How to Navigate Post-FTX Crypto Bankruptcy Regulatory Landscape Posts

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Preview June 15, 2023

Following several high-profile collapses of cryptocurrency exchanges, including FTX, Celsius, and Voyager, the state of the digital asset landscape is constantly changing, with more questions and landmines than clear paths. Among the many issues that arise in these bankruptcy cases is the question of how to treat and classify digital assets, especially cryptocurrencies, for example, who owns the cryptocurrencies deposited by customers.

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

General structure of the company

Cryptocurrency exchanges can be structured differently according to one or more of the following business models:

Pure Custody: Clients deposit cryptocurrencies with the company for custody purposes only. Earning services: customers deposit cryptocurrencies with the company; the company then uses the cryptocurrencies to generate high returns for customers. Lending services: retail and institutional clients borrow loans denominated in cryptocurrencies. Buy and sell services: Clients buy or sell cryptocurrencies in exchange for US dollars. monetized to repay loans and generate income 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 begins upon the opening of a bankruptcy case. The stay is designed to prevent creditors from pursuing claims against a bankrupt debtor, including seizure of the debtor’s assets, in the interest of maximizing the value of the debtor’s assets for all stakeholders.

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

Stakeholders should exercise caution when interacting with cryptocurrency exchanges that may be potential debtors, especially when it is unclear who owns the assets.

Transfers of ownership after the request

The debtor (acting as debtor in possession) or another representative of the estate (such as a court-appointed trustee if the debtor is not acting as debtor in possession) is a trustee of the bankruptcy estate. All actions to be taken by the estate representative outside of the normal course of business require court approval. With a cryptocurrency exchange, however, this requirement could become difficult if the debtor’s business conduct is unclear, particularly when the debtor does not have business records of past conduct.

The estate representative must obtain court approval for any use, sale or lease of the debtor’s property outside the normal course of business. Generally, transactions are approved when they are supported by the estate representative’s business judgment and comply with applicable non-bankruptcy laws. Unauthorized transactions are subject to reversal and retrieval or other outcome.

Pre-petition avoidance actions

There are two main types of pre-petition avoidance actions generally available to the estate representative.

Preferential action: The estate representative can avoid preferential transfers for 90 days (or one year for insiders) before bankruptcy. A transfer is preferential if it is made while the debtor was insolvent, allowing 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 can avoid intentional or implied fraudulent transfers made within two years (or more than two years under applicable non-bankruptcy law) prior to bankruptcy, including any transfer of ownership of a debtor or the undertaking of a guarantee or other obligation towards another party. An intentional fraudulent conveyance is determined by proof that the debtor actually intended to defraud or otherwise avoid paying his creditors. An implied fraudulent transfer occurs when the debtor received less than “reasonably equivalent value” in exchange for the transfer while it was insolvent or undercapitalized – or rendered insolvent or undercapitalized as a result.

Note: If a cryptocurrency is considered “safe”, a “safe harbor” defense may be available on a preference request or fraudulent transfer request with no actual intent to hinder, delay or defraud. This potential defense has yet to be tested in court.

What happens to customers’ cryptocurrency deposits?

If a cryptocurrency is owned by a bankrupt, there is no Federal Deposit Insurance Corporation (FDIC) or other government insurance program to protect the customer, who is left with an unsecured general claim. . Distributions on general unsecured debt are often pennies on the dollar. Customer may have FDIC insurance provided cash was held for Customer at an FDIC insured bank and Customer had FDIC pass-thru protection. However, such protection requires that meaningful records be maintained by the relevant debtor entity.

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

If the client has authorized the debtor to use the cryptocurrency for its own use, for example by lending the cryptocurrency or depositing it as collateral for loans to the debtor, the cryptocurrency is more likely to be considered as ownership of the bankruptcy estate rather than the customer. This may also be the case if the cryptocurrency is mixed with the cryptocurrency of other customers or the debtor and there is no “financial asset” agreement within the meaning of Article 8 of the Code uniform trade.

A recurring critical issue is how to value assets that must be returned due to avoidance actions. Although the Bankruptcy Code makes it clear that the amount of a claim against the bankrupt debtor is determined on the date the bankruptcy case is opened, it is not as clear as to how to value crypto- currency subject to a successful annulment action. The problem is particularly complicated given that the value of the cryptocurrency may have fluctuated, having different values ​​at the time of transfer, the start of the bankruptcy case or recovery.

Other issues

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

Disposal of solvent subsidiaries Absence of substantial consolidation, likelihood of inter-asset claims and distinct professions Federal forfeiture Treatment of the debtor as a broker in securities or commodities under the Bankruptcy Code Possibility of substantial consolidation Impact of foreign bankruptcy proceedings Protecting Certain Customer Credentials Useful to Fraudsters and Hackers Conclusion

With these high-profile cryptocurrency exchange failure cases, one of the likely outcomes is an increased focus on reform. Broader use of financial asset agreements under Article 8 of the Uniform Commercial Code under state law may be required by regulators.

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

For more information on the current cryptocurrency bankrupt market, proposed regulatory changes, and insights into the future of the industry, check out our Post-FTX presentation: Navigating Regulatory Waters After Crypto Bankruptcies ( Part 1), part of the company’s Web Technology Marathon series.

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