Bankruptcy in Crypto: 3 Key Clawback and Ownership Questions Emerging
The cryptocurrency industry was left reeling with FTX’s bankruptcy filing in November 2022, raising doubts about its future viability. This still-unfolding case is one of the most prominent crypto bankruptcies yet and could be the catalyst to push increased federal government oversight.
Cryptocurrencies—such as Bitcoin, ether (ETH), and Solana—offer an alternative financial system that relies on cryptography-protected transactions to prevent counterfeiting and fraudulent transactions without centralized regulation or governance from traditional authorities like banks or governments. Instead, they are powered by decentralized blockchain technology which records all exchanges and keeps track of new unit issuance. And while the limited regulation has been seen as a benefit to many advocates of cryptocurrency, it’s this lack of regulation that, in many ways, contributed to the recent rise and fall of FTX and several other crypto businesses that came before it.
For more information about the FTX scandal and insight into potential future regulatory developments, read The FTX Downfall: What It Means for the Future of Cryptocurrency.
3 Key Crypto Bankruptcy Questions
FTX is far from the first cryptocurrency company to declare bankruptcy, as there have now been five similar cases in the last two years alone. CRED was the first, followed by Voyager and most recently Celsius, whose case includes over $5.5 billion in claims. These recent crypto bankruptcy cases have common characteristics. Most of these companies lacked adequate internal controls and were susceptible to volatile market conditions. FTX was no different and likely will not be the last crypto company to declare bankruptcy. As FTX’s case continues to unfold, there are three critical questions the firm’s Blockchain and Crypto Assets Practice Group’s bankruptcy lawyers will be keeping a close eye on that will impact how crypto customers are affected in these cases going forward:
1. Who owns the cryptocurrency on deposit?
The threshold issue is ownership of the cryptocurrency on deposit with the debtors. Generally, the bankruptcy estate includes all of the debtor’s property interests. Creditors may not obtain any property of the estate without the court granting relief from the automatic stay in bankruptcy. But the automatic stay generally does not apply to property which is not owned by the debtor. Establishing ownership may be the difference between recovering all of a customer’s cryptocurrency or only a small fraction, if anything,
The agreements between the debtor and its customers typically address ownership. Some state the customer retains ownership of the cryptocurrency. Others give ownership to the debtor. However, even if the agreement states the customer retains ownership, the ownership could be defeated if the cryptocurrency is not specifically identifiable and is commingled with cryptocurrency belonging to other customers.
2. Will withdrawals be subject to clawback?
Many of these companies experienced a virtual version of a “run on the bank” before the bankruptcies. The customers who withdrew their crypto assets before the bankruptcies risk having to return the withdrawals. Generally, the bankruptcy code allows the debtor to claw back transfers of the debtor’s property within 90 days before the bankruptcy filing if the debtor was insolvent at the time of the transfer. There are defenses to the clawback right, but they may not apply when there is a virtual run on the bank.
3. What and how much will the customer have to return in as a clawback?
In a clawback case, there is uncertainty about what and how much will need to be repaid. Section 550 of the Bankruptcy Code gives judges the discretion to order the return of the cryptocurrency or require the return be made in U.S. dollars. This creates a dilemma for customers. If they liquidate the cryptocurrency and the value increases, they may have to buy it back at a higher price if the court orders the return of the cryptocurrency. Conversely, if the value of the cryptocurrency drops, customers who retained the cryptocurrency run the risk they will have to pay U.S. dollars and will not be able to liquidate the cryptocurrency for a sufficient amount.
Equally concerning for customers is there is no bright line rule regarding the valuation date. It could be the value of the cryptocurrency at the time of the: a) withdrawal; b) bankruptcy filing; c) clawback lawsuit; or d) clawback judgment.
In other words, customers who made withdrawals before the bankruptcy are exposed to valuation risk in both directions and may have to return more than they expect. As a result, these customers should carefully consider hedging strategies and may want to ask the court to decide the valuation issues early in the case.
The Need for Counsel Well-Versed in Cryptocurrency Issues
As these bankruptcy cases continue to emerge, the importance of working with experienced counsel when getting involved in crypto assets has never been greater. Buchanan Ingersoll & Rooney has developed a team of attorneys and government relations professionals focused on helping companies and individuals navigate cryptocurrency issues and assess the impact on their industry, clients, business, and personal investments.
Our firm’s Blockchain and Crypto Assets Practice Group is prepared to guide any individual or organization through the opportunities and challenges this fascinating space presents. For specific queries, contact Sahel A. Assar, Blockchain & Crypto Assets Practice Group Chair and Tax Counsel, or Mark Pfeiffer, Shareholder, Bankruptcy & Creditors’ Rights.