- Avoidance actions in the pending bankruptcy cases involving digital assets may turn on certain novel issues unique to cryptocurrencies and digital assets.
- A threshold question in evaluating these avoidance actions is whether cryptocurrency held on a crypto exchange platform is considered an “interest of the debtor in property.” This question is crucial because if such assets are not the debtor’s property, then the transfer of those assets could not be avoided by the debtor (i.e., it was merely the return of a customer’s own property that was not part of the debtor’s property).
- The critical question of whether to classify digital assets as securities, commodities, currencies, or something else, could have a material effect on the applicability of safe harbor defenses to protect against potential avoidance actions by debtors.
- Transactions involving smart contracts raises a question regarding determining the applicable transfer date for avoidance actions due to the self-executing nature of smart contracts.
On December 19, 2022, FTX Trading Ltd. issued a press release announcing a process for the voluntary return of avoidable pre-bankruptcy payments to “secure the prompt return of such funds to the FTX Estates for the benefit of customers and creditors.”Seeking to clawback or “avoid” pre-bankruptcy transfers is commonplace in bankruptcy. Such transfers may include customer withdrawals, payments to creditors, liquidations of DeFi loans, payments to insiders or charitable donations. However, as will be discussed in more detail below, there are several novel issues that could arise in crypto related chapter 11 cases that may implicate additional potential obstacles to avoid pre-bankruptcy transfers.
Background Law on Avoidance Actions
As background, chapter 5 of the Bankruptcy Code provides a debtor (or a trustee) with the ability to recover certain pre-bankruptcy payments made by the debtor for the benefit of the debtor’s entire estate, often referred to as avoidance actions or clawback actions. “The principal policies underlying the Code’s avoidance provisions are equal distribution to creditors and preserving the value of the estate through the discouragement of aggressive pre-petition tactics causing dismemberment of the debtor.” In particular, the Bankruptcy Code allows the trustee or debtor to avoid (i) preferential transfers under Section 547 or (ii) fraudulent transfers under Section 548.
Under the Bankruptcy Code, the trustee has the power to enlarge the bankruptcy estate by avoiding certain transfers to creditors that satisfied antecedent debt before the petition date. Section 547 of the Bankruptcy Code provides that a debtor can avoid a prepetition “transfer of an interest of the debtor” to a creditor made within 90 days of the bankruptcy filing as a preference if certain requirements are satisfied. The goal of the Bankruptcy Code’s preferential transfer provision is to avoid depletion of the debtor’s bankruptcy estate to certain creditors prior to the filing, and to promote equality of distribution among all similarly situated creditors.
Similarly, section 548 of the Bankruptcy Code empowers the debtor to avoid two categories of fraudulent transfers. Under section 548(a)(1)(A) of the Bankruptcy Code, a debtor may avoid any transfer of an interest of the debtor or any obligation incurred by the debtor, that was made or incurred within two years of the petition date if made with an actual intent to delay, hinder, or defraud creditors. The more common scenario is section 548(a)(1)(B) which enables a debtor to avoid a transfer that was made or incurred within two years of the petition if the debtor (1) received less than reasonably equivalent value and (2) was insolvent at the time of the transfer, was rendered insolvent by the transfer, was left with unreasonably small capital, or intended to incur, or believed that it would incur, debts that would be beyond its ability to pay as such debts matured. This is generally referred to as a “constructive fraudulent transfer” and does not require any specific intent. Additionally, section 544 of the Bankruptcy Code also enables a debtor to rely upon, and pursue, state fraudulent transfer laws, which often have longer lookback periods.
In addition to the traditional defenses available to defendants against preference and fraudulent transfer claims, avoidance actions involving digital assets may also turn on certain novel issues unique to cryptocurrencies and digital assets.
Are Crypto Withdrawals “Property” of the Debtor?
A threshold question in considering the application of these avoidance actions is whether cryptocurrency held on a crypto exchange platform is considered an “interest of the debtor in property.” This question is crucial because if withdrawn crypto assets are not the debtor’s property, then the transfer of those assets could not be avoided by the debtor (i.e., it was merely the return of a customer’s own property that was not part of the debtor’s property). As explained by the Supreme Court, “if the debtor transfers property that would not have been available for distribution to his creditors in a bankruptcy proceeding, the policy behind the avoidance power is not implicated.”
Does the Safe Harbor Provision Apply?
As is widely known, classification of cryptocurrencies and other digital assets is not only an existential question with big regulatory implications, but could also affect the availability of potential defenses to avoidance actions under the Bankruptcy Code. The Bankruptcy Code’s securities safe harbor includes a provision that provides a defense to avoidance actions (both preference actions and constructive fraudulent transfer actions) for certain transactions involving securities contracts, securities or commodities. Courts have explained that the rationale behind such safe harbor provisions is that “transactions made through these financial intermediaries promotes stability in their respective markets and ensures that otherwise avoidable transfers are made out in the open, reducing the risk that they were made to defraud creditors.” As previewed in a recent blog post, whether certain digital asset transactions could qualify for the safe harbor provisions and obtain a complete defense to such complaints is an unsettled question.
In particular, section 546(e) of the Bankruptcy Code exempts a transfer from avoidance if, among other things, the transfer is either a “settlement payment” or a “transfer . . . in connection with a securities contract,” in each case “made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant.” A “financial participant” is defined by the Bankruptcy code as “an entity that . . . enter[ed] into a securities contract, commodity contract, swap agreement, repurchase agreement, or forward contract . . . with the debtor or any other entity (other than an affiliate) [for a certain qualifying amount].” Although drafted in very technical defined terms, courts have consistently interpreted these provisions broadly. By way of example, payments to creditors to redeem notes have been found to be “settlement payments” and protected by section 546(e) because they are “the transfer of cash or securities made to complete [a] securities transaction.” If crypto and other digital assets are classified as securities, then the associated contracts could constitute “securities contracts” or “settlement payments” and the securities safe harbor provision may apply, protecting certain prepetition transfers of digital assets to customers under such agreements from being clawed back.
Similarly, Section 546(g) of the Bankruptcy Code protects transfers made by or to a swap participant in connection with any swap agreement before the commencement of the bankruptcy case. If classified as a currency, cryptocurrencies may be categorized as swap agreements, or contracts where parties exchange currency for another form of currency.
On the other hand, if cryptocurrencies and other digital assets are classified as commodities, the analysis is less clear. While section 546(e) also protects payments made under a commodities contract, the Bankruptcy Code does not provide a bankruptcy-specific definition of commodity to determine the scope of a commodity contract. Rather, section 761(8) of the Bankruptcy Code incorporates the definition from the Commodities Exchange Act (the “CEA”), which lists specific examples of commodities but also includes “all services, rights, and interests . . . in which contracts for future delivery are presently or in the future dealt in.” Certain non-bankruptcy courts have accepted arguments that cryptocurrency may be a commodity under the logic that a cryptocurrency is an “interest” in which futures are or can be “dealt in,” but the law is still unsettled how to interpret the definition. Likewise, the CFTC has publicly asserted that digital assets fall within the CEA’s definition.
In short, the critical question of whether to classify digital assets as securities, commodities, currencies, or something else, could have a material effect on the applicability of these safe harbor defenses to protect against potential avoidance actions by debtors.
Transfer Dates and Smart Contracts
Another open issue for avoidable preferences is how transactions involving smart contracts might be treated differently for purposes of determining the applicable transfer date. As discussed above, a trustee may avoid transfers made within certain specific time periods. Under the Bankruptcy Code, the date of a transfer is rarely in dispute because for ordinary contracts or negotiable instruments such as checks, courts generally hold that transfer does not occur until the property at issue is actually transferred, under the logic that a number of potentially superseding actions that could occur before transfer. However, there is uncertainty whether a payment made pursuant to a smart contract prior to a bankruptcy filing is deemed made at the time that the smart contract was entered into or at the time at which property was received. As a result, parties may seek to argue that the date of entry into the smart contact is determinative and that date occurred prior to the applicable clawback time period.
This potential argument rests upon the self-executing nature of smart contracts. Smart contracts are “self-executing contracts with the terms of the agreement between [a] buyer and seller being directly written into lines of code.” Once a smart contract has been created, “computer transaction protocols will execute the terms of a contract automatically based on a set of conditions,” or a triggering event, agreed upon by the parties. A smart contract therefore cannot be changed, and unlike ordinary contracts, any transfer of cryptocurrency can occur automatically in accordance with the smart contract’s terms without the need for any additional action (unlike a check). Accordingly, it is possible that the applicable transfer of assets under a smart contract out of the debtor’s estate occurred at the time that the smart contract was entered into. An argument could be made that smart contracts should be viewed similarly to an escrow account. While it is fact specific based on the applicable escrow agreement, certain courts have held in the context of an escrow account, that money placed into an escrow account is not property of the debtor’s estate. Following that logic for smart contracts, the relevant date of transfer for avoidance actions would be the date that property was transferred from the debtor into the smart contract, rather than the date that property was released from the smart contract.
Much like many other intersections of bankruptcy law and crypto, there are many novel issues that courts will need to address. As a result, this area of the law is unsettled, and because the Bankruptcy Code does not provide bankruptcy-specific definitions for currency or commodity, affected parties cannot look solely to bankruptcy courts to resolve the issue. Further complicating matters is the lack of consistency amongst regulators on how to classify cryptocurrency and other digital assets. As it stands now, those involved in these pending crypto bankruptcies have the ability to raise additional novel defenses in response to an avoidance action, in addition to the traditional defenses.