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Claims against crypto exchanges: the next battleground in crypto asset fraud?


United Kingdom

The recent case of D'Aloia v Persons Unknown and Others [2022] EWHC 1723 (Ch) (which we covered in an earlier article) held that crypto currency exchanges can hold crypto assets on constructive trust for a defrauded claimant and that claimant may have an action for breach of trust against the exchange and a direct avenue to seek relief against the exchange in the event the exchange fails to comply with duties of trustees when put on notice that they may hold the proceeds of a fraud.

There has not yet been a claim in the English Court against a crypto exchange that has been contested by an exchange. This article looks at the potential legal battlegrounds that could be fought between a defrauded claimant and a crypto exchange, in particular which claims a claimant could make against an exchange and how these might be defended.
The starting point: tracing and following
A claimant that has been defrauded of a crypto asset (whether crypto coin or NFT) will typically need to begin a tracing or following exercise before establishing any claim for recovery of those assets. In English law, tracing/following are evidential processes and are not claims or remedies as they do not determine substantive rights.
Assets can be 'followed' by following the asset in which the claimant has a proprietary interest as it moves from hand to hand (or in the case of crypto, wallet to wallet or wallet to exchange) identifying what happened to that asset. Tracing is the process of identifying that misappropriated property which has been used to acquire some other new identifiable property (e.g. if the crypto asset has been converted into a different crypto asset or converted into fiat currency). Because each transfer of a crypto asset is recorded on the blockchain, a claimant will in principle be able to follow/trace it to a wallet or exchange with the assistance of the right technical knowhow.
After a successful following or tracing exercise a claimant will then need to prove their proprietary claim and seek an appropriate remedy. That remedy may be either personal or proprietary. In circumstances where a claimant has traced or followed its assets to an exchange, its primary target will likely be the wallet holder or persons responsible for the theft of the asset. However, whilst the Court has an equitable jurisdiction to make an order for disclosure against the exchange (i.e. to determine the identity of the wallet holder), the wallet holder or ultimate wrongdoer may remain unknown or out of reach of enforcement. So would a claimant be able to target an exchange and what types of claim could they bring?
Constructive trust
A constructive trust "arises by operation of law whenever the circumstances are such that it would be unconscionable for the owner of the property…to assert his own beneficial interest in the property and deny the beneficial interest of another". The circumstances in which the Court has been prepared to recognise constructive trusts has been gradually expanding, particularly in the context of fraud claims, as the D'Aloia case has demonstrated. However, it remains to be seen whether the D'Aloia decision, which was an interlocutory hearing, will be followed in future decisions. The judgment D'Aloia only held that there was an arguable case that the defendant exchanges held the assets on constructive trust, and the judge emphasised that the claimant would not necessarily be able to establish that that was the case at a return hearing or trial.
An exchange would in most circumstances have a straightforward defence to the argument that it held assets on constructive trust. This is because the claimant would need to demonstrate that the exchange had the requisite level of knowledge. For a constructive trust to be established, the claimant would need to prove that the exchange was aware that the crypto assets were tainted. The argument that a constructive trust exists will perish if the exchange can demonstrate that it received good title to the assets in question. This was not in issue in the D'Aloia case as no exchange contested the claim at the interlocutory hearing.
A claimant would need to demonstrate that the exchange had been on constructive notice of the impropriety of the transfer of the crypto assets. As a minimum, the claimant would need to demonstrate that the exchange had failed to make inquiries if there was a serious possibility of a third party having a proprietary right or, to put it in another way, if the facts known to the exchange would have given a reasonable exchange in the position of the particular exchange serious cause to question the propriety of the transaction (following Credit Agricole v Papadimitrou [2015] UKPC 13). In practice, where an exchange operates thousands of wallets, it would be very difficult to demonstrate that an exchange had the requisite knowledge. The knowledge element would likely be satisfied if a significant deposit, millions or even billions of value in crypto assets was transferred to an exchange following a significant and well publicised hack. Constructive knowledge could also be satisfied in instances of 'hot' wallets that were regularly being used for fraudulent purposes. If an exchange has been put on notice that a wallet or multiple wallets were being used for fraudulent purposes, but failed to make any inquiries,  the knowledge element would likely be satisfied. Exchanges should be particularly vigilant in this regard.
But even if the claimant is able to establish a constructive trust, that still leaves the claimant needing to prove that the trust had been breached by the exchange. Therefore, the establishment of a constructive trust only gets a claimant so far. The claimant may simply end up falling back on obtaining judgment against the ultimate wrongdoers. Ultimately, having established a proprietary claim (coupled with a freezing injunction to 'hold the ring' until judgment) against the ultimate wrongdoers, a final judgment could then be enforced against those defendant(s) and the assets returned by the exchange, potentially using a third party debt order as per Ion Science Ltd v Persons Unknown (although enforcement against a foreign exchange may not be without difficulties).
In circumstances where the assets have been transferred away from the exchange, the claimant would have to look to different causes of action, which are analysed below.
Knowing receipt
The requirements for a claim in knowing receipt are as follows:
  • Receipt of the claimant's assets by the defendant
  • Such receipt arising from a breach of trust or fiduciary duty owed to the claimant by a third party
  • Knowledge on the part of the defendant that the assets it received are traceable to a breach of trust, sufficient to make it unconscionable for him to retain the benefit of the receipt.
Here again an exchange would likely be able to put forward a cogent defence that it did not have the  requisite level of constructive knowledge to satisfy the third element of the claim above. Yet, if these elements are made out by the claimant, it could claim from the exchange either the value of the assets received, together with any profits derived; or, the loss the claimant suffered as a result of the misappropriation of the assets. From a crypto perspective, this gives the claimant a significant amount of flexibility given the volatile nature of crypto assets.
Dishonest assistance
The elements of a claim in dishonest assistance can be summarised as:
  • Breach of trust or fiduciary duty
  • Procurement of or assistance with that breach by the defendant
  • Dishonesty on the part of the defendant

In fraud litigation this is a particularly useful cause of action as it allows the defendant to cast a the net of liability wide. Misappropriated assets are often transferred through multiple recipients and the fraud itself can involve the participation of multiple individuals and entities (who may have not actually received the claimant's assets). A claim in dishonest assistance can enable a claimant to encapsulate a defendant who has deeper pockets than the principal wrongdoer.
An exchange would again have the defence that it lacked the necessary knowledge. The dishonesty element would require the claimant to prove that the exchange had acted dishonestly if it had received misappropriated assets and then allowed these to be transferred on. The dishonesty element can be satisfied by the aforementioned level of constructive knowledge, but this may be very difficult for the claimant to evidence. Again, where a wallet is known by the exchange to be 'hot', this could potentially satisfy the dishonesty requirement.
Unjust enrichment
Unjust enrichment is a distinct and separate claim that does not require any proof of wrongdoing or the existence of a trust or fiduciary duty. It is concerned with circumstances in which a defendant is enriched at the expense of a claimant and if those circumstances are unjust for the defendant to retain that enrichment, then it can provide for its return to the claimant. However, the difficulty for a claimant in respect of bringing a claim against an exchange in this regard is satisfying the 'unjust' element. In this scenario, the claimant would need to demonstrate that the exchange was aware that the relevant wallet holder was a fraudster and the contract between the exchange and fraudster was therefore unlawful. Without being able to satisfy this element, an unjust enrichment claim would effectively fall at the first hurdle.
A practical solution?
Exchanges remain in a reasonably strong position against claims from third parties resulting from stolen crypto assets. This could change if the English Court elects to apply a more lenient test for constructive knowledge. The case of Baden v Société Générale [1983] BCLC 325 established five different types of knowledge to satisfy constructive knowledge, the fifth being knowledge of circumstances which would put an honest and reasonable man on inquiry. This test has since fallen out of favour, but a similarly flexible formulation could be adopted to assist victims of crypto fraud.
A claimant may take an alternative, more practical approach. If a claimant is able to trace or follow misappropriated crypto assets to an exchange, and if it is then able to establish a proprietary claim to those assets at an interlocutory stage (coupled with a freezing injunction) it may then be able to persuade the exchange through settlement negotiations simply to return those assets on the basis that the English Court has determined that the claimant has a proprietary right to the assets and that they have been misappropriated.
It is likely that a claim against a crypto exchange will be contested in the future, and that will certainly set valuable precedent for both exchanges and claimants alike.

With many thanks to Sam Goodman of Twenty Essex for canvassing ideas for this article.

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