How to Navigate the Post-FTX Crypto Bankruptcy Regulatory Landscape
Perception
June 15, 2023
Within the wake of a number of high-profile collapses of cryptocurrency exchanges, most notably FTX, Celsius, and Voyager, the state of the digital asset panorama is ever-changing, with extra questions and landmines than clear paths ahead. Among the many many points that come up in these chapter circumstances is the query of the way to deal with and classify digital property, particularly cryptocurrencies—e.g., who owns the cryptocurrencies deposited by clients.
On this Perception, Morgan Lewis attorneys take a look at the business legislation and chapter implications for trade members in addition to look at among the long-term results and potential reforms.
Common Enterprise Construction
Cryptoforex exchanges may be structured in another way alongside any a number of of the next enterprise fashions:
Pure Custody: Clients deposit cryptocurrencies with the corporate solely for safekeeping
Earn Providers: Clients deposit cryptocurrencies with the corporate; the corporate then makes use of the cryptocurrencies to generate excessive yields for the purchasers
Lending Providers: Retail and institutional clients borrow loans denominated in cryptocurrencies
Buy and Sale Providers: Clients purchase or promote cryptocurrencies in trade for US {dollars}
Swap: Clients swap cryptocurrencies
Mining: New cryptocurrencies are monetized to repay loans and generate income
DeFi and Lending Protocols: The corporate borrows cash utilizing cryptocurrencies as collateral by way of a decentralized lending platform
Utility of the US Bankruptcy Code to Cryptocurrencies
Automated Keep
Underneath the US Bankruptcy Code, an automated keep snaps into place upon graduation of a chapter case. The keep is designed to forestall collectors from pursuing claims towards a bankrupt debtor, together with seizing property of the debtor, within the curiosity of maximizing the worth of the debtor’s property for all stakeholders.
Part 362: The “worldwide” automated keep enjoins debt assortment and different enforcement actions towards a debtor apart from, amongst different exceptions, actions by governmental models to implement police and regulatory powers. To the extent {that a} overseas creditor has any connection to america, the chapter court docket won’t hesitate to implement the automated keep towards the creditor and maintain the creditor in contempt if the creditor violates the keep.
Part 365(e): As soon as the chapter case is commenced, a debtor’s rights underneath an present contract are thought of property of the property. Any provision in a contract that gives for its termination or different modification based mostly solely on the graduation of the case or the monetary situation of the debtor is usually unenforceable.
Part 525: A governmental unit could not revoke a license, allow, constitution, franchise, or different comparable grant solely as a result of a debtor filed for chapter safety.
Stakeholders ought to train warning when interacting with cryptocurrency exchanges that could be potential debtors, particularly when it isn’t clear whose property belong to whom.
Post-Petition Transfers of Property
The debtor (appearing as debtor-in-possession) or different property consultant (reminiscent of a court-appointed trustee if the debtor isn’t appearing as debtor-in-possession) is a fiduciary of the chapter property. Any actions to be taken by the property consultant exterior the strange course of enterprise require court docket approval. With a cryptocurrency trade, nevertheless, this requirement may change into tough if the conduct of the debtor’s enterprise operations isn’t clear, notably when the debtor lacks enterprise data of its prior conduct.
The property consultant should search court docket approval of any use, sale, or lease of the debtor’s property exterior the strange course of enterprise. Typically, transactions are accredited when they’re supported by the property consultant’s enterprise judgment and are in accordance with relevant nonbankruptcy legislation. Unauthorized transactions are topic to avoidance and clawback or different unwinding.
Prepetition Avoidance Actions
There are two major kinds of prepetition avoidance actions usually obtainable to the property consultant.
Desire Motion: The property consultant could keep away from preferential transfers throughout the 90 days (or a yr for insiders) previous to chapter. A switch is preferential if made whereas the debtor was bancrupt, enabling the transferee to obtain greater than it might in any other case be entitled to in a hypothetical liquidation underneath Chapter 7 of the Bankruptcy Code.
Fraudulent Transfers: The property consultant could keep away from intentional or constructive fraudulent transfers made inside two years (or greater than two years underneath relevant nonbankruptcy legislation) earlier than chapter, together with any switch of a debtor’s property or incurrence of a warranty or different obligation to a different celebration. An intentional fraudulent switch is set by proof that the debtor truly supposed to defraud or in any other case keep away from paying its collectors. A constructive fraudulent switch is the place the debtor obtained lower than “reasonably equivalent value” in trade for the switch whereas it was bancrupt or undercapitalized—or rendered bancrupt or undercapitalized thereby.
Be aware: If a cryptocurrency is taken into account to be a “security,” a “safe harbor” protection is likely to be obtainable on a choice declare or a fraudulent switch declare with out precise intent to hinder, delay, or defraud. This potential protection has not but been examined within the courts.
What Occurs to Buyer Cryptoforex Deposits?
If a cryptocurrency is the property of a chapter property, there is no such thing as a Federal Deposit Insurance coverage Company (FDIC) or different authorities insurance coverage program to guard the client—who’s left with a normal unsecured declare. Distributions on normal unsecured claims are sometimes pennies on the greenback. The shopper could have FDIC insurance coverage to the extent that money was held for the client in an FDIC-insured financial institution and the client had “FDIC pass-thru” safety. However, such safety requires that significant data be maintained by the relevant debtor entity.
For cryptocurrency to be considered as property of the client to be returned to the client, frequent legislation bailment and belief theories could also be related if the cryptocurrency is held by the debtor in pure custody for the client. As well as, whereas the difficulty has not been raised in cryptocurrency trade chapter circumstances to date, cryptocurrency ought to be considered to be property of the client if the trade and the client have agreed to treat the cryptocurrency as a “financial asset” underneath Article 8 of the Uniform Business Code.
If the client permitted the debtor to make use of the cryptocurrency for the trade’s personal use, reminiscent of lending out the cryptocurrency or posting it as collateral for loans to the debtor, the cryptocurrency is extra prone to be thought of property of the chapter property moderately than the client. This may increasingly even be the case if the cryptocurrency is commingled with the cryptocurrency of different clients or the debtor and there’s no “financial asset” settlement underneath Article 8 of the Uniform Business Code.
A reoccurring vital difficulty is the way to worth property which can be to be returned attributable to avoidance actions. Whereas the Bankruptcy Code is evident that the quantity of a declare towards the bankrupt debtor is set on the date of the graduation of the chapter case, it isn’t so clear as to the way to worth cryptocurrency topic to a profitable avoidance motion. The problem is particularly sophisticated provided that the cryptocurrency could have fluctuated in worth, having completely different values on the time of switch, graduation of the chapter case, or restoration.
Different Points
There are different points in crypto-related chapter circumstances that will contain any of the next:
Sale of solvent subsidiaries
Absent substantive consolidation, the probability of inter-estate claims and separate units of pros
Federal forfeiture
Remedy of the debtor as a stockbroker or a commodity dealer underneath the Bankruptcy Code
Chance of substantive consolidation
The affect of overseas insolvency proceedings
Safety of sure buyer figuring out info helpful to fraudsters and hackers
Conclusion
With these extremely seen cryptocurrency trade chapter circumstances, one possible consequence is an elevated give attention to reform. A wider use of the monetary asset agreements underneath Article 8 of the Uniform Business Code underneath state legislation could also be required by regulators.
On a federal stage, there could also be larger requires readability underneath the Bankruptcy Code. For instance, it might be essential to craft guidelines that particularly handle the classification and therapy of digital property. It might even be essential to offer a precedence for buyer claims, just like the precedence afforded to buyer claims in commodity dealer liquidation proceedings.
For extra info on the present cryptocurrency chapter market, proposed regulatory modifications, and insights on the trade’s future, view our presentation Post-FTX: Navigating the Regulatory Waters After Crypto Bankruptcies (Half 1), as a part of the agency’s Expertise Marathon net sequence.
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