Knowing the Evolution of Crypto Helps Defenses in Legal Disputes

Financial institutions, cryptocurrency companies, and other organizations that use digital assets face an array of legal and regulatory issues involving contracts, fiduciary obligations, security failures, fraud, and more.

Legal teams can ensure an effective and defensible response plan by understanding the unique technical, legal, and financial nuances that often arise in digital assets disputes, and by having a framework for handling litigation or an investigation.

Organizations that have a strong posture for thwarting fraud and abuse and executing efficient investigations can better protect their market value and their customers. This often requires a holistic approach.

In the early days of digital assets, most investigations were centered on tracking and tracing misappropriated funds. While this facet of investigations remains important, the scope of fact finding and enforcement in digital assets disputes has expanded significantly.

Transaction-based review, attribution and correlation, wallet analysis, and accounting review are key aspects of tracking and tracing the flow of misappropriated funds, such as when cryptocurrency has been stolen or is used for illicit financing. Track and trace of funds may also include decentralized finance analysis (such as liquidity pool and staking), token design and function assessment, investigation into anonymizing techniques, and examination of cross-chain swaps or mixers.

Analysis of supporting information on social media and messaging platforms (such as Discord, Telegram, and X) and industry-specific channels (such as Bloxy and Blockchair) can provide important background on investigation subjects, adding to the complete picture of what happened and who was involved.

Investigators also often conduct research to establish individual attribution for specific transactions, behavioral patterns of subjects, and regulatory implications or intelligence across agencies.

Review of compliance and regulatory analysis adds another layer of insight during an investigation. This typically includes analysis of asset movements, protocol deployment and company structure in relation to varying legal and regulatory environments. Understanding these details can help determine whether regulatory violations occurred or if the involved parties have a history of criminal activity.

A holistic review of tokenomics across digital asset trading, “pump and dump” schemes, addressing profitability, and other market variables provides important information about the structure and use of certain digital assets, which may be pertinent in establishing facts in a dispute.

A comprehensive forensic and technical analysis of smart contract code is crucial for uncovering security vulnerabilities and potential exploits. This process focuses on identifying malicious code or weaknesses that could be exploited, including code auditing to detect security flaws and conducting security assessments to evaluate potential attack vectors.

Analysis can identify similar code on the blockchain and trace activities to attribute them to the contract creator. Such analysis is essential to determine whether malicious code exists or if vulnerabilities could allow manipulation of the contract’s functions, as well as for identifying and defining the behaviors of the contract creator.

Valuation of losses involved and value of tokens across different groups is often necessary during resolution of a dispute or investigation. This can be determined through examining time frames, using a wide array of buy, sell, hold, transfer scenarios, and identification of valuation methodologies based on specific circumstances and available token data.

Analyzing price dispersion and correlation helps when examining individual price fluctuations of different tokens to identify the strength, direction, and the nature of the relationship between different assets. Dispersion analysis also can help identify the price effect of internal and external factors when working toward recovering losses or resolving a dispute involving digital assets.

Mass claims litigation has become a mainstay in the digital assets industry, and it requires careful consideration of the costs and benefits of each approach while weighing data availability and evaluation of legal issues.

If the purchase and sale of the at-issue tokens are identified for each creditor, damages for each investor can be calculated based on their trades. This approach may require extensive data analytics, depending on the number of claims.

Estimating aggregated damages using an accepted trading model that accounts for a digital asset’s turnover rate is another approach. These models may be similar to models commonly used for securities fraud class action damages analysis. The anonymous and unregulated nature of crypto will require some modifications to these approaches, but they provide a guide for how trading models can inform outcomes in a mass claims matter.

Value of the tokens for current holders and the losses (and any offsetting gains) incurred on derivatives may also need to be determined. If a token is traded in multiple exchanges, aggregating the prices across exchanges will be necessary.

If market prices aren’t available, there will need to be alternative approaches, such as proxying tokens to another token with a set value, evaluation of utility or benefits associated with the token, and statistical analysis to estimate values. Advisers also should consider factors such as liquidation costs, costs and benefits of staking, borrowing fees or proceeds, and any token manipulation.

Legal teams working in this space are likely to experience increased pressure and complexity surrounding digital assets disputes and investigations. They can prepare by understanding how the industry has evolved and what issues may arise in an investigation. Doing this can reduce risk and improve defensibility, whether a case relates to a regulatory inquiry, class action litigation, or other legal matters.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jeremy Sheridan is managing director, Bobby Lowe is senior director, and Emma Spencer is senior consultant at FTI Consulting.

Jason Trager, senior director at FTI Consulting, contributed to this article.

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