How to Navigate the Post-FTX Crypto Bankruptcy Regulatory … – Morgan Lewis

In the wake of several high-profile collapses of cryptocurrency exchanges, most notably FTX, Celsius, and Voyager, the state of the digital asset landscape is ever-changing, with more questions and landmines than clear paths forward. Among the many issues that arise in these bankruptcy cases is the question of how to treat and classify digital assets, especially cryptocurrencies—e.g., who owns the cryptocurrencies deposited by customers.

In this Insight, Morgan Lewis lawyers look at the commercial law and bankruptcy implications for industry participants as well as examine some of the long-term effects and potential reforms.

General Business Structure

Cryptocurrency exchanges can be structured differently along any one or more of the following business models:   

• Pure Custody: Customers deposit cryptocurrencies with the company solely for safekeeping
• Earn Services: Customers deposit cryptocurrencies with the company; the company then uses the cryptocurrencies to generate high yields for the customers
• Lending Services: Retail and institutional customers borrow loans denominated in cryptocurrencies
• Purchase and Sale Services: Customers buy or sell cryptocurrencies in exchange for US dollars
• Swap: Customers swap cryptocurrencies
• Mining: New cryptocurrencies are monetized to repay loans and generate revenue
• DeFi and Lending Protocols: The company borrows money using cryptocurrencies as collateral through a decentralized lending platform

Application of the US Bankruptcy Code to Cryptocurrencies

Automatic Stay

Under the US Bankruptcy Code, an automatic stay snaps into place upon commencement of a bankruptcy case. The stay is designed to prevent creditors from pursuing claims against a bankrupt debtor, including seizing assets of the debtor, in the interest of maximizing the value of the debtor’s assets for all stakeholders.

• Section 362: The “worldwide” automatic stay enjoins debt collection and other enforcement actions against a debtor except for, among other exceptions, actions by governmental units to enforce police and regulatory powers. To the extent that a foreign creditor has any connection to the United States, the bankruptcy court will not hesitate to enforce the automatic stay against the creditor and hold the creditor in contempt if the creditor violates the stay.
• Section 365(e): Once the bankruptcy case is commenced, a debtor’s rights under an existing contract are considered property of the estate. Any provision in a contract that provides for its termination or other modification based solely on the commencement of the case or the financial condition of the debtor is generally unenforceable.
• Section 525: A governmental unit may not revoke a license, permit, charter, franchise, or other similar grant solely because a debtor filed for bankruptcy protection.

Stakeholders should exercise caution when interacting with cryptocurrency exchanges that may be potential debtors, especially when it is not clear whose assets belong to whom.

Post-Petition Transfers of Property

The debtor (acting as debtor-in-possession) or other estate representative (such as a court-appointed trustee if the debtor is not acting as debtor-in-possession) is a fiduciary of the bankruptcy estate. Any actions to be taken by the estate representative outside the ordinary course of business require court approval. With a cryptocurrency exchange, however, this requirement could become difficult if the conduct of the debtor’s business operations is not clear, particularly when the debtor lacks business records of its prior conduct.

The estate representative must seek court approval of any use, sale, or lease of the debtor’s assets outside the ordinary course of business. Generally, transactions are approved when they are supported by the estate representative’s business judgment and are in accordance with applicable nonbankruptcy law. Unauthorized transactions are subject to avoidance and clawback or other unwinding.

Prepetition Avoidance Actions

There are two primary types of prepetition avoidance actions typically available to the estate representative.

Preference Action: The estate representative may avoid preferential transfers during the 90 days (or a year for insiders) prior to bankruptcy. A transfer is preferential if made while the debtor was insolvent, enabling the transferee to receive more than it would otherwise be entitled to in a hypothetical liquidation under Chapter 7 of the Bankruptcy Code.

Fraudulent Transfers: The estate representative may avoid intentional or constructive fraudulent transfers made within two years (or more than two years under applicable nonbankruptcy law) before bankruptcy, including any transfer of a debtor’s property or incurrence of a guaranty or other obligation to another party. An intentional fraudulent transfer is determined by evidence that the debtor actually intended to defraud or otherwise avoid paying its creditors. A constructive fraudulent transfer is where the debtor received less than “reasonably equivalent value” in exchange for the transfer while it was insolvent or undercapitalized—or rendered insolvent or undercapitalized thereby.

Note: If a cryptocurrency is considered to be a “security,” a “safe harbor” defense might be available on a preference claim or a fraudulent transfer claim without actual intent to hinder, delay, or defraud. This potential defense has not yet been tested in the courts.

What Happens to Customer Cryptocurrency Deposits?

If a cryptocurrency is the property of a bankruptcy estate, there is no Federal Deposit Insurance Corporation (FDIC) or other government insurance program to protect the customer—who is left with a general unsecured claim. Distributions on general unsecured claims are often pennies on the dollar. The customer may have FDIC insurance to the extent that cash was held for the customer in an FDIC-insured bank and the customer had “FDIC pass-thru” protection. However, such protection requires that meaningful records be maintained by the applicable debtor entity.

For cryptocurrency to be viewed as property of the customer to be returned to the customer, common law bailment and trust theories may be relevant if the cryptocurrency is held by the debtor in pure custody for the customer. In addition, while the issue has not been raised in cryptocurrency exchange bankruptcy cases so far, cryptocurrency should be viewed to be property of the customer if the exchange and the customer have agreed to treat the cryptocurrency as a “financial asset” under Article 8 of the Uniform Commercial Code.

If the customer permitted the debtor to use the cryptocurrency for the exchange’s own use, such as lending out the cryptocurrency or posting it as collateral for loans to the debtor, the cryptocurrency is more likely to be considered property of the bankruptcy estate rather than the customer. This may also be the case if the cryptocurrency is commingled with the cryptocurrency of other customers or the debtor and there is no “financial asset” agreement under Article 8 of the Uniform Commercial Code.

A reoccurring critical issue is how to value assets that are to be returned due to avoidance actions. While the Bankruptcy Code is clear that the amount of a claim against the bankrupt debtor is determined on the date of the commencement of the bankruptcy case, it is not so clear as to how to value cryptocurrency subject to a successful avoidance action. The issue is especially complicated given that the cryptocurrency may have fluctuated in value, having different values at the time of transfer, commencement of the bankruptcy case, or recovery.

Other Issues

There are other issues in crypto-related bankruptcy cases that may involve any of the following:

• Sale of solvent subsidiaries
• Absent substantive consolidation, the likelihood of inter-estate claims and separate sets of professionals
• Federal forfeiture
• Treatment of the debtor as a stockbroker or a commodity broker under the Bankruptcy Code
• Possibility of substantive consolidation
• The impact of foreign insolvency proceedings
• Protection of certain customer identifying information useful to fraudsters and hackers

Conclusion

With these highly visible cryptocurrency exchange bankruptcy cases, one likely outcome is an increased focus on reform. A wider use of the financial asset agreements under Article 8 of the Uniform Commercial Code under state law may be required by regulators.

On a federal level, there may be greater calls for clarity under the Bankruptcy Code. For example, it may be important to craft rules that specifically address the classification and treatment of digital assets. It may also be important to provide a priority for customer claims, similar to the priority afforded to customer claims in commodity broker liquidation proceedings.

For more information on the current cryptocurrency bankruptcy market, proposed regulatory changes, and insights on the industry’s future, view our presentation Post-FTX: Navigating the Regulatory Waters After Crypto Bankruptcies (Part 1), as part of the firm’s Technology Marathon web series.