Hong Kong Court looks into the features of Bitcoin and the operation of “wallets” as it considers protection and ownership of crypto assets

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Authored by: Vivien Wong

We recently reported on the judgment in Nico Constantijn Antonius Samara v Stive Jean Paul Dan [2022] HKCFI 1254, where the Hong Kong Court granted proprietary remedies over misappropriated bitcoin.

In the recent case of Yan Yu Ying v Leung Wing Hei [2002] HKCFI 1660, the Court was posed with “rather unusual circumstances” and had to consider the features of Bitcoin, the digital keys, their storage in “wallets” and how wallets are initialised, before determining whether an interlocutory proprietary injunction should be granted to the Plaintiff.

Factual Background

The Plaintiff claimed that the Defendant stole her Bitcoin, after persuading her to put them in a “cold” wallet provided by the Defendant. The Defendant claimed to have helped the Plaintiff purchase and set up a new Trezor wallet at a meeting. The Plaintiff, who thought she was the only person with the recovery seed, transferred her Bitcoin into the wallet. Subsequently when she wanted to sell the Bitcoin, she discovered they had gone.

It turned out that the wallet that the Defendant alleged to have set up for the Plaintiff at the meeting was not a new Trezor hardware, but was a hardware which the Defendant had set up before the meeting and contained a wallet that he created.

Since the hardware was set up by the Defendant, he had the discovery seed. As explained by the expert, the Defendant could use the recovery seed to re-create his wallet and then access the private keys associated with the subject Bitcoin which the Plaintiff subsequently transferred to the wallet (without knowing that the Defendant had access to it although the Defendant did not have physical possession of the Plaintiff’s Trezor hardware).

The Defendant’s defence was that he took the Trezor hardware provided to the Plaintiff for the purpose of receiving the Plaintiff’s Bitcoin, pursuant to a swap agreement, but the Plaintiff refused to then effect the transfer. There was then an inadvertent mix-up of the Trezor hardware such that the Defendant ended up with the new wallet that was supposed to be provided to the Plaintiff. Although he was not sure whether this is what happened, he simply wiped clean the hardware in his possession later that day and re-created his wallet with the recovery seed.

Features of Bitcoin, digital keys, their storage in wallets and how wallets are initialised

With the assistance of expert evidence, the Court summarised the features of Bitcoin and the role of digital keys in Bitcoin transactions:-

1. Bitcoin involves no physical coin;
   
2. Bitcoin technology is a distributed, peer-to peer system. Bitcoin users communicate with each other using the Bitcoin Protocol;
   
3. There is no central control or authority that issue Bitcoin. Nor is there any centralised ledger similar to traditional banking and payment systems. Bitcoin transactions are recorded in an open distributed ledger using blockchain technology;
   
4. Ownership of Bitcoin is established through digital keys, Bitcoin addresses, and digital signatures;
   
5. A Bitcoin transaction is the operation that allows the payment of Bitcoin from one owner to another;
   
6. Each Bitcoin transaction requires a valid signature to be included in the blockchain, which can only be generated with valid digital keys. Anyone with a copy of those digital keys has control of the Bitcoin in that account;
   
7. In the payment portion of a Bitcoin transaction, the recipient’s public key is represented by its Bitcoin address, which is used in the same way as the beneficiary’s name on a cheque. The Bitcoin address is generated, and corresponds to a public key;
   
8. Digital keys come in pairs,namely – a private key and a public key.
   
9. A Bitcoin transaction relies on a digital signature to confirm the ownership of Bitcoin that can be spent by the payer. The digital signature used in Bitcoin is based on elliptic curve public key cryptography, of which the public key is generated from a randomly generated private key, and the Bitcoin address (used as the recipient’s address) is generated from the public key. With the private key, the recipient is able to use Bitcoin that is received by the Bitcoin address that is generated by the corresponding public key.

Since the dispute involved understanding the distinction of the use of a “cold” wallet, i.e. the hardware, and a “hot” wallet, the court explained that the digital keys are stored in a “wallet”, which may be “hot”, which is connected to the internet, or “cold”, which is not. Trezor was one brand of hardware device in which a cold wallet may be created. A wallet does not actually “store” Bitcoin. The purpose of the wallet is to generate and store the private keys that are associated with the “wallet” and provides an interface for carrying out cryptocurrency transactions. When a wallet is initialised, a 24-word recovery seed is created for recovery purposes and the Bitcoin associated with the private keys stored in the wallet will also exist in the wallet.

Proprietary Injunction granted in favour of the Plaintiff

The Defendant ended up having control of the wallet into which the Plaintiff transferred the private keys associated with her Bitcoin and he had the ability to access those Bitcoin. The court concluded that the circumstances in which the state of affairs arose warranted serious and thorough consideration at trial.

The Plaintiff sought both a Mareva injunction to freeze the Defendant’s assets and a proprietary injunction in respect of the Bitcoin transferred into the wallet which the Defendant retained. The court was not satisfied that a good arguable case was established for granting a Mareva injunction, as it considered that the Plaintiff faced problems in the forensic evidence on the authenticity of messages related to the existence of the swap agreement, which remained a serious issue to be tried. The court, however, agreed that the Plaintiff had established a serious issue to be tried, which is the lower threshold for granting the proprietary injunction.

Commentary

With the growing population of crypto users and the excitement created by the metaverse and NFTs, more people are familiarising themselves with concepts in the fintech world. This case shows that the terminology and concepts used in the crypto world are gradually and inevitably becoming part of society with which our courts have to familiarise themselves, especially as there is likely to be an increasing number of disputes concerning cryptocurrencies and fintech products and services. The granting of a proprietary injunction in this case demonstrates again that Bitcoin, and other cryptocurrencies, may be protected as property under Hong Kong law.

This case shows that it would greatly assist the court in considering the parties’ arguments if the parties in cryptocurrency disputes can clearly explain the relevant concepts and terminology and adduce expert evidence as appropriate. It also provides useful guidance in assessing the amount of fortification required to support a proprietary injunction over cryptocurrencies. The court had difficulty in this task, given the volatility of Bitcoin and assessing the risk of losing business for the Defendant (who was a businessman in the blockchain industry) as a result of the injunction. The court considered the Defendant’s investment pattern and ordered the Plaintiff to pay fortification to cover the costs of the Defendant borrowing 50% of the value of the Bitcoin for two years, which was rounded off at HK$5.5 million.