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What Happens If a Cryptocurrency Exchange Files for Bankruptcy?

posted by Adam Levitin

Exchanges play a key role in the cryptocurrency ecosystem, but no one seems to have given any consideration to so far is what happens when a cryptocurrency exchange that provides custodial services for its customers ends up in bankruptcy. We’ve never had such a crypto-exchange bankruptcy in the US—Mt. Gox, for example, filed in Japan—but it’s certainly a possibility.  These exchanges are not banks, so they are eligible for Chapter 11 if they have any US assets or incorporation, and they face substantial risks from hacking and their own proprietary trading in extreme volatile assets.

So what happens to a customer if an exchange files for bankruptcy?  I think it ends very badly for the customers, as explained below the break. I do not think customers understand the legal nature of the custodial relationships, and exchanges have no incentive to make the legal treatment clear to customers. In fact, the exchanges are lulling the consumers with language claiming that the consumer "owns" the coins, when in fact the legal treatment is quite likely to be different in bankruptcy. In bankruptcy, it is likely to be treated as a debtor-creditor relationship, not a custodial (bailment) relationship. That means that customers are taking on real credit risk with the exchanges, which is a particular problem because of the opacity of the exchanges and their lack of regulation.

Custodially Held Crypto Currency Is Likely Property of the Bankruptcy Estate

First, the custodially held cryptocurrency is property of the bankruptcy estate—that's the new legal entity that springs into existence upon the filing of the bankruptcy. The bankruptcy estate accedes to all of the debtor exchange’s property rights, and those include, at the very least, the exchange’s possessory interest in the cryptocurrency.

But wait, you bluster, the custodial agreement clearly says that I am the owner, that it’s my property, that I retain title to it. Yup, but that’s not how the law actually works. Just because they wrote that doesn’t mean it’s true.

For starters, the idea of “ownership” is a little more tricky. It’s not a binary concept in law. Legal thinking generally conceives of ownership as a bundle of sticks, and the sticks can be separated and doled out to different folks. For example, I might “own” an estate called Blackacre, but I can rent the back 40 to you, lease the westfold to your cousin, give you brother fishing rights in the stream, your sister an easement to cross the forest, and the bank a mortgage (that’s a contingent property interest). I still “own” Blackacre, but lots of other folks have property interests in it.  Same story with crypto. Once deposited with the exchange, the customer does not have the possessory interest and, as explained below, the customer might not have any interest at all, because the transaction could well be deemed a sale, not a deposit.

At the very least, the cryptocurrency exchange has a possessory interest in the cryptocoins. If that’s all there is, you might get your coins back, but it won’t be immediate or automatic, and you won't be able to trade in the interim. 

Things get much worse, however, if the exchange has any right to use the cryptocurrency—to rehypothecate it or to use its staking rights—that too is property of the estate.  Not to pick on Coinbase, but under its staking arrangement it gets  a 25% “commission” on any staking rewards and it indemnifies the customer for any slashing losses. The shared gains and internalized losses sure looks like an investment partnership there. 

But even if the exchange can’t use your crypto in any way, things could still be bad. If the exchange can commingle customers’ coins and is not obligated to return a specific cryptocoin (e.g., #25601), but just a cryptocoin—and that’s typically how this works—then the entire cryptocurrency deposit, root and stem, is property of the estate. 

The situation is no different than with your bank account—you have a general deposit—an unsecured claim for a dollar value, rather than a right to specific bills, as you would with a specific deposit in a safe deposit box.  Put in fancier terms, if the obligation isn’t to return the same or altered/improved good, then it’s not a bailment, but a sale, which makes the crypto property of the debtor and the customer a creditor. A recent SDNY case dealt with this issue in the context of a precious metal refining operation. Because of the commingling and lack of right to get back the specific metal given, the court said it was a sale, not a bailment. (The outcome might be different with fungible goods, but cryptocoins aren’t entirely fungible precisely because the ownership history is traceable for each coin. That means certain liabilities attach to particular coins and not others.)

The Automatic Stay Will Prevent Customers from Redeeming Their Crypto

Here’s why it matters whether the crypto is “property of the estate.”  When the exchange files for bankruptcy there is a stay that goes into place automatically of almost all attempts to collect from the property of the estate. If you knowingly transgress the stay, you're facing sanctions.  With a few exceptions, the stay prevents any attempt to collect from the debtor outside of the bankruptcy process. Instead, a creditor, like the exchange’s customer, would have to either wait to the end of the bankruptcy case to possibly get paid or would have to move for the court to lift the automatic stay. It doesn’t matter that the creditor says, “but it’s my cryptocurrency!” That’s not how this works. 

Now, there are a bunch of exceptions to the automatic stay. In particular, there’s a set for securities contracts (contracts to buy/sell a security), swaps (including currency swaps), repos, and forward contracts (contracts to buy/sell commodities in the future). You might think that this all takes us to the unresolved debate about whether any particular cryptocurrency is a security, commodity, currency, or something else. It doesn’t. The reason why is that none of these exceptions matter here. The exceptions are only for a creditor to terminate, accelerate, and liquidate or setoff the margin posted to guaranty performance of its counterparty’s obligations under these transactions. There’s no margin posted to guaranty the performance of any of the exchange’s custodial obligations. In other words, the automatic stay applies to the cryptocurrency exchange’s customers.

The cryptocurrency exchange’s customers can always move to lift the automatic stay, but that requires lawyering up and going to court.  It will involve cost and delay and even then it might not be successful. If the exchange has nothing more than a pure custodial interest and does not commingle its custodial holdings or use them itself, then perhaps the stay could be lifted “for cause.”

Unless the cryptocurrency exchange’s customers have a right to get back the specific cryptocurrency they deposited with the exchange (coin #25601), however, they are not likely to succeed because the court is likely to say that they do not “own” the coins.  They are just creditors of the exchange. 

The Customers Are Likely General Unsecured Creditors of the Exchange

Not only are the customers likely mere creditors, but they are also likely general unsecured creditors, which means they will have to wait at the back of the line for repayment with everyone else.  They will share on a pro rata basis whatever assets are leftover (if any) after the secured creditors and the priority creditors (including the expenses of running the bankruptcy) get paid, and any payment might not be for quite a while. That’s not a happy to place to be.  Recoveries could be pennies on the dollar.

(Perhaps the customers get a 507(a)(7) priority (which doesn’t guaranty any actual repayment outside of a Chapter 11 plan confirmation), but I’m skeptical of that because it’s not a downpayment for a purchase—the deposit is itself the transaction. In any case, that priority would only be for the first for $3,025 of their deposit.)

What’s worse for the cryptocurrency exchange’s customers, is that their claims will be for the dollar value of the coins as of the date of the filing of the bankruptcy, so any future appreciation will go to the debtor and thus be available to first to repay higher priority creditors.

All of which is to say that cryptocurrency exchange customers are taking on real credit risk with the exchange. This is exacerbated by the lack of regulatory oversight of the exchanges.  

That’s not the end of things, however. Once in bankruptcy, the cryptocurrency exchange can clawback certain pre-bankruptcy transfers, like redemptions by its customers as voidable preferences. If the transfers were made to unsecured creditors in the 90 days prior to bankruptcy, they are preferences. The only issue is whether an exception or defense applies. The only obvious exceptions would be the de minimis amount exception or the ordinary course exception, but the ordinary course exception requires that the withdrawal be made in the ordinary course of the customer’s business, not just the exchanges. Does the customer generally withdraw its funds? There’s some risk here. 

There is the possibility that the section 546(e) defenses—settlement payment or financial institution—apply as well. These defenses require determining if the cryptocurrency is a security or commodity or something else, something that might create uncomfortable law for the cryptocurrency world. But I can easily see a court saying that the 546(e) defenses are predicated on the application of extensive non-bankruptcy regulatory regimes (that’s what the 2nd Circuit basically said in Tribune), so they do not apply to cryptocurrencies that are not regulated under those regimes. All of which is to say that there is clawback risk, which in turn raises the question of whether the clawback is of the coin or its value and as of what date. I'm not going to try to figure that out here.

The big point here is the if you are a customer of a cryptocurrency exchange, you risk being a general unsecured creditor of the exchange if it should file for bankruptcy. It doesn’t matter that the exchange’s contract with you says that you “own” the currency. That’s not determinative of what will happen in bankruptcy. If you’re a cryptocurrency exchange customer you’re actually in a worse position than if you dealt with a traditional financial institution for a bank deposit or security, as the exchange is not regulated for safety-and-soundness and there’s no insurance protecting your assets.

Comments

hi there thank you for this very informative article.

I am not a lawyer but I have been very interested in securities law ... I am considering writing to the SEC about regulating Venture Capital investments into these scam crypto coins...

There is one question that I have related to bankruptcy and crypto it is: IF prominent Venture Capital firms like Andreessen Horowitz, [ which is involved both in 'investments' in these "companies" as well as the sale of these 'coins' ( Pump and Dump style )] is indicted by the SEC for fraud, could the government collect the money from other non-crypto companies they have invested in?

Like what happened in the clawback case with Irving Picard in the Madoff case? Or in this hypothesis, would the VC firm ( technically now a broker dealer registered with FINRA ) have to declare bankruptcy in order for the government to collect the money?

In my mind, because they invested 3b+ into these crypto companies and a massive crash is imminent, they will have to declare bankruptcy at some point. But they invest in many sectors other than crypto.

And if the government goes after them like they did with Madoff, could the government somehow force non-crypto companies that received money from Andreessen return the money or is it too far-fetched? Is the Madoff case a legal precedent for a scenario like this?

I’m wondering, if the crypto exchange formed a bankruptcy remote entity, would that solve this problem?

As a technical clarification: Bitcoin is entirely fungible to the extent that the miners do not discriminate in validating transactions—which is hypothetically possible but is probably more an instance of demurrage—but Bitcoin is entirely fungible in the sense that Bitcoins do not have integer denominations with distinct serial numbers. The Bitcoin ledger doesn’t record the owner of a given Bitcoin (or fraction thereof); Bitcoin records transfers between Bitcoin addresses (i.e. owners), with each address having a net balance, just like with a bank account. (I don’t know how this compares to custody of conventional registered securities, where individual stocks might very well have serial numbers.)

I keep saying “Bitcoin” because it’s the progenitor model for all other cryptocurrencies, but it’s entirely possible for a newer cryptocurrency to involve serially numbered tokens. Aside from the obvious (art NFTs as collectibles with market prices varying wildly within a set), the main reason this probably hasn’t taken off is that it increases the already ridiculous transaction overhead, and people aren’t quite that willing to shell out for transaction fees.

I would compare this to making a large in-person purchase with physical pennies: the store would probably be extremely annoyed at the inconvenience of counting them out, and the bag of little metal discs would become impractically very quickly. I mean, sure, have proportional transaction fees in order to penalize small transactions, but no cryptocurrency has succeeded in that sort of demurrage. Indeed, some sovereign currencies explicitly make smaller denominations no longer legal tender over a certain payment value: for example, in Canada 1c coins are only legal tender up to 25c, past which point the creditor can negotiate a transaction fee for the inconvenience.

It would be fair for the customer agreements to provide the customer with a precautionary security interest in the coins. Do they?

(1) If a VC firm committed fraud vis-a-vis its investors, I do not think that the companies in which it invested would have to return funds, assuming that they gave value (e.g., shares) for them. If the VC firm committed fraud vis-a-vis the federal government, then criminal forfeiture would deem the assets related to the fraud to be government property as of the moment of the crime. I assume, but don't actually that there's a bona fide purchaser defense to criminal forfeiture.

(2) A bankruptcy-remote structure potentially avoids the problem. It's just very difficult to achieve in these circumstances. If the crypto exchange is structured as a corporation or LLC, it's going to need to rely on a golden share or a rent-a-director, and those strategies haven't held up consistently in bankruptcy.

(3) Elsie H. makes a very good point about the BTC actually being fungible. That could potentially affect the property of the estate analysis.

(4) A security interest is worthless if you can't perfect it. It's not currently possible to take a non-possessory (ok, UCC nerds, it's control, not possession here) interest in a crypto currency. But even if it were, I doubt most customers would know how to perfect their SI.

Adam -- one thing missing from your analysis is the application of pre-SIPA bankruptcy case law dealing with insolvent financial institutions. While SIPA governs brokerages, people tend to forget that the pre-SIPA case law still governs financial institutions that are not governed by SIPA. And those cases generally held that where the financial institution acts as a custodian, and there are identifiable securities that are property of the estate, the claims of customers to those identifiable securities (and proceeds)are ahead of general unsecured creditors (which is the rule incorporated into SIPA).

Switzerland created a new law that was set into force last August to address this problem. (Art. 242a SchKG) This law specifies clearly under what circumstances crypto assets still belong to the client, and when the crypto assets are considered to belong to the custodian and therefore would also end up in the bankruptcy estate. In the former case, the crypto assets reside outside the balance sheet of the custodians (like stocks held by banks on behalf of their clients). In the latter case, the crypto assets appear on the balance sheet and the client only has a claim towards the custodian (like money in a bank account). The link below is a comment on an early version of the law. There doesn't seem to be a good English source on the actually enacted version.

The concrete criteria for preserving the "ownership" of the clients are: the custodian must be committed to hold the deposited assets ready at all times (i.e. no borrowing) and the crypto assets must either be stored on segregated addresses for each client or, if stored on collective accounts, the custodian must have fully audited accounting with a clear assignment on what belongs to whom.

https://www.bitcoinassociation.ch/bitcoin-association-switzerland/2019/6/27/our-comment-on-the-swiss-blockchain-law

A potential argument that this analysis fails to consider is that the crypto-assets, even if commingled, are being held by the exchange in a constructive trust

A constructive trust is an equitable remedy that requires a court to take a discretionary action. Bankruptcy courts are generally very skeptical of constructive trusts, not least because they run contrary to basic bankruptcy policy of equality of distribution among unsecured creditors. Additionally, in many states, a contractual agreement governing the parties' relationship precludes a constructive trust. It's basically a remedy for unjust enrichment, and that's not the custodial situation.

The short of it is yes, it's possible that a court would rule that there's a constructive trust, but you cannot at all count on it.

Thanks for your reply. Do you think language in the custodial agreement providing for an "express trust" would fare better than language providing that the crypto-assets are "owned" by the customer?

Zack—Maybe. Depends on state law on express trusts. I’m not sure that there is a perfect contractual solution. The Wyoming SPDI law seems to solve things by clarification that the assets are a bailment, but there hasn’t been bug takeup of the SPDI charter, suggesting that most investors don’t understand or care.

Thanks for the analysis! This is something I've been worrying about, so I appreciate hearing from someone with real expertise to confirm my suspicions.

I wanted to add a little more detail to Elsie H.'s explanation of Bitcoin fungibility: there's a subtlety that could have legal ramifications, especially with money that's the product of crimes.

Conceptually, each wallet address has an account balance, but when you want to transfer the funds to another wallet, you can't just pay the exact amount. Instead, you have to use one or more previously-received transactions that add up to at least the amount you want to pay. You also have to return the "change" that's left over from the payment back to your original wallet, or to a new temporary wallet for further use (a technique called transaction peeling, sometimes used for anonymity, and sometimes for convenience when exchanges want to pay several wallets).

Each of the recipients adds their portion of the payment to their individual wallets, where it becomes a new "coin", in a sense, that they can spend as part or all of a future transaction. Each transaction is like combining coins and bills to pay in cash, but with arbitrary units. A better analogy would be receiving personal checks and then endorsing one or more of them to pay someone else, and getting the change back from them in the form of a new personal check.

Unlike cash, physical or electronic, which truly is fungible by default, Bitcoin and other cryptocurrencies have a more direct traceability that enables investigators to follow the money in both directions, back to the original miner and forward for perpetuity.

Blockchain is a solution looking for a problem - just about anything it can do, other technologies can already do faster/cheaper/better. Film financing is a solved problem - memoranda of understanding, etc. If there really is zero trust requiring a fully public duplicated ledger, it's no basis for investing in a movie, which is necessarily collaborative. Also to add, to learn more about crypto calculator, you may check this tool https://tools.dexfolio.org/crypto-calculator/

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