Cryptocurrency lender BlockFi filed for Chapter 11 bankruptcy protection on November 28th, a little more than two weeks after FTX, one of the world's largest cryptocurrency exchanges, filed for bankruptcy. Many users have had their assets locked on these platforms and will likely be forced to wait for the conclusion of the Chapter 11 proceedings before receiving any distributions, while other customers were able to make pre-bankruptcy withdrawals. However, even those able to withdraw assets may be in for a rude awakening as the debtors-in-possession or bankruptcy trustees begin to explore clawback – or, here, "preference" – claims against withdrawing customers. Although the crypto bankruptcy cases are in their early stages, some of the initial Bankruptcy Court rulings and positions taken by major stakeholders can shed light on customers' preference exposure and potential defenses. This article will explore potential preference risks and defenses for customers that withdrew crypto assets pre-bankruptcy.
Crypto Clawback: Preference Claims
The Bankruptcy Code's preference statute is designed to equalize treatment among creditors. Preference lawsuits are used by the debtor-in-possession or trustee to recover assets transferred to creditors – i.e., customers – during the period immediately preceding the bankruptcy so that such assets can be administered and distributed according to the Bankruptcy Code. A withdrawing user who is unsuccessful in defending against a preference claim will be forced to return all assets received during the preference period, and then wait to receive the same distribution as those users who were not able to withdraw their assets pre-bankruptcy. Therefore, the stakes are high for these customers – many of whom narrowly escaped with their assets in the first place.
Bankruptcy Code section 547 contains the preference statute, which allows the debtor-in-possession or trustee to "avoid any transfer of an interest of the debtor in property":
Each of the above elements must be present in order for the debtor-in-possession or trustee to sustain a preference claim. Although the Bankruptcy Code does provide that the debtor is presumed to have been insolvent during the 90 days preceding the bankruptcy filing.1
For ordinary users, the look back period for transfers subject to challenge will be the 90 days preceding the date the platform filed bankruptcy. Withdrawals made before that time period would not be subject to preference risk.
For insiders of the debtor – rather than regular customers – the preference period is a full year, which takes into account that insiders actually had visibility and control over the debtor in the period leading up to the bankruptcy filing.
This article will next explore certain unique aspects of the nascent crypto-bankruptcies that offer the potential for precedent-making rulings for the digital currency space.
Voyager: Your Cash is Yours, Your Crypto Is Ours
Only transfers "of an interest of the debtor in property" are subject to clawback, and a ruling in the Voyager Digital Holdings case will bear on what types of withdrawals from a failing crypto firm may give rise to liability.
In In re Voyager Digital Holdings, Inc., Voyager filed a motion to permit customers to withdraw funds from two "for the benefit of" (or "FBO") accounts held at Metropolitan Commercial Bank ("MC Bank"), arguing the funds on deposit in the FBO accounts belonged directly to Voyager's customers and were not property of the bankruptcy estates. 22-10943 (MEW), 2022 WL 3146796, at *1 (Bankr. S.D.N.Y. Aug. 5, 2022). The Creditors Committee, which represents the interests of general unsecured creditors, did not oppose the motion.
The Court analyzed Voyager's Customer Agreement, which provided differing treatment for cash and cryptocurrencies. In short, each customer's cash deposits were held in an omnibus account at Metropolitan Commercial Bank, which was responsible for "the movement of, and holding of, USD in connection with each Account." The customer agreement also stated that the customer, rather than Voyager, was the customer of Metropolitan. The Court also referred to the FBO Account Payment Services Agreement between Voyager and Metropolitan and heard evidence that the FBO agreement did not permit Voyager to hold or take ownership of customer funds.
In contrast, the Customer Agreement disclosed cryptocurrencies were held on the customer's behalf by Voyager and treatment of those assets in the event of an insolvency was uncertain. Further, the agreement stated cryptocurrency would be held in Voyager's own name, granting it certain rights for lending, staking, and rehypothecation "with all attendant rights of ownership." The debtors wielded this language to support their position that cryptocurrency held by Voyager constituted property of the bankruptcy estate.
The Court ruled that cash held in FBO accounts was not property of the estate; it did not rule on whether the cryptocurrency held by Voyager was property of the estate. Interestingly, the Judge qualified his decision, citing the lack of vigorous opposition by creditors (who were overwhelmingly customers) and noting his holding should not be imputed to other cases. Critically, however, for withdrawing customers, the Voyager ruling provides comfort to withdrawing customers that cash held in FBO accounts will likely be protected against clawback claims.
BlockFi: Your Crypto is Mostly Your Crypto
The BlockFi bankruptcy offers a contrast in the terms of its customer agreement as compared to the customer agreement in Voyager. In the section titled "Ownership of Cryptocurrency," BlockFi's terms of service directly addresses the issue of who owns the assets in its non-interest bearing wallet. This section states:
The title to the cryptocurrency held in your BlockFi Wallet shall at all times remain with you and shall not transfer to BlockFi. You hereby represent and warrant to us at all times during which you maintain a balance in your BlockFi Wallet that: (i) any cryptocurrency that you transferred into your BlockFi Wallet is owned by you at the time of transfer; and (ii) you are validly authorized to instruct us to carry out transactions relating to your BlockFi Wallet balance and that all transactions initiated with your BlockFi Wallet are for your own account (or, in the case of business accounts, for your business's account) and not on behalf of any other person or entity. Except as required by a valid court order or applicable law, BlockFi shall not sell, transfer, loan, hypothecate or otherwise alienate cryptocurrency held in your BlockFi Wallet unless specifically instructed by you.
This provision is clear: "title to the cryptocurrency held in your BlockFi Wallet shall at all times remain with you and shall not transfer to BlockFi." The contrast with Voyager's customer agreement – which allowed Voyager to claim title to its customers' cryptocurrency for lending, staking, and rehypothecation – is stark. Thus, not only does the BlockFi customer agreement provide more favorable language for users ultimately seeking to withdraw assets from the platform through the bankruptcy, but similarly offers a better defense against any potential clawback claims arising from pre-bankruptcy withdrawals. The BlockFi bankruptcy case remains in its infancy, but the language in the BlockFi customer agreement provides the potential for a different data point in future litigation over crypto asset ownership.
Ordinary Course of Business in Extraordinary Times
The Bankruptcy Code contains defenses to preference lawsuits. The ordinary course of business defense is one of the most-often asserted. Section 547(c)(2) of the Bankruptcy Code provides that the debtor-in-possession or trustee cannot avoid a preferential transfer:
to the extent that such transfer was in payment of a debt incurred in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was – (A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or (B) made according to ordinary business terms.
The burden of proof for the ordinary course of business defense would be on the customer. The defense is fact-intensive, and the crypto business failures will likely give rise to a host of arguments about whether or not a given transaction was in the ordinary course of a business or under plainly extraordinary circumstances.
Solvency vs. Insolvency
A preference claim against a customer can only succeed if the crypto platform was insolvent at the time that the transfer was made. The Bankruptcy Code lessens the burden on debtors-in-possession and trustees for this element by providing that the debtor is presumed to have been insolvent during the 90 days immediately preceding the bankruptcy filing.2 This presumption, however, is "rebuttable" – meaning that the customer is free to argue that the platform was, in fact, solvent – if the customer has valuation evidence to support such a claim.3 The solvency or insolvency of a crypto business during the latest "crypto winter" would involve – among many other issues – expert testimony regarding the value of the crypto assets and liabilities at given points in time – a challenging task made only more difficult by the violent swings in asset values during the same period.
Bankruptcy Safe Harbors
The Bankruptcy Code contains detailed safe harbors for certain types of securities transactions, which bar a debtor-in-possession or trustee from pursuing preference – or other avoidance – claims under certain circumstances.4
A settlement payment made by (or to) a financial participant in connection with a securities contract, that is made before the commencement of the case, may be insulated from clawback. The courts have held that payments made by (or to) a financial participant to settle a debt may fall within the meaning of "settlement payment" for safe harbor purposes.5 The term financial participant includes entities of a certain net worth that enter into securities contracts.6
Some non-bankruptcy regulatory actions and litigation may lend support to the safe harbor defense by establishing that certain crypto products were securities. For example, BlockFi settled suits with state securities regulators and the SEC alleging its interest-bearing products constituted securities.7 Similarly, several state securities regulators have alleged that the "Earn Rewards" offered by Celsius constitute unregistered securities in the form of interest earning accounts.
While BlockFi's customer-friendly agreement is good news for those who held cryptocurrency in the wallets, the open question is how the assets held in interest-bearing accounts will be treated. Celsius has argued that assets withdrawn from its platform within the 90-day preference window should be subject to clawback if they were held in interest-bearing accounts at any time. Accordingly, the securities transactions safe harbor provisions could prove to be an important defense for customers that were able to liquidate their positions pre-bankruptcy.
Conclusion
The crypto bankruptcies are a new phenomenon that will likely lead to cutting-edge litigation on a host of issues never-before-seen in preference disputes. Those seemingly lucky customers who received withdrawals from failed crypto firms on the eve of bankruptcy would be well-advised to move quickly to explore their potential exposure and strategically plan for possible litigation.
This article was Co-authored by Julian Gurule, a Shareholder in the Los Angeles office of Buchalter
Footnotes
1. See 11 U.S.C. § 547(f).
2. See 11 U.S.C. § 547(f).
3. Lawson v. Ford Motor Co. (In re Roblin Indus.), 78 F.3d 30, 34 (2d Cir. 1996).
4. See 11 U.S.C. § 546(e).
5. Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V., 651 F.3d 329, 339 (2d Cir. 2011).
6. See 11 U.S.C. § 101(22A)
7. See In the Matter of BlockFi Lending LLC, Securities Act Release No. 11029, Investment Company Act Release No. 34503, 2022 WL 462445 (Feb. 14, 2022); see also, In the Matter of BlockFi Lending, LLC, Consent Order, State of New Jersey Bureau of Securities.
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.
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