Digital Asset Recovery in Chapter 11 Bankruptcy – Insolvency/Bankruptcy

This article was originally published in Bloomberg Law. Reprinted with permission. The views expressed in this article are not those of Winston & Strawn or its clients. The opinions expressed in this article are solely the opinions of the author.

On July 5, 2022, digital asset lender Voyager Digital Holdings, Inc. made headlines by filing a voluntary request for Chapter 11 relief. Shortly after, competitor Celsius Network filed its own protection against bankruptcy in the Southern District of New York. It’s entirely possible that this news represents just the beginning of a wave of bankruptcies in the digital asset space.

While an increase in digital asset bankruptcies will give rise to a number of new issues in the field of bankruptcy and restructuring, this article will address the emerging question of how traditional recovery mechanisms might work when recoverable assets are digital assets stored on a blockchain.

RECOVERY OVERVIEW

In a typical bankruptcy case, a trustee can trace a debtor’s assets by reviewing the debtor’s bank accounts, tax returns, and financial statements, as well as relevant public documents such as Uniform Commercial Code filings. When reviewing debtor transactions, a trustee will identify certain types of transfers that are vulnerable to attack.

A trustee then has a set of tools to recover and recover the assets of the estate for the benefit of all creditors. If a trustee succeeds in proving to the bankruptcy court that a particular transfer was either a “preference” or a “fraudulent transfer”, the bankruptcy court will then order the return of the assets to the bankruptcy estate.

But what if the debtor’s books do not identify the recipient of an unquestionably preferential or fraudulent transfer? This is precisely the situation presented to a trustee seeking to recover digital assets.

PREFERENCES

The first tool a trustee can use to recover assets in the bankruptcy estate is the power to avoid certain “preferential” transfers made shortly before filing for bankruptcy. Generally speaking, although certain defenses may be raised by a creditor who has received an alleged preference, Section 547(b) of the Bankruptcy Code provides that a transfer is considered to be a preference if it has been made within 90 days of the date of the bankruptcy petition and was made to or for the benefit of a less than fully secured creditor due to a prior debt of an insolvent debtor. The prototypical preference is a transfer made to a preferred creditor on the eve of the bankruptcy filing. The policy behind allowing the collection of preferences is to promote the guiding principle of the Bankruptcy Code of facilitating equal distribution among like-situated creditors.

Once a trustee in bankruptcy identifies a preferential transfer, the trustee typically sends a demand letter to the beneficiary of the preference. Although most preferences are settled out of court, a trustee can also initiate adversarial proceedings in a debtor’s bankruptcy. This latter method allows for formal discovery and even litigation to enable a fiduciary to recover a disputed preference.

FRAUDULENT TRANSFERS

The second tool available to a fiduciary is the possibility of unwinding fraudulent transfers. Under Section 548 of the Bankruptcy Code, a trustee has two lines of attack to prevent a fraudulent transfer occurring within two years of the date of the petition.

First, a fiduciary can unwind an actual fraudulent conveyance. A transfer is effectively fraudulent if a debtor has made a transfer or entered into an obligation with the actual intention of hindering, delaying or defrauding his creditor(s).

Second, a fiduciary can unwind an alleged fraudulent transfer. Generally, a transfer is fraudulent by construction if a debtor received less than reasonably equivalent value in exchange for a transfer and the debtor was insolvent at the time of the transfer or was rendered insolvent by the transfer; kept unreasonably small capital to engage in business or transactions; intended or believed that the debtor would incur debts beyond his ability to pay; or made such a transfer or incurred such an obligation to or for the benefit of an insider, pursuant to an employment contract, and outside the ordinary course of business.

A trustee in bankruptcy can also use bankruptcy law to avoid a fraudulent conveyance. Section 544(b) of the Bankruptcy Code allows a trustee to avoid any transfer of a debtor’s interest in property or an obligation entered into by the debtor that is voidable under applicable law, such as state fraudulent conveyance law, by a creditor holding an unsecured interest. claim. Notably, state law often extends the statute of limitations for bringing fraudulent conveyance actions up to six years.

Under Bankruptcy Rule 7001, a trustee must initiate adversarial proceedings in a bankruptcy case in order to unwind a fraudulent conveyance. Unlike preferred shares, where a debtor’s insolvency is presumed, a trustee bringing an action for fraudulent conveyance has the burden of proving insolvency by a preponderance of the evidence. In the event of an intentional fraudulent transfer, the trustee must prove the intention to defraud with clear and convincing evidence.

Like preference laws, fraudulent conveyance laws prevent an unfair windfall for a creditor by allowing a trustee to recover for the benefit of all creditors property that has been improperly transferred by a debtor. . Current fraudulent conveyance laws date back to the Statute of Elizabeth, enacted in 1571. Today, 450 years after the first fraudulent conveyance law was first introduced, fraudulent conveyance actions have proven to be an agile tool for recovering a wide range of assets, including digital ones.
assets.

UNMASKING ASSET OWNERS

Digital assets, such as bitcoin and ethereum, are decentralized digital currencies that can be transferred electronically without relying on an institutional intermediary. Instead of employing a central trusted intermediary to record and facilitate digital asset transfers, digital asset transfers are recorded on the blockchain, a digital public ledger hosted on a network of computers on a peer-to-peer network. -peer.

While each transaction is recorded on the blockchain’s public ledger for all to see, the respective identities of the transferor and transferee are only represented by an “address”, similar to a bank account number, which consists of a series of 26-35 alphanumeric characters instead of each person’s name. These characters are called a “public key”, which is publicly available and acts as the mailing address to which digital assets can be sent. In order to verify digital asset transactions, prove ownership of digital assets on the blockchain, and transact with those digital assets, a “private key” is also required. The private key is essentially a password.

Public and private keys are stored in a “wallet”. Thus, ownership of digital assets is not truly anonymous. Rather, it is a pseudonym, as one-to-one transactions between masked individuals take place on the public blockchain forum.

The decentralized and pseudonymous nature of many digital assets means that any bankruptcy trustee who knows the identity of a debtor’s blockchain address can examine the public blockchain to discover every transaction the debtor has ever committed to, including the transfer of preferential or fraudulent transfers on the eve of bankruptcy. The unique problem presented by digital assets in bankruptcy is the difficulty of tracing exactly which person or entity received the debtor’s digital assets via their own home address.

However, solutions to this problem are emerging. Blockchain forensics firms now specialize not only in tracking the movement of these digital assets across the blockchain, but even in de-anonymizing the identities of those involved. This was done successfully in the recent bankruptcy case of cryptocurrency lender Cred Inc. In this case, a former executive got away with millions of dollars in bitcoins and refused to return the assets to Cred. The attorney for Cred’s Official Unsecured Creditors Committee worked with a digital asset tracing consultant to identify and ultimately recover nearly $6 million in digital currency stolen from the former executive.

In addition, trustees may resort to more traditional methods of asset recovery. For example, like traditional banks, public digital asset exchanges typically operate from omnibus accounts in which client assets are co-mingled. A trustee can subpoena the exchange to recover its omnibus accounts. Additionally, if digital assets are sent from a personal wallet to an exchange wallet, an exchange may provide the identity of the holder of the exchange wallet.

Many problems in this rapidly changing space are difficult to solve. For example, sophisticated parties can create their own digital wallets that are not hosted by an institutional exchange. In such cases, a fiduciary cannot simply assign the exchange to recover the digital assets. Additionally, people wishing to avoid public visibility can engage in transactions using “privacy coins”, which are designed to maintain the privacy of their users by hiding transactions on their blockchain using advanced cryptography. .

However, tracing may still be possible, as the required privacy options are not always used or “enabled” by privacy coin users. Additionally, tools can be used to detect the identity of people using confidential coins, such as matching timestamps of private transactions with concurrent real-world activities such as online purchases or sales of digital assets against fiat currency.

CONCLUSION

For centuries, debtors in possession and trustees in bankruptcy have been able to recover certain improper transfers of debtor assets that took place shortly before a bankruptcy petition was filed. To do this, a trustee or a debtor in possession can sue for preference or for fraudulent conveyance to recover the assets of the estate and distribute them more equitably among the creditors.

Today, a potentially impending wave of bankruptcy filings in the digital asset industry may shed light on whether these historically reliable asset recovery methods may prove more difficult to apply in the modern digital asset sphere. recorded on a blockchain.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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