A crash in the cryptocurrency industry started this past spring, causing a significant number of cryptocurrency exchanges and related entities to seek bankruptcy protection, including the recent filing of one of the largest cryptocurrency exchanges, FTX. The volatility in the industry continues, with the subsequent filing of the cryptocurrency firm BlockFi and the crypto-mining company Core Scientific.
Before understanding the issues facing cryptocurrency industry, it is important to have a basic understanding of the fundamentals of cryptocurrency. Cryptocurrency, or crypto, is a class of digital assets created with cryptographic techniques and supported by a technology called a blockchain. A blockchain is an open-sourced string of code that ensures the existence of a tamper-resistant record of transactions and ownership, facilitating the creation of, and subsequent transactions in, a particular cryptocurrency.
There are a few different types of cryptocurrencies:
- Stablecoins: Cryptocurrencies that tie their market value to a currency or other external reference point to reduce price volatility;
- Fungible tokens: Interchangeable and divisible assets, similar to normal currency in which any $5 bill is exchangeable for another $5 bill (this includes both utility tokens and securities tokens)
- Nonfungible tokens (NFTs): Unique, collectible assets non-divisible or interchangeable with similar asset (such as art, music, books, etc.)
Cryptocurrency is often stored in a digital wallet, which is a software program allowing the user to store, send and receive cryptocurrency. The digital wallet may be accessed by a public key, to allow a different user to send digital coins to the wallet owner, or by private key, which is the individual owner’s private information used to access the wallet, similar to a PIN or password.
Cryptocurrency caused the formation of an entire industry. Significant human and energy resources are expended on cryptomining, which is a process of validating cryptocurrency transaction to prevent fraudulent transactions. Cryptocurrency exchanges also formed to serve as marketplaces where users buy and sell cryptocurrencies (the customer interface is often similar to online stock brokerages). Yield earning platforms also developed, which borrow cryptocurrency from customers and promise to pay them back at later date, plus interest. The recent volatility in the crypto market has focused the spotlight on many players in the crypto industry and highlighted significant issues facing cryptocurrency entities seeking bankruptcy protection.
Beginning in the spring of 2022, the crypto industry experienced a significant downturn, causing cryptocurrency prices to plummet. Since the spring, a number of crypto-related entities were forced to file for bankruptcy protection:
- Cryptocurrency Exchanges
- In re Celsius Network LLC, No. 22-10964 (Bankr. S.D.N.Y.)
- In re FTX Trading Ltd., No. 22-11068 (Bankr. Del.)
- In re BlockFi Inc., No. 22-19361 (Bankr. D.N.J.)
- Cryptocurrency Lenders
- In re Voyager Digital Holdings, Inc., No. 22-10943 (Bankr. S.D.N.Y.)
- In re Three Arrows Capital Ltd., No. 22-10920 (Bankr. S.D.N.Y.)
- Cryptocurrency Mining Facility
- In re Compute North Holdings, Inc., No. 22-90273 (Bankr. S.D. Tex.)
- Core Scientific, In re Core Scientific, Inc., No. 22-90341 (Bankr. S.D. Tex.)
Due to the digital nature of cryptocurrency, the lack of specific regulation and how various crypto-based companies operate, bankruptcy practitioners and courts will be forced to deal with significant new issues:
Property of the Estate
For individual debtors, cryptocurrency purchased by the debtor is considered an asset. In re Carmack, No. 17-41438-CJP, 2018 WL 5288912, at *13 (Bankr. D. Mass. Oct. 22, 2018)
It becomes significantly more complicated if the cryptocurrency is held by a debtor operating as an exchange or a lender, with courts focusing on the nature of the agreement between the individuals and the debtors. In re Voyager Digital Holdings, Inc., No. 22-10943 (MEW), 2022 WL 3146796 (Bankr. S.D.N.Y. Aug. 5, 2022)
- Article 9 does not expressly include digital assets, so how do lenders perfect security interests granted in cryptocurrency?
- Is cryptocurrency a “general intangible,” which can be perfected by filing a UCC-1 financing statement?
- Is cryptocurrency “investment property,” which can be perfected by filing a UCC-1 financing statement or, preferably, exercising control?
- Is cryptocurrency “money,” which must be perfected by possession?
- If perfection requires possession, how does a lender possess the cryptocurrency?
- Does the lender need sole possession of the digital wallet’s private key?
- The Uniform Law Commission has proposed an Article 12 to address some of these issues, but states have not yet adopted it and there is currently a patchwork system of laws throughout the country
Preference, Avoidance Actions and Fraud
- It is unclear how courts will handle preference actions brought against individuals who made withdrawals during the preference period for debtors that are cryptocurrency lenders or exchanges
- Debtors and trustees have commenced actions to avoid large cryptocurrency transactions, including transactions involving insiders, such as in the Cred Inc. case
- The fraud allegations in the FTX case may have significant impacts on the crypto-industry as a whole
As more issues are litigated in the recently-filed bankruptcy case, it is likely that we will see a growing body of law develop. It will be worthwhile for bankruptcy practitioners to stay up to date regarding these legal developments due to the growing prevalence of cryptocurrency and digital assets owned by the businesses and individuals we call clients.
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