The Rise of Bitcoin in Bankruptcy

July 30, 2018 by Alexa P. Stephenson, Esq.

Cryptocurrency is taking the world by storm. It started in 2009 with the creation of Bitcoin, but there are now over 900 digital currencies in circulation. Bitcoin began as a way to buy a variety of online items and is most notably associated with the purchase of illegal goods and services on the dark web.

As familiarity with the digital currency grew, more and more merchants began accepting Bitcoin as a legal form of payment, further legitimizing its use. Today, Bitcoin is recognized all around the world as a form of payment in place of cash. The digital currency is not only a form of payment, but is now also considered by some as a vehicle for investment.

As demand for the currency grows, businesses and individuals are stockpiling the cryptocurrency in digital accounts as part of their “asset” ledger. Government regulatory agencies are now grappling with the idea of how to control and regulate an investment asset that can be held and transferred anonymously.

However, with the rise of Bitcoin comes many questions about how the currency is handled in legal situations such as divorce and bankruptcy. If a company or individual files for bankruptcy, the value and use of Bitcoin could play an essential role in the court deciding the value of the debtor’s “digital” assets. More specifically, as world governments and regulatory agencies come to terms on the definition of cryptocurrencies, the question that remains is whether Bitcoin is considered “property” in a bankruptcy filing.

Section 541 of the bankruptcy code broadly defines “property of the estate” to include “all legal and equitable interests of the debtor in property as of the commencement of the case.” With a definition that loosely defined, it seems beyond a doubt that digital currencies, that which hold a value, are considered property of the bankruptcy estate.

However, the issue of how Bitcoin is treated during bankruptcy is not so clear-cut as the court first has to decide if Bitcoin is a currency or a commodity. Unfortunately, there is currently little case law defining how cryptos should be handled during bankruptcy.

In Technologies LLC v. Lowe (In re HashFast Technologies LLC), Bitcoin played a central role when Bitcoin was transferred by a debtor to a third party as a fraudulent conveyance. The bankruptcy trustee claimed it was a commodity so that the bankruptcy estate would be entitled to any increase in value as of the date of recovery.

In the Technologies LLC case, the Bitcoin increased in value after the transfer to nearly three times the original amount. The defendant contended that Bitcoin was a currency and not a commodity, meaning that the value of transferred Bitcoin should be determined at the time of transfer.

However, the court did not reach a determination of whether Bitcoin should be considered a currency or commodity, stating that:

“The court does not need to decide whether [B]itcoin are currency or commodities for the purposes of fraudulent transfer provisions of the Bankruptcy Code. Rather, it is sufficient to determine that, despite defendant’s arguments to the contrary, [B]itcoin are not United States dollars.” “If and when the liquidating trustee prevails and avoids the subject transfer of [B]itcoin to defendant, the court will decide whether, under 11 U.S.C.A. §550(a), he may recover the [B]itcoin (property) transferred or their value, and if the latter, valued as of what date.”

The comment from the court asserting that “[B]itcoin are not United States dollars,” while not confirming a proper definition of Bitcoin, demonstrates that the court is leaning towards considering digital currency as a commodity rather than a currency.

Whether or not Bitcoin is considered currency may play an important role in future bankruptcy cases. If Bitcoin is not considered a currency for purposes of bankruptcy, then any exchanges of Bitcoin can be regarded as a “currency swap.” This interpretation is key because commodity and currency swaps are provided greater protections under U.S. Bankruptcy Code, and in many cases, are exempt from the automatic stay provisions and avoidance as a fraudulent transfer. To qualify for these protections, a Bitcoin transfer would need to constitute a “forward contract” as defined under the Bankruptcy Code. Given the fact that Bitcoin is becoming more widely accepted as legal tender, it may be harder for transfers and contracts to meet the definition of a forward contract.

Another area of concern is how Bitcoin is defined when used to secure a loan. A determination that Bitcoin is not currency may affect how the court interprets its use as “cash collateral” for secured debt.

Section 363 of the Bankruptcy Code defines “cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents whenever acquired in which the estate and an entity other than the estate have an interest,” including the cash collateral’s “proceeds” and “products.”

If the court deems that Bitcoin does not meet the requirement of cash collateral, it could allow a debtor to use it in the course of business without first seeking approval of a bankruptcy trustee or the court. While the price of Bitcoin may protect the creditor at the time of securing the loan, a fluctuation in price could leave the creditor unsecured in the future.

As cryptocurrencies go mainstream, more Initial Coin Offerings are sure to grow the market exponentially very soon. As it stands, there are nearly a thousand recognized digital currencies, however, as that number grows it will become inevitable that digital currency will play a part in bankruptcy cases.

To ensure that they are adequately protected, creditors need to stay informed on developments within the crypto markets and keep a close watch on how bankruptcy courts and other courts approach the subject of interpreting Bitcoin as either a liquid asset or a commodity in future cases.

If you have questions about investing in Bitcoin or how bankruptcy filings affect your investments, contact the attorneys at Geraci Law Firm and 949-379-2600.