Q: What Happens When a Blockchain Company Fails in the US? A: A Nightmare - DecisionBoundaries

Q: What Happens When a Blockchain Company Fails in the US? A: A Nightmare

 

My son wrote a paper on blockchain and he got quoted by a Nobel Prize winner on the New York Times.

My goal is more modest. All I am hoping for a like here, a share there, and, with luck, someone leaving a (flattering) comment.

The blockchain, or distributed ledger technology, has created a new and arguably more efficient and reliable way of recording data. Rather than storing data in a central location, the blockchain keeps a running tally in a decentralized network of computers that verify the source of “blocks” of data before adding them to the existing “chain.” Although the blockchain has many applications, perhaps its most visible use is serving as an electronic platform for issuing and recording transfers of cryptocurrencies.

Failure of a blockchain firm entails a number of threshold questions that must be answered to select the forum and regime under which claims will be adjudicated.

The first is What is a cryptocurrency? You may get as many answers to this one as there are experts willing to give an opinion times the number of cryptocurrencies in circulation (over 1,500, at last count). Some (very few) meet the formal definition of currency (means of payment, unit of account, store of value), others behave more like securities, especially in the cases where businesses finance themselves through the issuance of “coins”. A third broad category encompasses “utility tokens”, which can be used to pay for goods or services provided, generally, by the issuer.

Beyond the economic characterization, there are myriad legal definitions. The IRS treats cryptocurrencies as property1, FinCEN (also under Treasury) treats it as currency2. One Court has treated crypto as a commodity3, while another found that a finder of fact could conclude that the cryptocurrency at issue was a security4.

One key participant in the cryptocurrency ecosystem are the crypto exchanges that facilitate trades and, in some cases, hold customer accounts. Several of these exchanges have become insolvent for different reasons, including fraud, theft or mismanagement. The most notorious crypto exchange insolvency was that of Tokyo-based Mt. Gox which at one point handled 70% of the bitcoin trades worldwide. Mt. Gox filed for bankruptcy in Japan after discovering that BTC850,000 (worth $450 million at the time) had gone missing from customer accounts. Soon after the bankruptcy filing Mt. Gox was placed under liquidation proceedings.

Although it is estimated that some 200 cryptocurrency exchanges operate in the US, the better-known ones being Coinbase, Coinmama, Local Bitcoins, BitQuick, Gemini, and Bcause, none have so far become insolvent.

If a crypto exchange were to become insolvent in the US, the second threshold question would be Does it qualify for Chapter 11?

The answer is, the issue is likely to be litigated and the outcome is uncertain. For example, the exchange could be liquidated under a SIPA proceeding if found to have been required to register under the 1934 Act. Similarly, an exchange could be deemed to be a bank or, more likely, a commodities broker, each ineligible for Chapter 11 reorganization and subject to its own ad-hoc liquidation regime5.

If a court determines that an exchange is not an ineligible bank, stockbroker, or commodity broker, the exchange can be reorganized or liquidated under Chapter 11 or liquidated under Chapter 7. If the exchange has custody of customer cryptocurrency, the precise nature of the customers’ interest in stored cryptocurrency will have a major impact on various aspects of the case. See, 11 U.S.C. §541(d).

For example, a return of a customer’s cryptocurrency or proceeds prior to bankruptcy will not be avoidable as a preference or fraudulent transfer if the court determines it did not amount to a transfer of an “interest of the debtor in property.” The Supreme Court has interpreted that term to mean “property that would have been part of the estate had it not been transferred before the commencement of bankruptcy proceedings.” Begier v. IRS, 496 U.S. 53 (debtor’s payment of taxes taken from employee’s paychecks were not property of the debtor but funds held in trust for the government). Non-bankruptcy law will determine the rights of a customer who has a claim to cryptocurrency held by the exchanges or a third-party custodian working with the exchange. See, Butner v. United States, 440 U.S. 48 (1979). The voidability of transfers from an exchange to customers may also be limited by the “safe harbor” provisions of 11 U.S.C. §546(e).

One older case and two recent decisions may shed light on the rights of exchange customers. In the older case (Bullion Reserve of North America v. Bozek, 836 F.2d 1214 (9 Cir. 1988)), the debtor was in the business of purchasing precious metals for customers and storing the metals in a trust of which a debtor affiliate was trustee. The debtor did not hold sufficient inventory through the affiliate to satisfy all customer claims. Within 90 days of the debtor’s bankruptcy, a customer received a shipment of his metals. The court found that any express trust would have been with the affiliate, and even if there was a trust, the customer was not able to trace his funds to the metal. Thus, the metal was property of the debtor and the transfer could be avoided as a preference.

In a more recent case (In re Land America Financial Group, Inc., 412 B.R. 800, (Bankr. E.D. Va. 2009)), the debtor was in the business of serving as an intermediary for tax-free like-kind exchanges. A customer of the debtor executed a series of exchange management control agreements with the debtor to set up customer sub-accounts. Funds from the sales of the customer’s property were placed in the sub-accounts. The court found that the agreements, lacking explicit “trust” language, did not create an express or resulting trust because the agreement could have established a trust if intended. Thus, the court dismissed the customer’s complaint to turn over the funds in the sub-account.

The most recent case is eerily reminiscent of the Refco litigation, to which I was a customer-party. We settled with the holders of the non-customer accounts, so the issue was never adjudicated. But the court in Secure Leverage Group, Inc. v. Bodenstein, 558 B.R. 226 (N.D. Ill. 2016), declined to impose a resulting trust on customer funds held by a commodity broker in a liquidation under Subchapter IV of Chapter 7 of the Bankruptcy Code. The debtor, a futures commission merchant, dealt primarily in futures contracts traded on an exchange but also invested customer funds in foreign currency and spot metal transactions sold “over the counter.” Under its agreement with the foreign currency and metal customers, the debtor was not required to hold their funds in segregated accounts, as the law required for funds of customers investing in exchange-traded futures contracts.

The district court found that the customers investing in foreign currencies and metals were not “customers” protected under subchapter IV of Chapter 7 and the customers failed to prove by clear and convincing evidence that the parties intended to establish a trust under state law. The customers would thus be treated as general unsecured creditors.

As the title of this post foreshadowed, if an exchange ever files in the US, the courts will be confronted with difficult questions concerning the nature of cryptocurrency, the status of the operations of the exchange, and the relationship of customers to cryptocurrency in the custody of the exchange. It will indeed be a litigious and expensive nightmare.


1 IRS Notice 2014-21.
2 Application of FinCEN’s Regulations to Persons Administering, Exchanging or Using Virtual Currencies.
3 CFTC v. McDonnell, 287, F. Supp. 3rd 213,228 (EDNY 2018)
4 US v. Zaslavskiy, 2018 WL 4346339 (EDNY 2018)
5 Although not eligible for Chapter 11, both stockbrokers and commodity brokers are eligible for Chapter 7 liquidation in accordance with Subchapter III and Subchapter IV, respectively.


 

 

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