Potential preference exposure for crypto withdrawals

August 16, 2022 – Crypto customers who withdraw crypto assets from an exchange or custodian within 90 days of the exchange or custodian filing for bankruptcy may be sued to return those crypto assets as preferential transfers under Section 547 of the Bankruptcy Code. There are a number of considerations that are relevant to whether these requirements will be implemented. This article briefly identifies some of these considerations.

Fundamentals of preference law

The purpose of the preference provisions in section 547 is to ensure that all similarly situated creditors are treated equally, and that no one creditor is “preferred” over others in the run-up to a bankruptcy filing. In practice, many people question whether preferential actions provide anything more than additional fees for professionals, but there is little doubt that preferential actions will continue.

A debtor seeking to establish a prima facie case to avoid and recover an allegedly preferential transfer must establish that the transfer:

(1) was a transfer of the debtor’s property;

(2) was made on account of a debt existing at the time of payment;

(3) was made while the debtor was insolvent (ie, the debtor’s debts were greater than its debts);

(4) was made within 90 days prior to the bankruptcy filing date; and

(5) enabled the creditor to receive more than it would have received in a Chapter 7 case, had the transfer not been made.

To the extent that a creditor is required to repay a preferential transfer, that creditor is granted a claim against the debtor for the repaid amount under section 502(h) of the Bankruptcy Code, which effectively puts the creditor in the same position as it would have been. had been inside there would have been no transfer.

There are many defenses to repayment of preferences. For example, payments made in the ordinary course of business (either between the parties or in the creditor’s industry) are insulated from avoidance as preferences. Supply of new value after receipt of an otherwise preferential transfer is also a defence. The Bankruptcy Act’s securities safe harbor provisions provide a defense against preferential liability for certain transactions involving securities. The application of these defenses is a fact-intensive analysis and can be complex. They are also totally untested in connection with crypto bankruptcies. The creditor has the burden of proof, which makes it easier for the claimants to make claims.

Preferential law in crypto bankruptcies

The key questions in relation to crypto withdrawals are likely to be: (i) whether the transfer was the debtor’s property; (ii) whether the debtor was insolvent at the time of the transfer; and (iii) whether any defenses apply.

If the withdrawn crypto assets were not the property of the debtor, withdrawal of these assets will not be a preference. The analysis of whether crypto assets belong to the debtor or the customer is complex, and the law is unsettled. Our previous article for this publication explained the relevant assessments in detail and is briefly summarized below.

The terms of the customer agreement, and the way crypto assets are actually held, are key data points. If crypto-assets are to be held (and indeed are) held in trust for the customer, the assets may not be the debtor’s property. Conversely, if the agreement provides for the transfer of ownership of crypto assets to the exchange and for these assets to be commingled, there may be a different result.

State law may also be the basis for this analysis. Bankruptcy law looks to state law to determine ownership. If applicable state law provides for custodial crypto assets to be held in trust for the customer, it is possible that the crypto may be excluded from the bankruptcy estate. Certain states have money transmitters or other laws that regulate the relationship between customers and stock exchanges/custodians, which are also important for this analysis.

This high-stakes issue will likely be addressed in the bankruptcy case, potentially long before any preferential actions are initiated. Consequently, customers with potential preferential exposure must be vigilant and seek to participate in the matter to the extent that they wish to have a voice in this matter.

Pursuant to section 547(f) of the Bankruptcy Code, the debtor is presumed to be insolvent for the 90-day period prior to the bankruptcy petition. Most debtors rely on this presumption – or the absence of evidence rebutting this presumption – to prove this element. However, this presumption can be overcome if the customers can establish that the debtor was not insolvent (as defined in the Bankruptcy Act § 101(32)) — i.e. that the value of the debtor’s assets exceeded the debtor’s total debts.

Challenging the debtor’s insolvency is a significant undertaking and generally requires the retention of valuation experts, significant discovery and complex litigation. The costs can be significant. In many cases, this burden is too great for a creditor to bear, and insolvency goes unchallenged.

In the context of a crypto bankruptcy, however, it may make sense to challenge the debtor’s solvency assumption. Potentially tens of thousands of customers could be sued for preference. These clients can pool their resources, either by retaining common counsel, or by suggesting that their individual counsel coordinate with counsel for other defendants (or both), to reduce the costs associated with expert retention and litigation.

Essentially, the issues presented in a crypto bankruptcy pose interesting valuation issues. Crypto assets themselves are highly volatile, with dramatic swings possible from day to day, meaning that a debtor’s solvency can also change from day to day.

Even if the debtor succeeds in establishing a prima facie case, customers can make certain defenses. For example, as mentioned above, transfers cannot be avoided as preferences when made in the ordinary course of business. Whether the transfer has been made in the ordinary course of business is factual, and the law has not been applied in this context. However, considerations are likely to include, among other things, the length of the relationship between the customer and the debtor, the terms of the customer agreement and the nature of the transactions between the customer and the debtor.

Supply of new value to the debtor after withdrawal of an otherwise preferential transfer can serve to isolate the preferential withdrawal to the extent of such new value. New value, in this context, will likely take the form of new deposits to customers’ crypto accounts.

Finally, the Bankruptcy Code also has securities security provisions that insulate certain transactions involving securities and market participants from challenge and avoidance. Whether the securities security regulations will apply in connection with a crypto exchange is unknown. Their applicability may depend on the specific type of cryptoassets maintained by the customer, since the Securities and Exchange Commission has stated that it considers certain cryptoassets (but not all) to be securities.

Conclusion

It is not yet known whether any preference actions will be initiated in connection with the existing crypto bankruptcy cases – Voyager Digital and Celsius Network (both pending in the Bankruptcy Court for the Southern District of New York) – or in future cases. In the event that any of the exchanges are liquidated, it is likely with preference.

Clients who received money in the 90 days prior to the filings should seek assistance in advance to help them assess their risk and plan a strategy to retain as much value as possible.

Bethany D. Simmons, a partner in the firm’s Restructuring and Bankruptcy practice, contributed to this article.

Opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed under the fiduciary principles to integrity, independence and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.