One of the primary attractions of cryptocurrency, for libertarians and blackmailers alike, is its relative freedom from the governmental oversight and involvement that comes with traditional currency. Yet this anti-government tilt is a problem where chapter 11, or bankruptcy generally, is concerned.
Bankruptcy is all about government. The automatic stay, the bankruptcy “estate,” the power to impose a plan on dissenting creditors – key features of corporate bankruptcy – all flow from Congress’ powers under the Bankruptcy Clause. These tools are not easily replicated by contract, whether “smart” or conventional.
The problem is already becoming apparent. Two significant crytpo-brokers have filed chapter 11 petitions in New York. FTX, the failed crypto exchange, has filed in Delaware. Other, similar firms have filed insolvency proceedings in jurisdictions across the globe. More bankruptcies will surely follow.
In a new paper, I consider two, key bankruptcy-related policy issues in this area. First, the potential bankruptcy of a stablecoin, and second, the bankruptcy of a crypto broker.
On the first point, I identify several holes in the Bankruptcy Code’s ability to address such a bankruptcy filing. Nevertheless, chapter 7 (rather than chapter 11) might offer the best solution for a run on a stablecoin.
The basic problem with stablecoins is that, like banks, they operate with assets that might not be fully liquid in times of stress, meaning that a flood of redemptions might generate a self-perpetuating “run” scenario. Initially, it can be expected that stablecoins will attempt to address this issue by contract.
For example, buried deep in Tether’s “terms of service” is this nugget:
Tether reserves the right to delay the redemption or withdrawal of Tether Tokens if such delay is necessitated by the illiquidity or unavailability or loss of any Reserves held by Tether to back the Tether Tokens, and Tether reserves the right to redeem Tether Tokens by in-kind redemptions of securities and other assets held in the Reserves.
An extended hold could conceivably become the basis for an involuntary bankruptcy petition, although that petition might be the subject of legal dispute. And distributions in kind solve liquidity problems but do nothing to solve a shortfall in reserves.
In such a situation, chapter 11 might be an attractive option, but chapter 11 is designed around the premise that it is better to keep a business operating – better, in the sense that an operating business is typically worth more than a shuttered business. When the debtor’s business is intended to hold customer funds and return them upon demand, normal operations would undermine the very point of bankruptcy. Customers would resume their rush to the exits as soon as possible, and the “breathing spell” of bankruptcy would quickly disappear.
Indeed, it is notable that most debtors that operate like a pegged currency are excluded from chapter 11. Banks are typically resolved in FDIC receiverships and brokers in SIPA receiverships, and other similar entities find themselves directed to chapter 7, where a trustee can take charge of the debtor’s assets.
A chapter 11 case involving a pegged cryptocurrency would simply result in a pause until management filed a chapter 11 plan to wind down the business. It is not clear why management should be vested with such power. As such, I suggest amending the Bankruptcy Code to make clear that stablecoins should only file under chapter 7.
On the second point, the question of crypto brokers in bankruptcy, I observe that the status of customer claims in such bankruptcy cases and (again) the suitability of chapter 11 for such debtors are the key issues.
The question of customer claims is in large part an issue of non-bankruptcy regulation. That is, if crypto broker-exchanges have no obligation to hold customer property separate from the debtor-firm’s own property, they should make that clear to their customers. By the time the firm ends up in bankruptcy, the harm has been done.
One consequence of the lack of segregation of customer funds in crypto broker-exchanges is that those funds can flow through the entire corporate structure in a way that would be plainly illegal for a traditional broker. This is also an issue for pegged cryptocurrencies, where Tether has admitted that at times its reserves went to support the operations of related entities. Such movements might break contractual arrangements with the customers, but breach of contract simply adds an unsecured claim to the customers’ list of losses if the broker-exchange fails.
SEC Chair Gary Gensler has consistently said that most cryptocurrencies are securities, and most cryptocurrency broker-exchanges are thus unregistered securities exchanges. As such, it seems that most of the broker-exchanges currently in chapter 11 should instead be in chapter 7, as stockbrokers are not allowed in chapter 11.
The point has not been raised in any of the cases to date and would only address entities that are specifically brokers. That may result in artificial distinctions among entities within a corporate group, especially given the frequent lack of formalities among the group members noted earlier.
In the insolvency of a traditional broker-dealer, chapter 11 applies to the holding company and the unregulated subsidiaries, while the regulated subsidiary is resolved in a SIPA proceeding, under the control of a trustee appointed by SIPC. The trustee’s focus is on protecting customer property and transferring customer accounts to a new broker whenever possible.
In the crypto broker-exchange insolvency, there is no regulatory structure that ensures that customer property will only be in the regulated entity. And if a regulated entity exists, it is likely not a SIPC member. Thus, proceedings should be broader and more flexible in this context.
What is needed is clarity that a crypto broker-exchange is a broker for purposes of the Bankruptcy Code, and that the “broker” might comprise more than one legal entity. The first point could be addressed by a simple amendment to the definition of “stockbroker,” in section 101 of the Code. With the addition of the phrase “(and any affiliate of such person in possession of customer assets on the petition date)” after “person” in the existing definition of stockbroker, it would be clear that crypto broker-exchanges, and their affiliated entities, belong in chapter 7, rather than chapter 11. Moreover, that chapter 7 proceeding would extend to not only the broker itself, but related entities that are potentially part of the functional broker relationship.
In addition, we might consider granting the trustee the power to file involuntary bankruptcy petitions against other affiliates of crypto broker-exchanges.
But ultimately, I doubt the need for substantial changes to the Code, but rather argue for slight changes along with continued skepticism about subsidizing purported innovation through changes to bankruptcy law.
This post comes to us from Stephen J. Lubben, the Harvey Washington Wiley Chair in Corporate Governance & Business Ethics at Seton Hall University School of Law. It is based on his recent article, “We Got the Kingdom, We Got the Key: Corporate Bankruptcy and Cryptocurrency,” forthcoming in the Stanford Journal of Blockchain Law & Policy and available here.