U.S. Bankruptcy Court Is Promoting Improvement of Cryptocurrency Legal Framework

Source: TaxDAO

Cryptocurrencies are becoming a media focus and a target of the SEC. Concerned about ongoing fraud and market manipulation in the global currency market, which is valued at more than $2 trillion, the SEC and other regulators have attempted to use existing regulations to crack down on cryptocurrency companies to protect investors. This has pushed new issues and disputes to the US courts, and the judiciary has been forced to bridge the regulatory gap by interpreting old regulations to address new issues. Inevitably, inconsistent interpretations and applications have created an uncertain outlook for cryptocurrency companies and legal practitioners.

1. What is the current regulatory environment for the US cryptocurrency industry?

Despite the growing popularity of cryptocurrencies, the US Congress has not yet introduced any legislation specifically targeting cryptocurrencies. Laws and regulations designed for traditional financial instruments are not easily applicable to cryptocurrencies, but regulators and courts have had to apply these inappropriate rules to crypto instruments and platforms. First, it is unclear how cryptocurrencies should be classified, and therefore what regulations apply to companies in the industry. In the landmark 2014 case SEC v. Shavers in the U.S. District Court for the Eastern District of Texas, the traditional Howey test (derived from the 1946 Supreme Court case SEC v. W.J. Howey Co.) was applied to classify cryptocurrencies (in this case, Bitcoin tokens) as “securities” and therefore regulated by the SEC. However, in a subsequent case before the U.S. Commodity Futures Trading Commission — the 2015 case In re Coinflip Inc. — cryptocurrencies were classified as commodities under the Commodity Exchange Act. The classification of digital assets also affects which regulators have jurisdiction over cryptocurrency issues. Classification as a security places cryptocurrencies under the jurisdiction of the SEC, but classification as a commodity gives the CFTC oversight authority. Other agencies may also have jurisdiction — the Public Company Accounting Oversight Board, the Internal Revenue Service, the Financial Crimes Enforcement Network, or the U.S. Department of Justice, as well as state authorities. The multiplicity of regulators only adds to the confusion and unpredictability of the industry. Many companies operating in the crypto industry are private and therefore not subject to the stricter rules and reporting requirements that apply to public companies. Private companies are not required to provide audited financial statements or file reports with the SEC. Some cryptocurrency companies have published audited financial data, including proof of reserves reports, but the rigor of such audits has been questioned. FTX was famously audited by not one but two accounting firms before its collapse. The SEC has since filed hundreds of charges against one of the auditing firms for auditor independence violations.

2. The SEC’s aggressive enforcement is pushing crypto issues into bankruptcy court

Intensified scrutiny and enforcement have created an uncertain and risky environment for cryptocurrency companies, while the industry has also seen significant bankruptcy filings. In May 2022, the SEC announced that it would nearly double the staffing of its cryptocurrency enforcement unit and renamed it the “Crypto Assets and Networks Unit” to reflect its growing focus on cryptocurrencies. It has since initiated 26 enforcement actions against companies in the cryptocurrency space in 2023 alone, including actions in January 2023 against Genesis Global Capital LLC and Gemini Trust Company LLC, alleging unregistered securities offerings in connection with the Gemini Earn program. The SEC’s action was the final straw for Genesis, which filed for bankruptcy a week later, owing more than $3.4 billion to creditors. Genesis recently settled with the SEC for $21 million. The SEC then sued Bittrex and its co-founder William Shihara, alleging they operated an unregistered national securities exchange, broker-dealer, and clearing agency. Just three weeks later, the company filed for bankruptcy in Delaware Bankruptcy Court. Bittrex settled for $24 million. The SEC has also taken action against many other high-profile companies, including Kraken, Binance, and Coinbase Global Inc. Concerned about mismanagement of assets and possible illegal conduct, the Securities Commission of the Bahamas, where FTX is based, froze the company’s assets, suspended its registration, and filed for provisional liquidation. In just 10 days, the company was out of business. There are no signs that the push to tighten regulation of the cryptocurrency market will abate. After FTX’s collapse, the SEC was criticized for not doing more to protect American investors, and it has since aggressively pursued other cryptocurrency companies and executives.

In announcing the Gemini and Genesis actions, SEC Chairman Gary Gensler said:

Today’s charges build on previous actions and are intended to make clear to the market and the investing public that cryptocurrency lending platforms and other intermediaries must comply with our time-tested securities laws. Doing so best protects investors. It fosters trust in the marketplace. It is the law that is not negotiable (action).

Lawmakers are also pushing the envelope. Multiple legislative proposals related to cryptocurrency regulation are under consideration in the U.S. House of Representatives and Senate, and politicians from both parties generally support increased regulation.

3. Bankruptcy Courts Are Making Crypto Law

As cryptocurrency matters are referred to U.S. bankruptcy courts (usually in Delaware), the judiciary is forced to fill the regulatory gap and become the arbiter and legislator in the field. Seemingly inconsistent decisions and conflicting interpretations of inappropriate regulations only create more problems for practitioners and stakeholders in the cryptocurrency industry.

3.1 How to Classify Crypto Assets?

Currently, the classification of cryptocurrency assets is unclear. The Shavers case applied the Howey test to determine that Bitcoin tokens were investment contracts and therefore securities. By ruling that Bitcoin tokens were securities, they were brought within the SEC’s regulatory framework. However, the SEC was dealt a blow in a subsequent July 2023 decision by the District Court for the Southern District of New York in SEC v. Ripple Labs Inc., where the court ruled that Ripple’s XRP tokens were not securities and therefore were not subject to the registration requirements for securities offerings. Rather than accepting the SEC’s position that all crypto assets were securities, the court in the Ripple case applied the Howey test to each type of transaction and considered the overall circumstances of each transaction. The court ruled that only one of the four types of XRP transactions met the Howey test for a security. As a result, it is difficult for practitioners to predict how courts will evaluate and classify crypto assets in future cases, especially given the nuances of the technology and its rapid development.

3.2 How and when are cryptocurrencies valued?

In their short history, the value of cryptocurrencies has proven to be extremely volatile.

U.S. bankruptcy law does not specify when crypto assets should be valued, so courts make their own decisions. Some choose the filing date, some choose the date when the debtor transfers assets, and some choose the date of the recovery action. In November 2022, when FTX filed for bankruptcy, Bitcoin was valued at $16,871. As of March 13, Bitcoin's valuation has increased to $73,083. This volatility, coupled with the surge in litigation and bankruptcies following the so-called cryptocurrency winter, makes valuation decisions critical. In the FTX bankruptcy case, the U.S. Bankruptcy Court for the District of Delaware ruled that FTX's digital assets, including Bitcoin and other digital currencies, should be valued at November 2022 prices, resulting in significant losses for FTX customers who have been unable to access their cryptocurrencies since the company filed for bankruptcy. Outside the bankruptcy field, courts are forced to value crypto assets to determine damages, debts, and even succession decisions. Crypto asset valuations can also affect the strategy or feasibility of litigation or arbitration in this field. It is expected that the law in this field will continue to evolve like technology as companies, creditors, customers, and investors continue to compete for the most favorable valuations.

3.3 Does the Automatic Stay Protect Assets from Civil or Criminal Forfeiture?

When a bankruptcy petition is filed, Section 541 of the Bankruptcy Code creates a bankruptcy estate consisting of all of the debtor’s assets and imposes an automatic stay to protect those assets and prevent lawsuits from being filed against the debtor or his estate during the bankruptcy. Limited exceptions to the automatic stay include criminal activity and government enforcement or regulatory powers. However, the DOJ has seized crypto assets under its criminal and civil forfeiture powers in a number of high-profile crypto cases, raising controversy over whether ownership of crypto assets belongs to the debtor or the user, whether crypto assets can be lawfully seized while the automatic stay applies, and whether criminal courts or bankruptcy courts have jurisdiction over these issues. In the BlockFi case, the DOJ seized the company’s assets under criminal and civil forfeiture arguing that the automatic stay did not apply. In the FTX case, the DOJ seized approximately $150 million in cryptocurrency held in FTX bank accounts as well as cash deposits and other assets following its criminal indictment of Bankman-Fried. Crypto companies cannot assume that the automatic stay will protect them in bankruptcy, and crypto customers must remain vigilant about the risks posed by holding crypto assets in an unpredictable industry.

3.4 Can Creditor Anonymity Survive a Crypto Bankruptcy?

Under Section 107(a) of the Bankruptcy Code, all documents filed in bankruptcy are public records and available for inspection, but anonymity is a fundamental principle of cryptocurrency trading. Bankruptcy courts have the unwelcome task of reconciling these conflicting positions, but unfortunately, bankruptcy courts are not unanimous on this issue. Multiple court decisions, such as last year's decision by the U.S. Bankruptcy Court for the District of Delaware regarding FTX trading, have protected the anonymity of cryptocurrency customers in bankruptcy. However, some places have not done so, such as the 2022 Southern District of New York case in Celsius Network, where the court held that customer addresses, phone numbers, and email addresses should be kept confidential, but customer names should be disclosed. The court held that names do not constitute commercial or personally identifiable information under the Bankruptcy Code and do not meet the exceptions to the disclosure policy in bankruptcy cases. Crypto companies and customers must once again prepare for the unpredictability of the industry.

4. Conclusion

Some have described the cryptocurrency industry as the “Wild West.” The SEC’s aggressive stance reflects a growing awareness of the risks of this nascent industry. However, the resulting confusion, inconsistent court decisions, and an increase in bankruptcy filings highlight the urgent need for a comprehensive regulatory framework. It is clear that coordination among regulators, lawmakers, and industry participants is essential to nurturing the development of the cryptocurrency industry so that it can move beyond its current Wild West image and evolve into a well-regulated and thriving frontier of the financial world.