible personal property and clearly an identified thing of value and therefore capable of being the subject matter of a trust. 4 He cited Lord Wilberforce’s definition of property from the case of National Provincial Bank Ltd v Ainsworth (a) identifiable subject matter; (b) Identifiable by third parties; (c) capable of assumption by third parties; and (d) some degree of permanence of stability.5 In applying these to a modern invention, His Honour found that cryptocurrency was a type of intangible property because of fulfilling the four criteria. “I am satisfied that cryptocurrencies meet the standard criteria outlined by Lord Wilberforce to be considered a species of “property”. They are a type of intangible property because of the combination of three interdependent features. They obtain their definition as a result of the public key recording the unit of currency. The control and stability necessary to ownership and for creating a market in the coins are provided by the other two features- the private key attached to the corresponding public key and the generation of a fresh private key upon the transfer of the relevant coin”.6
Having established the cryptocurrency is property, can a trust be inferred in the current situation where there is limited or no express verbal declarations to that effect. His Honour found that the three traditional elements of a trust were present.
Certainty of subject matter: Justice Gendall having found that cryptocurrencies are property regardless of if they were held in hot or cold wallets, the fact that the cryptocurrencies were recorded in Cryptopia’s SQL database records provided sufficient certainty of subject matter.
Certainty of objects:
The beneficiaries were those that had positive coin balances for the respective currencies in Cryptopia’s SQL database.
Certainty of Intention:
Despite there not being intention directly expressed, there was an inference that this occurred from the conduct of Cryptopia. Cryptopia created an exchange without allocating to account holders the public and private keys for the digital assets. The SQL database created, showed that the company was the custodian and trustee of the digital asset. More importantly Cryptopia did not intend, nor did it trade in the digital assets in its own right.
Justice Gendall referred to the Singapore case of Quoine Pte Ltd v B2C2 Ltd.7 In this case all the parties accepted that cryptocurrencies were species of “property”,8 however the difference being that the operating trading platform used by Quoine was not one of a custodial relationship. Quoine was a major market maker and actively placed buy and sell orders on the system and loaned funds including cryptocurrency to other market makers and did not attempt to ensure there was actual cryptocurrency in its wallets to match the loans. It also engaged in futures trading. Other indicators that Cryptopia was acting as mere trustee were the provisions within the terms and conditions; the internal financial accounts and GST records showed that it did not assert ownership; its web-based instruction pages and live customer interface implied that the accountholders would be depositing, buying, selling and owning their own cryptocurrency; the Cryptopia Risk Statement stated that customers own their cryptocurrency; its marketing strategy stated that Cryptopia was providing a trading platform for global cryptocurrency investors and that they could deposit, trade and withdraw their cryptocurrency.
Justice Gendall concluded that during Cryptopia’s operations there were a series of express trusts in favour of account holders in respects of their representative digital assets information held in the SQL database. That the various cryptocurrencies were at equity held on separate express trusts by Cryptopia for all the accountholders and that these came into existence for every different type of currency which Cryptopia acquired because of a dealing with an accountholder. So, they arose in respect of each parcel of digital assets when they were acquired. As bare trustee, its role was limited to holding each group of digital assets as trustee for the accountholders and to follow their instructions.
Singapore
As previously mentioned, the case of Quoine determined that cryptocurrency was considered property as they “do have the fundamental characteristic of intangible property as being an identifiable thing of value”
Structure like a commercial trust given the nature of the asset
It is without doubt that the trust based legal arrangement if done properly, is not only the most effective structure for asset protection, but also the most flexible in terms of providing creative solutions for commercial transactions. John H Langebein from Yale School of Law has estimated that well above 90% of wealth in trusts in the United States is held in commercial as opposed to personal trusts 9 and that whilst traditional trusts are viewed as gratuitous transfers, the wealth held in trusts is placed there incidental to business deals and that the former is not connected to the later.
The idea of trusts for commercial purposes is not new but just probably not well known. Pension trusts, investment trusts, mutual funds, oil and gas royalty trusts and asset securitization are just to name a few. With the advent of cryptocurrency and digital assets one cannot help but think that if owned in a personal capacity, that they be best protected in a specially formulated trust structure considered as a gratuitous transfer as well as a private commercial security device. A trust would be flexible enough to accommodate holding digital technology assets. From a practical perspective, it may be difficult to find a trustee, who having experience in dealing with traditional assets within a trust, are now able to understand and manage more modern assets, therefore a trust with more of a private commercial purpose and management and administrative style would be more suitable. It is not being suggested that the structure be like a managed fund as that would require regulation by the relevant authority, but rather that for an individual wanting to protect their digital assets for themselves and their family, that it be managed with an awareness of risk and commercial management and administration in mind.
In establishing such a creature and managing it going forth, it’s important to remember the traditional trust principles should always be respected and enforced, otherwise a court of law could view such an arrangement as agency or contract which would not provide the asset protection afforded by a trust.
The settlor by creating a trust, imposes obligations on the trustee owed only to, and enforceable only by, the beneficiaries and not the settlor, unless he is one of the beneficiaries or unless he reserved the rights to himself within the trust instrument.10
Trusteeship is not an agency or bailee arrangement but rather an ownership management relationship as the settlor relinquishes full control of those assets by gifting them to the trustee for the benefit of the beneficiaries. It’s important to highlight the fundamentals as they provide the foundation for using trusts creatively.
Managing the risk
Where cryptocurrency is being held directly by the trust, and the trustee has competency to manage and administer the asset.
1. Understand the legal characteristics of the asset being placed in the trust, as well as the settlor’s intention and beneficiaries and build everything around it.
Choose a trust jurisdiction like New Zealand or Singapore that has formally recognised crypto assets as property so that it may hold such an asset that has legal standing.
3. Ring fence your assets and have one trust hold only crypto assets and corresponding bank account for trades. Do not add other kinds of assets to the trust. It is prudent to isolate not only a high-risk asset but also risks associated with administering and managing it. Co mingling could cause complications if problems were to arise in the future.
4. Every trust should have an investment mandate, consider its contents for high-risk assets such as crypto currencies and review frequently as the nature or holdings of tech assets change.
5. Any trust deed that will hold crypto assets should clearly set out the purpose of the trust in more of a commercial tone. Making such a declaration early sets out the parties’ intention and confirmation of risk and expectation to not only to the world at large but also to the beneficiaries who can enforce fiduciary obligations on the trustee.
6. Where the asset is not held in a cold wallet, consider what the virtual asset provider is. Is it a crypto exchange, custody service provider or virtual asset financing services? Consider the cases of Ruscoe v Cryptopia and Quoine. If something were to go wrong with the virtual asset provider, what rights would the account holder have against creditors?
7. If the cryptocurrency is not held in a hard wallet, choose an exchange that acts as custodian rather than an operating trading platform and preferably in a jurisdiction that recognises trusts and have a favourable tax position. Read the terms and conditions of the crypto exchange very carefully. Do they have insurance cover or are they too high risk to insure?
8. If holding a hard wallet, how will the trustee keep it along with the private and public keys securely? How will it be delivered to an international trustee? What policy and procedures are in place by the international trustee to keep them safe?
9. In a trust relationship, as the trustee is the legal owner of the asset, they have a fiduciary duty to manage and administer this asset. Will the trustee of choice have the capacity to understand, manage and administer crypto assets? Do they have insurance cover?
10. The trust document will need to include comprehensive anti-bartlett, liability and indemnity provisions covering high risk assets such as cryptocurrency.
11. Meticulous records of trades will need to be kept as tax liability is likely to be incurred not only when the cryptocurrency is sold but other events such as exchanges.
Asserting some measure of control
As well as implementing the above, if a client is having difficulty finding a competent trustee or trading cryptocurrency requires active participation of the settlor or another person.
12. Is having an offshore private trustee company an option? Would there be any tax or control implications? Could the settlor or trusted advisor be one of the directors of the PTC and take safe custody of the hard wallet, private and public keys. The constitution documents of the PTC would need to carefully specify how custody and trades can take place? Consider if having a private trustee company will afford the same asset protection as having an offshore trustee?
13. For active trading, would a custodial trustee and managing trustee relationship work?
14. Could the trust appoint the settlor as an investment advisor or manager. The trustee will use its discretion as to whether it follows the recommendations of the settlor.
15. Alternatively, a trust jurisdiction like Singapore that have reserved powers could be an option if there is little risk of asset protection and/or tax issues.
16. Consider the go to model of a trust holding shares in a company which holds the cryptocurrency. The settlor being the director of the company would manage the cryptocurrency instead of the trustee. Would there be any tax implications?
17. Where a trust is a beneficiary of a foundation. The foundation could manage this active high-risk asset. As the foundation is not a trust, there are no fiduciary duties imposed on the management board and anti- Bartlett provisions would not be required. The foundation should periodically make distributions down to its beneficiary, the trust for safe keeping. In an event of duress at either end, the foundation simply removes the trust as a beneficiary. It can then stand alone with all the assets that were transferred to it.
18. In a limited partnership structure, the general partner would have the day-to-day management of the cryptocurrency account and the trust being the limited partner benefits from the any profits or losses made.
19. Special purpose trust where the trustee simply holds the crypto assets for the beneficiaries until a specified event takes place.
Tax considerations
Traditional tax systems were built within country borders. With the aftermath of the Covid-19 pandemic and government spending, we are now seeing the landscape of borderless taxes expanding. With any wealth planning, it’s always important to be aware of tax considerations. With cryptocurrencies consider if tax liability will be incurred based on citizenship or residency of the settlor; in the location of the exchange; where the transaction took place, where the private or public keys are located. Tax awareness should not only be confined domestically but internationally. At the time of writing this article Switzerland and Singapore have no applicable tax provisions. 11
The old tried and tested working with the new
Trusts unlike companies, are flexible in not only providing proprietary protection to beneficiaries but can include in its trust instrument, provisions that can accommodate varying legal characteristics of a commercial transaction or unusual asset, used on its own or be part of a larger structure so long as there are no adverse tax disadvantages domestically and internationally.
Cryptocurrency is just one form of ‘new’ asset and there will no doubt be others in time. As far as wealth planning is concerned, working with the tried and tested trust still works.
[1 ]Federal Council Report on Virtual Currencies in Response to the Schwaab (13.3687) and Weibel (13.4070) postulates June 25 2014. https://www.news.admin.ch/NSBSubscriber/message/attachments/35355.pdf “ A virtual currency is a digital representation of a value which can be traded on the Internet and although it takes on the roles of money- it can be used as a means of payment for real goods and services- it is not accepted as legal tender anywhere. These currencies have their own denominations. They differ from emoney in that they are not based on a currency with legal tender status. Virtual currencies exist only as a digital code and therefore do not have a physical counterpart for example in the form of coins or notes. Given their tradability, virtual currencies should be classified as an asset”.
[2] Id pages 14-17
[3] Ruscoe v Cryptopia Ltd (in Liquidation) [2020] NZHC 728
[4] Ibd page 19
[5] National Provincial Bank Ltd v Ainsworth [1965] UKHL 1: [1965] AC 1175 (HL) at 1247-1248
[6] Page 30 Ruscoe v Cryptopia Ltd (in Liquidation) [2020] NZHC 728
[7] Quoine Pte Ltd v B2C2 Ltd [2020] SGCA(I) 2 [B2C2 (SGCA)]
[8] “Cryptocurrencies are not legal tender in the sense of being a regulated currency issued by government but do have the fundamental characteristic of intangible property as being an identifiable thing of value”.
[9] Langbein, John H., “The Secret Life of the Trust: The Trust as an Instrument of Commerce” (1997). Faculty Scholarship Series. 503
[10] Page3 Underhill and Hayton Law of Trusts and Trustees, David Hayton, Paul Matthews and Charles Mitchelll, Seventeenth Edition.
[11]https://www.bakermckenzie.com/en//-/media/files/insight/guides/2021/baker_mckenzie_crypto_around_the-world.pdf