9 November 2022 by and Business Rescue, Restructuring & Insolvency Newsletter

The dawn of crypto regulation: Impact on insolvency practitioners

Crypto creditors and investors are now one step closer to enjoying the same protections that any other creditors and investors enjoy. This comes as a result of the widely welcomed declaration by the Financial Sector Conduct Authority (FSCA) that “crypto assets” will now be considered a financial product under the Financial Advisory and Intermediary Services Act 37 of 2002 (FAIS Act) (declaration). 

Just a few weeks prior to the declaration, we wrote an article analysing the difficulties faced by liquidators of crypto companies, due to the unique nature of the crypto companies and crypto assets. While the focus of the article was on the liquidators themselves, many of the difficulties mentioned are also of concern for crypto creditors and investors, as they are the ones who feel the financial impact when things go wrong in the winding up of a company.

In this alert we focus on two important aspects of the liquidation process from a creditor and investor perspective, and look at how the declaration aims to provide some much needed protection when dealing with the winding up of financial services providers (FSPs) rendering financial services in relation to crypto assets (Crypto Asset FSPs). However, it should be noted that many of the additional protections are contained in the General Code of Conduct for Authorised Financial Services Providers and Representatives, 2003 (General Code) and Crypto Asset FSPs have until 1 December 2023 to ensure that they are compliant with the General Code.

Safeguarding crypto assets

Prior to the declaration, one of the issues liquidators had to deal with, was determining whether the crypto assets held by a Crypto Asset FSP, were held in the company itself, or in trust. Assets that are held in trust are separate to a company’s other assets and are not subject to distribution to creditors by a liquidator.

When it comes to crypto companies it is not always clear whether investors’ assets are held in trust or not, and foreign courts have held that the point of departure is what is set out in the “terms and conditions” of the company. However, due to a lack of regulation, crypto companies are free to change and update their terms and conditions regularly and without notice. Essentially, nothing prevents a crypto company from changing its terms and conditions when it is on the brink of insolvency. 

The ambiguity as to the manner in which crypto assets and funds are to be held by Crypto Asset FSPs are now largely addressed by the requirements contained in the General Code. To the extent that a Crypto Asset FSP either holds client funds for the purpose of purchasing crypto assets, or holds crypto assets on behalf of a client, section 10 of the General Code requires that the Crypto Asset FSP, amongst other things:

  • take reasonable steps to ensure that clients’ financial products are readily discernible from private assets or funds of the provider;
  • open and maintain a separate account, designated for client funds, at a bank; and
  • ensure that the separate account only contains funds of clients and not those of the provider.

Additionally, according to the FSCA, holding or maintaining a crypto asset in safe custody or managing a crypto asset on behalf of a client will cause the crypto asset to qualify as “trust property” under the Financial Institutions (Protection of Funds) Act 28 of 2001 (FI Act). Section 4 of the FI Act provides further protection and clarity by requiring that trust property be kept separate from other company assets and declaring that trust property “under no circumstances forms part of the assets or funds of the financial institution or nominee company”. 

The declaration has thus provided some much needed certainty as to the manner in which assets should be dealt with by a liquidator.

Tracing funds

In our previous alert, we discussed the practical difficulties faced by liquidators in tracing the assets or funds that are the subject of an impeachable transaction. In many instances, funds which should be included in the pool available for distribution to creditors, are untraceable. Additionally,

impeachable transactions prove impossible to reverse due to a lack of access to financial records and the relative anonymity surrounding many of the transactions.

Both the FAIS Act itself, as well as the General Code, contain monitoring, recording and control conditions which Crypto Asset FSPs will now be required to comply with. Section 3(2) of the General Code requires FSPs to have systems in place to store and retrieve records and any other material documentation relating to the client or the financial services rendered. Both sections 11 and 12 contain requirements relating to internal procedures that ensure the protection and accuracy of financial and other information. 

Furthermore, in terms of section 19(3) of the FAIS Act, an FSP is required to keep records regarding the money and assets it holds on behalf of clients and to submit to the FSCA a report from the auditor that conducted the audit, confirming, amongst other things, the amount of money and financial products it held on behalf of clients at year end.

These requirements, while not unreservedly solving the traceability issues, go a long way in ensuring that proper records and information regarding past transactions are kept. 

In our view, the declaration is a positive step in the direction of greater certainty and increased security in the crypto space. This means better protection for creditors and more certainty for liquidators faced with the task of winding down a Crypto Asset FSP. Although the declaration is less than a month old and the practical impact is yet to be seen, in theory, crypto creditors and investors can sleep easier at night.

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