Emerging Cryptocurrency Valuation Litigation
A Primer for Business Valuation, Forensic, and Litigation Support Professionals
This is the first article in a series related to the cryptocurrency valuation and litigation. This is an emerging area of practice. In this first article, the author explains what is a blockchain and the purposes blockchains serve.
Cryptocurrency litigation in the past decade has appeared in various dispute types:
- Matrimonial disputes where property characterization, asset concealment, and valuation are key components of the forensic practitioner’s work product;
- In civil disputes where a lack of professional skepticism, an over-reliance on 409(A) valuations, and subversive explanations are key pitfalls of a forensic practitioner’s work product;
- In criminal disputes where valuation standards are inconsistent at best and calculations border absurdity often erring on the side of higher values resulting in more severe sentencing; and
- In various disputes where issues like service (it has happened via air drop), enforceability, fiduciary and tortious duties of developers, and findings of a third-party exchange as a constructive trustee are providing mechanisms for recovery and pursuit.
Another growing area of practice related to commercial-focused practitioners is cryptocurrency mining. Interested companies require an economic analysis to determine whether and how to proceed. They often rely on the salesmen of crypto mining equipment for their factors in their calculations.
Requirements for admissible evidence are broadened when cryptocurrency is involved to the point that evidence gathered from witnesses with direct financial interests in the matter, data from firms who are paid for their noncompliant (Fair Credit Reporting Act [FCRA] etc.) information without revealing sources or methods, and sources from random blog posts or content marketing supplanting calculations are all somehow admitted. With this bizarre world of all things admissible, cases proceed where they would otherwise be dismissed and evidence is heard where it would otherwise be excluded in any other non-cryptocurrency case.
Stop the Madness
Common threads run through all areas of crypto forensics, more broadly known as blockchain forensics. In each dispute, courts need information to act—that information must be relevant, complete, and specific to the matter. It is the duty of the forensic practitioner to determine relevance, completeness, and sufficiency of information relied upon, and to deliver conclusions to the court that identify the specific relevance of the expert’s findings. To accomplish this task, the expert must: provide an explanation for the meanings of ‘complete’ and ‘sufficient’ related to specific cryptocurrency records; must clarify why specific formats are necessary to reach a conclusion to the matter; and must either provide assurance to the court that the expert’s calculations result from a review of complete and sufficient records or, in the alternative, identify to the court that calculations are limited on the basis of incomplete and insufficient records and, within this alternative, specify the degree to which that limitation affects the calculation.
These are not non-standard requirements for an expert’s work product, but professional standards and industry methods have somehow been deemed optional for this particular asset among some wayward experts. They are not, as evidenced by the exclusion of said wayward experts, post expense. This series will identify pitfalls in cryptocurrency and blockchain work products, will provide practice tips for the financial forensic expert practicing or pondering a practice in blockchain forensics, and will identify useful as well as not-so-useful tools for casework.
A Cryptocurrency Primer
Cryptocurrency is complex and the forensic practitioner who presumes “all cryptocurrency is liquid, so it is always an easy price x quantity calculation” does a disservice to himself/herself and to the profession. This method may suffice for a settlement conference and may be appropriate for fungible tokens tradeable in an active, liquid market; however, that qualifier does not encompass all cryptocurrency assets or their disposition, such as in staking, which prevents the transfer of an asset and pays a staking reward over time—somewhat analogous to a certificate of deposit, without the third-party, federal insurance security, or guarantee, among other things.
Cryptocurrency is a term referring to thousands of different assets such as bitcoin (BTC), ether (ETH), Bitcoin Cash (BCH), and others. Cryptocurrency is a type of asset stored at addresses located on a blockchain. A blockchain is a type of data storage technology that has ledger capabilities and tracks transfers between addresses. A wallet creates addresses on blockchains and controls access to those addresses. Separate from wallets, an exchange is a third-party provider that offers storage, like a wallet, along with the ability to buy and sell. Exchanges offer the account holder the ability to access multiple wallets, the ability to send and receive multiple cryptocurrencies, and the ability to buy and sell multiple cryptocurrencies using U.S. dollars, other currencies, and other cryptocurrencies. Some exchanges are based in the United States, some file reports with the IRS, and some will respond to a subpoena.
A loose analogy to understanding blockchains is the storage warehouse. A user can purchase any number of storage units in a warehouse and can place a lock on each of their units. In this analogy, the storage units are cryptocurrency addresses. Locks placed on storage units can each open with a different key or the user can choose locks that all open with only one key. It is wallet software that both creates addresses and controls access to those addresses using keys. Cryptocurrency is not stored in wallets, even when those wallets are physical devices. All cryptocurrency is stored as a value at an address on a blockchain (e.g. Address A = 5 would indicate that 5 bitcoins are stored at Address A). The blockchain, in this analogy, would be most equivalent to the warehouse itself—this is where cryptocurrency assets are located and it has rules for what kinds of things can be stored in each unit. For instance, perishable food items are often restricted from storage warehouses.
There are about 40 different blockchains as of this writing, each with their own rules and some with thousands of different cryptocurrencies allowable in the storage areas (i.e., in the addresses). For example, bitcoin is a cryptocurrency stored on the bitcoin blockchain; one of the rules of bitcoin’s blockchain is that executable code is not allowed to run and so, Address A will only ever hold a numerical value and will never hold a set of executable lines of code.[1] Ether is another cryptocurrency stored on the Ethereum blockchain; one of the rules on the Ethereum blockchain is that executable code is allowed to run and so Address B may hold a value for the number of ether tokens stored, may hold lines of executable code, and may also hold values for thousands of other cryptocurrencies that can be stored on the Ethereum blockchain. This code is referred to as a smart contract.
Many smart contracts exist to perform a wide variety of functions including executing loans, accepting collateral, paying interest, generating artwork, storing files, and more. Standards for smart contracts exist and code audits are available to identify and repair security risks in the code before they are deployed. Some smart contracts are fixed at deployment and others are editable in perpetuity. Smart contracts are blockchain assets; they are generally public and thus, are not likely to meet trade secret requirements, but they may still be valuable business processes.
Other blockchains include: Cardano, the XRP ledger, Hyperledger, Polygon, the Binance Smart Chain, and others. Each blockchain has a native token, which is generally used to pay fees and pay for smart contracts to run. The processing power and cost estimate associated to running a smart contract can be calculated from the functions that smart contract uses. Smart contracts enable individuals to create their own tokens of different types. For instance, the Ethereum blockchain has ERC-20 and ERC-721 token types, among others. These standards allow for fungible tokens or non-fungible tokens, respectively. There are other token standards maintained by groups such as Open Zeppelin, an organization that produces and maintains standardized code for creating tokens on the Ethereum blockchain.
The forensic or valuation practitioner must be knowledgeable of the industry they are attempting to analyze and value and how each characteristic of a cryptocurrency can affect their determinations—which blockchain is it on, is it a native token or was it issued using a smart contract on a blockchain, can it be traded on any U.S.-based exchanges, can it be traded on exchanges based outside the United States only, is it a fungible token or a non-fungible token, does the smart contract follow any contract standard, was the code audited, and many more.
In addition to pitfalls, tips, and tools, this series will also address how to find answers related to blockchain forensics and cryptocurrency valuation using authoritative public sources. Stay tuned.
[1] This explanation is oversimplified; the Bitcoin blockchain does allow a small amount of data to also be stored at addresses but does not allow code to be executed on the blockchain like the Ethereum blockchain.
Dorothy Haraminac, MBA, CFE, MAFF, PI, is one of the first court-qualified experts in bitcoin asset and cryptocurrency tracing. She has provided consulting, tracing, valuation, and expert witness testimony in complex commercial disputes in the oil and gas industry and in high net worth, tech-centric matrimonial cases. She conducts traditional fraud investigations and financial forensic engagements, deploying sophisticated methods to determine whether indications of fraud exist, to prevent fraud, to assess the risk of fraud in an organization, and to monetize risk assessments in valuations.
Ms. Haraminac can be contacted at (346) 400-6554 or by e-mail to admin@ybr.solutions.
