Cryptocurrency Exchange Insolvencies May Force Reg Action

April 29, 2014Articles Law360

Reprinted with permission from Law360. (c) 2014 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.

There has been much in the news in the last several months regarding the downward spiral of Mt. Gox into insolvency, its collapse and ultimate insolvency filings. Mt. Gox was the world’s largest bitcoin exchange at the time of its collapse. Since the Mt. Gox insolvency filings and commencement of related litigation, there have been several articles talking about Mt. Gox customer/account holder claims in the bankruptcy proceedings and what to file, how, etc.

However, there is an issue that has yet to really surface and it is one that is necessarily tied to the more global issue of cryptocurrency (aka virtual currency) regulation in the United States and other countries, including Japan, which is where Mt. Gox is headquartered.

The lack of regulation of cryptocurrency systems such as Bitcoin (and the exchanges that deal in them) creates an interesting, and potentially problematic, situation for possible claim holders of an insolvent exchange like Mt. Gox, the insolvent exchange itself (or bankruptcy trustee) and the courts involved in its insolvency proceedings.

Simply stated, what exactly are customers’ claims against an exchange such as Mt. Gox (or any other insolvent cryptocurrency exchange) and what is the legal basis for such claims? Little or no regulation of cryptocurrencies and cryptocurrency systems, as well as the exchanges that deal in them, (as is the case in the jurisdictions of the Mt. Gox insolvency proceedings) means that the answer to that question is what one might consider a legal gray area. Such a situation could have an unanticipated impact on what the government does next.

These issues are centered on Mt. Gox in this article because it’s the first cryptocurrency exchange to enter formal insolvency proceedings, but it may not be the last, as evidenced by the recent problems encountering other exchanges such as Vircurex, Flexcoin and CryptoTrade.[1]

Furthermore, cryptocurrency exchanges are often thinly capitalized companies that are not required to meet minimum capital requirements like other financial intermediaries, and thus may not be able to absorb much risk despite seemingly taking on significant risk at times (and in an insecure environment).[2]

Finally, all hope may not be lost for Mt. Gox and its customer/creditors, as will be discussed below, and the situation with Mt. Gox is in flux at the moment. Thus, this article is in no way predicting what will happen with Mt. Gox; it merely uses Mt. Gox as an example to explore the issues set forth above.

But before the issues are addressed, some background is necessary.

Cryptocurrency

Cryptocurrency is an alternative, digital medium of exchange using peer-to-peer networking and open-source software. By and large, most cryptocurrencies are based (in whole or part) on Bitcoin as to creation (mining) and transfer.

Transfers of ownership, such as using bitcoin in a commercial transaction, are broadcast to the bitcoin network showing transfer from one bitcoin address (bitcoin wallet) to another address. Due to the nature of virtual currencies, discussion of regulating them is really about regulating transactions in virtual currencies rather than the currency itself (because it is open source).

Mt. Gox Insolvency Proceedings

According to Mt. Gox, its descent into insolvency was created by a massive theft(s) (or disappearance) of bitcoin in Mt. Gox’s possession by unknown black-hat hackers. The amount of bitcoin stolen is alleged by Mt. Gox to be 744,408 of its customer’s bitcoins and 100,000 of its own bitcoins. Mt. Gox has stated that the theft was achieved by exploiting a flaw in the software algorithm that underlies Bitcoin (interestingly, there is no mention in Mt. Gox disclosures about any deficiencies in its own security system and software).

As a result, on Feb. 24, 2014, Mt. Gox filed for reorganization in Tokyo where it is headquartered, under the Japanese Corporate Reorganization Act. The JCRA is for companies seeking to reorganize, similar to Chapter 11 in the United States, but different at the same time.

For example, in a JCRA proceeding, a supervisor and examiner is appointed right at the inception of the proceeding, and the supervisor has wide-ranging powers, though a JCRA debtor does remain “in possession” like a Chapter 11 debtor. Under the JCRA, if accepted for reorganization, Mt. Gox would be given time to formulate a reorganization plan, solicit votes from creditors and seek Japanese court approval.

However, on April 16, 2014, the Japanese court dismissed the company’s bid to reorganize Mt. Gox. The court entered an order for provisional administration and put the Mt. Gox assets under the supervisor’s control until liquidation proceedings officially begin and a bankruptcy trustee is appointed.

Subsequently, on April 24, 2014, the Tokyo court entered an order for the commencement of the bankruptcy proceedings of Mt. Gox and appointed the supervisor/administrator as the bankruptcy trustee.[3] The bankruptcy trustee will administer the Mt. Gox bankruptcy estate and liquidate (or “realize”) assets, as well investigate potential claims of Mt. Gox. At the time of the original filing, Mt. Gox disclosed that it had approximately $38 million in assets and $64 million in liabilities. Importantly, Mt. Gox had approximately 127,000 customers/potential creditors at the time of the original filing.

Shortly after the commencement of the JCRA proceeding, on March 9, 2014, Mt. Gox filed a Chapter 15 petition in the Northern District of Texas, Dallas Division, seeking, among other things, recognition of the JCRA proceeding as a foreign main proceeding and for certain provisional relief, such as a provisional stay of litigation against Mt. Gox in the United States, which is specifically two pending actions: Coinlab v. Mt. Gox KK et al[4]and Greene et al. v. Mt. Gox Inc. et al. (the class action).[5]

The provisional relief requested by Mt. Gox was granted, the litigation has been temporarily stayed and the class action litigants have taken the fight into the Dallas Bankruptcy Court over, among other things, the Chapter 15 recognition, the provisional relief and related discovery. It will remain to be seen what impact the denial of the JCRA reorganization and the bankruptcy filing has on the United States proceedings.

However, the situation with Mt. Gox is still somewhat in flux and there have been efforts by a group of investors to try to salvage Mt. Gox and its reorganization. The investors had asked for reconsideration of the Japanese court order dismissing the restructuring, which is moot now that Mt. Gox is formally in bankruptcy.

These investors have taken to the press and launched the website, www.savegox.com , in an effort to garner support from Mt. Gox customers/creditors. It will be interesting to see if the investors try to pursue an acquisition deal with the bankruptcy trustee for the Mt. Gox assets.

Cryptocurrency Regulation

In the United States, the regulation of crytpocurrencies is virtually nonexistent. After a number of hearings in late 2013, Congress decided that they would not focus on regulation of cryptocurrencies yet. It (or at least certain parties dealing in cryptocurrencies) has been made subject to U.S. anti-money laundering regulations at the disposal of the United States Financial Crimes Enforcement Network, and the IRS has come out and stated that cryptocurrencies are “assets” for tax purposes. But there has been nothing else as far as regulation in the United States, even to simply provide a legal definition of what exactly is cryptocurrency.

At the state level in the United States, there has been no regulation as of yet. Earlier this year, a group of nine states announced that they are investigating the regulation of virtual currencies. New York is trying to lead the way by publicly announcing it is going to regulate it later this year. However, nonuniform, state-by-state regulation of virtual currencies is more likely to create more problems than it attempts to solve.

Bankruptcy Claims: General

The U.S. Bankruptcy Code provides simply that “a ‘claim’ [is] a right to payment ... or breach of an equitable remedy that gives rise to a right to payment ....”[6] However, U.S. bankruptcy practitioners know that in reality, it’s not so simple. In terms of the claims process, the filing of a claim in bankruptcy does not ultimately mean a potential creditor will have an allowed claim in the bankruptcy proceeding. In order to do so, a claimant typically needs to have a legal basis and factual support for the claim.

Bankruptcy Claims: Mt. Gox Customers and Lack of Regulation/Law

Anyone looking at the potential claims of customers of an insolvent cryptocurrency exchange such as Mt. Gox would think that surely they have claims under U.S. bankruptcy law. After all, they deposited traditional money and bitcoins in accounts held and controlled by Mt. Gox.

Leaving the factual issues aside, articulating the legal basis for how this translates into an allowed bankruptcy claim, without existing law or regulation, is where things are not so clear-cut. Strong evidence of this is a review of the complaint and amended complaint filed in the class action, which had to take a “kitchen-sink” approach to customer claims and lists 18 causes of action ranging from general civil consumer fraud, breach of contract, trespass against chattels (personal property in the 21st century) to conversion of personal property. So, asserting customer claims against Mt. Gox, or any other insolvent exchange, is currently a wide open affair and subject to many possible legal theories.

So, in any bankruptcy proceeding in the United States for an insolvent cryptocurrency exchange like Mt. Gox, the issues that are really central to cryptocurrency regulation would have to be dealt with through the bankruptcy claims process. That means the important questions and issues that would typically be addressed through legislation and regulation will all be before the courts to ultimately decide without any legislative and/or regulatory guidance.

These questions and issues include things such as what is the legal definition of cryptocurrency/cryptocurrency system, how do you define the relationship of customers with intermediaries and what law may be applicable (i.e., contract law, payment systems law, etc.), what rights does a holder of cryptocurrency have vis-a-vis third parties, do such rights of holders give rise to claims against intermediaries, what obligations does an intermediary such as an exchange have to its customers, investors and other stakeholders.

In the absence of legislation and/or regulation, court decisions in exchange insolvencies would become, at a minimum, de facto law. That could be problematic for United States lawmakers and regulators, because they may not like the way the courts decide the issues and the court-made law that is created, ultimately leaving Congress and regulators with no choice but to take action.

Whether this is positive or negative depends on your viewpoint, but in either scenario, a formal exchange insolvency would likely result in some level of cryptocurrency law and regulation whether it’s court-made, legislated or a combination of the two.

Reprinted with permission from Law360. (c) 2014 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.