On July 5, 2022, cryptocurrency brokerage Voyager Digital filedfor chapter 11 in the Southern District of New York BankruptcyCourt, citing a short-term "run on the bank" due to the"crypto winter" in the cryptocurrency industry generallyand the default of a significant loan made to a third party as thereasons for its filing. At Voyager's first day hearing on July8, 2022, the Bankruptcy Court asked the critical question ofwhether the crypto assets on Voyager's platform were propertyof the estate or its customers. Voyager asserted the crypto assetswere assets of the estate pursuant to the terms of its customeragreements, but the question of ownership was more problematic inthe context of a liquidation. In that context, Voyager's planof reorganization proposes to resolve any mystery of ownership bydelivering the reorganized company to its customers.
On July 13, 2022, cryptocurrency lender Celsius Network filedfor chapter 11 in the Southern District of New York BankruptcyCourt. Celsius had frozen customer withdrawals on June 12, 2022and, at the time of its chapter 11 filing, indicated that it wouldnot be requesting court authority to allow customer withdrawals.Celsius noted in a press release that customer claims would beaddressed through the chapter 11 process.
Voyager's and Celsius' chapter 11 bankruptcy filingshighlight the question of whether crypto assets held by anexchange, or similar platform, may be considered property of abankruptcy estate and, therefore, not recoverable by the customer,who would then likely be an unsecured claimholder of thedebtor.
While some commentators have suggested that crypto assets mightbe considered property of the exchange's bankruptcy estate,existing common law, existing provisions of Uniform Commercial Code(UCC) Article 8, and proposed amendments to the UCC recognize thatif the arrangement and relationship between the exchange and itscustomers is one that is characterized as "custodial,"the crypto assets held by the exchange should remain property ofthe customer and, hence, not subject to dilution by generalunsecured claimholders.
The common law. When assets are heldby a "custodian" for the benefit of the customers of thecustodian, the assets are owned by the customer and would not formpart of the debtor's bankruptcy estate. The United States Courtof Appeals for the Seventh Circuit determined in In reJoliet-Will County Community Action Agency1 thatproperty held by the debtor as a custodian or other intermediarywho then generally lacks beneficial ownership rights is not anasset of the bankruptcy estate.
The court then looked to see if the relationship between thedebtor and those who transferred funds to the debtor was in fact"custodial." The court concluded the answer depends on"the terms under which the grants were made" and the"relationship" between the holder of the funds and itscustomer. In Joliet-Will, the agreement provided forcontrols on the holder's use of the funds and the holder was"in effect an agent to carry out specified tasks rather than aborrower, or an entrepreneur using invested funds." The courtconcluded the relationship was "custodial" and, thus, thefunds were not property of the bankruptcy estate.
In the context of a cryptocurrency exchange bankruptcy, the sameanalysis should apply where the terms of the relationship betweenan exchange and its customer are comparable and, thus,"custodial". In that case, the customer would have abasis to assert that it should remain the beneficial owner of theassets, rather than become a general unsecured claimholder of theexchange.
The commingling of customer assets, or the contractual right ofan exchange in possession or control of the customer's assetsto grant a security interest in that property do not, ofthemselves, prevent the assets from remaining the property of thecustomer.2
Conversely, if the entity in possession or control of theproperty has extensive rights to use the property for its ownbenefit, a court is more likely to conclude that the relationshipis not "custodial." In that case, the customer"would have a contractual claim for the return of the money[it] had paid, but he would not have a property right in themoney."3
However, even if a court was to determine the customer shouldremain the beneficial owner of assets held by a custodianin such capacity, notwithstanding any commingling and any right topledge the cryptocurrency, any contractual rights of thecustodian (for example, any rights under a staking arrangement)should become property of the estate. In such a case, while thecustomer remains the beneficial owner of its cryptocurrency, whichwould not be subject to distribution to general unsecuredclaimholders in the exchange's bankruptcy, it could be tied upunder the automatic stay preventing parties from exercising controlover the exchange's contractual rights (e.g., under astaking arrangement, the automatic stay might prevent a customerfrom recalling the cryptocurrency to its account).
Article 8 of the Uniform CommercialCode. Article 8 mirrors these rules for financialassets held by a securities intermediary. Under Article 8, asecurities intermediary4 includes a"custodian" of a "financial asset"5who otherwise meets the definition of a securitiesintermediary.6 Critically, existing language in Section8-503(a) of the UCC outlines the ownership interest of a customerwhose cryptocurrency is held by an intermediary such as anexchange, if the exchange is a "securities intermediary,"has agreed with the customer to treat the cryptocurrency as a"financial asset,"7 and has credited thefinancial asset to a securities account.8 This is trueunder Article 8 even though the securities intermediary holds thefinancial assets in "fungible" form (i.e., theyare commingled).9 Article 8 in effect codifies thecommon law custodian rules for transactions within the scope ofArticle 8the customer of the custodian retains its propertyinterest and has a pro rata interest in the commingled assets heldby the custodian.
Proposed Amendments to the Uniform CommercialCode. Pending amendments to the UCC further implementthe rule that custodially held crypto assets should not be propertyof the bankruptcy estate in a bankruptcy of acustodian-cryptocurrency exchange. The drafting of amendments tothe UCC specifically to address certain cryptocurrencies and otherdigital assets is nearing completion and is expected to go to theStates for consideration in the Fall of 2022. Under theseamendments, cryptocurrencies would fit into a new category ofcollateral under the UCC, referred to as "controllableelectronic records" (a form of general intangible) (CERs),which would generally include information stored in a nontangiblemedium that can be subjected to control. Under these amendments,CERs will have many characteristics of negotiability similar tonegotiable instruments and securities; however, cryptocurrenciesordinarily will not be considered "money" for purposes ofthe UCC (that is, the amendment generally provides thatcryptocurrencies generally are not considered "money,"but a cryptocurrency created and adopted by a government as anauthorized medium of exchange could be "money" under theUCC).
Notably, the proposed amendments to the official comments toArticle 8 of the UCC primarily serve to make clear that asecurities intermediary and a customer of a securities intermediarycan agree to treat a cryptocurrency as a "financialasset" and credit it to a securities account with thetreatment described above.
The proposed amendments to the official comments in Section8-501(d) note that assets such as CERs might also be controlled bya securities intermediary outside of a securities account for thebenefit of a customersimilar to traditional securities, inwhich case the bankruptcy of the intermediary often times would notput in doubt the customer's ownership of securities in in thatcircumstance held by the intermediary:
[A]ssets such as controllable electronic records, controllableaccounts, and controllable payment intangibles also might beassociated with an intermediary as well as with its customer undera similar direct holding arrangement. . . . As with conventionalcertificated securities, whether an intermediary has created asecurity entitlement in favor of an entitlement holder or isholding a financial asset directly for a customer depends on thenature of the relationship and the nature of the rights of theintermediary and the customer with respect to the financialasset.
In addition, revisions to Article 9 of the UCC will provide thata security interest in a CER can be perfected the old fashionedwayby filing a financing statementor by obtaining"control" of the CER. Under current distributed ledgertechnology structures such as blockchain, a secured party normallywould normally obtain "control" of a cryptocurrency thatis a CER if the secured party has the private key. A secured partycan have control through a custodian that has control for thebenefit of a secured party. Where a securities intermediary and acustomer of a securities intermediary agree to treat acryptocurrency as a "financial asset"10 andcredit it to a securities account, the customer would have"security entitlement" related to the cryptocurrency, andthe secured party could obtain and perfect a security interest insuch security entitlement under existing procedures under Articles8 and 9 of the UCC.
A new Article 12 to the UCC is being proposed that includesprovisions addressing transactions in cryptocurrencies fallingunder the category of a CER, such as sales of the cryptocurrency.In these transactions, a buyer of a CER can take free of theproperty claims of others if the buyer obtains control of the CER(e.g., holding the private key), gives value, and does nothave notice of the property claims of others.
While the proposed amendments to the UCC have yet to befinalized and adopted by the States, many of the amendments to theUCC as they relate to the ownership interest of a cryptocurrencyexchange customer in custodially held cryptocurrency are proposedas amendments to the official comments, without revision to theoperative statutory provisions themselves because the existingstatutory provisions already provide for the described results.Thus, a bankruptcy court could rely on the existing state UCCstatute as a basis to determine that when cryptocurrency is held asa financial asset credited to customer accounts, the cryptocurrencyis property of the customer, rather than bankruptcy estate. This isthe same result outside of Article 8 as discussed above.
Crypto assets held custodially by an exchange or other entityfor a customer should be treated as the property of the customer.The analysis of when a "custodial" relationship existswill depend on the agreements and other facts in a particularrelationship.
Footnotes
1. See In re Joliet-Will Cnty. CommunityAction Agency, 847 F.2d 430, 431 (7th Cir. 1988) (Posner, J)("Did they constitute JolietWill a trustee,custodian, or other intermediary, who lacks beneficialtitle and is merely an agent for the disbursal of funds belongingto another? If so, the funds (and the personal property bought withthem, cf. In re Kaiser, 791 F.2d 73, 77 (7th Cir.1986)) were notassets of the bankrupt estate." (Emphasis added)).
2. See also Restatement (Third) of Restitutionand Unjust Enrichment 59 (property interest in assetcontinues in commingled assets when the interests can be traced).See also Illustration 26 (400 customers of smelter deliversilver to smelter, who keeps records of the amount of silverdelivered by each customer, refines the silver for a fee, andagrees to return a corresponding amount of silver to each customer;when smelter fails, each customer has a pro rata property interestin the refined silver, which is not the property of smelter); UCC 9-207(c)(3).
3. Joliet-Will, 847 F.2d at432.
4. "Securities intermediary" is defined inSection 8-102(a)(14) of the UCC.
5. "Financial asset" is defined in Section8-102(a)(9) of the UCC.
6. UCC 8-102(a)(14) and Comment 14.
7. See Section 8-102(a)(9)(iii) of theUCC.
8. Section 8-503(a) provides that "[t]o the extentnecessary for a securities intermediary to satisfy all securityentitlements with respect to a particular financial asset, allinterests in that financial asset held by the securitiesintermediary are held by the securities intermediary for theentitlement holders, are not property of the securitiesintermediary, and are not subject to claims of creditors of thesecurities intermediary, except as otherwise provided in Section8-511."
9. This rule is the same as the smelting exampledescribed above from the Restatement (Third) of Restitution andUnjust Enrichment.
10. A financial asset does not have to be a"security" (as defined in Article 8 of the UCC) to be afinancial asset. As long as the relationship between the securitiesintermediary and the customer creates a "securitiesaccount" (UCC 8-501, Comment 1), the securitiesintermediary and its customer (referred to as an "entitlementholder") can agree to have any asset treated as a"financial asset". UCC 8-102(a)(9)(iii).
The Other Side Of The Coin: Cryptocurrency AssetsIn Bankruptcy
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