Crypto Exchanges Grapple With Aftermath of Bankruptcy Filing | Patterson Belknap Webb & Tyler LLP

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In the world of cryptocurrency, exchanges act as intermediaries allowing investors to buy and sell assets while earning money through commissions and transaction fees. All assets purchased may be held in non-custodial or custodial wallets. If a client chooses a custodial wallet, the platform holds and manages the assets via a private key, which is a string of characters that serves as a password. If a key is lost or forgotten, it may not be possible to retrieve it, resulting in the permanent loss of the asset. In contrast, assets held in non-custodial wallets remain under the control of the client with a private key.

Exchanges also operate similarly to traditional stockbrokers that facilitate the trading of investment products that are generally not held in the name of the beneficial owner. However, brokerage firms must be members of the Securities Investor Protection Corporation (“SIPC”), which is a not-for-profit corporation that protects investors’ cash and securities in the event that brokerage firms go bankrupt. When a company files for bankruptcy, SIPC provides insurance coverage that will help replace or restore customers’ cash and investments. There is no SIPC or equivalent protection for cryptocurrency.

This poses a potential risk to clients of cryptocurrency exchange platform companies when assets are held in custodial wallets. If a company files for bankruptcy, client investments held in custodial portfolios could be considered property of the bankrupt company. If so, immediately after filing for bankruptcy, custodial wallet users would not be able to sell their assets or remove them from the platform without court approval. Since companies facing bankruptcy usually try to keep an early filing silent in order to prevent creditors from taking adverse action, customers may unexpectedly lose control of their crypto assets.

In addition, a debtor may use or sell his property either in the ordinary course of business or with the permission of the court. Although the bankruptcy code offers certain guarantees to interested parties when a debtor seeks to sell assets, including the right to adequate protection such as periodic cash payments or replacement privileges, it is not clear how these protections would apply to customers of a bankrupt cryptocurrency. trading platform. It is conceivable that a debtor holding cryptocurrency in custodial wallets on behalf of its clients could sell those assets without the client’s consent.

In addition, these customers cannot have any priority right to the proceeds of the sale; instead, these products can simply be distributed in accordance with the order of priority established in the Bankruptcy Code. In all likelihood, customers would be treated as general unsecured creditors who would receive no recovery until all other creditors were paid in full, with any resulting recovery earning pennies on the dollar.

Given these risks, some industry watchers have advised cryptocurrency investors to move their assets into non-custodial wallets, where exchanges have less access and control. While a viable option, some merchants may prefer custodial wallets and the convenience of not having to remember or store their private keys. For those weighing their options, it is useful to consider how an actual failure of an exchange may unfold.

First, this is an untested area of ​​law, so it is uncertain whether bankruptcy courts will find that cryptocurrency held in custodial accounts should be treated as platform assets. in the event of bankruptcy. But, from a practical standpoint, it is also unclear whether debtors would actually benefit if client assets were considered the property of a bankruptcy. Generally, a debtor looking to continue business after bankruptcy will want to avoid doing anything that will alienate customers because they are the lifeblood of the debtor’s business. Rather than selling client assets, the debtor could go to great lengths to reassure clients of the security of their crypto assets.

Alternatively, if a sale were contemplated, it might be more attractive for the debtor to sell their entire business, or at least their clients’ accounts, to competing platforms rather than liquidate the cryptocurrency held in wallets. on guard. This type of operating sale should leave customers intact, while hopefully generating enough revenue to provide significant recoveries to other creditors. Moreover, this type of sale would also avoid flooding the crypto market, which could occur in the event of a massive sale of crypto assets held in custodial wallets and which would lead to both lower prices and lower prices. the value of transactions.

Second, as noted above, it is unclear whether clients could successfully argue for adequate protection, but clients would certainly have standing to oppose any proposed sale of assets on this basis. Although adequate protection is generally afforded to secured creditors, there may be an acceptable argument that, in the event that a debtor seeks to sell assets held in custodial portfolios, clients have an interest in those assets and are therefore entitled to adequate protection. Again, the law is untested, but simply raising these objections (and not necessarily winning them) may be enough leverage for clients to negotiate more favorable treatment, as the debtor and its creditors may want to avoid an unfavorable decision and/or costly litigation. Helpfully, account holders could mitigate legal costs by forming an ad hoc group that hires a set of professionals to defend the interests of the group. More generally, acting together in a group can give these clients a stronger position throughout the bankruptcy case compared to those acting alone.

In conclusion, while the failure of exchanges is another risk of investing in cryptocurrency, the quintessential risk-seeking cryptocurrency investor may not be so easily scared off. Even so, users of custodial wallets should continue to monitor the financial health of their exchange platform. There is no doubt that the possibility of an exchange seizing its client’s assets to pay off other creditors in the event of bankruptcy is probably less likely than a collapse in the value of cryptocurrency holdings. of an investor.

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