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Looming Legal Troubles in Cryptocurrency Bankruptcies


The following article is the second in a two-part series written by Adam Levitin, a professor at Georgetown University Law Center and a member of Gordian Crypto Advisors LLC.

The US bankruptcy system is getting its first experience with cryptocurrency businesses. It is impossible to identify in advance all possible new cryptocurrency problems in the event of bankruptcy, but several are likely to arise: the handling of deposit funds; the treatment of collateral held by cryptocurrency lenders that go bankrupt; avoidance actions; the treatment of secured crypto loans granted to debtors; feasibility of the plan; and enforcement of orders against decentralized self-governing organizations.

Treatment of Deposit Funds

Cryptocurrency companies, especially exchanges, often hold customer funds, both in cryptocurrency and in cash. The legal capacity in which these funds are held is subject to some uncertainty. Possible legal characterizations are a deposit, a trust, or as “financial assets” governed by Article 8 of the Uniform Commercial Code – all of which would make deposit funds the property of the client – ​​or simply as the property of the cryptocurrency exchange itself.[1]

Complicating this issue, some cryptocurrency firms re-mortgage client funds, i.e., they use client funds as collateral for their own borrowings. When client funds are remortgaged, who has rights to the collateral, the client or the lender? Although there are well-established rules in this regard regarding securities and commodities, it is not clear whether these rules would apply to cryptocurrency.

Resolving the status of clients’ funds will be an important issue, as it will determine the extent of the debtor’s assets and whether clients are unsecured creditors or will be able to recover their cryptocurrency (as long as the debtor owns it). still).

Treatment of collateral held by debtor-lenders

Another likely issue is the treatment of collateral held by cryptocurrency companies that provide loans to customers. Customers who do not wish to sell their cryptocurrency but want fiat currency can borrow against their cryptocurrency. In such a situation, the cryptocurrency business is holding the crypto as collateral, which raises the question of whether the lending relationship is a “binding contract” that the cryptocurrency business can choose to assume or not. reject in its business judgment.

If the contract is assumed, it will be performed according to its terms — if the client repays the loan, the security will be returned. But if the contract is rejected, the customer will keep the loan proceeds, the cryptocurrency company will keep the collateral, and the customer will have an unsecured claim for the extent of the overcollateralization. What is unclear in this situation, however, is whether the claim will be based on the value of the collateral as of the date of bankruptcy or the date the customer learns of the rejection.

Bankruptcy law allows creditors to avoid – that is, to unwind – certain pre-bankruptcy transactions. These include transfers made for less than a reasonably equivalent value while the debtor is insolvent or undercapitalized (implied fraudulent transfers) and transfers made to unsecured creditors within 90 days of bankruptcy (cancellable preferences ).[2] There are exceptions to liability for rescission action if the transfer involved a security, commodity, or repurchase agreement, but if it did not, it remains a question for voidable preferences whether the transfer falls under an exception for transfers made in the ordinary course of business. . A range of transactions could potentially be subject to avoidance actions, including crypto collateral, margin closeouts, redemption payments, and customer withdrawals.

Processing Secured Crypto Loans Provided to Debtors

There are cryptocurrency money markets, usually based on overcollateralized loans structured as repo transactions with smart contracts. It is unclear whether the security interests in these transactions have been properly perfected, meaning that the necessary steps have been taken to prioritize the security interest over competing interests in the collateral. An imperfect security can be avoided in the event of bankruptcy.[3]

If these security interests are not perfect, they will likely be avoided, leaving lenders unsecured and opening the possibility for the debtor to recover any transfers made to lenders within 90 days of bankruptcy, including redemption payments and liquidations of the debt. debtor’s guarantee due to a margin trigger.

Confirmation of a Chapter 11 plan requires the bankruptcy court to conclude that the plan is workable, which means that it is likely that the plan can be successfully implemented. For many cryptocurrency companies, the feasibility of any restructuring depends on unpredictable cryptocurrency prices, which could prevent any discovery of feasibility.

Enforcement of orders against DAOs

Some entities in the crypto world are structured as DAOs – decentralized autonomous organizations. While some DAOs have a formal legal entity, others are looser, unincorporated collectives. This situation presents a potential complication for the enforcement of court orders: who is liable when no party has control? Courts have already been creative in dealing with issues such as serving process on strangers at blockchain addresses by allowing service via NFTs; more creativity may be required for courts to enforce orders against non-traditional organizational structures.

[1]Adam J. Levitin, “Not your keys, not your coins: Unrated Credit Risk in Cryptocurrency,” 101 TEX. L. REV. (to be published 2022).

[2]11 USC § 547.

[3]11 USC § 544(a).