Crypto Winter Series: Principles of Bankruptcy, Insolvency and Liquidation for Crypto Investors | Part 2 of 3

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In bankruptcy parlance, the look-back period does not sound good for the crypto industry. Over the past 90 days, the cryptocurrency markets have suffered huge losses, and over the past 14 days, two major players have filed for bankruptcy protection. In the previous 365 days, nearly three trillion dollars of value was withdrawn from the digital wallets of cryptocurrency investors, and the industry was forced to cut thousands of jobs. In this context, our blockchain team publishes a series of articles to provide you with information to understand the legalities behind the developments of “crypto winter”. While many established players will brave the storm, which will also give rise to new opportunities, there is a lot of blood in the water.

Part 1 of our Crypto Winter series, which is available hereexamines lessons learned from recent bankruptcies to hit the crypto space, including the debate surrounding Three Arrows Capital (3AC) and Voyager filings.

Market forces create legal uncertainty

In the space of 10 years, cryptocurrency has evolved from an obscure “peer-to-peer” cash system discussed in online chat rooms to a Main Street investment class that, until recently, many financial advisors were touting it as a valuable asset to diversifying a 401k plan. This optimism is questioned by some analysts who predict a total collapse of the cryptocurrency market. While a total collapse is unlikely, the questions now are, first, how far will the market collapse go and, second, will Wall Street’s fleeting perception of the value of cryptocurrency assets become a major thorn in the side of traditional finance? players?

Those of us in the restructuring world are about to get a front-row seat to how the unique characteristics of cryptocurrency and blockchain will impact the success or failure of businesses forced to seek bankruptcy protection due to their investment in cryptocurrency and the related impact on customers and investors. On July 1, 2022, Three Arrows Capital, Ltd (3AC) filed for Chapter 15 bankruptcy in the United States Bankruptcy Court for the Southern District of New York as a national counterpart to the liquidation proceedings that began on June 24 in the British Virgin Islands (BVI). The liquidation/bankruptcy of 3AC was a major trigger that caused Voyager Digital Holdings, Inc. (Voyager) and its related entities to file Chapter 11 bankruptcy petitions in New York on July 7, 2022. Both companies have cited massive losses in the value of the cryptocurrency. as grounds for filing for bankruptcy.

These bankruptcy proceedings are likely to become a road map for investors and begin to answer many legal questions regarding the valuation methodology and classification of cryptocurrency. Historically, bankruptcy courts faced with the challenges of administering cryptocurrency as an asset for the benefit of creditors have avoided these issues. But we anticipate that the 3AC and Voyager cases will bring crypto valuation and classification issues to the fore as investors clamor to recover their cryptocurrency or the cash value of it. Currently, we are evaluating which strategies and tools from the world of bankruptcy and restructuring can be used to answer these cutting-edge questions about the legal nature of cryptocurrency.

Of equal importance will be the arguments of cryptocurrency investors who believed that their cryptocurrency on deposit with the platforms remained theirs instead of being shuffled and potentially lost forever. The terms and conditions of the various cryptocurrency investment platforms will be reviewed, with exposed investors claiming that they were materially misled when depositing their cryptocurrency on a specific platform.

Overview of Bankruptcy for Crypto Investors

Bankruptcy may be an unfamiliar concept to many cryptocurrency investors. As such, a high-level introduction may be helpful to some readers. When a business files for bankruptcy, an “estate” is created that includes all of the debtor’s assets, wherever located, including cryptocurrency. A debtor may file a petition under various chapters of the United States Bankruptcy Code and may pursue the liquidation of assets to settle its debts or undertake a reorganization of its debts and related matters. Importantly, the automatic stay is triggered the moment a debtor files its petition, thereby protecting the debtor’s assets from continued attacks by creditors. A bankruptcy estate can be controlled by a trustee or by the debtor himself as debtor in possession. An additional layer of complexity in bankruptcy exists regarding cryptocurrency – the entities involved are all over the world. Therefore, as we have seen in the 3AC developments, many foreign insolvency proceedings will result in domestic filings to recognize the foreign proceeding.

To further complicate the analysis is whether a Decentralized Autonomous Organization or DAO – a popular concept in cryptocurrency and blockchain – can legally qualify as a debtor under the bankruptcy code. Finally, those who are stakeholders of the debtor, as investors, customers, or coin/token holders, will all want to know how they will be ranked in the creditor priority scheme under the US Bankruptcy Code. Creditor status largely dictates the likelihood of debt collection in bankruptcy, and higher priority debt enjoys greater protections.

In addition to asset classification, we see at least one other issue that needs to be considered. Knowing the value of crypto assets as well as value preservation strategies are essential keys for a liquidator or trustee, as well as any other adviser in a crypto bankruptcy. To protect themselves, creditors should also seek advice from a lawyer familiar with crypto assets. Crypto assets range from Bitcoin (which is well known to traditional mainstream players) to securities tokens which can signify an equity stake in a start-up company. The specific characteristics of a cryptocurrency held by a debtor must be understood by the liquidator or trustee – and the creditors’ lawyer – to avoid loss of value.

In most cases, trustees or liquidators will likely be permitted to convert crypto assets into US dollars. This approach may not be the best strategy for succession. Experience with crypto agreements is essential to preserve the value of crypto assets. For this reason, stakeholders facing a crypto bankruptcy will need to seek out and rely on advisors who are familiar with both the nuances of bankruptcy law and the digital asset market in order to preserve and enhance the value of the estate and , ultimately, recovery from creditors.

The next article in our Crypto Winter series will focus on cryptocurrency classification, specifically, what the classifications are and what they mean for investors and others involved in the bankruptcy process. Our Blockchain and cryptocurrency The team will continue to produce articles to offer insight into management during the crypto winter. If you have specific questions, please contact the authors of this article.

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