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Global | Publication | January 2019
Late 2017 will be remembered as the period in which everyday investors adopted cryptocurrency as an alternative investment class and rode the highs of Bitcoin at USD$20,000. In contrast, 2018 will be remembered as the year that cryptocurrency plunged and insolvency practitioners globally had to start considering how the asset class could be dealt with.
The year began with one formal insolvency proceeding in the ongoing Mt Gox saga in Japan. By year’s end courts around the world began grappling with the many issues that arise once an insolvency proceeding includes crypto-assets. Below we examine some of those insolvency proceedings and the issues that have and will continue to require the attention of insolvency professionals, lawyers, creditors and investors.
A fundamental issue for determination in insolvency proceedings involving crypto-assets is whether the assets form part of an insolvent estate. In 2018 an insolvency professional (IP), managing the personal insolvency estate of Mr Tsarkov, applied to the Commercial Court of Moscow seeking disclosure of the contents of a cryptocurrency wallet[i], which held Bitcoin asserted to be an asset of the estate. Additionally, the IP sought orders for the production of Mr Tsarkov’s private key so he could seize the crypto-assets.
Mr Tsarkov successfully opposed the application in the lower court on the basis that Russian law did not recognise transactions involving cryptocurrency, so it could not be an object of property rights and could not form part of the bankrupt estate. The Commercial Court agreed, finding that the legal nature of cryptocurrency meant that there was no analogy with other property rights. But the 9th Appellate Court in Moscow criticised and overturned the decision, opining that the economic value of cryptocurrency should not be arbitrarily excluded from an insolvency estate as to do so would deprive creditors of the right to satisfaction of their claims. Orders were also made requiring Mr Tsarkov to produce the private key to the cryptocurrency wallet relevant to the crypto-assets.
Even though cryptocurrency is clearly a form of asset, some jurisdictions may allow challenges to its inclusion within a bankrupt estate. Even within jurisdictions where ‘property’ is defined broadly to clearly include any rights attaching to crypto-assets within the estate, debate continues as to the nature of the asset and the implication of its characterisation. For example, cryptocurrency as a currency has been doubted in the United States but whether it has the status of a commodity is yet to be judicially determined. This uncertainty may affect recovery and remedies in cases of antecedent transactions.
In the context of opening main insolvency proceedings, under Article 3 of the European Insolvency Regulation (EC 1346/2000), the Court of Midden-Nederland considered whether a failure to comply with an obligation to transfer Bitcoin was sufficient to qualify as a debt for the purpose of opening the proceeding.
The Court had made prior orders that Koinz Trading B.V. pay mining proceeds in Bitcoin to a third party. The order expressly prescribed payment in Bitcoin involving the transfer to Koinz Trading B.V. from the third party payer.
Koinz Trading B.V. failed to comply with the order and a petition was filed for the company’s insolvency in accordance with Article 1 of the Dutch Bankruptcy Act.
In determining whether it could open the insolvency proceedings the Court considered whether there was a verifiable claim and if so, whether the obligation to pay had been satisfied.
On the first issue, the Court determined that Bitcoin represented a value and was transferable, therefore showing characteristics of a property right. A claim for payment in Bitcoin qualified for verification. With respect to payment, the Court opined that the civil obligation on Koinz Trading B.V. to pay the Bitcoin had not been met. Further, the term ‘payment’ refers not only to the satisfaction of a monetary claim but more generally to the satisfaction of a commitment. That commitment had not been satisfied. The Court found that the criteria for opening the insolvency proceedings was met.
In 2014 Mt Gox became the first cryptocurrency company and particularly, digital currency exchange (DCE)[ii] to be subject to formal insolvency proceedings. However, in 2018 Bitgrail Srl in Italy and Cointed GmbH, in Austria rounded out the trifecta of DCEs facing bankruptcy proceedings. With the downturn in cryptocurrency trading, inevitably other parts of the market suffered including mining firms[iii] and companies that enthusiastically sought investors’ money, via ICO fundraising, for projects that never eventuated.
Cointed GmbH was founded in Austria in 2016 and had a meteoric rise, with businesses in multiple European hubs and sales of 150 million Euro in 2017. The holding company of the Cointed Group, it operated a DCE, cryptocurrency mining business, and one of the largest networks of cryptocurrency ATMs in Austria and Eastern Europe. In September 2018 the company quietly filed for bankruptcy in the Innsbruck Regional Court.
Controversy arrived at Cointed GmbH in early 2018 following an investigation by the Austrian Economic authorities into allegations of fraud, a pyramid scheme, and breach of regulations associated with the issue of the prospectus for the Cointed Group’s ICO.[iv] A raid of Cointed GmbH’s office and seizure of company property followed. Investigations escalated and claims of embezzlement ensued after clients of the company’s DCE alleged that fiat currency intended for exchange through the DCE had simply disappeared. Concerns peaked in mid-2018 when customers began experiencing long delays in attempts to withdraw fiat currency from the DCE and by August 2018 access to customer accounts had ceased.
The company’s CEO confirmed financial difficulties in July 2018 but appeased investors with news that he was speaking to investors in China with a view to comprehensively restructuring the company. It appears the CEO instead relocated to China, joined the board of Cointed’s Hong Kong based shareholder (Cointed Limited) and facilitated a transaction in which Cointed Limited became the holding company of the Cointed Group.
Because the prospectus for the ICO represented the Austrian entity, as the holding company with the assets of the Cointed Group, the trustee is expected to undertake a detailed investigation into inter-company property transfers prior to the bankruptcy filing. Should there be a need to recover crypto-assets improperly transferred prior to bankruptcy, it may be an appropriate opportunity to revisit the decision in In re Hashfast Technologies LLC. That decisionheldthat, for the purpose of section 550(a) of the US Bankruptcy Code, Bitcoin was not equivalent to US dollars.[v]
BitGrail Srl, an Italian DCE, with users in multiple jurisdictions, first experienced difficulties in late October 2017 after approximately 17 million Nano[vi] was stolen from users of the DCE who had their asset stored in wallets on the exchange.[vii]
Users immediately experienced difficulty in accessing their crypto-assets and exchanging fiat currency. Despite various assurances and settlement proposals by the director of BitGrail Srl, by mid-year a representative ‘customer creditor’[viii] filed a bankruptcy petition under article 6 of Italian bankruptcy law. In May 2018, orders were made by the Italian courts, that all assets of the company (including the crypto-assets contained in customer wallets on the DCE), be brought under the control of an appointed trustee pending further order.
Rather than produce the keys to enable the assets to be brought under the trustee’s control, the owner of BitGrail Srl instead attempted to reopen the DCE. The Italian courts moved swiftly, ordering on 5 June 2018, that all cryptocurrency stored in wallets owned and operated by BitGrail Srl be seized and transferred to the trustee.
A final determination on the bankruptcy of BitGrail Srl is pending with much depending on the trustee’s report. A decision following the court hearing on 11 December 2018 is expected in the late December 2018/early January 2019.
If the company’s bankruptcy is confirmed, the most significant issues are likely to be the status of customers of the exchange, including whether they are creditors or whether the manner in which the crypto-assets were held on the DCE gives rise to some other legal status. Consideration will also need to be given to whether a distribution to creditors is made in cryptocurrency or fiat currency and how the pari passu rule will be employed in circumstances where only one form of cryptocurrency was the subject of the theft yet all crypto-assets were seized.
Mt Gox, the first insolvency proceeding involving a DCE, commenced in the Tokyo District Court on 28 February 2014 following the disappearance of 744,800 Bitcoins with equivalent value of approximately US$473M. Initially filed as a civil rehabilitation proceeding, the Court subsequently dismissed the application in favour of appointing a trustee in bankruptcy and ordering that the company be wound up.
The Mt Gox bankruptcy illustrates many issues that can confront an insolvency professional in the liquidation of a cryptocurrency business, including cross-border matters. Upon appointment, the Japanese trustee moved quickly to apply for chapter 15 recognition of the bankruptcy proceeding in the United States and sought equivalent orders in Canada in an attempt to stay pending and active class actions in both jurisdictions. The borderless nature of cryptocurrency businesses means that applications for cross-border insolvency recognition are likely to become more common following appointment.
Between 2014 and late 2017, the trustee successfully recovered some 200,000 Bitcoin. With the co-operation of a DCE and following court approval, tranches of the crypto-assets were sold between December 2017 and February 2018 generating some JPY$42,988,044,343. Even though the trustee sought Court approval for the method and timing of the sale of the crypto-asset, the simultaneous sale of significant quantities of the token led to criticism that the trustee’s actions had triggered the Bitcoin bear market.
It became apparent in the course of the case that the available assets would exceed the provable creditor claims. Accordingly, on 24 November 2017 a group of creditors petitioned the court for conversion of the bankruptcy proceeding to a civil rehabilitation proceeding. On 22 June 2018, in a first for Japanese bankruptcy law, the Court granted the request.
Japanese bankruptcy proceedings require creditors with non-monetary claims to convert those claims into a fiat currency value as of the commencement of the bankruptcy. Civil rehabilitation proceedings do not require the claim conversion and provide more flexibility to the trustee with respect to the method of distribution to creditors via a rehabilitation plan.
Current indications are that the trustee will reimburse Mt Gox creditors, wholly or in part, with Bitcoin at current market prices. Even though the price of Bitcoin has decreased in recent months, this recovery will remain a significant windfall for creditors who held Bitcoin in 2014.[ix] Fiat currency held by the trustee will be paid to creditors with ‘cash’ claims prior to any distributions of fiat currency to creditors with cryptocurrency claims.
Distributions are expected to begin in mid-2019, subject to the implementation of the civil rehabilitation plan.
Envion AG had been battling allegations of criminality for some time prior to the business grinding to a halt and a formal decision to liquidate the company on 14 November 2018. The liquidation will be conducted by the bankruptcy authority in Zug, Switzerland in accordance with the Swiss Act on Debt Enforcement and Insolvency, marking the first use of the legislation for a crypto-currency liquidation and the first bankruptcy globally of a major ICO.
In addition to its mining operations, Envion AG issued an ICO in early 2018,raising approximately USD$100 million from some 39,000 investors who purchased “EVN tokens” valued at approximately USD$1 each. The White Paper[x] promoting the ICO represented that EVN token holders would receive the benefit of participating in revenues generated by the success of the crypto-mining company. The ICO did not hold the appropriate banking licence and was allegedly unauthorised. The EVN tokens last traded at approximately 5 cents each.
Two critical issues are likely to play out in the liquidation. First, the treatment of ICO investors and in particular, whether they are characterised as shareholders or creditors. Second, how (if at all) investors will be paid distributions given the (Revised) EVN Subscription Agreement (Subscription Agreement) (issued at the time of the ICO) which prescribed that any repayments to investors are to be made in Ether.
The Subscription Agreement specifically provides that token holders have no shareholder rights nor do they have any right to a liquidation surplus. This is consistent with the position that investors in an ICO are not likened to shareholders (or equity holders). Investors in the Envion AG ICO are not likely to receive any distribution of assets from the liquidation in a shareholder capacity. The Subscription Agreement also states that token holders must waive their claims to the extent required to cover the claims of other creditors and claims arising in a liquidation process.
The preferred course for token holders therefore appears to be to try to establish their claims as creditors. A claim for damages arising from the prospectus and/or ICO is most likely and if accepted by the trustee the creditor claim will rank in priority to those of shareholders.
Under Swiss law, all bankruptcy petitions are required to be filed in Swiss francs. Token holder creditors will likely be required to convert claims, as at the date of the liquidation, from Ether (and potentially EVN initially) to Swiss francs. The claim could then be adjudicated with all claims in fiat currency. This was the course initially adopted in Mt Gox before its conversion to a civil rehabilitation proceeding where Bitcoin is now being returned to creditors.
Giga Watt’s status as a cryptocurrency mining pioneer, and the world’s biggest cryptocurrency miner just 5 years ago, was not enough to protect it from a Chapter 11 filing in the U.S. District Court in Spokane, Washington on 19 November 2018. The filing marks the first significant bankruptcy of a cryptocurrency miner.
A little under 12 months ago the company was riding high on a proposal to provide turnkey mining services and custom packages for a full range of mining services from equipment sales, maintenance, and repair to private blockchain servicing. The proposal was the subject of an ICO where token holders raised USD$22.6 million in exchange for Giga Watt tokens and the promise that they would receive hosting services for mining computers.
The Chapter 11 filing appears to be a consequence of the ICO project being overly ambitious in a volatile cryptocurrency market. Following Giga Watt’s failure to deliver on a number of ICO deadlines, two class action lawsuits were issued by ICO investors alleging impropriety in relation to the ICO.
As in the Swiss case of Envion AG, the United States courts will need to consider the rights of the Giga Watt token holders under the US Bankruptcy Code.
When determining rights of token holders consideration must always be given to the description of the token holders’ interests in the White Paper. In the Giga Watt White Paper the tokens, subscribed as part of the ICO, appear to be true utility tokens[xi] as the benefits ascribed to them were the right to use the Giga Watt mining centre for 50 years to accommodate a token holder’s own mining equipment. Accordingly, token holders are unlikely to be considered members of the company, and any equity invested appears to be tied to the services proffered by the utility token. Establishing a provable debt for token holders may be difficult in the absence of a claim that sounds in loss or damages.
Global activity will continue to increase as the market dips. As many of the insolvency proceedings above have only commenced in the latter half of 2018, it can only be hoped that the next 12 months will give rise to judicial authority that may assist insolvency professionals, lawyers, and creditors alike to manage their way through the new maze of cryptocurrency insolvencies.
[i]Digital wallets operate similarly to a wallet that stores fiat currency insofar as they are the means by which cryptocurrency is able to be accessed. A wallet is an address on a blockchain that stores a crypto trader’s private and public keys, which allows the trader to send and receive cryptocurrency. Wallets can be stored online, through a digital currency exchange, on a hard drive, or a removable device such as an encrypted USB.
[ii]A DCE is a place to buy and sell cryptocurrency that runs on similar principles to a stock exchange but has many features of a bank. DCEs can exchange fiat currency for cryptocurrency and vice versa and can also trade different forms of cryptocurrency. DCEs are loosely regulated in many jurisdictions and save for Japan there are no solvency or audit requirements. It is thought that many DCEs operate on fractional reserve principles similar to those within the banking sector but without the necessary regulatory requirements.
[iii]Cryptocurrency miners are responsible for operating the computers (nodes) that undertake the algorithmic formulas necessary to verify cryptocurrency transactions for adding to the blockchain.
[iv]ICOs are a means of fund raising for cryptocurrency enterprises which involve the issue of generally tradeable cryptocurrency tokens reflecting a specific dollar value. ICO tokens are generally referred to as ‘utility’ tokens indicating that there are no voting rights or entitlements to dividends attributable to the tokens. Rather, token holders are generally entitled to trade the tokens and once the funded cryptocurrency project is delivered the token ordinarily entitles a holder to various benefits such as use of the services the project delivers.
[v]The proceedings were filed in the United States Bankruptcy Court, Northern District of California under the fraudulent transfer provisions of the US Bankruptcy Code, against a person who had been paid 3000 Bitcoin in 2013 by Hashfast Technologies LLC (Hashfast). At the time that the payment was made the 3000 Bitcoin had an approximate value of $360,000 and had since appreciated to a value of $1.2 million. The critical issue was how the Bitcoin should be valued for purposes of recovery, should the transfer be successfully avoided. Section 550(a) of the Code states that if a transfer is avoided, the trustee is entitled to recover "the property transferred, or, if the court so orders, the value of such property." The bankruptcy trustee argued that Bitcoin was property and that the estate was entitled to recover either the 3,000 Bitcoin or their current value of $1.2 million[v]. The defendant argued that Bitcoin was not property but rather the equivalent of U.S. dollars that retained its "face" value as at the date of transfer.
[vi]Nano is a cryptocurrency token predominantly traded on the BitGrail exchange.
[vii]Following the theft a dispute ensued between the developers of the Nano (XRB) token and the owner of the BitGrail DCE because neither party accepted responsibility for the hack giving rise to the theft.
[viii]The petition is allegedly filed in a representative capacity on behalf of 3,000 former customers of the BitGrail DCE. Not all former customers of the BitGrail DCE were affected by the hack with only the Nano (XRB) token being the subject of the theft. But the BitGrail DCE also traded in Bitcoin and other tokens and those other crypto-assets were held in wallets of customers on the BitGrail DCE.
[ix]At the time of Mt Gox’s collapse Bitcoin was trading at USD$547 compared to its current value as at 9 December 2018 of USD$3385.
[x]A White Paper is the ICO equivalent of a prospectus issued to prospective investors interested in participating in the token purchase/ fund raising.
[xi]Utility tokens are defined as a digital token of cryptocurrency issued to fund development of an IT project (usually on a blockchain) and which can be used later to purchase a good or service offered by the issuer. However, the tokens are often used in an effort to avoid securities legislation.
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