30 July 2018

Cryptocurrencies - Risks Faced by Investors

(First published on 5 June 2018, updated as of 26 July 2018)

This article was written by Barbara Chiu, Alex Cheng and Michael Tang.

With the Bitcoin price reaching an historical height in 2017, it is of no surprise that cryptocurrencies and initial coin offerings (“ICOs”) have been taken more seriously than ever with their increasing popularity. 2018’s market downturn has diminished prices and liquidity, but interest does not appear to have abated.

In this article, we will take a look at some of the recent cases and emerging disputes that may shed light on the risk trends involving cryptocurrencies in Hong Kong.

Current Regulatory Status in Hong Kong

In Hong Kong, there is currently no tailored regulatory regime for cryptocurrencies as a distinct class, and no one single central authority that regulates cryptocurrencies. Cryptocurrencies are considered virtual commodities by the Hong Kong Government, and depending on their precise features, some cryptocurrencies may be regulated as shares, collective investment schemes, stored value facilities or otherwise. The Customs & Excise Department (responsible for protecting consumer interests, legitimate trade and industry, and regulating money service operators), the Hong Kong Monetary Authority (responsible for maintain monetary and banking stability and regulating stored value facilities) and the Securities and Futures Commission (“SFC”) (responsible for regulating the securities market and collective investment schemes) are some of the departments that have roles to play in regulating the sector in Hong Kong.

Recent Cases and Emerging Disputes

Unsurprisingly, with the quick adoption of the new technology, a number of disputes and conflicts have arisen in connection with cryptocurrencies. The following are some of the recent cases and emerging disputes that highlight some of the risks in dealing with cryptocurrencies in Hong Kong:-

  • Regulatory risks: In Hong Kong, the SFC has been active in monitoring the cryptocurrency market, focusing on unauthorised marketing of collective investment schemes. A recent example is the action taken by the SFC in relation to Black Cell Technology Limited, on the ground that the ICO may constitute a collective investment scheme, resulting in the issuer halting its ICO. There is so far no challenge to the SFC in this case because Black Cell reached agreement with the SFC in relation to the halting, but the scope of the SFC’s authority in relation to cryptocurrencies could well be tested in future actions.

    Anti-money laundering / counter-terrorist financing (“AML/CTF”) regulations have also been a concern for financial institutions. There have been instances of cryptocurrency exchanges in Hong Kong having their bank accounts suspended without notice and/or explanation or bank account opening rejected, which are suspected to be caused by AML/CTF regulations. Without a tailored regulatory regime in place, it is (unfortunately) expected that financial institutions continue to take a cautious approach and may be inclined to reject bank account opening that engage in cryptocurrency transactions. However, bank attitudes to cryptocurrencies are rapidly developing, with many keen to participate in the sector.

  • Tax implication and disputes: While cryptocurrencies are regarded by the Hong Kong Government as virtual commodities, there is currently no specific accounting guidance on how they should be treated in balance sheets and financial reports. In calculating the tax for such transactions, there could also be a conversion rate issue. Moreover, since the Hong Kong tax system is based on the territorial concept, the issue of whether profits earned from cryptocurrency-related transactions are actually sourced from Hong Kong may arise. It is foreseeable that tax-related disputes involving cryptocurrencies may arise in the near future.
  • Hacking and other forms of theft: In the digital context of cryptocurrencies and their exchanges, there is always a risk that cryptocurrencies will be targeted and/or stolen by hackers. There are already a number of reported thefts stealing cryptocurrencies, such as Coincheck (a Japanese cryptocurrency exchange) reporting a loss of US$534.8 million worth of NEM coins in their customers’ accounts when its system was said to be intruded by hackers. In Hong Kong, Gatecoin (a Hong Kong-based cryptocurrency exchange) also claimed it suffered a loss of funds as much as US$2 million as a result of a cyberattack on its system. The very significant rise in value of cryptocurrencies during 2017 exacerbated the problem by inflating the value of claims month on month, and made it more difficult for hacked systems to satisfy claimants’ demands. With the market downturn in 2018, this might well ease, but with the increasing use of cryptocurrencies, it is expected the number of hacking and theft involving cryptocurrencies will rise causing significant losses.

    There is a recent court case in which the plaintiff alleged to be a victim of cryptocurrency fraud. In Nico Constantijn Antonius Samara v Stive Jean-Paul Dan (HCA 902/2018, 15 May 2018), the plaintiff alleged that there was an agreement between the plaintiff and the defendant, under which the defendant would allow the plaintiff to use his bitcoin wallet and his bank account to trade bitcoins, but the defendant suddenly put the money out of reach of the plaintiff without prior notice. The plaintiff successfully applied for an ex parte injunction order freezing the bitcoin wallet and the bank account of the defendant, but the injunction was subsequently discharged on the basis of abuse of process in failing to justify proceeding ex parte (because the plaintiff had waited for two months before taking out the application), and material non-disclosure (that the bitcoin wallet and the bank account sought to be frozen under the injunction had already been frozen independently of any court order).

  • Technical breakdowns of exchange platforms: Disruptions caused by technical breakdowns of exchange platforms could also affect the execution of trade orders and result in loss. In late December 2017, the Singapore International Commercial Court (“SICC”) heard a dispute concerning the failure of a cryptocurrency exchange platform in mistakenly executing certain trade orders. The platform then proceeded to unilaterally reverse those orders after discovering the technical error. The trader (which would have benefited from the mistaken execution) sued the platform for breach of contract in view of its unilateral reversion of the trade. The SICC rejected the application of the trader for summary judgment and held that the matters should be heard in a full trial. We await further developments in this case.

    There have also been incidents of technical breakdowns of exchange platforms in Hong Kong, and some victims have made reports to the SFC, although the SFC may not have jurisdiction in handling those incidents. For cases with suspicion of fraud, the SFC may refer them to the Hong Kong Police for investigation. We expect Hong Kong courts would soon need to hear and adjudicate claims arising from these breakdowns. Customers have become very jittery when using exchanges. It is relatively common for backlogs to occur in processing orders. The industry standard is for support requests to be undertaken by ‘system support tickets’, which are common in online services, but often not transparent for the users. We have dealt with cases where customers facing delay have feared the worst and escalated matters in a much shorter time frame than would historically be seen in conventional debt issues. This is also a product of the frenetic pace of the industry.

  • Breach of contract: While the technology is new, disputes in cryptocurrencies may still arise in traditional forms such as breach of contract. For example, there is a breach of contract case in the United States, of which 2 blockchain developers entered into an option agreement, whereby the purchaser had an option to buy 5 billion “XRP” (a form of cryptocurrency) for less than a penny each. When the price of XRP skyrocketed, the seller cancelled the option and the purchaser sued to enforce the option. The value at stake was estimated at an amount of US$16.6 billion. The latest development was that the seller counterclaimed that the agreement was signed in bad faith in January 2018.

    In Hong Kong, there is also a recent case of alleged breach of investment agreement in relation to a cryptocurrency exchange platform. In the case of SCC Venture VI Holdco G, Ltd v Zhao Changpeng (HCMP 2770/2017, 24 April 2018), the plaintiff obtained an ex parte injunction order restraining the defendant from entering into any agreement with other parties in connection with equity financing of a cryptocurrency exchange platform. The dispute emerged when different parties tried to seize new business opportunities. The injunction was subsequently discharged on the basis of an abuse of process, that the plaintiff was wrong to pursue the application ex parte without notice to the defendant.

The above are just some of the examples illustrating the emerging trend of disputes and other risks which are, and will be faced by the market participants. While the new technology may have opened a new world of possibilities, people dealing with cryptocurrencies should remain cautious and bear in mind the risks associated with cryptocurrencies. They are advised to seek early legal advice whenever a dispute may arise.

KWM has issued a number of alerts and articles on cryptocurrencies, digital assets and token sales. You may wish to read more in our 10 points on ICOs, our Know Your Token article and in the Fintech Association of Hong Kong’s Best Practices for Token Sales and the ASIFMA Best Practices for Digital Asset Exchanges in which KWM played strong drafting roles.

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