In the last few years, an increasing number of digital platforms have launched initial coin offerings (ICOs). ICOs are primarily studied from the perspective of securities laws. In a new paper, however, I examine how bankruptcy law applies to entities that have tokens in their investment portfolios. What happens, for example, if a debtor that owns tokens becomes insolvent and is subject to insolvency proceedings? How can tokens be made available to the debtor’s creditors? How can the bankruptcy stay be preserved? And how can rules against fraudulent conveyances be enforced?
In general, when insolvency proceedings are opened against a debtor, a trustee or other entity in charge of administering the bankruptcy estate (hereinafter the insolvency practitioner or IP) must determine what assets of the debtor are available to creditors in accordance with property law and contract law. However, if those assets include tokens, the process becomes more complicated. First, the owner of the tokens can access them only through a secret digital key. Second, the debtor may have acquired the tokens under a pseudonym that cannot be easily traced back to the debtor. Both issues make it relatively easy for the debtor to hide the tokens from creditors. But what happens if the IP discovers the tokens and the debtor’s ownership of them? How can the tokens be made available to creditors’?
The commencement of insolvency proceedings often divests the debtor of assets and grants the IP control over them. However, if the debtor nevertheless transfers an asset, most jurisdictions make this transaction legally invalid or ineffective under post-commencement avoidance rules. This implies that the IP will be entitled to require the transferee to return that asset, or its value, to the estate. Theoretically, these rules should also apply to cases in which the debtor has transferred assets via blockchain. Again, here the IP might not be aware of these transactions. But if the IP is aware of them, he or she will certainly encounter some difficulty in reversing those operations since blockchain transactions are technically irreversible. The IP could, certainly, apply the rule that covers situations when the transferred items have perished or are no longer among the transferee’s assets. In that case the IP’s only claim against the transferee is for money. However, if a transaction concerns tokens, money may not be sufficient. Like a house or a car, tokens have a specific value, but, like traditional securities, they also confer a bundle of rights, including the right to vote and the right to be paid a proportion of profits. Moreover, like traditional securities, tokens may appreciate in value.
Consider the following example. After the opening of insolvency proceedings against debtor A, debtor A transfers to entity B a token issued by platform C. Under post-commencement avoidance rules, the transfer is void or ineffective with regard to the debtor’s creditors. As a result, the IP can claim money from B as compensation for the value of the token at the time A transferred it to B. However, while this remedy restores the integrity of the insolvency assets at the time of the transfer, it does not allow the IP to exercise both the participatory rights of the transferred security or to be paid profits – leaving transferee B to exercise those rights. Moreover, any appreciation in the value of this token will go to transferee B rather than the IP and creditors.
Finally, almost all jurisdictions have rules aimed at reversing transactions by a debtor within a specific period before the opening of insolvency proceedings if those transactions have diminished the debtor’s assets. The specific requirements vary from jurisdiction to jurisdiction, but generally they apply to transactions performed via blockchain. However, again in this case, the aforementioned caveats apply.
In my paper, I make essentially two arguments. First, the issues discussed above originate from the fact that ICOs are creating a divide between the world where tokens are issued, offered, and sold and the world where law is enforceable. Second, the sandbox approach that the UK‘s Financial Conduct Authority (FCA) adopted is much more than a highly controlled environment where software is put to test; it is evolving into a regulatory framework that – under certain conditions – could help fill this gap by directly shaping the digital-token platforms in pursuit of regulatory goals. The success of this approach will mainly depend on the ability of the FCA to encourage cooperation from firms that issue tokens and on the willingness of those firms to accept the requirements of the financial authority.
This post comes to us from Professor Renato Mangano at the University of Palermo (Italy). It is based on his recent article, “Blockchain Securities, Insolvency Law and the Sandbox Approach,” available here.