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Emerging Issues at the Intersection of Digital Assets and Bankruptcy Law

By Hunter Grasso

I. Introduction

Many Crypto exchanges operate on a national or global scale, but in recent years, Florida has emerged as a crypto-industry hub. Naturally, we have seen an influx of crypto, fintech, Web3, and blockchain-related companies, and of course, consumers. With that comes an increase in deals, disputes, and unfortunately, bankruptcies. This article provides a brief overview of some emerging trends at the intersection of bankruptcy law and digital assets that have significant implications for businesses and consumers in Florida, and throughout the country.

II. Proposed Legislation Impacting Bankruptcy Proceedings

In July, Republican House Financial Services and House Agriculture Committee members introduced and approved the Financial Innovation and Technology for the 21st Century Act (the Act). The Act is intended to establish a regulatory framework for the digital asset market and provide clarity for market participants. Among other things, the Act attempts to create a framework for determining whether a particular digital asset should be classified as a commodity or a security and delineates the joint and respective regulatory powers of the Commodity Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC).

The Act also provides protections for consumers in the event a digital commodity exchange files for bankruptcy. The Act provides that customer assets held by a digital commodity exchange are to be treated as “customer property” under section 761 of the Bankruptcy Code, which in conjunction with other sections of the Bankruptcy Code, would facilitate the prompt return of customer assets held by the bankrupt exchange. Act, § 404, 5i(d)(3)(A) This provision seemingly addresses the issues that arose in the Celsius Network LLC bankruptcy case, where substantial time and estate resources were dedicated to litigating whether certain customer funds were property of the estate and subject to distribution, or whether such customers were entitled to the prompt return of their funds. See generally In re Celsius Network LLC, et. al., Case No. 22-10964 (Bankr. S.D. N.Y.).

On the other hand, the Act would impair the rights of digital commodity exchanges by limiting the available forms bankruptcy relief. Specifically, the Act provides that a digital commodity exchange shall be considered a “futures commission merchant” for purposes of section 761 of the Bankruptcy Code. Act, § 404, 5i(d)(3)(C). A “futures commission merchant” is also a “commodity broker”, as defined in section 101(6) of the Bankruptcy Code, and section 109(d) of the Code states that a “commodity broker” cannot be a chapter 11 debtor. Meaning, the Act would effectively limit a digital commodity exchange to filing for chapter 7 liquidation.

In most cases, bankrupt exchanges will file under chapter 11 of the Bankruptcy Code, so long as they can satisfy the best interests of creditors test. Under the best interests of creditors test, impaired creditors (those receiving less than the full value of their claim) must either (i) accept the chapter 11 plan; or (ii) if they oppose it, the plan must provide for distributions equal to, or in excess of the amount impaired creditors would otherwise receive if the debtor were liquidated under chapter 7. See 11 U.S.C. § 1129(a)(7). By prohibiting digital commodity exchanges from filing under chapter 11, without considering whether doing so would result in greater distributions to creditors, the Act substantially impairs the rights of potential debtors and creditors alike.

III. Tokenization

The tokenization of real-world assets (RWAs) is gaining traction with finance and lending circles. Among other things, real property, cars, art, commodities, and financial instruments can be tokenized and put on-chain to be sold or pledged as collateral. The tokenization of RWAs globalizes access to liquidity and is more efficient and cost-effective than traditional lending, particularly for smaller players.

As tokenization becomes more common between lenders and borrowers, claims secured by tokenized assets will naturally arise more frequently in bankruptcy proceedings. Similarly, bankruptcy estates will inevitably include tokenized assets and navigating the sale or liquidation of such assets will become a critical component of maximizing value for a bankruptcy estate and its creditors.

Even bankruptcy claims can be tokenized and sold or pledged as collateral. Doing so enables creditors to obtain immediate value for their claim instead of waiting for distributions from the bankruptcy estate.

For example, earlier this year, one of FTX Trading Ltd.’s (FTX) creditors tokenized its $31,000 claim as a non-fungible token (NFT) on the Ethereum blockchain and later sold it to a third-party for around $12,000. The third-party subsequently pledged the tokenized claim as collateral for a short-term loan and received the funds immediately. It remains to be seen whether tokenization will appeal to larger creditors, but either way, this transaction illustrates one of the many ways that tokenization will affect bankruptcy proceedings moving forward.

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