One key element of the DLT Draft Law concerns the question of how crypto-based assets are treated in bankruptcy. When it comes to storing such assets there are basically two options: either the owner of the crypto-based assets stores the tokens him/herself, or the tokens are stored by a third party custodian. Under current Swiss law, it is not clear whether crypto-based assets held by a custodian on behalf of a client will be segregated in bankruptcy. The DLT Draft Law therefore proposes to introduce a new insolvency regime that will allow for such segregation.

By Benedikt Maurenbrecher / Urs Meier (Reference: CapLaw-2020-03)

1) Introduction

Crypto-based assets (kryptobasierte Vermögenswerte) are often stored with third party custodians, such as crypto exchanges or wallet providers. There are various reasons why the owner may choose to store tokens with a third party, such as the facilitated handling of private keys or improved security. If, however, a third party custodian becomes insolvent, it needs to be determined which assets belong to the bankruptcy estate of the custodian. This can be particularly difficult whenever the bankrupt custodian had control over assets to which a third party asserts legal or beneficial ownership.

Under current Swiss law, it is not clear whether crypto-based assets held by a custodian on behalf of a client will be segregated in bankruptcy, especially if the client of such custodian, i.e., the creditor or investor, does not hold (any) private key(s). The DLT Draft Law therefore proposes to introduce a new insolvency regime that will allow the segregation of crypto-based assets for the benefit of the relevant creditors or investors.

In this article, we will first outline the key elements of the proposed regulation that will apply to all types of crypto-based assets, including tokenized financial instruments, such as shares or bonds issued in the form of uncertificated register securities (Registerwertrechte). Thereafter, we will address the special rules for segregating crypto-based assets in the insolvency of a regulated financial institution. And finally, we will discuss the proposed regulation concerning the segregation of data in insolvency.

2) Insolvency law aspects

a) Crypto-based assets

The DLT Draft Law does not define the term crypto-based assets. In the Dispatch, the Swiss federal government mentions that the term covers assets (Vermögenswerte) with regard to which the power of disposal (Verfügungsmacht) is conveyed exclusively via a crypto-based access procedure (kryptobasiertes Zugangsverfahren).

Consequently, the proposed new rules (see paragraphs 2 b) and 2 c) below) will not apply to assets, with regard to which the power of disposal is not conveyed via a crypto-based access procedure. In our view, this does, however, not mean that a particular token – for example a payment token – would stop qualifying as a crypto-based asset if the custodian’s client only has an account-based access. From an insolvency law perspective, the relevant question is not how the client’s access is structured, but whether the power of disposal regarding the asset, i.e., the relevant token per se, is conveyed exclusively via a crypto-based access procedure.

The DLT Draft Law does not differentiate between the various categories of crypto-based assets. As a result of the public consultation process it was decided that the possibility of segregating crypto-based assets shall apply to all types of crypto-based assets with a view to avoiding possible delimitation difficulties between the different token categories. Consequently, not only uncertificated register securities, but also asset tokens, utility tokens, payment tokens, hybrid tokens as well as stablecoins will be subject to the envisaged new segregation regime, provided always that the relevant tokens represent assets and that the power of disposal over these tokens is conveyed exclusively via a crypto-based access procedure.

b) Segregation of crypto-based assets according to article 242a Draft-DEBA

According to the Dispatch, crypto-based assets only form part of the custodian’s bankruptcy estate if the custodian’s client had no access of his own and the bankrupt custodian at the same time had all the necessary keys to access the assets directly by itself. Hence, only if the custodian had such exclusive actual power of disposal (ausschliessliche tatsächliche Verfügungsgewalt) over the crypto-based assets in question, such crypto-based assets will form part of his bankruptcy estate. Accordingly, the custodian’s client must request segregation based on article 242a of the draft of the Debt Enforcement and Bankruptcy Act (“Draft-DEBA”) only in such a scenario, i.e., where the custodian had all the necessary keys. In set-ups where the client and the custodian hold the necessary keys separately or jointly, article 242a Draft-DEBA will, however, not apply. Keys are held separately, for example, if there are two keys, each of which allows to access the assets, i.e., to initiate a transaction in the relevant register, and if one of these keys is held by the custodian and the other key by the client. On the other hand, keys are held jointly, for example, if two keys are necessary to access the assets (“two out of two multi-signature” set-up), i.e., initiate a transaction in the relevant register, and if one of these keys is held by the custodian and the other key by the client. In both of these scenarios the custodian does not have exclusive actual power of disposal (ausschliessliche tatsächliche Verfügungsgewalt) over the crypto-based assets in question and therefore they will not form part of his bankruptcy estate.

The custodian’s bankruptcy estate will hence only include crypto-based assets to which the entitled party had no access of its own and for which the bankrupt custodian held all the necessary keys to dispose of these assets independently. Therefore, the bankruptcy administrator will have to assess whether he can dispose of these assets independently, i.e., whether he has all the necessary keys to do so. Should this not be the case, the assets cannot be segregated on the basis of article 242a Draft-DEBA. In such a scenario, the client might, however, be able to obtain the necessary keys on the basis of article 242b Draft-DEBA, i.e., based on the proposed new rules governing the segregation of data in insolvency (see paragraph 2 d) below).

Once it has been established that the bankrupt custodian had exclusive actual power of disposal over the relevant crypto-based assets, article 242a Draft-DEBA provides for two requirements which need to be met cumulatively in order for a client to have a segregation claim:

The first requirement is that the bankrupt custodian must have had an obligation vis-à-vis the relevant client to keep the crypto-based assets “available for it [i.e., the client] at all times” (article 242a (2) Draft-DEBA). This means that the bankrupt custodian must have been obliged to uninterruptedly keep the power of disposal (Verfügungsmacht) over the crypto-based assets for the client. It is, however, sufficient if the corresponding obligation is limited to the uninterrupted retention of the number of units, i.e., tokens, held for third parties. The custodian may therefore, if agreed with the client(s) accordingly, replace individual tokens as long as the total number of tokens under custody remains unchanged, which may, from a custodian’s perspective, in particular facilitate the handling of tokens held in cold storage and hot storage.

According to the Dispatch, the custodian may, however, not carry out any proprietary business or own-account transactions (Eigen- oder Aktivgeschäfte) with the deposited crypto-based assets. Consequently, the custodian can for example not act as principal in lending transactions with such crypto-based assets. If the contract allows such transactions, that would, according to the Dispatch, mean that no bailment (Hinterlegung) occurred and that the assets are therefore to be regarded as deposits within the meaning of the Banking Act (“BA”) (triggering corresponding consequences). 

The second condition requires a sufficient nexus between the crypto-based assets and the client and can be met in two different ways:

– In the first alternative (individual allocation), the crypto-based assets can be “individually allocated” to the relevant client (article 242a (2) (a) Draft-DEBA). With regard to this type of allocation – in contrast to the initial draft of the envisaged new rules – it is no longer required that the individual allocation has to occur directly on the relevant blockchain / DLT-system itself. Instead, it suffices that each token can be assigned individually to a particular entitled person when the bankruptcy proceeding is opened. According to the Dispatch, such individualized allocation is generally achieved by crediting the tokens to a special account / address on the blockchain / DLT-system assigned to the relevant client. For this purpose, it shall, according to the Dispatch, be sufficient if this allocation is derived from an internal register of the bankrupt custodian. Also, if it is technically possible to individualize the tokens, for example by giving each token its own serial number, they do not have to be registered on a special account either. In such cases, it is sufficient that the tokens specified with numbers can be assigned to the individual entitled person by means of an “allocation chart”, which must be available at the bankrupt custodian. In this context it must be noted, that it should in our view not negatively affect the clients’ segregation claim under article 242a Draft-DEBA, if a custodian does not avoid shortfalls of tokens or if its internal books and records do not correctly reflect the individual allocation of tokens.

– The second alternative (allocation to a community) allows to segregate crypto-based assets held in collective custody. It is applicable if the assets cannot be individually allocated to the entitled person, but if they are allocated to a community and if it is evident what share of the joint holdings belongs to a given client, i.e., creditor or investor (article 242a (2) (b) Draft-DEBA). The particular client’s quota / share in the crypto-based assets held in collective custody can then be segregated. This makes it possible to store tokens from several clients in a collective account allocated to a community, much like it is possible to store other assets in collective custody. 

If financial instruments, such as shares or bonds, are issued in the form of uncertificated register securities, their legal owners – unlike “holders” of pure cryptocurrencies such as Bitcoin or Ether – may demand segregation of the relevant uncertificated register security (and the claims against the issuer “embodied” therein) already on the basis of their substantive legal position (e.g., as a shareholder or bondholder). The corresponding uncertificated register securities will therefore not become part of the bankruptcy estate of the custodian in the first place. This applies regardless of whether a uncertificated register security has been transferred to the account / address of a custodian or how the access keys (private keys) are managed in the specific case and corresponds to the legal situation under current law applicable to (regular) uncertificated securities (Wertrechte), negotiable securities in collective custody (sammelverwahrte Wertpapiere) and intermediated securities (Bucheffekten).

Since the DLT Draft Law is not intended to put investors in a worse position, it can in our view be assumed that article 242a Draft-DEBA will only have a procedural effect at most with regard to the segregation of tokenized financial instruments in the form of uncertificated register securities, i.e., that this provision will solely govern the procedure for segregation (but not the conditions for segregation).

c) Segregation according to article 16 (1^bis) Draft-BA

If the custodian of the crypto-based assets is a bank, a securities firm, a fund management company or a financial market infrastructure, special legal provisions for segregation apply. In the event of bankruptcy of such institutions, assets are transferred to the client in accordance with article 16 BA in conjunction with article 37d BA, i.e., assets are separated ex officio from the bankruptcy estate in favor of the clients. The purpose of this provision is to give privileged treatment to rights in rem and certain contractual rights that are evidenced by the books and records of a regulated financial institution. 

Parallel to this, the envisaged new provision of article 16 (1^bis) Draft-BA will cover all types of tokens which are individually allocated to the custodian’s client or which are allocated to a community and where it is clear which share of the community assets the custodian’s client is entitled to (see the corresponding provisions under paragraph 2 b) above). 

This means that collectively deposited crypto-based assets are also segregable pursuant to article 37d BA if they are individually allocated at any time in a suitable manner. However, it is not a prerequisite for segregation that the tokens on the blockchain / the DLT system itself are individually allocated. 

If financial instruments, such as shares or bonds, are issued in the form of uncertificated register securities, they should in most cases also constitute intermediated securities (Bucheffekten) within the meaning of the Intermediated Securities Act (“FISA”). Accordingly, they can be separated directly on the basis of article 16 (1) BA, regardless of whether the requirements under the new article 16 (1^bis) Draft-BA are met or not. This also applies with regard to uncertificated register securities that are being “converted” into intermediated securities in accordance with the envisaged article 6 (1) (d) Draft-FISA.

d) Segregation of data in insolvency according to article 242b Draft-DEBA

The DLT Draft Law also contains rules concerning the access to data in insolvency in general. Under current Swiss law, it is not clear whether digital data stored by a third party custodian (e.g., a cloud provider) may be segregated from the bankruptcy estate, if such a custodian becomes insolvent. The Swiss federal government therefore proposes to establish a right to request segregation of digital data regardless of whether such data has any (market) value or not (e.g., a holiday picture). The person requesting such segregation must show that it has a particular entitlement to the relevant data (e.g., a statutory or contractual claim). Furthermore, the person requesting segregation might pay a fee in advance, which will then be used to cover the costs of the data retrieval and segregation.

3) Appraisal

The proposed new Swiss insolvency law regime governing both the segregation of crypto-based assets as well as the segregation of data is well balanced and will help to significantly increase legal certainty. However, it must be noted that from an operational point of view, storing tokens in a compliant way will be challenging. Custodians will, for example, have to ensure that there is no shortfall of tokens and that internal registers and / or “allocation charts” correctly reflect the individual allocation of tokens. Furthermore, legal uncertainties to be addressed will remain with regard to questions such as for example how pure cryptocurrencies like Bitcoin or Ether are to be treated outside of insolvency or how third party objection procedures pursuant to article 106 – 109 DEBA (in particular if crypto-based assets had been used as collateral) will be conducted. Finally, it will have to be clarified in particular that article 242a Draft-DEBA solely governs the procedure for the segregation of tokenized financial instruments in the form of uncertificated register securities but not the conditions for such segregation.

Benedikt Maurenbrecher (benedikt.maurenbrecher@homburger.ch)
Urs Meier (urs.meier@homburger.ch)