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Cryptocurrency Brings Disruption to Bankruptcy Courts—What Parties Can Expect and the Open Issues Still To Be Resolved (Part Two)

In this second part of our blog exploring the various issues courts need to address in applying the Bankruptcy Code to cryptocurrency, we expand upon our roadmap. In part one, we addressed whether cryptocurrency constitutes property of the estate, the impacts of cryptocurrency’s fluctuating valuation, issues of perfection, and the effects of cryptocurrency on debtor-in-possession financing. In this part two, we explore preferential transfers of cryptocurrency, whether self-executing smart contracts would violate the automatic stay, and how confusing regulatory guidelines negatively impact bankruptcy proceedings, including plan feasibility.

Preferential Transfers

Pursuant to section 547(a) of the Bankruptcy Code, a debtor-in-possession (or trustee) can avoid a transfer of the debtor’s property to a creditor made in the 90-days before filing the petition if, among other things, the creditor received more than it would have in a Chapter 7 liquidation proceeding. Notably, such a transfer can only be avoided if the thing transferred was the debtor’s property. When cryptocurrency is valued and whether cryptocurrency is considered to be property of the estate can impact preference liability.

Perhaps the first question to arise in cryptocurrency preference litigation is whether the transferred cryptocurrency is property of the estate. If, as in the Chapter 11 bankruptcy case of Celsius Network LLC and its affiliates, the cryptocurrency withdrawn by the accountholder during the ninety days prior to the bankruptcy is determined to be property of the estate, and not the accountholder’s property, a preferential transfer claim could be asserted. If, however, the cryptocurrency was property of the accountholder, for instance if it was held in a wallet to which only the accountholder had exclusive rights, no preference liability would attach to the withdrawal of the cryptocurrency.

Assuming that a preferential transfer claim lies, the court must decide how to value the preferential transfer. Section 550 of the Bankruptcy Code allows a debtor-in-possession to recover “the property transferred, or, if the court so orders, the value of such property.”[1] This gives the debtor-in-possession wide latitude in asserting a preference claim. For instance, the debtor-in-possession could take the position that the cryptocurrency is a commodity, in which case a claim could be asserted to recover the cryptocurrency itself, which, by the end of the case, may be worth a much more than it was at the time of the transfer, with any gain accruing to the estate’s benefit.[2] In contrast, the party receiving the transferred cryptocurrency would likely take the position that the cryptocurrency is currency, in which case a claim would be limited to the value of the cryptocurrency at the time of the transfer.[3]

The proper valuation methodology has not to date been definitively addressed by the courts. Perhaps the closest a court has come to deciding that issue was in Hashfast Techs. LLC v. Lowe,[4] where the trustee claimed that a payment of 3,000 bitcoins to a supplier was a preferential transfer. The bitcoin was worth approximately $360,000 at the time of the transfer but was worth approximately $1.2 million when the trustee asserted the preferential transfer claim. The trustee argued that the payment to the supplier was intended to be a transfer of bitcoins and not a payment of $360,000, and that the supplier was required to pay 3,000 bitcoins to the estate, notwithstanding the substantial increase in value (and the resulting windfall to the estate). Ultimately, the court refused to decide whether bitcoin is either currency or commodities and held that “[i]f and when the [trustee] prevails and avoids the subject transfer of bitcoin to defendant, the court will decide whether, under 11 U.S.C. § 550(a), he may recover the bitcoin (property) transferred or their value, and if the latter, valued as of what date.”[5]

The changing value of cryptocurrency will also impact the question of whether the creditor received more than it would have in a Chapter 7 liquidation proceeding.[6] While the value of preferential transfers are determined at the time of the transfer,[7] the analysis of whether such transfer made the creditor better off than in a Chapter 7 liquidation is determined at the time of a hypothetical distribution, which means, practically, at the time of the petition.[8] Therefore, if a customer withdraws cryptocurrency from a platform during the 90-day preference period, and the cryptocurrency experiences a decrease in value during those 90 days, that customer could arguably be liable for a preferential transfer because the withdrawn cryptocurrency was worth more at the time of the transfer than at the time of the petition.

Presently unanswered is whether the safe-harbor provisions provided for in section 546(e) of the Bankruptcy Code shield cryptocurrency transfers from preferential transfer attack. Pursuant to section 546(e), a debtor-in-possession cannot avoid as a preference a margin payment or settlement payment made to “financial participant . . . in connection with a securities contract . . . commodity contract . . . [or] forward contract . . . that is made before the commencement of the case.” If the court determines that cryptocurrency is a security or commodity, and that the transfers were made in connection with forward or commodities contracts, then section 546(e) may shield those transfers from attack as preferential.

Violations of the Automatic Stay and Smart Contracts

The self-executing nature of smart contracts may raise automatic stay concerns. The automatic stay arises upon the filing of a bankruptcy petition, and in general, prevents creditors and other parties from continuing their collection efforts against the debtor.[9] Of relevance to smart contracts, section 362(a)(3) of the Bankruptcy Code states that the stay applies to “any act” to obtain possession of or control of property of the estate. Very recently, in Chicago v. Fulton, the United Stated Supreme Court held that section 362(a)(3) prevented any “affirmative act that would alter the status quo at the time of the bankruptcy petition.”[10]

Prior to Fulton, a bankruptcy court in Arkansas examined an analogous issue in Hampton v. Yam’s Choice Plus Autos, Inc. (In re Hampton).[11] In Hampton, the court adjudicated whether a device that automatically locked the debtor out of her car violated the automatic stay when it disabled function of the car’s engine postpetition. The device relied on a code—if the debtor paid, the creditor sent her a code, which she would then input, and this prevented the device from automatically disabling the car’s starter. In this instance, the court found a violation of the automatic stay.[12]

Based on current case law, it remains unclear whether a smart contract, operating automatically, would violate the automatic stay. For example, if a smart contract is based on a DeFi loan, and it automatically executes postpetition to transfer to the lender assets of the estate, a court may find a violation of the automatic stay.

Hampton would suggest that such actions would be a violation—but two issues caution against relying on Hampton as a clear bellwether. First, Hampton was decided pre-Fulton and it remains unclear whether, and to what extent, the Supreme Court’s holding in Fulton would change the outcome of Hampton. Second, a potentially key factual distinction exists: the device in Hampton required the creditor to give the debtor a code to prevent the disabling of the car, but smart contracts can be programmed to automatically execute postpetition without any further action by the parties. If a smart contract is found to violate the automatic stay, the next question is whether such a violation is willful, meaning that a court can impose monetary penalties, including potentially punitive damages.[13]

Note that even if a smart contract is found not to violate the automatic stay, it does not mean that a creditor can retain the property. Section 542 of the Bankruptcy Code requires those in possession of estate property to turnover the property to the estate. The estate is created at the time of the filing of the petition, and therefore, any smart contract that executes postpetition would theoretically concern estate property and be subject to turnover. Unfortunately, ambiguities arise even in this statute, as section 542 contains a good-faith exemption to the turnover mandate if the recipient is not aware of bankruptcy filing and transfers the assets.[14] Thus, the turnover mandate may be difficult to apply to non-debtor parties to smart contracts who program the contract ahead of time with the knowledge that such a contract may execute after a bankruptcy petition but with no actual knowledge of such petition having been filed.

Regulatory Confusion

The regulatory world has no uniform approach to cryptocurrency. Both the Securities and Exchange Commission (SEC) and the Commodities Future Trading Commission (CFTC), perhaps in part spurred by executive pressure, recently advanced heavier regulatory oversight of cryptocurrency.[15] The two agencies also share jurisdiction; one agency asserting authority to regulate cryptocurrency does not preclude the other from doing so.[16] Other agencies, such as the Department of the Treasury’s Office of Foreign Assets Control (OFAC) and Financial Crimes Enforcement Network (FinCen), have also asserted the jurisdiction to regulate cryptocurrency.[17] The result is regulatory confusion for market participants, both because of the sheer number of agencies asserting jurisdiction and the fact that individual agencies can sometimes issue confusing and ill-defined guidelines.

For instance, the SEC applies the Howey test, developed in the 1940s, to determine whether a specific cryptocurrency is a security.[18] Unfortunately, the SEC has stated that whether a specific cryptocurrency is a security can change overtime, and recently announced even more cryptocurrencies that they believe meet Howey’s definition of a security via their lawsuits with crypto exchanges Binance.US and Coinbase.[19]

The regulatory confusion clouding cryptocurrency has directly impacted bankruptcy proceedings. One recent case study offers a glimpse into that disconcerting influence. In 2022, crypto exchange Voyager Digital Holdings Ltd. filed for Chapter 11 bankruptcy. Another major crypto exchange, Binance.US, entered into an agreement with Voyager to acquire its assets—valued at around $1 billion. The SEC, the New York Department of Financial Services (NYDFS), and the New York Attorney General all filed sale objections in Voyager’s bankruptcy proceedings, arguing that if Voyager’s crypto assets constitute securities, then Binance.US’s rebalancing and redistribution of these assets to its account holders would be an “unregistered offer, sale or delivery after sale of securities” in violation of Section 5 of the Securities Act.[20] The NYDFS also alleged that the agreement “unfairly discriminates” against New York citizens by subordinating their recovery of diminished assets in favor of Voyager’s creditors—as well as foreclosing the option to recover crypto rather than liquidated assets.[21]

SEC trial counsel noted that, “regulatory actions, whether involving Voyager, Binance.US or both, could render the transactions in the plan impossible to consummate, thus making the plan unfeasible.”[22] In April 2023, Binance.US sent Voyager a legal notice canceling the prospective transaction, writing that “the hostile and uncertain regulatory climate in the United States has introduced an unpredictable operating environment impacting the entire American business community.”[23]

The SEC’s desire towards regulating cryptocurrency as securities appears to be growing. On August 15, 2023, the SEC settled for $24 million its claims against Bittrex, which included violations of Section 5 of the Securities Act.[24] Upon the settlement, the director of the SEC stated that Bittrex “worked with token issuers . . . in an effort to evade the federal securities law. They failed.”[25] Uncertainty combined with aggressive enforcement leaves cryptocurrency entities in an uncertain and precarious position.

Plan Feasibility

The Voyager case also highlights issues with plan feasibility in Chapter 11. In Voyager, the SEC objected to plan feasibility on the basis that one known digital asset of Voyager was a security, and therefore, the purchaser should register as a securities dealer.[26] Although the court overruled the SEC’s objection, as noted above, Binance.US ultimately withdrew its purchase offer, placing blame on the overall regulatory climate.[27] As regulations remain uncertain, and government authorities have shown a willingness to assert themselves into the process of reorganization, debtors who file for bankruptcy will have to brace for new or unforeseen objections to an otherwise confirmable plan.

Conclusion

Cryptocurrency has been seen by some as a disruptive force in finance. As the above issues show, it also appears to be a disruptive force in bankruptcy cases. Debtors and creditors alike will have to weather the disruption as best they can while the courts continue to grapple with the many open issues raised by cryptocurrencies.

See Cryptocurrency Brings Disruption to Bankruptcy Courts—What Parties Can Expect and the Open Issues Still To Be Resolved (Part One)

[1] See 11 U.S.C. § 550(a).

[2] This position would arguably be consistent with cases interpreting section 550(a) of the Bankruptcy Code that have held that the estate is entitled to recover the value of the property when value has appreciated subsequent to the transfer. See, e.g., In re Am. Way Serv. Corp., 229 B.R. 496, 531 (Bankr. S.D. Fla. 1999) (noting that when the value of the transferred property has appreciated, “the trustee is entitled to recover the property itself, or the value of the property at the time of judgment.”).

[3] Mary E. Magginis, Money for Nothing: The Treatment of Bitcoin in Section 550 Recovery Actions, 20 U. Pa. J. Bus. L. 485, 516 (2017).

[4] No. 14-30725DM (Bankr. N.D. Cal. Feb. 22, 2016),

[5] Order on Motion for Partial Summary Judgment at 1-2, Hashfast Techs. LLC v. Lowe, Adv. No. 15-3011DM (Bankr. N.D. Cal. 2016) (ECF No. 49).

[6] See 11 U.S.C. § 547(b)(5) (requiring the transferee to have received more that it would have received in a Chapter 7 liquidation).

[7] Maginnis, supra note 3.

[8] See In re CIS Corp., 195 B.R. 251, 262 (Bankr. S.D.N.Y. 1996) (“Thus, the Code § 547(b)(5) analysis is to be made as of the time the Debtor filed its bankruptcy petition); Sloan v. Zions First Nat’l Bank (In re Casteltons, Inc.), 990 F.2d 551, 554 (9th Cir. 1993) (“When assessing an alleged preferential transfer, the relevant inquiry . . . [is] . . . the actual effect of the payment as determined when bankruptcy results.”).

[9] 11 U.S.C. § 362(a).

[10] 141 S.Ct. 585, 590 (2021).

[11] 319 B.R. 163 (Bankr. E.D. Ark. 2005).

[12] Hampton, 319 B.R. at 165-170.

[13] See 11 U.S.C. § 362(k) (providing that, subject to a good faith exception “an individual injured by any willful violation of [the automatic stay] shall recover actual damages, including costs and attorneys’ fees, and, in appropriate circumstances, may recover punitive damages.”).

[14] See 11 U.S.C. § 542(c).

[15] David Gura, The White House calls for more regulations as cryptocurrencies grow more popular (Sept. 6, 2022, 6:00 AM), https://www.npr.org/2022/09/16/1123333428/crypto-cryptocurrencies-bitcoin-terra-luna-regulation-digital-currencies.

[16] See, e.g., CFTC v. McDonnell, 287 F. Supp. 3d 222, 228-29 (E.D.N.Y. 2018) (“The jurisdictional authority of CFTC to regulate virtual currencies as commodities does not preclude other agencies from exercising their regulatory power when virtual currencies function differently than derivative commodities.”).

[17] See Treasury Announces Two Enforcements Actions for over $24M and $29M Against Virtual Currency Exchange Bittrex, Inc., (October 11, 2022), https://home.treasury.gov/news/press-releases/jy1006.

[18] See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

[19] Emily Mason, Coinbase Hit With SEC Suit That Identifies $37 Billion of Crypto Tokens As Securities, (June 6, 2023 5:08 pm), https://www.forbes.com/sites/emilymason/2023/06/06/coinbase-hit-with-sec-suit-that-identifies-37-billion-of-crypto-tokens-as-securities/?sh=3cc4c6d667a9; SEC Charges Crypto Asset Trading Platform Bittrex and its Former CEO for Operating an Unregistered Exchange, Broker, and Clearing Agency, https://www.sec.gov/news/press-release/2023-78 (last visited July 31, 2023).

[20] Jack Schickler, SEC Objects to Binance.US’ $1B Voyager Deal, Alleging Sale of Unregistered Securities, (last updated Feb. 23, 2023 at 2:32 p.m.), https://www.coindesk.com/policy/2023/02/23/sec-objects-to-binanceus-1b-voyager-deal-alleging-sale-of-unregistered-securities/.

[21] See NYDFS Objection to Plan, In re Voyager Digital Holdings, et al. at 9-10, No. 22-10943 (Bankr. S.D.N.Y. Feb. 22, 2023) [ECF No. 1051].

[22] Kari McMahon, SEC and New York Regulators Push Back on Binance.US’s Acquisition of Voyager, The Block (Feb. 23, 2023), https://www.theblock.co/post/214333/sec-and-new-york-regulators-push-back-on-binance-uss-acquisition-of-voyager.

[23] Yueqi Yang & Steven Church, Binance US Ends $1 Billion Deal to Buy Bankrupt Crypto Firm Voyager, Bloomberg (April 25, 2023), https://www.bloomberg.com/news/articles/2023-04-25/binance-us-terminates-deal-to-buy-bankrupt-crypto-firm-voyager.

[24] See Crypto Asset Trading Platform Bittrex and Former CEO to Settle SEC Charges for Operating an Unregistered Exchange, Broker, and Clearing Agency, https://www.sec.gov/news/press-release/2023-150 (last visited Sept. 18, 2023).

[25] Id.

[26] See Objection of the U.S. Securities Exchange Commission to Confirmation at 3 n.5, In re Voyager Digital Holdings, et al., No. 22-10943 (Bankr. S.D.N.Y. Feb. 22, 2023) (ECF No. 1047).

[27] See supra at n. 23.

The Future of Stablecoins, Crypto Staking and Custody of Digital Assets

In the wake of the collapse of cryptocurrency exchange firm FTX, the Securities and Exchange Commission (SEC) has ratcheted up its oversight and enforcement of crypto firms engaged in activities ranging from crypto staking to custody of digital assets. This is due in part to concerns that the historically free-wheeling and largely unregulated crypto marketplace may adversely impact U.S. investors and contaminate traditional financial systems. The arguments that cryptocurrencies and digital assets should not be viewed as securities under federal laws largely fall on deaf ears at the SEC. Meanwhile, the state of the crypto economy in the United States remains in flux as the SEC, other regulators and politicians alike attempt to balance competing interests of innovation and investment in a relatively novel and untested asset class.

Is Crypto Staking Dead?

First, what is crypto staking? By way of background, it’s necessary to understand a bit about blockchain technology, which serves as the underpinning for all cryptocurrency and digital asset transactions. One of the perceived benefits of such transactions is that they are decentralized and “peer-to-peer” – meaning that Person A can transact directly with Person B without the need for a financial intermediary to approve the transaction.

However, in the absence of a central authority to validate a transaction, blockchain requires other verification processes or consensus mechanisms such as “proof of work” (which in the case of Bitcoin mining ensures that transactions are valid and added to the Bitcoin blockchain correctly) or “proof of stake” (a network of “validators” who contribute or “stake” their own crypto in exchange for a chance to validate a new transaction, update the blockchain and earn a reward). Proof of work has come under fire by environmental activists for the enormous amounts of computer power and energy required to solve complex mathematical or cryptographic puzzles to validate a transaction before it can be recorded on the blockchain. In contrast, proof of stake is analogous to a shareholder voting their shares of stock to approve a corporate transaction.

Second, why has crypto staking caught the attention of the SEC? Many crypto firms and exchanges offer “staking as a service” (SaaS) whereby investors can stake (or lend) their digital assets in exchange for lucrative returns. This practice is akin to a person depositing cash in a bank account in exchange for interest payments – minus FDIC insurance backing of all such bank deposits to protect investors.

Recently, on February 9, 2023, the SEC charged two crypto firms, commonly known as “Kraken,” for violating federal securities laws by offering a lucrative crypto asset SaaS program. Pursuant to this program, investors could stake their digital assets with Kraken in exchange for annual investment returns of up to 21 percent. According to the SEC, this program constituted the unregistered sale of securities in violation of federal securities laws. Moreover, the SEC claims that Kraken failed to adequately disclose the risks associated with its staking program. According to the SEC’s Enforcement Division director:

“Kraken not only offered investors outsized returns untethered to any economic realities but also retained the right to pay them no returns at all. All the while, it provided them zero insight into, among other things, its financial condition and whether it even had the means of paying the marketed returns in the first place.”¹

Without admitting or denying the SEC’s allegations, Kraken has agreed to pay a $30 million civil penalty and will no longer offer crypto staking services to U.S. investors. Meanwhile, other crypto firms that offer similar programs, such as Binance and Coinbase, are waiting for the other shoe to drop – including the possibility that the SEC will ban all crypto staking programs for U.S. retail investors. Separate and apart from potentially extinguishing a lucrative revenue stream for crypto firms and investors alike, it may have broader consequences for proof of stake consensus mechanisms commonly used to validate blockchain transactions.

NY DFS Targets Stablecoins

In the world of cryptocurrency, stablecoins are typically considered the most secure and least volatile because they are often pegged 1:1 to some designated fiat (government-backed) currency such as U.S. dollars. In particular, all stablecoins issued by entities regulated by the New York Department of Financial Services (NY DFS) are required to be fully backed 1:1 by cash or cash equivalents. However, on February 13, 2023, NY DFS unexpectedly issued a consumer alert stating that it had ordered Paxos Trust Company (Paxos) to stop minting and issuing a stablecoin known as “BUSD.” BUSD is reportedly the third largest stablecoin by market cap and pegged to the U.S. dollar.

The reasoning behind the NY DFS order remains unclear from the alert, which merely states that “DFS has ordered Paxos to cease minting Paxos-issued BUSD as a result of several unresolved issues related to Paxos’ oversight of its relationship with Binance in regard to Paxos-issued BUSD.”²The same day, Paxos confirmed that it would stop issuing BUSD. However, in an effort to assuage investors, Paxos stated “All BUSD tokens issued by Paxos Trust have and always will be backed 1:1 with U.S. dollar–denominated reserves, fully segregated and held in bankruptcy remote accounts.”³

Separately, the SEC reportedly issued a Wells Notice to Paxos on February 12, 2023, indicating that it intended to commence an enforcement action against the company for violating securities laws in connection with the sale of BUSD, which the SEC characterized as unregistered securities. Paxos, meanwhile, categorically denies that BUSD constitute securities, but nonetheless has agreed to stop issuing these tokens in light of the NY DFS order.

It remains to be seen whether the regulatory activity targeting BUSD is the beginning of a broader crackdown on stablecoins amid concerns that, contrary to popular belief, such coins may not be backed by adequate cash reserves.

Custody of Crypto Assets

On February 15, 2023, the SEC proposed changes to the existing “custody rule” under the Investment Advisers Act of 1940. As noted by SEC Chair Gary Gensler, the custody rule was designed to “help ensure that [investment] advisers don’t inappropriately use, lose, or abuse investors’ assets.”⁴The proposed changes to the rule (referred to as the “safeguarding rule”) would require investment advisers to maintain client assets – specifically including crypto assets – in qualified custodial accounts. As the SEC observed, “[although] crypto assets are a relatively recent and emerging type of asset, this is not the first time custodians have had to adapt their practices to safeguard different types of assets.”⁵

A qualified custodian generally is a federal or state-chartered bank or savings association, certain trust companies, a registered broker-dealer, a registered futures commission merchant or certain foreign financial institutions.⁶ However, as noted by the SEC, many crypto assets trade on platforms that are not qualified custodians. Accordingly, “this practice would generally result in an adviser with custody of a crypto asset security being in violation of the current custody rule because custody of the crypto asset security would not be maintained by a qualified custodian from the time the crypto asset security was moved to the trading platform through the settlement of the trade.”⁷

Moreover, in a departure from existing practice, the proposed safeguarding rule would require an investment adviser to enter into a written agreement with the qualified custodian. This custodial agreement would set forth certain minimum protections for the safeguarding of customer assets, including crypto assets, such as:

Implementing appropriate measures to safeguard an advisory client’s assets⁸
Indemnifying an advisory client when its negligence, recklessness or willful misconduct results in that client’s loss⁹
Segregating an advisory client’s assets from its proprietary assets¹⁰
Keeping certain records relating to an advisory client’s assets
Providing an advisory client with periodic custodial account statements¹¹
Evaluating the effectiveness of its internal controls related to its custodial practices.¹²

The new proposed, cumbersome requirements for custodians of crypto assets appear to be a direct consequence of the collapse of FTX, which resulted in the inexplicable “disappearance” of billions of dollars of customer funds. By tightening the screws on custodians and investment advisers, the SEC is seeking to protect the everyday retail investor by leveling the playing field in the complex and often murky world of crypto. However, it still remains to be seen whether, and to what extent, the proposed safeguarding rule will emerge after the public comment period, which will remain open for 60 days following publication of the proposal in the Federal Register.

¹ SEC Press Release 2023-25 (Feb. 9, 2023).

²NY DFS Consumer Alert (Feb. 13, 2023) found at https://www.dfs.ny.gov/consumers/alerts/Paxos_and_Binance.

³ Paxos Press Release (Feb. 13, 2023) found at https://paxos.com/2023/02/13/paxos-will-halt-minting-new-busd-tokens/.

⁴ SEC Press Release 2023-30 (Feb. 15, 2023).

⁵ SEC Proposed Rule, p. 79.

⁶ SEC Fact Sheet: Proposed Safeguarding Rule.

⁷ SEC Proposed Rule, p. 68.

⁸For instance, per the SEC, this could require storing crypto assets in a “cold wallet.”

⁹ Per the SEC, “the proposed indemnification requirement would likely operate as a substantial expansion in the protections provided by qualified custodians to advisory clients, in particular because it would result in some custodians holding advisory client assets subject to a simple negligence standard rather than a gross negligence standard.” See SEC Proposed Rule, p. 89.

¹⁰ Per the SEC, this requirement is intended to “ensure that client assets are at all times readily identifiable as client property and remain available to the client even if the qualified custodian becomes financially insolvent or if the financial institution’s creditors assert a lien against the qualified custodian’s proprietary assets (or liabilities).” See SEC Proposed Rule, p. 92.

¹¹ Per the SEC, “[in] a change from the current custody rule, the qualified custodian would also now be required to send account statements, at least quarterly, to the investment adviser, which would allow the adviser to more easily perform account reconciliations.” See SEC Proposed Rule, p. 98.

¹² Per the SEC, the proposed rule would require that the “qualified custodian, at least annually, will obtain, and provide to the investment adviser a written internal control report that includes an opinion of an independent public accountant as to whether controls have been placed in operation as of a specific date, are suitably designed, and are operating effectively to meet control objectives relating to custodial services (including the safeguarding of the client assets held by that qualified custodian during the year).” See SEC Proposed Rule, p. 101.

Article By Anjali C. Das of Wilson Elser Moskowitz Edelman & Dicker LLP

For more cryptocurrency and finance legal news, click here to visit the National Law Review.

NFT Endorsed by Celebrities Prompts Class Action

Since the early days of the launch of the Bored Ape Yacht Club (BAYC) non-fungible tokens (NFTs), several celebrities have promoted the NFTs. On Dec. 8, 2022, plaintiffs Adonis Real and Adam Titcher brought a lawsuit against Yuga Labs, creators of the BAYC, alleging that Yuga Labs was involved in a scheme with the “highly connected” talent agent Greg Oseary, a number of well-known celebrities, and Moonpay USA LLC, a crypto tech company. According to the complaint:

Yuga Labs partnered with Oseary to recruit celebrities to promote and solicit sales of BYAC;
Celebrities promoted the BAYC on their various platforms;
Oseary used MoonPay to secretly pay the celebrities; and
The celebrities failed to disclose the payments in their endorsements.

According to the complaint, as a result of the various and misleading celebrity promotions, trading volume for the BYAC NFTs exploded, prompting the defendants to launch the ApeCoin and form the ApeCoin decentralized autonomous organization (DAO). Investors who had purchased the ApeCoin allegedly lost a significant amount of money when the value of the coins decreased.

This case highlights the potential risks that may arise in connection with certain endorsements. In addition to the FTC, the SEC also has issued guidance on requirements in connection with promotional activities relating to securities, which may include digital assets, such as tokens or NFTs. Under SEC guidance, any paid promoter, celebrity or otherwise, of a security, including digital assets, must disclose the nature, scope and amount of compensation received in exchange for the promotion. This would include tv/radio advertisements and print, in addition to promotions on social media sites.

Article By Barbara A. Jones, William B. Mack, and India L. Sneed of Greenberg Traurig, LLP

For more finance legal news, click here to visit the National Law Review.

Quantifying Cryptocurrency Claims in Bankruptcy: Does the Dollar Still Reign Supreme?

In the past six months, four major players in the crypto space have filed for chapter 11 bankruptcy protection: Celsius Network, Voyager Digital, FTX, and BlockFi, and more may be forthcoming. Together, the debtors in these four bankruptcy cases are beholden to hundreds of thousands of creditors. The bulk of the claims in these cases are customer claims related to cryptocurrency held on the debtors’ respective platforms. These customer claimants deposited or “stored” fiat currency and cryptocurrencies on the debtors’ platforms. Some of these funds allegedly were commingled or rehypothecated, leaving customer accounts severely underfunded when liquidity crunches arose at the various entities. The total amount of such claims is estimated to be in the billions — that is, if these claims ultimately are measured in United States Dollars (“USD”).

Crypto-watchers and bankruptcy lawyers alike have speculated how customer claims based on digital assets such as cryptocurrencies should be valued and measured under bankruptcy law. Given the volatility of cryptocurrency prices, this determination may have a significant effect on recoveries, as well as the viability of the “payment-in-kind” distribution mechanics proposed in Voyager, Celsius, and BlockFi. A number of creditors appearing pro se in these proceedings have expressed a desire to keep their mix of cryptocurrencies through these proposed “in-kind” distributions.

However, a crypto-centric approach to valuing claims and making distributions raises a number of issues for consideration. For example, measuring customer claims in cryptocurrency and making “in-kind” distributions of these assets could lead to creditors within the same class receiving recoveries of disparate USD value as the result of the fluctuation in cryptocurrency prices. Moreover, as has been discussed in the Celsius proceedings, the administrative burden associated with maintaining, accounting for, and distributing a wide variety of cryptocurrencies as part of a recovery scheme would likely prove complex. Equity holders also might challenge the confirmability of a plan where valuations and recoveries are based on cryptocurrency rather than USD, as a dramatic rise in cryptocurrency values could return some value to equity.

Like most issues at the intersection of insolvency and cryptocurrency, there is little precedent to guide creditors through the uncertainties, but a recent dispute in the Celsius bankruptcy proceedings as to whether a debtor is required to schedule claims in USD, or whether cryptocurrency claims can be scheduled “in-kind,” may serve as a preview of things to come.

I. General Background

Celsius Network (“Celsius” and, together with its affiliated debtors and debtors in possession, the “Debtors”), self-described as one of the “largest and most sophisticated” cryptocurrency-based finance platforms and lenders that claimed over 1.7 million users worldwide,¹ filed petitions under Chapter 11 of the Bankruptcy Code on July 13, 2022.² On October 5, 2022, the Debtors filed their schedules of assets and liabilities (“Schedules”). Each Debtor’s schedule of unsecured creditors’ claims (Schedule E/F) lists the claims of the Debtors’ customers by the number of various forms of cryptocurrency coins and account types, rather than in USD.³

On October 25, 2022, a group of beneficial holders, investment advisors, and managers of beneficial holders (collectively, the “Series B Preferred Holders”) of the Series B Preferred Shares issued by debtor Celsius Network Limited filed a motion seeking entry of an order directing the Debtors to amend their Schedules to reflect customer claims valued in USD, in addition to cryptocurrency coin counts.⁴

II. Arguments

a. Series B Preferred Holders

Broadly, pursuant to Bankruptcy Rule 1009(a),⁵ the Series B Preferred Holders sought to have the Debtors amend their Schedule E/F to “dollarize” creditors’ claims, i.e., value customer claims in their dollar value as of the petition date. As filed, the Series B Preferred Holders asserted that the Debtors’ schedules were “improper, misleading, and fail[ed] to comply” with the Bankruptcy Rules “because they schedule[d] customer claims in cryptocurrency coin counts, rather than in lawful currency of the United States as of the Petition Date.”⁶ The Series B Preferred Holders asserted that such amended schedules are essential to the Debtors’ ability to structure, solicit, and confirm a plan of reorganization under the requirements of Section 1129, including whether “(i) claims are impaired or unimpaired, (ii) holders of similarly situated claims are receiving the same treatment, and (iii) the plan meets the requirements of the ‘absolute priority rule.’”⁷ In support of their arguments that USD valuation of a customer’s claim should be required, the Series B Preferred Holders relied on provisions of the Bankruptcy Rules, Bankruptcy Code, and Official Forms. The Series B Preferred Holders stressed that the motion “takes no position regarding the form of distribution customers” should receive under the Debtors’ plan, but rather that the Debtors must “add the [USD] amount of each customer claim in Schedules E/F to the cryptocurrency coin counts.”⁸

The Series B Preferred Holders also asserted that the requirement to denominate claims in USD is consistent with Section 502(b) of the Bankruptcy Code, which provides that when a debtor or party-in-interest objects to a claim, the court determines the amount of the claim in USD as of the debtor’s petition date.

b. Debtors’ Response

The Debtors had previously indicated that they were not seeking to dollarize its customers’ claims; rather, the Debtors represented that they intend to return cryptocurrency assets to its customers “in kind.”⁹ The Debtors stated that they interpreted Bankruptcy Rule 9009(a)(1)-(2) and General Order M-386, dated November 24, 2009 (the “General Order M-386”) to allow the Debtors to remove the dollar symbol when scheduling claims regarding cryptocurrency coin counts.¹⁰ This approach, the Debtors argue, lessens confusion for its customer case and decreases administrative expense for the estate.¹¹

Further, the Debtors argued that the Series B Preferred Holders’ reliance on Section 502(b) was misplaced because the application of such section is inapplicable at this stage of the proceedings where no claims objection has taken place.¹²

The Committee of Unsecured Creditors (“UCC”) agreed with the Debtors’ approach, stating that it “makes sense” for account holders to validate their scheduled claims by cryptocurrency type and that it wished to be consulted on the petition date prices used by the Debtors if they filed an amendment to the schedules.¹³

III. Analysis

a. Bankruptcy Code & Rules & Forms

Bankruptcy Rule 1007(b)(1) requires that a debtor’s schedules of assets and liabilities must be “prepared as prescribed by the appropriate Official Forms.”¹⁴ The relevant official form that a debtor must use to prepare its schedule of assets and liabilities is Official Form 206, which contains a USD symbol to denote the amount of liabilities that a debtor must list.¹⁵ Specifically, Official Form 206 provides:

As seen above, Official Form 206 does “hardwire” a dollar sign (“$”) into the boxes provided for claim amounts. Bankruptcy Rule 9009 states that the official forms are to “be used without alteration, except as otherwise provided in the rules, [or] in a particular Official Form.”¹⁶ Bankruptcy Rule 9009 permits “certain minor changes not affecting wording or the order of presenting information,” including “expand[ing] the prescribed areas for responses in order to permit complete responses” and “delet[ing] space not needed for responses.”¹⁷ Lastly, General Order M-386 permits “such revisions as are necessary under the circumstances of the individual case or cases.”¹⁸ The introduction to General Order M-386 states that standard forms were adopted to “expedite court review and entry of such orders” and that courts will expect use of the standard forms “with only such revisions as are necessary under the circumstances of the individual case or cases.”¹⁹

b. Section 502(b)

Bankruptcy Code Section 502(b) provides that if there is an objection to a claim, the court “shall determine the amount of such claim in lawful currency of the United States as of the [petition] date . . . .”²⁰ This “prevents the value of a claim from fluctuating by setting the claim as of the petition date and converting it to the United States dollars.”²¹ Acknowledging the “novel phenomenon” of dollarizing claims in cryptocurrency, the Series B Preferred Holders analogize this to cases where courts have required claims asserted in or based on in foreign currency or amounts of gold should be valued in USD. However, these cases were decided in the context of a claims objection. The Celsius Debtors argued that these cases have limited utility in the context of a motion for an order directing the Debtors to amend their schedules pursuant to Bankruptcy Rule 1009(a).²²

IV. The Court’s Order

Ahead of the hearing regarding the motion for an order directing the Debtors to amend their schedules, the Debtors and the Series B Preferred Holders were able to consensually resolve the motion and filed a revised proposed order prior to the hearing on the motions on November 15.²³ The Debtors agreed to amend their schedules by filing a conversion table within three days of the entry of the order, in consultation with the UCC and Series B Preferred Holders, that reflects the Debtors’ view of the rate of conversion of all cryptocurrencies listed in the Debtors’ schedules to USD as of the petition date. The idea is that the conversion table could be used by customers as a reference for calculating the USD value of their claim, to the extent needed for filing a proof of claim. The conversion table is not binding – the order preserves the rights of all parties to contest the conversion rates and does not require a party-in-interest to file an objection that is not stated in USD “solely on the basis that such claims should be reflected in [USD].”²⁴ The order also requires the Debtors to file updated schedules “dollarizing” its account holders’ cryptocurrency holdings to the extent required by any future court order or judicial determination.

On November 17, 2022, the court entered the revised proposed order.²⁵

V. Cash Is Still King?

Other bankruptcy courts have taken similar approaches as the Celsius court in this issue. An earlier cryptocurrency case, In re Cred Inc., the debtors did not schedule cryptocurrency claims in USD, but included a conversion table in their filed schedules, which set forth a conversion rate to USD as of the petition date.²⁶ Debtors in other cases, such as Voyager Digital, scheduled the amounts of their customer claims as “undetermined” and listed them in Schedule F in cryptocurrency.²⁷ BlockFi, which filed for bankruptcy on November 28, 2022, already has filed a proposed plan that would distribute its cryptocurrencies to its customers in–kind in exchange for their claims against the BlockFi debtors.²⁸ To date, neither BlockFi nor FTX have filed their schedules, and it remains to be seen whether they will follow the pattern established in Celsius and Voyager.

For creditors and equity holders, whether claims are measured in USD or the applicable cryptocurrency is only the beginning of what will likely be a long and contentious road to recovery. It remains to be seen whether any of these debtors will be able to confirm a viable restructuring plan that relies on any sort of “in-kind” distribution of cryptocurrencies. Further issues are likely to arise in the claims resolution process even further down the road as claimants and liquidation trustees (or plan administrators) wrestle with how to value claims based on such a volatile asset, subject to ever-increasing regulatory scrutiny. However, for the time being, the bankruptcy process continues to run on USD.

FOOTNOTES

¹ Declaration of Alex Mashinsky, CEO of the Debtors ¶¶ 1, 9, 20, In re Celsius Network LLC, Case No. 22-10964 (MG) (Bankr. S.D.N.Y. 2022) [ECF No. 23].

² Id. at ¶ 131.

³ Debtors’ Schedules of Assets and Liabilities and Statements of Financial Affairs, In re Celsius Network LLC, Case No. 22-10964 (MG) (Bankr. S.D.N.Y. 2022) [ECF No. 974]; see also Schedule E/F, Case No. 22-10967 [Docket No. 5]; Case No. 22-10970 [Docket No. 5]; Case No. 22-10968 [Docket No. 5]; Case No. 22-10965 [Docket No. 6]; Case No. 22-10966 [Docket No. 7]; Case No. 22-10964 [Docket No. 974]; Case No. 22-10969 [Docket No. 5]; Case No. 22- 10971 [Docket No. 5].

⁴ Series B Preferred Holders Motion to Direct Debtors to Amend Schedules, In re Celsius Network LLC, Case No. 22-10964 (MG) (Bankr. S.D.N.Y. 2022) [ECF No. 1183].

⁵ “On motion of a party in interest, after notice and a hearing, the court may order any . . . schedule . . . to be amended and the clerk shall give notice of the amendment to entities designated by the court.” Fed. R. Bankr. P. 1009(a).

6 Series B Preferred Holders Motion to Direct Debtors to Amend Schedules ¶ 1.

⁷Id. ¶ 3 (citing 11 U.S.C. §§ 1123(a)(2)-(4), 1129(a)(1), 1129(b)).

⁸ Series B Preferred Holders’ Reply ¶ 10, In re Celsius Network LLC, Case No. 22-10964 (MG) (Bankr. S.D.N.Y. 2022) [ECF No. 1334].

⁹ See 8/16/22 Hr’g Tr. at 35:5-7 (“The company is not seeking to dollarize claims on the petition date and give people back a recovery in fiat.”); id. at 42:11-16 (“[The UCC is] pleased that the company is not focused on dollarization of claims . . . an in-kind recovery is absolutely critical.”).

¹⁰ General Order M-386 is a resolution of the Board of Judges for the Southern District of New York, which provides for “a standard form for orders to establish deadlines for the filing of proofs of claim . . . in chapter 11 cases” to “thereby expedite court review and entry of such orders.”

¹¹ Debtors’ Objection to Series B Preferred Holders’ Motion ¶ 9, In re Celsius Network LLC, Case No. 22-10964 (MG) (Bankr. S.D.N.Y. 2022) [ECF No. 1304].

¹² Id. ¶ 12 (citing In re Mohr, 425 B.R. 457, 464 (Bankr. S.D. Ohio)).

¹³ Id. at 42:12-16 (“We are pleased to hear that the company is not focused on dollarization of claims . . . receiving an in-kind recover is 16 absolutely critical.”); UCC Statement and Reservation of Rights ¶ 6, In re Celsius Network LLC, Case No. 22-10964 (MG) (Bankr. S.D.N.Y. 2022) [ECF No. 1303].

¹⁴ Fed. R. Bankr. P. 1007(b)(1).

¹⁵ See Official Form 206, Part 2, Line 4 (using the USD sign into Form 206 for scheduling the debtor’s liabilities).

¹⁶ Fed. R. Bankr. P. 9009(a).

¹⁷ Id.

¹⁸ General Order M-386 ¶ 9.

¹⁹ General Order M-386 ¶ 2 (unnumbered, preliminary statement).

²⁰ 11 U.S.C. § 502(b).

²¹In re Aaura, Inc., No. 06 B 01853, 2006 WL 2568048, at *4, n.5 (Bankr. N.D. Ill. Sept. 1, 2006).

²² In re USGen New Eng., Inc., 429 B.R. 437, 492 (Bankr. D. Md. 2010) (using the exchange rate in effect on the petition date, in the context of a claims objection, to convert the claim to USD), aff’d sub nom. TransCanada Pipelines Ltd. v. USGen New Eng., Inc., 458 B.R. 195 (D. Md. 2011); Aaura, 2006 WL 2568048, at *5 (“Section 502(b) converts Aaura’s obligation to repay the obligation in gold into a claim against the estate in dollars, but it makes this transformation only as of the petition date, not retroactive to the date on which Aaura first became liable.”); Matter of Axona Intern. Credit & Com. Ltd., 88 B.R. 597, 608 n.19 (Bankr. S.D.N.Y. 1988) (noting Section 502(b) refers to the petition date as “the appropriate date for conversion of foreign currency claims”), aff’d sub nom. In re Axona Intern. Credit & Com. Ltd., 115 B.R. 442 (S.D.N.Y. 1990); ABC Dev. Learning Ctrs. (USA), Inc. v. RCS Capital Dev., LLC (In re RCS Capital Dev., LLC), No. AZ-12-1381-JuTaAh, 2013 Bankr. LEXIS 4666, at *38-39 (B.A.P. 9th Cir. July 16, 2013) (same).

²³ Notice of Proposed Order, In re Celsius Network LLC, Case No. 22-10964 (MG) (Bankr. S.D.N.Y. 2022) [ECF No. 1342].

²⁴ Id. at ¶¶ 7, 8.

²⁵ Order Pursuant to Bankruptcy Rule 1099 Directing the Debtors to Amend Their Schedules in Certain Circumstances, In re Celsius Network LLC, Case No. 22-10964 (MG) (Bankr. S.D.N.Y. 2022) [ECF No. 1387].

²⁶ Schedules at 12, In re Cred Inc., Case No. 20-128336 (JTD) (Bankr. D. Del. 2021) [ECF No. 443].

²⁷ Schedules, In re Voyager Digital Holdings, Inc., Case No. 22-10943 (MEW) (Bankr. S.D.N.Y. Aug. 18, 2022) [ECF No. 311].

²⁸ Joint Plan of Reorganization § IV.B.1.a, In re BlockFi Inc., Case No. 19361 (MBK) (Bankr. D.N.J. 2022) [ECF No. 22].

Article By Cadwalader, Wickersham & Taft LLP

For more financial legal news, click here to visit the National Law Review.

CFPB Investigates Crypto Lender

On December 1, 2022, the Consumer Financial Protection Bureau (Bureau) made public an administrative order denying Nexo Financial LLC’s (Nexo) petition to modify the Bureau’s civil investigative demand. The order represents the first publicly known Bureau investigation of a digital asset company, in this case, over Nexo’s “Earn Interest” crypto lending product.

The Bureau served Nexo with a civil investigative demand in late 2021 seeking further information about whether Nexo products were subject to federal consumer financial law, and in particular Nexo’s compliance with the Consumer Financial Protection Act and regulations under the Electronic Funds Transfer Act. Nexo sought to set aside the civil investigative demand and argued that, because the SEC had taken the position that other crypto lending products were securities, the Bureau was estopped from investigating it under provisions of federal law that preempt the Bureau from regulating securities products.

The Bureau rejected Nexo’s line of reasoning. According to the Bureau order, “Nexo Financial is trying to avoid answering any of the Bureau’s questions about the Earn Interest Product (on the theory that the product is a security subject to SEC oversight) while at the same time preserving the argument that the product is not a security subject to SEC oversight.” The order continues, “This attempt to have it both ways dooms Nexo Financial’s petition from the start.” The Bureau also found that Nexo’s petition was not timely filed.

As we recently noted, the Bureau has been increasing its attention to the digital asset sector. The Nexo order includes a lengthy discussion about the breadth of its jurisdiction and ability to investigate potential violations of law. As the crypto winter persists, we expect to see the Bureau continue to explore ways to assert its authority to regulate elements of the digital asset sector.

Article By Scott H. Kimpel of Hunton Andrews Kurth

For more financial legal news, click here to visit the National Law Review.

New York Enacts Crypto Mining Moratorium

On November 22, 2022, New York Governor Kathy Hochul signed into law a two-year moratorium against granting permits to crypto mining operations that “are operated through electric generating facilities that use a carbon-based fuel.” Renewable sources of energy are not impacted.

The legislation, among the first of its kind in the nation, prohibits the state’s Department of Environmental Conservation from issuing any new or renewal permits to electricity generating facilities reliant on carbon-based fuel supporting crypto mining operations that use proof-of-work authentication methods to validate blockchain transactions. The law applies to all permits and renewal applications filed after its effective date, and therefore grandfathers certain businesses that held permits prior to the date of enactment. The Department of Environmental Conservation and the Department of Public Service are also tasked under the legislation with preparing an environmental impact statement on cryptocurrency mining operations that use proof-of-work authentication techniques.

For more Environmental Law news, click here to visit the National Law Review.

Dead Canary in the LBRY

In a case watched by companies that offered and sold digital assets¹ Federal District Court Judge Paul Barbadoro recently granted summary judgment for the Securities and Exchange Commission (“SEC”) against LBRY, Inc.² This case is seen by some as a canary in the coalmine in that the decision supports the SEC’s view espoused by SEC Chairman Gary Gensler that nearly all digital assets are securities that were offered and sold in violation of the securities laws.³ For FinTech companies hoping to avoid SEC enforcement actions, the LBRY decision strongly suggests that all companies offering digital assets could be viewed by courts as satisfying the Howey test for investment contract securities.⁴

LBRY is a company that promised to use blockchain technology to allow users to share videos and images without the need for third-party intermediaries like YouTube or Facebook. LBRY offered and sold LBRY Credits, called LBC tokens, that would compensate participants of their blockchain network and would be spent by LBRY users on things like publishing content, tipping content creators, and purchasing paywall content. At launch, LBRY had pre-mined 400 million LBC for itself, and approximately 600 million LBC would be available in the future to compensate miners. LBRY spent about half of the 400 million LBC tokens on various endeavors, such as direct sales and using the tokens to incentivize software developers and software testers.

Judge Barbadoro concluded as a matter of law (i.e., that no reasonable jury could conclude otherwise) that the LBC tokens were securities under Section 5 of the Securities Act. Applying the Howey test, Judge Barbadoro noted the only prong of the Howey test that was disputed in the case was: Did investors buy LBC tokens “with an expectation of profits to be derived solely from the efforts of the promoter or a third party”? Judge Barbadoro answered resoundingly, “Yes.”

Most important to his conclusion that investors purchased LBC tokens with the expectations of profits solely through the efforts of the promoter (i.e., LBRY) were: the many statements made by LBRY employees and community representatives about the price of LBC and trading volume of LBC; and many statements that LBRY made about the development of its content platform, including how the platform would yield long-term value to LBC holders. Critically, however, Judge Barbadoro found that even if LBRY had made none of these statements, the LBC token would still constitute a security because “any reasonable investor who was familiar with the company’s business model would have understood the connection” between LBC value growth and LBRY’s efforts to grow the use of its network. Even if LBRY had never said a word about the LBC token, Judge Barbadoro found that the LBC token would constitute a security because LBRY retained hundreds of millions of LBC tokens for themselves, thus signaling to investors that it was committed to working to improve the value of the token.

Judge Barbadoro flatly rejected LBRY’s defense that the LBC token cannot be a security because the token has utility.⁵ The judge noted, “Nothing in the case law suggests that a token with both consumptive and speculative uses cannot be sold as an investment contract.” Likewise, Judge Barbadoro was unmoved by LBRY’s argument that it had no “fair notice” that the SEC would treat digital assets as unregistered securities simply because this was the first time the SEC had brought an enforcement action against an issuer of digital currency.⁶

In sum, if Judge Barbadoro’s reasoning is applied more broadly to the thousands of digital assets that have emerged over the last several years—including companies that tout the so called “utility” of their tokens—they will all likely be deemed digital asset securities that were offered and sold without a registration or an exemption from registration.

The LBRY decision is yet another case in which a court has concluded a digital asset is a security. Developers of digital assets must proceed with a high degree of caution. The SEC continues to display a high degree of willingness to initiate investigations and enforcement actions against issuers of digital assets that are viewed as securities under the Howey and Reeves tests, investment companies, or security-based swaps.

For more Securities Law and Digital Assets news, click here to visit the National Law Review.

FOOTNOTES

¹The SEC defines “digital assets” as intangible “asset[s] that [are] issued and transferred using distributed ledger or blockchain technology.” Statement on Digital Asset Securities Issuance and Trading, Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets, SEC (Nov. 16, 2018), available here.

²SEC v. LBRY, Inc., No. 1:21-cv-00260-PB (D.N.H. filed Mar. 29, 2021), available here. A copy of the complaint against LBRY can be found here.

³See, e.g., Gary Gensler, Speech – “A ‘New’ New Era: Prepared Remarks Before the International Swaps and Derivatives Association Annual Meeting” (May 11, 2022) (“My predecessor Jay Clayton said it, and I will reiterate it: Without prejudging any one token, most crypto tokens are investment contracts under the Supreme Court’s Howey Test.”), available here. Section 5(a) of the Securities Act of 1933 (the “Securities Act”) provides that, unless a registration statement is in effect as to a security, it is unlawful for any person, directly or indirectly, to sell securities in interstate commerce. Section 5(c) of the Securities Act provides a similar prohibition against offers to sell or offers to buy securities unless a registration statement has been filed.

⁴SEC v. W.J. Howey Co., 328 U.S. 293 (1946). This case did not address when digital assets could be deemed debt securities under the test articulated by the U.S. Supreme Court in Reves v. Ernst & Young, 494 U.S. 56, 66-67 (1990), or when digital assets could be deemed an investment company under the Investment Company Acy of 1940. See, e.g., In the Matter of Blockfi Lending, Feb. 14, 2022, available here. This case also does not address when a digital asset is a security-based swap. See, e.g., In the Matter of Plutus Financial, Inc., (July 13, 2020), available here.

⁵The argument a digital asset is not a security because it has “utility” is a favorite argument of critics of the SEC’s enforcement actions against issuers of digital assets. Unfortunately, the “utility” argument appears to be of little merit when the digital asset is offered and sold to raise capital.

⁶This is an argument that has been made by a number of defendants in SEC enforcement actions involving digital asset securities.

Is Crypto Collapsing?

November 11, 2022, brought news of yet another massive crypto bankruptcy filing. One of the largest crypto exchanges, FTX, filed a petition for bankruptcy protection in Delaware. FTX, Alameda, and other affiliates estimated in their filings that they have more than 100,000 creditors. With their estimated range of between $10 and $50 billion worth of assets and liabilities, this could well be the largest crypto-related bankruptcy ever filed.

This follows a slew of other big names in crypto which have filed bankruptcy petitions recently, including lender Three Arrows Capital (3AC) and the Celsius crypto exchange. Others have sought similar protections overseas, such as Zipmex’s proceeding in Singapore.

Why are these companies filing bankruptcy? The reasons vary.

Business models built on unsustainable growth rates in cryptocurrency prices
Collapse in cryptocurrency prices, leading to “runs on the bank”
Financial irregularities

Is your crypto safe? That depends on what it is and where you park it. Some newer tokens and wallet software may not have been extensively tested, and so may have weak points that an attacker might exploit. Even “safe” currencies like Bitcoin can be hacked if stored in a hot wallet. Of particular interest, customers of a bankruptcy exchange may find it difficult to recover their crypto deposits because their investments may be treated as mere unsecured claims against the exchange, drastically reducing the odds of recovery.

Filings by crypto-based entities come with a host of thorny issues. The most obvious is whether a crypto exchange’s bankruptcy estate owns the tokens it holds for others. But there are many others, including privacy concerns with respect to what previously were anonymous transactions and questions about the propriety of large financial withdrawals by high-ranking individuals in the days surrounding the filing of bankruptcy petitions.

For More FinTech Legal News, click here to visit the National Law Review.

OFAC Offers Guidance in the Wake of Tornado Cash Sanctions

The U.S. Treasury Department’s Office of Foreign Asset Control (OFAC) updated its “frequently asked questions” (FAQs) Tuesday, providing guidance relating to the sanctions against Tornado Cash, the Ethereum “mixer” it blacklisted in August, following allegations that North Korea used Tornado Cash to launder stolen digital assets. The updated information from OFAC comes as a welcome snippet of communication, allowing for clarity on the scope of the action taken against Tornado Cash, as well as providing guidance for U.S. persons affected by the blacklisting who, through no fault of their own, were caught up in federal action.

The updated FAQs provide guidance on four points: (1) the ability to withdraw funds from wallets associated with the Tornado Cash blacklist; (2) whether the OFAC reporting obligations apply to “dusting” transactions; (3) whether U.S. persons can engage in transactions involving addresses implicated in the blacklist without a license; and (4) what, more generally, is prohibited in the wake of the OFAC blacklisting of Tornado Cash.

(1) Withdrawing Funds

If a U.S. person sent virtual currency to Tornado Cash, but did not complete the mixing transaction or otherwise withdraw such virtual currency prior to August 8, 2022 (the effective date of the OFAC blacklist), such person can request a specific license from OFAC to engage in transactions involving that virtual currency (assuming such person conducts the contemplated transactions within U.S. jurisdiction).

In order to obtain this license, such persons will need to provide, “at a minimum, all relevant information regarding these transactions with Tornado Cash, including the wallet addresses for the remitter and beneficiary, transaction hashes, the date and time of the transaction(s), as well as the amount(s) of virtual currency.”

OFAC indicates that they will embrace a favorable licensing policy towards such applications, so long as the contemplated transactions did not involve conduct that it deems to be otherwise sanctionable, and that licensing requests can be submitted by visiting the following link: https://home.treasury.gov/policy-issues/financial-sanctions/ofac-license-application-page.

(2) “Dusting” Transactions

Dusting is the act of sending unsolicited and nominal amounts of virtual currency or other digital assets to third parties. This can be done in order to cause consternation on the part of the recipient, particularly in a situation where there is confusion as to the legality of receiving such funds or actions.

OFAC indicates that it has been made aware of Dusting involving virtual currency or other virtual assets from Tornado Cash, and indicates that while, technically, OFAC’s regulations would apply to these transactions, to the extent that these Dusting transactions have no other sanctions associated with them other than Tornado Cash, “OFAC will not prioritize enforcement against the delayed receipt of initial blocking reports and subsequent annual reports of blocked property from such U.S. persons.”

In short, while not a desirable transaction to take place, OFAC does not intend to pursue action against persons simply because they are the target of Dusting.

(3) Engaging in Transactions With Tornado Cash

OFAC clarified that, without explicit license from OFAC, U.S. persons are prohibited from engaging in any transaction involving Tornado Cash, including any transaction done via currency wallet addresses OFAC has identified as part of the blacklist.

Specifically, “[i]f U.S. persons were to initiate or otherwise engage in a transaction with Tornado Cash, including or through one of its wallet addresses, such a transaction would violate U.S. sanctions prohibitions, unless exempt or authorized by OFAC.”

(4) Further Tornado Cash Guidance

Referencing FAQs 561 and 562, OFAC reemphasized their authority to include as identifiers on the Specially Designated Nationals and Blocked Persons List (SDN List) specific virtual currency wallet addresses associated with blocked persons, and that such SDN List entry for Tornado Cash included as identifiers certain virtual currency wallet addresses associated with Tornado Cash, as well as the URL address for Tornado Cash’s website.

While the Tornado Cash website has been deleted, it remains available through certain Internet archives, and accordingly OFAC emphasized that engaging in any transaction with Tornado Cash or its blocked property or interests in property is prohibited for U.S. persons.

Interacting with open-source code itself, in a way that does not involve a prohibited transaction with Tornado Cash, is not prohibited. By way of example, “U.S. persons would not be prohibited by U.S. sanctions regulations from copying the open-source code and making it available online for others to view, as well as discussing, teaching about, or including open-source code in written publications, such as textbooks, absent additional facts. Similarly, U.S. persons would not be prohibited by U.S. sanctions regulations from visiting the Internet archives for the Tornado Cash historical website, nor would they be prohibited from visiting the Tornado Cash website if it again becomes active on the Internet.”

While this update to FAQs come as a welcome bit of clarity, Web3 investors, entrepreneurs, and users should continue to tread carefully when engaging with opportunities and technologies on the periphery of Tornado Cash and the accompanying OFAC action. When questions arise, it is important to seek out informed counsel, to discuss the risks of proposed actions and how best to mitigate that risk while working to pioneer new and emerging technologies.

Article By David A. Lopez-Kurtz of Dinsmore & Shohl LLP

For more finance and cryptocurrency legal news, click here to visit the National Law Review.

Federal Reserve Doubles Down on Oversight of Crypto Activities for Banks

The Federal Reserve Board (the “FRB”) issued Supervision and Regulation Letter 22-6 (“SR 22-6”), providing guidance for FRB-supervised banking organizations (referred to collectively herein as “FRB banks”) seeking to engage in activities related to cryptocurrency and other digital assets. The letter states that prior to engaging in crypto-asset-related activities, such FRB banks must ensure that their activities are “legally permissible” and determine whether any regulatory filings are required. SR 22-6 further states that FRB banks should notify the FRB prior to engaging in crypto-asset-related activities. Any FRB bank that is already engaged in crypto-asset-related activities should notify the FRB promptly regarding the engagement in such activities, if it has not already done so. The FRB also encourages state member banks to contact state regulators before engaging in any crypto-asset-related activity.

These requirements send a clear message to FRB banks and in fact to all banks that their crypto-asset related activities are considered to be risky and not to be entered into lightly.

Indeed, the FRB noted that crypto-asset-related activities may pose risks related to safety and soundness, consumer protection, and financial stability, and thus a FRB bank should have in place adequate systems, risk management, and controls to conduct such activities in a safe and sound manner and consistent with all applicable laws.

SR 22-6 is similar to guidance previously issued by the OCC and FDIC; in all cases, the agencies require banks to notify regulators before engaging in any kind of digital asset activity, including custody activities. The three agencies also released a joint statement last November in which they pledged to provide greater guidance on the issue in 2022. Further, in an August 17, 2022 speech, FRB Governor Bowman stated that the FRB staff is working to articulate supervisory expectations for banks on a variety of digital asset-related activities, including:

custody of crypto-assets
facilitation of customer purchases and sales of crypto-assets
loans collateralized by crypto-assets, and
issuance and distribution of stablecoins by banking organizations

Interestingly, SR 22-6 comes a few days after a group of Democratic senators sent a letter to the OCC requesting that the OCC withdraw its interpretive letters permitting national banks to engage in cryptocurrency activities and a day after Senator Toomey sent a letter to the FDIC questioning whether it is deterring banks from offering cryptocurrency services.

Although past guidance already required banks to notify regulators of crypto activity, this guidance likely could discourage additional banks from entering into crypto-related activities in the future or from adding additional crypto services. In the end, it could have the unfortunate effect of making it more difficult for cryptocurrency companies to obtain banking services.

Article By Grant F. Butler, Jeremy M. McLaughlin, Anthony R.G. Nolan, and Judith E. Rinearson of K&L Gates

For more finance and banking legal news, click here to visit the National Law Review.

Tag: cryptocurrency

Cryptocurrency Brings Disruption to Bankruptcy Courts—What Parties Can Expect and the Open Issues Still To Be Resolved (Part Two)

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