How Bankruptcy Courts Will Treat Cases Involving Cryptocurrency Exchanges

The cryptocurrency market has created a broad "ecosystem" of participants. They include issuers of cryptocurrency, owners of cryptocurrencies, operators of computers in the network (sometimes known as "miners") who authenticate and record cryptocurrency transfers, and cryptocurrency exchanges that facilitate trades, and in some cases, hold cryptocurrency accounts for customers. Other participants sell derivatives based on cryptocurrency, such as the Chicago Mercantile Exchange selling bitcoin futures and the Chicago Board of Options Exchange selling bitcoin options.

For various reasons, including fraud, theft or mismanagement, a number of substantial cryptocurrency exchanges in different parts of the world have become insolvent and gone into liquidation. See, for example, Mt. Gox in Japan described by Pascoe in "Bankruptcy, Recognition Proceedings and Recoveries in a Cryptocurrency World, Insolvency and Restructuring International," Vol. 12, No. 1 (March 2018); or Youbit, a South Korean cryptocurrency exchange profiled on CNBC.com.

This article looks at some of the issues that may arise if a cryptocurrency exchange becomes a debtor in a case under the Bankruptcy Code.

How Cryptocurrency Exchanges Work

It is difficult to estimate the total number of cryptocurrency exchanges. Some operate throughout the world. Others operate primarily in a single country or region. Some of the larger and better known exchanges based in the U.S. are Coinbase, Coinmama, Local Bitcoins, BitQuick, Gemini and Bcause. One website identifies over 200 exchanges.

Different exchanges perform different functions. Some exchanges buy cryptocurrency from sellers and sell it to buyers. They earn money through charging commissions on trades or profiting from favorable price spreads. Other exchanges merely match buyers and sellers on a website platform and charge a commission on transfers, much like eBay. Exchanges will also sometimes serve as an escrow agent in a trading transaction between the buyer and seller. A smaller number of exchanges allow investors to purchase cryptocurrency "on margin" in a manner similar to the way stockbrokers or commodity brokers operate.

Many exchanges also offer related custodial services for investors. Cryptocurrency might be stored at an exchange or a custodian designated by the exchange in a virtual "hot wallet" or in "cold storage." Hot wallets, identified by a "public key" similar to an e-mail address, are connected to the Internet. However, the wallet can be accessed only through a unique cryptographically created alphanumeric password called a "private key." Anyone with the private key, usually the owner or custodian, can transmit the cryptocurrency in the wallet. If the private key is lost, the cryptocurrency will be lost too. In general, hot wallets are relatively easy to set up, access, and use, but they are susceptible to theft or embezzlement by someone who hacks into the exchange's files with the private key.

Cold storage refers to a cryptocurrency wallet not connected to the Internet. Exchanges may hold a copy of the private key for a cold storage wallet in a vault or other safe place and retrieve it only when a transfer is made. Cold storage wallets are more secure, but anyone who obtains the private key can invade its wallet. In some respects, an exchange with custody of an investor's cryptocurrency is similar to a financial institution with customer accounts. Cryptocurrencies in a collective wallet cannot be identified by a serial number or some other distinguishing factor. Thus, it may be difficult to trace cryptocurrency in a wallet that holds cryptocurrency for multiple owners.

Cryptocurrency Exchange Regulation

Exchanges are subject to a patchwork of federal and state regulation. State law, which exists in about half of the states, focuses primarily on licensing and operations. For example, New York law requires a "Bitlicense" for operations. Other states, like Illinois, provide no specific regulation. A number of states require a "money transmitter" license. See, "Cryptocurrency and Blockchain — The Technological and Regulatory Frontier of FinTech" (Bloomberg Law, Robert Kim, Editor).

Federal law provides additional layers of regulation under anti-money laundering laws (18 U.S.C. §1956-7, for example) but, thus far, it is not clear whether cryptocurrency exchanges will be subject to specific federal regulations imposed on financial institutions like stockbrokers or commodity brokers. 28 U.S.C. §959 strongly suggests that bankruptcy would ordinarily not free the estate of an operating exchange from existing state or federal regulations.

Do Exchanges Qualify for Chapter 11?

One question likely to arise is whether an exchange will meet the eligibility requirements for a Chapter 11 case. Exchanges might also be liquidated in a federal equity receivership, and in the case of an exchange qualifying as a stockbroker, possibly in a proceeding under the Securities Investor Protection Act (SIPA), 15 U.S.C. §78 aaa, et. seq. However, SIPA proceedings appear to apply only to broker-dealers required to register under the Exchange Act of 1934. Thus far, there has been at least one exchange liquidated in a federal court receivership. See, Brandon Leidel v. Project Investors d/b/a Cryptsy, Case No. 9:16-CV-80060-MARRA (S.D. Fla. 2016).

Chapter 11 eligibility will turn on whether the exchange is found not to be a stockbroker, commodity broker or disqualified bank within the meaning of the Bankruptcy Code.

Almost all domestic "banks" are excluded from the bankruptcy laws because specific provisions are made for their insolvency under other regulatory laws. See, Senate Report No. 95-989, 95^th Cong., 2^nd Sess. 31 (1978). To determine if an entity is a "bank," courts have generally employed two tests. If the state statute creating the entity classifies it as a bank, there is a strong inference that it does not qualify for bankruptcy relief. If state law is not conclusive, courts will sometimes look to the text and purpose of 11 U.S.C. §109. See, In re Cash Currency Exchange, Inc., 762 F.2d 542 (7 Cir.), cert. den. 474 U.S. 904 (1985) (Illinois currency exchanges not "banks"); and Kansas ex. rel. Rogaton v. Hayes, 62 F.2d 597 (10 Cir. 1932) (Kansas trust company not a bank). In the absence of contrary state law, it seems unlikely that an exchange would be characterized as a "bank."

If the exchange is a "stockbroker" or "commodity broker," it will be eligible for treatment only under Chapter 7 and will be liquidated in accordance with Subchapter III for stockbrokers or Subchapter IV for commodity brokers.

Under 11 U.S.C. §101(53A), the term "stockbroker" means person –

(A) with respect to which there is a customer, as defined in section 741 of this title; and

(B) that is engaged with the business of effecting transactions in securities –

            (i) for the account of others; or

(ii) with members of the general public, from or for such person's own account."

The status of a cryptocurrency exchange holding customer accounts as a "stockbroker" may turn on whether the currency held for customers is considered a "security." Some cryptocurrencies, like bitcoin, may not be a security while others will be. The test for a security continues to focus on the so-called "Howey" rule set forth in SEC v. W.I. Howey Co., 328 U.S. 293 (1946). See also, "Public Statement: Cryptocurrencies and Initial Coin Offerings," by Jay Clayton, Chairman of the SEC dated Dec. 11, 2017.

The definition of "stockbroker" does not specify a result if the exchange is dealing with a mix of currencies, only some of which are securities. See, Collier on Bankruptcy ¶740.01[5] at p. 740-80, discussing the problem of liquidating a debtor that functions as a stockbroker and commodity broker. However, from both a textual and policy standpoint, it seems that an exchange holding some customer cryptocurrencies considered securities might qualify as a "stockbroker." If an exchange is buying and selling unregistered "securities", there may be additional complications stemming from the bankruptcy. For example, there might be claims for rescission as opposed to a claim for the value of the cryptocurrency as of the date of the filing of the petition under 11 U.S.C. §502(a). See, §5 of the Securities Act of 1933 (15 U.S.C. §77(e)).

An exchange would be viewed as a "commodity broker" if: a) the exchange qualifies as a "futures commission merchant" under the Commodity Exchange Act or a "foreign futures commission merchant," "leverage transaction merchant," or "commodity options dealer" under 11 U.S.C. §761; and b) the exchange has a "customer" under that Section. See, 11 U.S.C. §§101(6) and 761(12), (6), (14). At this point in the development of the cryptocurrency market, it seems unlikely an exchange would be a "clearing organization" because it would need to be registered under the Commodity Exchange Act, 11 U.S.C. §761(2). A list of "clearing organizations" appears in the CFTC website.

In 1982, the Court of Appeals for the Ninth Circuit reversed a lower court and held that a particular investment company fell outside the definition of "commodity broker." In re Co Petro Marketing Group, Inc., 680 F.2d 566 (9^th Cir. 1982). In that case, the debtor entered into contracts with investors under which the investor paid a deposit to the debtor and the debtor entered into a contract for the customer to purchase a quantity of petroleum for future delivery.

In arriving at its decision, the court focused on the Bankruptcy Code definition of "futures commission merchant," which means an entity:

"…engaged in soliciting or in accepting orders for the purchase or sale of any commodity for future delivery on or subject to the rule of any contract market …." (Emphasis added.)

Unlike the lower courts, the Court of Appeals found that the debtor was not a "futures commission merchant" (or thus a commodity broker) because the petroleum contracts were not "on or subject to the rules of any contract market."

An exchange might qualify as a "commodity broker," depending on whether it is trading cryptocurrency considered a "commodity," that "commodity" is subject to the rules of a contract market, the exchange is allowing purchases on margin, the exchange is dealing in "commodity contracts," and the exchange has "customers."

Implications of Status as a Stockbroker or Commodity Broker

One of the principal distinguishing features of stock and commodity broker liquidations under the Bankruptcy Code is the enhanced protection given to customers under 11 U.S.C. §§749(a) and 764. With this goal in mind, the ability of the estate to avoid pre-bankruptcy transfers of "customer property" to customers is significantly limited. Moreover, "customer name securities" and commodity contracts "specifically identifiable" to a customer are promptly returned to the customer. See, 11 U.S.C. §§751 (securities) and 766(c) (commodities). It is questionable whether these provisions would apply to an exchange. See also, 17 C.F.R. §190.01(11) (defining "specifically identifiable property").

The proceeds of other "customer property" (usually the bulk of property held by the broker) is distributed ratably to customers, subject only to administrative claims attributable to the administration of the customer property. See, 11 U.S.C. §§752(a) (securities) and 766(h) (commodities). If customers are still not made whole, their deficiency claims share pro rata with unsecured creditors. See, 11 U.S.C. §§ 752(b) (securities) and 766(j)(2) (commodities). In the case of stockbrokers, there are also provisions requiring subordination of claims of certain related parties broader than the class of claims subordinated under 11 U.S.C. 510. See, 11 U.S.C. §747.

Exchange Insolvencies Outside of the Special Subchapters

If a court determines that an exchange is not an ineligible bank, a stockbroker, or commodity broker, the exchange can be reorganized or liquidated under Chapter 11 or liquidated under Chapter 7. If the exchange has custody of customer cryptocurrency, the precise nature of the customers' interest in stored cryptocurrency will have a major impact on various aspects of the case. See, 11 U.S.C. §541(d).

For example, a return of a customer's cryptocurrency or proceeds prior to bankruptcy will not be avoidable as a preference or fraudulent transfer if the court determines it did not amount to a transfer of an "interest of the debtor in property." The Supreme Court has interpreted that term to mean "property that would have been part of the estate had it not been transferred before the commencement of bankruptcy proceedings." Begier v. IRS, 496 U.S. 53 (debtor's payment of taxes taken from employee's paychecks were not property of the debtor but funds held in trust for the government). Non-bankruptcy law will determine the rights of a customer who has a claim to cryptocurrency held by the exchanges or a third-party custodian working with the exchange. See, Butner v. United States, 440 U.S. 48 (1979). The voidability of transfers from an exchange to customers may also be limited by the "safe harbor" provisions of 11 U.S.C. §546(e).

One older case and two recent decisions may shed light on the rights of exchange customers. In the older case (Bullion Reserve of North America v. Bozek, 836 F.2d 1214 (9 Cir. 1988)), the debtor was in the business of purchasing precious metals for customers and storing the metals in a trust of which a debtor affiliate was trustee. The debtor did not hold sufficient inventory through the affiliate to satisfy all customer claims. Within 90 days of the debtor's bankruptcy, a customer received a shipment of his metals. The court found that any express trust would have been with the affiliate, and even if there was a trust, the customer was not able to trace his funds to the metal. Thus, the metal was property of the debtor and the transfer could be avoided as a preference.

In a more recent case (In re Land America Financial Group, Inc., 412 B.R. 800, (Bankr. E.D. Va. 2009)), the debtor was in the business of serving as an intermediary for tax-free like-kind exchanges. A customer of the debtor executed a series of exchange management control agreements with the debtor to set up customer sub-accounts. Funds from the sales of the customer's property were placed in the sub-accounts. The court found that the agreements, lacking explicit "trust" language, did not create an express or resulting trust because the agreement could have established a trust if intended. Thus, the court dismissed the customer's complaint to turn over the funds in the sub-account.

Most recently, the court in Secure Leverage Group, Inc. v. Bodenstein, 558 B.R. 226 (N.D. Ill. 2016), declined to impose a resulting trust on customer funds held by a commodity broker in a liquidation under Subchapter IV of Chapter 7 of the Bankruptcy Code. The debtor, a futures commission merchant, dealt primarily in futures contracts traded on an exchange but also invested customer funds in foreign currency and spot metal transactions sold "over the counter." Under its agreement with the foreign currency and metal customers, the debtor was not required to hold their funds in segregated accounts, as the law required for funds of customers investing in exchange-traded futures contracts.

The district court (as well as the bankruptcy court below) found that the customers investing in foreign currencies and metals were not "customers" protected under subchapter IV of Chapter 7 and the customers failed to prove by clear and convincing evidence that the parties intended to establish a trust under state law. The customers would thus be treated as general unsecured creditors.

Foreign Exchanges and Chapter 15

If an exchange is the subject of a non-U.S. insolvency proceeding and its foreign insolvency representative seeks relief under Chapter 15 of the Bankruptcy Code, there may be questions about eligibility to commence an ancillary proceeding.

Chapter 15 explicitly does not apply to:

"… a proceeding concerning an entity … identified by exclusion in section 109(b) … or … an entity subject to subchapter III of Chapter 7 of this title, or a commodity broker subject to subchapter IV of Chapter 7 of this title."

Analysis

As of the time this article was written, there are no reported decisions of cryptocurrency exchanges becoming a debtor in a case under the Bankruptcy Code. If an exchange files a voluntary case or is the subject of an involuntary case, the courts may be confronted with difficult questions concerning the nature of cryptocurrency, the status of the operations of the exchange, and the relationship of customers to cryptocurrency in the custody of the exchange. Hopefully, this article will provide some assistance for arriving at answers.

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Richard J. Mason ([email protected]) concentrates his practice on commercial bankruptcy and related litigation out of the Chicago office of McGuireWoods LLP. He can be reached at . The author wishes to acknowledge input concerning the commodities and cryptocurrency markets from James M. Falvey ([email protected]) general counsel and chief regulatory officer at EverMarkets, a crypto derivatives marketplace, . The views expressed herein are purely those of the authors.