Notwithstanding the turbulent past few months, which have seen roughly $2 trillion worth of value disappear from the digital asset ecosystem, we are still seeing an increase in enquiries by high net worth individuals (“HNWIs”) wanting exposure to digital assets.
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However, for this asset class, trustees and those advising HNWIs face a set of unconventional types of risk (including extreme volatility, cyber security, fraud, scammers and hackers) that are quite different to those that need consideration for more traditional investments such as real estate, art, bullion, stocks, bonds and ETFs.
The question that arises: how do trustees administer such a risk-bearing asset class, whilst at the same time satisfying their general fiduciary duty to “…observe the utmost good faith and act en bon pére de famille” and their statutory duty to“subject to the terms of the trust and to the provisions of this Law […] (b) preserve and enhance, so far as is reasonable, the value of the trust property.”?1
It is not an academic point. Failing to satisfy the general fiduciary duty or statutory duty can leave trustees in breach of trust and personally liable for any losses – for this reason, trustees must have a good understanding of the digital asset ecosystem and must appreciate the risk factors associated with digital assets.
This article sets out some points for trustees to consider in the context of investments into digital assets:
Understand Different Types of Cryptoassets
As with other asset classes, different kinds of digital assets carry different degrees of risk. Trustees should carefully consider the type of cryptoassets to be settled into trust as some pose a higher risk than others. Digital coins with large market capitalisation and relatively strong reputations like Bitcoin or Ethereum might be considered to pose a lower risk compared to, say, NFTs marketed on social media. In addition, cryptoassets held indirectly through a regulated fund or a publicly traded entity, pose a lower risk than cryptoassets held directly under trust, since managers bear responsibility to properly manage portfolios.
Subject of course to the relevant client’s goals, and appropriate regulatory and tax advice, trustees might consider, (a) establishing a trust with an underlying company structure be used to hold cryptoassets; (b) the cryptoassets be held at company level, in a separate company, segregated from other trust assets; and (c) not offering professional directorship services for such underlying company.
This type of structure affords trustees the ability to employ several risk mitigation strategies, including:
Who has the Power?
Building in clear lines of responsibility over investment directions is a powerful risk mitigation strategy that trustees can employ when holding cryptoassets in a trust. By reserving such powers for the settlor (or protector or such other “power holder” as the case may be), the onus is on them to ensure the correct investment decisions are taken when buying or selling or retaining cryptoassets. The trustees should therefore be protected where an investment decision results in a loss to the trust fund.
Custodianship of digital assets brings its own challenges – risk can be mitigated by third-party custodians, to provide for better protection against theft and cyber security breaches. Where a third party custodian is used, the onus is placed squarely on such third party custodians to keep the cryptoassets safe. The power to select and appoint a crypto custodian should similarly be reserved for the settlor (or protector or such other “power holder” as the case may be).
It is essential that the trust instrument contains a robust “Anti-Bartlett” clause to limit the trustees’ duty to enquire into or interfere in the management and conduct of the underlying company holding the cryptoassets. Limiting the trustees’ involvement with the day-to-day management of the cryptoassets further assists with mitigating the risk to the trustees when, for example, the company invests in cryptoassets which diminish in value or fail completely. Trustees should, however, ensure that they have sufficient information from the underlying company about the state and amount of its digital assets portfolio and general company affairs in order to undertake a high-level supervisory role.
Robust Indemnity Provisions
The importance of robust and comprehensive exoneration and indemnity clauses within the trust instrument cannot be overstated. Trustees act in their personal capacities and may in certain circumstances be personally liable for liabilities arising from their office. Where trustees have acted within the ambit of their powers and were not in breach of trust or infringed any statutory provision, they can generally call upon the trust assets to meet their liabilities. However, in certain circumstances the trust fund may either be insufficient to meet potential liabilities or the trustees may have no right to be indemnified out of the trust fund. In such circumstances, trustees should seek a robust indemnity to ensure it can be sufficiently recompensed upon, for example, the transfer of trusteeship or upon the appointment of assets to beneficiaries.
The trust instrument should make provision for the trustees to exit the trust relationship where, for example, remaining involved with the trust relationship gives rise to an unacceptable high reputational risk, or the risk tolerance of the trustees’ business changes over time. Trustees should have the appropriate powers to resign or retire as well as the power to appoint a replacement trustee.
As the digital economy becomes progressively more mainstream, trustees and wealth advisers are likely to have to engage with digital assets as a distinct asset class, with its own challenge and risk profile. While not prescriptive or exhaustive, the above sets out some of the issues for consideration, and outline the questions regarding risk mitigation that trustees might usefully ask themselves when dealing with digital assets.
1 Section 22 and 23 of The Trusts (Guernsey) Law, 2007