Tracey Walker

Virtual assets have experienced an explosion in growth, in part due to the meteoric rise of initial coin offerings (ICOs) in 2017. Only a small number have succeeded in becoming longer-term prospects, but many are trickling down onto the client books of liquidators.

Given the nature and functionality of the underlying virtual assets, this has meant a shift from some of the traditional recovery, valuation and safeguarding processes that liquidators have been used to.

Some of the process changes and challenges now faced by liquidators in this new environment are outlined below.

The initial observations are the fundamental principles involved in traditional insolvency and how they translate to a digital environment. They are asset discovery and collection; key pair safeguarding (public and private key pairs); and asset valuation.

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Asset discovery and collection

Uncovering assets and proving ownership can prove problematic with traditional assets. However, virtual assets have an added technical layer to be navigated relating to key ownership, transfer and proof.

Liquidators need proof of key ownership when retrieving assets. At the point of distributing assets to shareholders, they must also determine the correct address they are sending assets to. This is challenging if the initial investments were involved in the likes of ICOs, which have been notorious for pseudonymous and opaque transactions with little-to-no contractual terms. These types of assets are likely to appear at this point, given some of the 2017 ICO projects are starting to reach, or have reached, the end of their life cycle.

Some exchanges may also start to become clients of liquidators having, at this point, reached maturation over the last few years. Asset proof and discovery for exchanges requires its own distinct framework and step process which liquidators must plan for.

Exchanges may, for example, follow a 98% cold custody wallet and 2% hot custody wallet rule. Cold wallet assets are often stored in safe deposit boxes and vaults around the world. This is prudent for exchanges, yet potentially challenging for asset discovery and recovery.

Liquidators must start by taking inventory of all public/private key pairs stored by the exchange. These will be split between assigned and unassigned. and stored on a specific database by the exchange.

A reconciliation process will be required between the used and unused public/private key pairs, along with a reconciliation of the public keys to the private keys. The last piece of the puzzle is to reconcile the public key to the client. This closes the loop to ensure all keys and relationships are accounted for.

It is in principle reverse engineering the process carried out by the exchange when initiating keys to clients.

Once assets have been discovered, they must be moved to an address under the control of the liquidator as soon as possible, to mitigate the risk of a third party having access to the private keys and thus the ability to move the funds.

Key pair safeguarding & public/private key management

A robust framework housed within updated policies will be required to manage the security of private keys. This will include controls over access to keys.

Key retrieval

Depending on the nature of the situation, acquiring private keys may or may not be straightforward. For example, enforced receivership could provide a hostile environment, creating a challenge in this respect. The liquidator would need a checklist covering its approach on how to retrieve private keys, in line with general practices and internal policies.

Transfer the keys or transfer the assets?

Retrieval of private keys in a different jurisdiction may require a bonded courier, to enable the liquidator to take control of the assets. The liquidator must also be satisfied that the holder of the private keys does not have a copy of those keys.

Virtual assets can also be transferred from the previous owners’ address to an address under the liquidators’ control. For this, trust is placed in the private key holder to transfer the assets to a new address controlled by the liquidator. The liquidator will require guidelines to determine how to carry out and control this process.

Once the assets have been identified, a decision must be made on where to safely store them. Liquidators may prefer to transfer the assets to a custodian to avoid the responsibility of managing addresses and private keys. Some custodians have started to provide insurance for the assets it holds, in this respect. Liquidation of assets likely requires a new entity to be incorporated with new accounts. Relationships need to be established with custodians beforehand to ensure this process is smooth and seamless.

Asset valuation

Asset values will likely come from several sources and therefore need to be aggregated prior to reconciliation and equitable distribution. Clear, defined processes are required to ensure all asset values are captured. Price valuations should be sourced from the most-liquid exchange markets where the assets could realistically be sold. A price-discovery policy should be drawn up to provide a framework around these processes.

The primary goal, for the majority of liquidations, is to accumulate assets and redistribute proceeds back to shareholders in a process aligned with the best interests of the key stakeholders.

The nature of virtual assets presents unique risks and challenges. Portfolios may include assets types acquired through the likes of initial coin offerings, initial exchange offerings (IEOs), security token offerings (STOs), simple agreements for future equity (SAFEs), simple agreements for future tokens (SAFTs) and private equity as well as investments in kind. Hence, proof of ownership and portfolio valuation is not necessarily straightforward.

Other challenges faced by the liquidator

Smart contracts

Virtual assets may not be immediately accessible or identifiable and could remain outside the control of the liquidator for some time. For example, coins may be tied up in a time-lapsed smart contract which has no option but to see out its contract term. Liquidators would need to carry out a detailed analysis on the smart contract to ensure it is acting in accordance with such terms.

A document could then be drawn up confirming the findings to the appropriate parties. This may be required to absolve the liquidator from the liability of discovering the asset, yet not be able to immediately release the virtual assets back to investors.

Network credibility

Liquidators need to assess whether virtual assets are operating on a functioning network (an open network requires minimum criteria such as an optimal number of nodes etc. to run securely and remain operational). A non-functioning network can cause the assets to be impaired or reduced to zero value. This consideration relates to security, control and price of decentralised virtual assets in particular.

Credibility of the beneficiary

Liquidators are usually bound by law to return the recovered assets of a liquidation to the shareholders. Confirming the credibility of those staking claim to assets requires public key validation. Liquidators may need to lean on their relationships with exchanges and custodians to provide evidenced documentation, if the assets were acquired through such means.

If the assets were not acquired through an exchange (or easily evidenced means), yet the shareholder is adamant they own the public key, the assets could be returned to that same public key; however, challenges occur if the address has changed, which is a function in some wallets. The liquidator would require a policy on what they do in this circumstance.

Looking forward

Liquidators face new challenges. Current systems and processes require adaptation to service clients in the recovery, valuation and safeguarding of virtual assets. Policies are being rewritten, technical expertise is being gained and systems are being developed to build a robust encompassing framework to handle these new rapidly evolving assets.

Tracey Walker is a senior financial consultant at Cartan Group LLC.

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