D'Aloia v Persons Unknown: A Landmark Judgment On Tracing Crypto Fraud

Those following developments in the crypto space will be familiar with D'Aloia. In a judgment spanning over 80-pages handed down on 12 September 2024, and the first following a fully contested trial, the High Court of England and Wales dismissed a claim brought by the Claimant, Fabrizio D'Aloia, against Bitkub Online Co Ltd ("Bitkub"), a crypto exchange which offers customers custodial digital wallet services for cryptocurrency, including Tether ("USDT"). The decision is of importance for victims of crypto fraud – shedding light on how they might legally recover digital assets across various jurisdictions. Before diving into the detail, we set out below the key points for crypto exchanges and practitioners arising out of the judgment relating to potential liability of exchanges to victims of crypto-fraud and the presentation of pleadings and expert evidence, which was arguably was at the heart of why the claim failed.

Guidance for crypto exchanges

In an effort to recover their assets, it has become normal for victims of crypto fraud to make crypto exchanges defendants to their claims (similar to banks in push payment fraud), particularly so when the victim does not know the true identity of the fraudster(s). For a bank or an exchange to be held liable it must be required to do something it has failed to do or have done something it was not required to do.

In this case, the key argument was whether Bitkub was a constructive trustee in respect of Mr D'Aloia's USDT. If so, Mr D'Aloia might be entitled to the more favourable remedial consequences, which arise from breach of trust. To make that point good, Mr D'Aloia argued that Bitkub had failed to safeguard the assets. However, fundamental to the claim was that the court was unable to trace the USDT to the 82e6 Wallet and therefore Mr D'Aloia was unable to show that Bitkub should hold the USDT within that wallet as a constructive trustee for his benefit. Arguably, had there been better quality expert evidence (explained further below), Mr D'Aloia may have established that Bitkub was a constructive trustee.

Furthermore, in the context of considering whether Bitkub failed to comply with KYC/AML duties and corporate governance duties, the court appeared critical of Bitkub's policies and procedures. Whilst no proper evidence was advanced as to what standard Bitkub was required to meet in order for the court to find a breach of any duty, it did find that Bitkub "was on notice of suspicious account activity....and failed or failed properly to investigate it" and therefore was unable to rely on defences premised on good faith.

The judgment gives rise to two key takeaway points relevant to crypto exchanges:

1. If a crypto exchange is put on notice that they are potentially holding stolen or fraudulently obtained assets, they may be required to ringfence them. Failure to protect the assets that may be subject to a constructive trust could give rise to a liability for breach of trust.
2. A crypto exchange should carefully consider that, as well as ensuring that appropriate KYC and AML policies and procedures are in place and adhered to and monitored, it is imperative that internal systems and controls are in place – particularly for exchanges which manage custodial wallets on behalf of account holders – whereby suspicious transactions are identified and any breaches are flagged and remedied as quickly as possible.

Lessons for practitioners

In addition to crypto exchanges, the judgment makes a number of key findings and observations which should be on the radar of all practitioners in the crypto litigation space:

1. As the first judgment following a full trial:
   
   1.1 the court's recognition that USDT attracts property rights is a welcomed and landmark finding because (i) previous findings were only made for the purposes of interlocutory applications; and (ii) now victims of crypto-fraud involving USDT are permitted to bring equitable claims to trace or follow those assets.
   
   1.2 in circumstances where frauds often lead to claims against crypto exchanges increasingly being framed as breach of trust claims, the detailed analysis of the law of constructive trust and complexities involved within tracing and following crypto frauds is useful.
   
   
2. Whilst the court found the evidence of both experts "not to be especially helpful" [47], Mr D'Aloia's evidence was "chaotic and, ultimately, contradictory" [58], and ultimately did not reliably demonstrate any flow of funds into the 82e6 Wallet (defined below), which was "fatal" to the claim. This was fundamentally problematic in a case like this where much turned on the experts' work to understand the flow of funds in order to demonstrate that the assets in question were in a particular wallet. To that end, the judgment highlights the significance of having robust expert evidence that is not only clear but also coherent about the basis for a particular methodology used (or not used) in an expert report under CPR 35, as the Court will want to understand why it can rely on a particular methodology used. Part of this involves ensuring that practitioners also understand the technical aspects that underpin cryptocurrency cases so that they are able to stop and scrutinise the evidence, before the court is invited to make a finding.
   
   
3. A stark reminder to practitioners of the importance of ensuring that their case is properly pleaded as intended to be argued at trial. One of the purposes of the statements of case is as a "legal audit" [383] to ensure that a complete claim is asserted. This simply did not happen in this case, such that the legal link connecting Mr D'Aloia with Bitkub was absent. For this reason, he did not succeed in his breach of trust claim.

The remainder of this article is structured as follows:

• Background to Mr D'Aloia's claim and the alleged fraud
• Key Findings: USDT is property
• Key Findings: Hurdles with tracing the USDT into the 82e6 Wallet
• Mr D'Aloia's claim for unjust enrichment
• Mr D'Aloia's equitable proprietary claim

The background

In an effort to recover their assets, it has become normal for victims of crypto fraud to make crypto exchanges defendants to their claims (similar to banks in push payment fraud), particularly so when the victim does not know the true identity of the fraudster(s). For a bank or an exchange to be held liable it must be required to do something it has failed to do or have done something it was not required to do. By way of summary of the claim:

1. Mr D'Aloia alleged that a fraud was perpetrated on him by the First Defendants - Persons Unknown A - in which he was induced to hand over cryptocurrency and USDT totalling circa £2.5 million.
2. Persons Unknown A then passed that cryptocurrency through a number of blockchain wallets before it was withdrawn as fiat currency by the Seventh Defendants – Persons Unknown B.
3. Polo Digital Assets Inc, the Third Defendant, Gate Technology Corp, the Fourth Defendant, and Bitkub were the cryptocurrency exchanges with whom Persons Unknown B are said to have held their various accounts.¹

A brief chronology of the fraud alleged is:

Key Findings

1. USDT is property

Whilst neither party sought to suggest that USDT could not be property, central to the case were issues of tracing and following of assets, which depended on not just USDT being property, but the nature of the property rights associated with them.

In light of the strong line of authorities in this jurisdiction, including Tulip Trading v van der Laan [2023] EWCA Civ 83, the court recognised that (a) there is "broad recognition that it is at least arguable that crypto assets attract property rights" (b) "a key aspect of crypto assets is that they are rivalrous", namely ownership by one prevents ownership by another; and (c) crypto assets "exist as something outside the mind of their users" [112].

Having considered opposing arguments, it will come as no surprise that, in summary, the court's view was that USDT, "while neither a chose in possession nor a chose in action, it is capable of attracting property rights for the purposes of English law" and that "crypto assets have a conceptual existence that is independent of the legal system and of their individual users". The rights attached to the USDT itself, rather than the right to control it, for example, the right to use a private key [173].

The status of crypto assets as property has been addressed repeatedly at interlocutory hearings and was at the core of the Law Commission's Report issued in June 2023, which Enyo Law discussed here. In that regard, the court's judgment was consistent with the findings and recommendations made by the Law Commission and reiterates the Law Commission's draft Property (Digital Assets) Bill introduced to the House of Lords on 11 September 2024, which gives effect to the Law Commission's recommendation, namely of a statutory confirmation that a thing will not be deprived of legal status as an object of personal property rights merely by reason of the fact that it is neither a thing in possession nor a thing in action.

2. Was it possible to trace the USDT into the 82e6 Wallet?

Fundamental to Mr D'Aloia's claim was the need to bridge the gap between the 1dDA Wallet into which he paid his USDT and the 82e6 Wallet, from which it left the blockchain universe and re-entered the traditional banking system.

Following versus Tracing

It was accepted that, as a matter of law, tracing and following are different things [176]. As Lord Millett explained in Foskett v McKeown [2001] 1 AC 102 at [127B], "Following is the process of following the same asset as it moves from hand to hand. Tracing is the process of identifying a new asset as the substitute for the old."

Noteworthy is that, at the outset, Bitkub made the submission that tracing was not open to Mr D'Aloia because the statements of case and Mr D'Aloia's expert evidence referred only to following. This was not accepted by the court for the following reasons:

• First, the concept of tracing formed part of Mr D'Aloia's case [178], as they referred to "substitutes" and "substitute assets" which Foskett made clear falls within the domain of tracing, not following.
• Second, while the concepts are distinct, the law recognises that sometimes they are used collectively or interchangeably [180] (see Supreme Court in Byers v Saudi National Bank [2023] UKSC 51 at [68]).
• Third, the court also found it would be "odd" if tracing could be used in a combined sense to include following but following had to be limited to its strict meaning [181].

Ultimately, the court accepted that Mr D'Aloia could advance claims on the basis of tracing.

Further, when considering the legal test for tracing, the court made a number of observations:

• English law still recognises separate regimes for tracing in equity and at common law and Agip (Africa) Ltd v Jackson [1991] Ch 547 was binding on the court such that tracing through a mixed fund is not possible at common law [200].
• In considering the treatment of USDT for the purposes of following, the court considered that USDT is better characterised as a persistent thing albeit the evidence before the court was "thin" [208], but more consistent with what Tether itself says about its currency in published documents and because USDT maintains a "distinct identity even in a mixture" [209]. Therefore, and in line with the Law Commission's report, in principle, the USDT could have been followed, including through different wallets used in the various Hops, even where those wallets contained or subsequently received USDT from other sources. However, as explained further below, there was simply no evidence before the court that allowed the exercise to be undertaken and Mr D'Aloia's expert was not in a position to say with certainty how much, if anything, of any given sum was Mr D'Aloia's USDT [212].

Tracing the USDT

The parties agreed that "First In First Out" ("FIFO") - a mechanical exercise, which assumes that the first funds deposited are the first to be withdrawn - was one approach that could be used to trace the USDT: the rule in Devaynes v Noble; Clayton's Case (1816) 1 Mer 572. In short, the court's view was that the Mr D'Aloia's expert did not apply FIFO.

In response to the Mr D'Aloia's submission that his expert had undertaken a "somewhat similar exercise modified on the basis of his own experience and the training he received from Crystal Blockchain" [217], having reviewed a number of authorities, the court agreed that (a) the rule in Clayton's Case could be displaced where appropriate to do so; and (b) where it was displaced, the parties are not limited to pari passu distribution or the rolling charge [218]. The court also observed that it was open to Mr D'Aloia, at least in the case of a claim involving fraud such as this one, to trace on a basis other than FIFO, pari passu and the rolling charge provided that it "treated all innocent claimants and potential claimants comparably and was properly evidenced." [221]

Mr D'Aloia's expert evidence

At the heart of the criticism of Mr D'Aloia's expert evidence was "whether the methodology used was recognised as a means of tracing in English law." [223]

In his evidence, the expert accepted that his understanding of FIFO was "incorrect". In summary, Mr D'Aloia's expert's position was that FIFO was never applied, rather it was "more nuanced" and whilst the right approach, the "wrong label" was used for it [225]. Contrary to Mr D'Aloia's position, the court's view was it is not clear what had in fact been done by way of methodology, although it was clear that the basis stated in the Arrowsgate Report - prepared for the use for trial - for tracing Mr D'Aloia's funds was FIFO.

Less than a week before trial started, Mr D'Aloia attempted to explain the methodology applied in correspondence, namely that the expert (a) did not take account of opening balances or intermediate incoming transactions (b) ignored outgoing transactions of 1,000 USDT or less (c) looked for the largest outgoing transaction next in time rather than the next in time transaction. Notably, no revised report was filed and the methodology was formally adopted as his evidence in the course of his cross-examination.

Ultimately, the court found that the methodology was described in three different places and in three different, contradictory ways and ultimately "lacked coherence or a principled basis" [259] and made a few key observations including:

• First, while Mr D'Aloia made clear that he did not use FIFO, the Arrowsgate Report expressly advanced the rule in Clayton's Case as its rationale.
• Second, Mr D'Aloia sought to explain in correspondence how his expert "usually traces the funds", which suggested that other methodologies were used albeit no further information was provided about how the methodologies were selected, contrary to PD 35 paragraph 3.2(6).
• Third, the only justification offered belatedly for the approach adopted was that it was a method taught by TRM Labs and Crystal Blockchain (the blockchain analysis software employed by the expert) and better reflected the practices of organised crime groups. However, it transpired that TRM Labs' approach produced a significantly different figure to that produced using Crystal Blockchain. To that end, it was not clear how two different approaches were both likely to reflect the approach of those behind td-finan.
• Fourth, in breach of PD 35 paragraph 3.2(6), no explanation was provided as to how the different systems, namely TRM Labs and Crystal Blockchain, were selected or preferred.
• Fifth, it was unclear how the funds could have been traced in the way that had been done for Hop 2, which was fundamental to Mr D'Aloia's case against Bitkub.
  
  
  
  In summary, the court applied the expert's methodology in its various iterations, but the numbers did not add up. The court's observation was that if Mr D'Aloia could not show that his funds were part of the USDT 326,868 then what happened thereafter was simply irrelevant because somebody else's funds would be traced. Further difficulty arose in applying the methodology to later Hops.
  
  
• Sixth, the reliability of the approach and its application was questioned based on the claim against Aux Cayes Fintech being struck out as a result of shifts in the expert's conclusions that meant that the wallet into which Mr D'Aloia's funds had been traced in fact contained none of Mr D'Aloia's USDT. Similarly, in this claim, the amount sought was less than half the original amount, again a result of shifts in the expert's conclusions, which, in light of the lack of transparency in the methodology applied, ultimately casted doubt on the reliability of the expert's conclusions.

The court found that, while FIFO could be disapplied, that did not give the expert "a free hand." Understanding the methodology applied and why, in the expert's view, it was reliable, was important. Instead, the expert had explained why FIFO was reliable in circumstances where a different approach had been employed, and the details of the approach were not set out until the eve of trial, and even then, in only broad and contradictory terms that were impossible to apply to the transfers in issue in this case. Accordingly, the court did not accept that Mr D'Aloia's evidence reliably demonstrated any flow of Mr D'Aloia's funds to the 82e6 Wallet. This was fatal to Mr D'Aloia's claims against Bitkub so far as they relied on tracing.

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