Bankruptcy In Crypto: 3 Key Clawback And Ownership Questions Emerging – Fin Tech

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.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.