Kathy Bazoian Phelps
Senior Counsel in Ponzi Scheme Litigation
and Bankruptcy Matters

Kathy is a senior business trial attorney with more than 30 years experience prosecuting and defending claims for high net worth clients involved in Ponzi scheme matters and in bankruptcy proceedings. Kathy’s practice includes recovering assets for clients in complex fraud cases under standard fee and alternative fee arrangements. She also handles SEC and CFTC whistleblower claims. Kathy also serves as a mediator in bankruptcy matters, in complex business disputes, and in matters requiring detailed knowledge about fraud or Ponzi schemes.

Kathy’s Clients in Ponzi Scheme Cases and Bankruptcy Matters
Equity Receivers
Bankruptcy Trustees
High Net Worth Investors
Debtors in Bankruptcy
Secured and Unsecured Creditors

Sunday, July 31, 2022

July 2022 Ponzi Scheme Roundup

Posted by Kathy Bazoian Phelps 

Below is a summary of the activity reported for July 2022. The reported stories reflect at least 3 new Ponzi schemes worldwide, 2 guilty pleas, more than 53 years of prison sentences, and an average age of approximately 47 for the alleged Ponzi schemers. Please feel free to post comments about these or other Ponzi schemes that I may have missed. 

Paulette Carpoff, 48, was sentenced to 11 years in prison and ordered to pay $661 million in restitution in connection with the scheme run with her husband, Jeff Carpoff, through DC Solar. Jeff Carpoff was previously sentenced to 30 years in prison and ordered to pay $790.6 million in restitution. DC Solar manufactured solar generator units to be mounted on trailers, but generators were sold that did not exist.

Celsius Network LLC filed for bankruptcy amidst lawsuits alleging that the company was running a Ponzi scheme. The lawsuits allege that the crypto lender artificially inflated the price of its own digital coin and offered large interest rates to attract new investors when it had a cash crunch. Celsius filed for bankruptcy after freezing customer funds last month. Celsius supposedly made money by lending to institutional borrowers at higher interest rates than it offered for deposits. Alexander Mashinsky and other Celius executives have been accused of enriching themselves at the customers’ expense.  A former employee has sued the company for manipulating the cryptocurrency markets.

Mark and Sharon Dente were sued by the state of Ohio on allegations that they ran a Ponzi scheme. The scheme was a house-flipping business through EM Capital Fund and allegedly defrauded more than 90 investors out of $53.1 million. Investors were promised returns as high as 36% over 9 months.

Matthew Eckstein, 52, of New York, was sentenced to 10½ years in prison in connection with a $12 million Ponzi scheme. Eckstein previously pleaded guilty to the scheme run through Conmac Funding Corp that targeted nearly 50 victims. Eckstein was a CPA and financial advisor who used his role to defraud mostly elderly victims into investing in Conmac owned by Kevin Brody. Eckstein and Brody used the stolen funds to invest in other business enterprises, for personal purchases, and for a down payment on a home. Brody was previously sentenced to 7 years in prison. 

Jordan E. Goodman, 67, marketed as “America’s Money Answers Man” was charged by the SEC in connection with advising people to invest in the Woodbridge Group Ponzi scheme. The scheme, run by Robert Shapiro, lured in investors in a real estate scheme that involved $1.2 billion. Goodman helped Woodbridge raise $147 million from 1,200 investors. 

Patrick O. Howard, 50, of Texas, was ordered to pay back $2.8 million in connection with a scheme that defrauded more than 100 investors. Howard previously pleaded guilty to the scheme that promised investors a 12% return. 

Ruja Ignatova, 42, was added to the FBI’s Most Wanted List with a $100,000 reward. Ignatova, a Bulgarian women known as the “Queen of Cryptography,” is wanted in connection with the One Coin cryptocurrency Ponzi scheme. Ignatova and her co-conspirators raised at least $3.4 billion in connection with the scheme, seeking to replace bitcoin as the world’s leading cryptocurrency. Her brother, Konstantin Ignatov, was arrested in Los Angeles in 2019 and pleaded guilty to related charges. Another partner, Sebastian Greenwood, was detained in Thailand in 2018 and sent to the U.S. where he remains in prison awaiting trial. Mark Scott, a U.S. lawyer, was convicted in 2019 on charges relating to the washing of $400 million for the group.

Justin Kimbrough, 25, of Texas was charged by the SEC on allegations related to a scheme run with Terry Nikopoulos and his company, TKJ Investments Corp. The scheme was supposedly a real estate wholesale business, and at least $3 million was obtained from at least 31 investors. Funds were also placed into Preeminent Trade Group Inc, a company specializing in selling medical equipment for resale in India. Kimbrough was criminally indicted last month. Authorities alleged that Kimbrough wired some investor funds his business, Prosperity Consultants, LLC.

Jason “Lottery Lawyer” Kurland was found guilty in connection with an $80 million scheme in which he misappropriated his clients’ lottery jackpots. Kurland steered his clients to invest in companies that he secretly owned and took kickbacks without their knowledge. Kurland stole $100 million from a $245 million Powerball jackpot winner and funds from a $150 million jackpot winner and others. 

Marco Perez Jr. aka Sully Perez, 37, of Texas, was sentenced to 14 years in prison and ordered to pay more than $14.5 million in restitution in connection with the Ponzi scheme run through Permian Basis Proppants, Inc. Perez promised returns to investors from the purchase of frac sand at a discount and the resale to fracking operations in and around the Permian Basin. Perez used the funds for his personal expenses, paying for property, vacations, luxury vehicles, a helicopter, and a lavish wedding. 

Gilbert J. Peter Jr., 62, was arrested on allegations that he stole millions of dollars in connection with a clinic called My Doc Urgent Care and Doctor Doctor.

David Saffron, 49, was charged with running an alleged cryptocurrency Ponzi scheme through Circle Society. Saffron allegedly misrepresented to investors that he generated profits by using a trading bot that could execute over 17,000 transactions per hour on various cryptocurrency exchanges. He also falsely represented that his trading bot would generate between 500% to 600% returns on the amount invested.

Jon Seawright, 50, pleaded guilty in connection with his role in the timber Ponzi scheme ran by Arthur Lamar Adams through Madison Timber Properties LLC. Seawright admitted that he and a co-conspirator participated in the scheme and represented to investors that they were in the business of loaning funds to buy timber rights from landowners and then sell those rights to lumber mills at a higher price. Seawright operated an investment company, Alexander Seawright LLC, with Brent Alexander. Adams was sentenced to 19½ years in prison in 2018.

Jeremy Spence, 25, was sentenced to 42 months in prison in connection with the Coin Signals Ponzi scheme. Coin Signals defrauded more than 170 people in a cryptocurrency scheme involving more than $5 million. 

Cornelius Johannes Steynberg, and Mirror Trading International Proprietary Limited, were charged by the CFTC with running a fraudulent commodity pool worth more than $1.7 billion in bitcoin. Mirror Trading is a South African company that solicited bitcoin from thousands of people, including 23,000 Americans. 

Le Anh Tuan, 26, a Vietnamese national, was charged in connection with an alleged cryptocurrency-related fraud involving the Baller Ape NFT. Tuan was involved with the Baller Ape Club, a supposed NFT investment project. In a “rug pull,” the website was deleted after the first day and $2.6 million of investor funds went missing. A blockchain analysis revealed that the investor funds were laundered through “chain-hopping” where one type of coin is converted to another type and funds are moved across multiple cryptocurrency blockchains to obscure the trail of the funds.

Tyler Tysdal, 51, was sentenced to 6 years in prison in connection with a $46 million Ponzi scheme. The scheme ran for a decade and defrauded about 77 investors. Tysdal pleaded guilty last year. Co-conspirator, Grant Carter, 51, also pleaded guilty and was sentenced to 4 years in prison. The scheme was run through Cobalt Sports Capital, which purported to make short-terms, high-interest loans to startup companies, and a second scheme promised returns of 10 to 15 times their principal investment from investments in a wine distributor.

INTERNATIONAL PONZI SCHEME NEWS 

Australia

Chris Marco, 63, was charged in connection with an alleged Ponzi scheme that defrauded over $36 million from at least 9 investors between 2013 and 2018, and $250 million for over 300 investors over a 20-year period. The scheme was run through AMS Holdings (WA) Pty Ltd.  Marco disputes the charges. 

Canada

Joshua James Tenhove, 49, was sentenced to 4 years in prison and ordered to pay $3.3 million in restitution. Tenhove previously pleaded guilty to a Ponzi scheme that took in $10 million from investors to buy light towers so they could be rented to customers.

India

Authorities attached properties held in the name of Dreamz Infra India Ltd, TGS Constructions Pvt Ltd, Disha Choudhary, and Mandeep Kaur, in connection with an alleged Ponzi scheme.

Malta

JuicyFields is accused of running a Ponzi scheme which may be the largest such scam in the cannabis industry. The cannabis investment platform promised returns between 6% and 14% from investments in cannabis plants. The scam operated worldwide and allegedly involved hundreds of millions of dollars. JuicyFields stopped operations in July, froze cash withdrawals, removed profiles from social media, and disappeared.

South Korea

Officials raided at least 7 cryptocurrency exchanges as part of an investigation of Terraform Labs, including Upbit, Bithumb, and Coinone. Terraform collapsed earlier this year.

Nigeria

Bamise Samson Ajetunmobi and Elizabeth Anuoluwapo Ajetunmobi have been ordered to pay N18.8 billion to 27 defrauded investors in connection with a scheme that promised 10% monthly returns. The scheme was run through Imagine Global Holding Company Ltd and Imagine Global Solutions Limited and supposedly offered microloans to small and medium-sized companies and low-income workers in Africa.

Amanda Chisom was arrested in connection with an alleged Ponzi scheme run by Marksman Chinedu Ijeoma aka Chinmark. The scheme involved N50 billion.

Philippines

Authorities revoked the corporate registration of Wellcons Unlimited Systems Inc. in connection with its “double-your-money” program called Binary System. Investors were told they could double their money in 6 months. 


Sunday, July 24, 2022

Cryptocurrency in Bankruptcy: Breaking It Into Small Bytes

By Kathy Bazoian Phelps

July 24, 2022

This article covers the Who, What, Where and Hows of issues arising when cryptocurrency lands in a bankruptcy proceeding, with a particular focus on cryptocurrency exchanges and investment funds. Those who think they own the cryptocurrency reflected on their monthly statements may want to keep reading to learn how to assess the risks associated with those exchanges and investments.

What is Cryptocurrency?

Is cryptocurrency a commodity, a security, currency, or something else? 

Cryptocurrency is a medium of exchange that exists in the form of a virtual currency or digital asset. It can be used to purchase goods or services, as collateral in a lending transaction, or as an investment, either by itself or pooled in an investment fund with others.

Unlike sovereign-issued currencies like the dollar or euro, cryptocurrencies are not backed by any government, fiat currency, or commodity. 

Cryptocurrency uses a digital signature mechanism to generate a “public key” and a “private key” that are mathematically related. The public key identifies the user and is like an account username. The private key is a string of characters that serves as a password and identifies the owner of the wallet, allowing the user to access and transfer the digital assets. Digital wallets store cryptocurrencies, and owners can exchange cryptocurrencies over the internet directly from peer to peer. “Miners” are computer operators who use software to validate transactions and are awarded cryptocurrency as they solve computational puzzles to add new blocks to the blockchain. 

Cryptocurrency exchanges facilitate the exchange of cryptocurrencies for other currencies or cryptocurrencies.

In characterizing cryptocurrency, the line between currency and commodity remains blurred, but it has become clear that the characterization of cryptocurrency as a “security” for regulatory purposes is limited to investment contracts and does not extend to outright ownership of cryptocurrency. The SEC monitors the formation of investment funds that solicit investors, through Initial Coin Offerings (ICOs) or otherwise, concluding that these are investment contract securities transactions subject to SEC regulations if they satisfy the “Howey Test.” SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The following criteria are used to establish whether investment contracts are securities transactions subject to securities regulation: (1) an investment of money; (2) in a common enterprise; and (3) with an expectation of profits mostly from the efforts of others. Therefore, while cryptocurrency itself may not be a security, an investment in a fund handling cryptocurrency or an ICO certainly may be subject to securities regulations if the arrangement is deemed to be an investment contract that meets these criteria. 

The debate over whether cryptocurrency is a commodity, a security or a currency is ongoing. However, in a bankruptcy case, the consequences of how to characterize cryptocurrency is highly significant, as explained below.

Who Filed Bankruptcy?

As an asset, cryptocurrency can land in a bankruptcy proceeding in a few different ways, depending on who filed the bankruptcy: 

  • An Individual: An individual who files bankruptcy may own cryptocurrency, holding it in a private “cold” wallet to which they hold the private digital key, in a “hot” wallet connected to the internet, in an exchange, or otherwise. When an individual files bankruptcy, all property of the individual becomes property of the bankruptcy estate, wherever located, including cryptocurrency.

  • An Exchange: An Exchange is a platform that offers customers the ability to buy, sell, and trade cryptocurrencies. Customers can have their assets held in custodial wallets. There is no SIPC or FDIC insurance for the assets held in a cryptocurrency Exchange. If an Exchange ends up in bankruptcy, the legal ownership of the digital assets is a complex question that is just now making its way to the courts. Tough issues arise in a bankruptcy involving competing claims from customers wanting the Exchange to return their digital assets and the Exchange claiming that the assets are property of the bankruptcy estate.


  • An Investment Fund: An Investment Fund may aggregate investor dollars to purchase cryptocurrency on behalf of the investors in the Fund. Similar to issues arising in a bankruptcy of an Exchange, a Fund bankruptcy may tee up battles between the investors seeking the return of the in-kind digital assets that they thought they owned and the company seeking to liquidate the assets and pay pro rata claims to its unsecured creditors, including its investors. 

Depending on who ends up in bankruptcy, the issues can play out very differently. In this cast of characters, all are likely to be eligible to file for bankruptcy under the Bankruptcy Code; that is, if they are not otherwise excluded from eligibility by section 109 of the Bankruptcy Code (11 U.S.C. § 109). Banks, insurance companies, and railroads, among a few others, are not eligible for bankruptcy relief. The question of whether a company filing bankruptcy qualifies as a bank might be an issue in circumstances where, for example, a financial institution also holds digital currencies. Or, if an Exchange has both a cryptocurrency division as well as a banking division, the lines may become blurred regarding eligibility for bankruptcy.

Where is the Cryptocurrency Located?

Cold Wallet: This is a personal wallet where the owner holds a private digital key to control the digital wallet. The holder of that very important key has the exclusive ability to make withdrawals or payments from the wallet. The cold wallet stores digital assets offline using tools such as USB devices or paper wallets with QR codes. If the key is lost, however, the digital assets are lost. Some estimates are that 20% of Bitcoin is locked in cold wallets where the key is lost and the assets are inaccessible.

Hot Wallet: A hot wallet is connected to the internet and uses devices or systems such as desktop wallets, mobile wallets, and web-based wallets. A hot wallet can be connected to a trading platform, such as an Exchange. Hot wallet keys are stored on the internet. Hot wallets can be more accessible and easier to use, but they are less secure and more vulnerable to hackers. 

An Exchange: An Exchange can be more convenient for customers who do not want the hassle or the responsibility for maintaining a personal cold wallet. But there is a risk here. If custodially held cryptocurrencies in an Exchange land in bankruptcy, an issue may arise as to whether the Exchange or the customer legally owns the cryptocurrency. Custodial cryptocurrencies may be treated differently than a user’s own digital keys and noncustodial accounts in a bankruptcy proceeding. Whether or not digital assets that are held by an Exchange become property of the bankruptcy estate subject to satisfying creditor claims is likely going to be fact dependent and potentially a hotly contested issue. 

An Investment Fund: If an investor hands cash or cryptocurrency over to an Investment Fund in the hope that they will turn a profit, they are pooling their assets with other investors in the fund. What that Fund then does with that cash and assets is out of the investors’ control. Unfortunately, sometimes the cash is never even converted into digital assets. Or perhaps a wallet is held by the Fund and then the Fund loses control over that wallet – due possibly to insider theft, hacking, or some other dissipation of the assets. The Fund could also choose to place the money and digital assets with an Exchange in the Fund’s name, making the assets one step further removed from the investor. 

Who Owns the Cryptocurrency in Bankruptcy?

If an Individual Files: If the individual owned it before bankruptcy, whether located in a cold wallet, hot wallet, or at an Exchange, that asset becomes property of the bankruptcy estate pursuant to section 541 of the Bankruptcy Code.

If an Exchange Files: Unlike a brokerage statement reflecting actual ownership of shares of a company, a statement from an Exchange that reflects a certain number of a type of cryptocurrency, i.e., Bitcoin or Ethereum, may state the value at a given time, but may or may not reflect an actual ownership in a particular thing. Cryptocurrency may be deemed fungible, like dollars, creating some ambiguity as to who owns what. The fine print in the User Agreement with an Exchange might offer some insight in this regard as to who the owner is. If assets are deemed fungible and are commingled, however, a legal battle may ensue over ownership. 

Once in bankruptcy, whether a custodial account at an Exchange remains property of the customer or becomes the Exchange’s property may depend on the intent of the parties, the fine print in the agreement with the Exchange, whether customer assets are commingled or can be separately traced, and who has control of those assets.

One of the more popular exchanges generally considered to provide customers comfort, Coinbase Global Inc. (“Coinbase”), recently reported that:

"[B]ecause custodially held crypto assets may be considered to be the property of a bankruptcy estate, in the event of a bankruptcy, the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors." 

That statement was buried in Coinbase’s quarterly Form 10-Q (May 10, 2022), which also discloses that Coinbase has $256 billion in custodial fiat currencies and cryptocurrencies that it holds on behalf of its customers. 

However, the fine print under Legal on the Coinbase website for the Coinbase User Agreement (https://www.coinbase.com/legal/user_agreement/united_states last checked July 24, 2022) tells a different and somewhat confusing story:

  • Assets are fungible: Under section 2.5 of the User Agreement, users must agree that Coinbase may hold assets on shared blockchain addresses and that digital assets that are held across multiple blockchain addresses may be treated as fungible. Fungible means that a particular “thing” is not a distinct identifiable asset.
  • Custodial and ownership arrangements: Section 2.7 states that digital assets are held by Coinbase for the customer’s benefit, and section 2.7.1 states that title remains with the customer and not Coinbase. “All interests in Digital Assets we hold for Digital Asset Wallets are held for customers, are not property of Coinbase, and are not subject to claims of Coinbase’s creditors.” If true, then why the recent disclosure that “customers could be treated as our general unsecured creditors”?
  • Commingled accounts: Section 2.7.4 states that “In order to more securely and effectively custody assets, Coinbase may use shared blockchain addresses, controlled by Coinbase, to hold Supported Digital Assets for Digital Asset Wallets on behalf of customers and/or held on behalf of Coinbase. Although we maintain separate ledgers for users’ Coinbase Accounts and Coinbase accounts held by Coinbase for its own benefit, Coinbase shall have no obligation to create a segregated blockchain address for your Supported Digital Assets.” 

So, can a customer make a claim to particular digital assets, and are those assets actually traceable to the customer?

The Coinbase User Agreement language definitely creates confusion about what would happen in a bankruptcy. 

The recent bankruptcy filing of Celsius Network LLC further highlights the complexity of this issue. Celsius disclosed in its bankruptcy case (https://cases.stretto.com/celsius/) that it has several different programs under the Celsius umbrella, each of which may ultimately be treated distinctly in bankruptcy. The first day presentation by Celsius as filed with the bankruptcy court provides the following explanation of its programs:

"Earn Program: Retail customers transferred coins to Celsius and earned rewards

  • Under the Terms of Use (“TOUs”), title to coins is transferred to Celsius, and Celsius is entitled to use, sell, pledge, and rehypothecate those coins. 
  • Since April 15, 2022, the Earn product has been limited to U.S. accredited investors and foreign customers. 

Borrow Program: Celsius leant USD or coins to borrowers who post coins as collateral 

  • Borrowers were able to choose from different loan products based upon LTV ratios of posted collateral, with applicable interest rates being higher for higher LTV loans. 
  • Title to coins is transferred to Celsius and Celsius is entitled to use, sell, pledge, and rehypothecate those coins. 

Custody Program: Custodial services for customer, incl. U.S. non-accredited investors 

  • Began in April 2022 
  • Title remains with customer and Celsius cannot use coins without instructions from the customer.

Institutional Lending and Borrowing Program: Bespoke lending and borrowing with institutional clients, such as hedge funds and market-makers 

  • Depending on the creditworthiness of the counterparty, loans to institutional investors may be secured, partially secured, or unsecured 

Mining: Celsius, through its Debtor subsidiary Celsius Mining LLC, operates one of the larges Bitcoin mining enterprises in the U.S. 

  • Celsius operates over 43,000 rigs and plans to operate 112,000 rigs by Q2 2023."

Quite early in the Celsius bankruptcy case, customers of Celsius are already filing letters with the court, imploring the court to return the digital assets to them in kind. The Celsius bankruptcy case may establish some important precedent as to how it will all shake out in a bankruptcy. On the one hand, if title really does belong to the customer and the Exchange is holding those assets in trust and for the benefit of the customers, the customer should get the property back in kind. On the other hand, if assets are fungible and commingled, can the customers really trace what they claim is theirs? 

If there is no fraud or mismanagement involved in an Exchange bankruptcy case, the Exchange should in theory have enough cryptocurrency to return to customers, even if the value of the assets has dropped due to volatility in the market. If fraud or mismanagement is involved, however, and insufficient assets remain, returning digital assets in kind to customers will present challenges and create priority battles. This would potentially cause courts to invoke equitable principles, such as pro rata distribution methodologies, to divide a pie that is too small to feed everyone.

If and when a bankruptcy is filed, an automatic stay will immediately kick into place prohibiting the withdrawal of assets from the bankrupt Exchange, at least until these ownership issues are worked out.

If the Investment Fund files: Investment programs that solicit investor funds to turn a profit are generally required to follow applicable regulations, registering with the SEC or CFTC and making certain disclosures unless otherwise exempt. Unfortunately, this is an area in which it is too easy for fraudsters to take advantage of unsuspecting investors, and for investors to fall short of solid due diligence. Similar battles may ensue among investors in a bankruptcy proceeding all seeking to get “their” digital assets back, while the Fund may hold insufficient assets to satisfy all investors.

How to get cryptocurrency out of a bankruptcy?

The automatic stay that is imposed under section 362 of the Bankruptcy Code upon the filing of a bankruptcy petition will stop all actions to take control of all assets of the bankruptcy estate, including all assets in the possession of the bankrupt debtor. So, at least initially, customers will not be able to withdraw their cryptocurrencies after a bankruptcy filing of an Exchange or Fund. 

There are a few ways, however, that a customer or an investor might be successful in extracting something of value from such a bankruptcy. 

Tracing

First, if the customer can establish a unique, traceable interest to a particular digital asset, then it may be possible to assert a constructive trust position over that identifiable asset. In such an instance, the customer would have a claim in kind, for the digital asset which can be traced to a wallet with a unique identity for that customer. If assets are held in an identifiable cold wallet in a noncustodial account at the Exchange, then tracing might be possible.

Given the fungible nature of digital assets held by an Exchange or Fund, however, such tracing might prove problematic for custodial accounts under the control of the Exchange. The customers will undoubtedly seek to retrieve their digital assets in kind. The bankrupt Exchange may seek to affix a value to the claim amount of that customer and allow a claim in the bankruptcy case to be satisfied in cash. So, if the assets are in a custodial account, it remains to be seen how this will play out in bankruptcy. The fine print could ultimately be critical in hashing out these issues. 

        Unsecured Creditor

If no tracing can be established and the customer is merely a general unsecured creditor of the Fund or Exchange, then, to the extent assets are available, distributions will ultimately be made to creditors, likely in the form of cash, pursuant to the priority scheme set forth in the Bankruptcy Code. Non-monetary claims for digital assets may be converted into monetary claims based on the valuation at the time of the commencement of the bankruptcy case. 

An Exchange or Investment Fund wishing to stay in business through bankruptcy will likely have filed a Chapter 11 reorganization case. In such a case, the business will want to retain its customers. So it would presumably retain the assets that its customers claim and try to propose a plan for distributing or retaining the assets that the customers would support. In a Chapter 11 reorganization proceeding, the creditors may have an opportunity to vote on a plan of reorganization. But they will have to wait for the debtor to propose and confirm a plan before they either retain their digital assets or get paid whatever percentage of their claim that is ultimately disbursed under the plan. 

In the meantime, the unpredictability and volatility in the price of cryptocurrency may create significant issues in the plan confirmation process, making it challenging to establish the required feasibility of a plan in the first instance. Even more frustrating for general unsecured creditors is that they will get paid only after administrative, priority and secured creditors are paid, so payment can be slow and disappointing in many cases. A Chapter 11 plan could also theoretically propose the return of digital assets in kind if sufficient assets remain, moving the benefits or risks of past and future fluctuation in price back to the customer.

If the bankruptcy case is instead a Chapter 7 liquidation, or if the company has decided to liquidate in Chapter 11, the challenges for the creditor will likely be greater and the distribution quite possibly smaller. Without any incentive to retain customers, a Chapter 7 trustee or a company in liquidation mode may have little reason to try to honor the claims of one particular creditor over another and would instead seek to sell everything and pay a pro rata share out to creditors in the order of priority. Depending on the scope of the sale, a forced liquidation of crypto assets can drive down the value of those assets for other investors in that type of asset, potentially on a global scale. However, more importantly for the creditors in the particular bankruptcy case, the recovery for the creditor will be limited to a pro rata share of net sales proceeds, with no hope of future appreciation on the assets that would come of an in kind return of digital assets. A benefit of an in-kind distribution is that it would move the potential future upside or downside of the asset back to the customer pursuant to the customer’s expectations when the asset was originally acquired.  

What are the risks to customers in bankruptcy?

As discussed above, customers and investors are subject to the risk of nonpayment, delayed payment, or a small distribution. But there is more. They may also be required to give back any assets that they received within the 90 days prior to the bankruptcy filing under the bankruptcy preference laws in section 547 of the Bankruptcy Code. A bankruptcy trustee or the debtor in bankruptcy may seek to avoid and recover any transfers made to or for the benefit of a creditor within 90 days of the filing of the bankruptcy petition for antecedent debt while the debtor was insolvent. An investor in a Fund or a customer that has digital assets at an Exchange may be deemed a creditor of that Exchange and will want to explore possible defenses if such a claim is made.

Similar to the risks of avoidance from a preference action, customers could also be required to return digital assets transferred to them during the two years before bankruptcy if those transfers are deemed avoidable under the fraudulent transfer provision in section 548 of the Bankruptcy Code. State fraudulent transfer laws may also apply and those laws may have lookback periods even longer than two years. While the word “fraudulent” feels accusatory as to the recipient customer’s intent, it is actually the intent of the Exchange or Fund - the transferor – to hinder, delay or defraud other creditors that is the triggering intent under section 548(a)(1)(A) of the Bankruptcy Code. Alternatively, a transfer may be deemed fraudulent as a constructive fraudulent transfer under section 548(a)(1)(B) where that debtor received less than reasonably equivalent value in exchange for the transfer at a time when the debtor was insolvent. 

Further complicating the analysis, there are defenses to these types of actions to recover transfers if the transfers involve securities, commodities or a repurchase agreement. This begs the question, of course, of what is cryptocurrency? 

The value of the cryptocurrency that was transferred becomes an important part of the analysis for these types of avoidance claims, leading to yet more issues to resolve in a bankruptcy case. Section 550 of the Bankruptcy Code, states that “the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property.” Whether cryptocurrency is a currency or commodity will therefore impact what can be recovered in an avoidance action. If a currency, the value at the time of the transfer can be recovered. If a commodity and property is transferred, then the value of the property at the transfer date or time of recovery, whichever is greater, can be recovered, allowing for the capture of any appreciation. 

At least one bankruptcy court was confronted with this issue but unfortunately declined to offer any guidance. Kasolas v. Lowe (In re Hashfast Technologies LLC), Adv. No. 15-3011 (Bankr. N.D. Cal.). In that case, the liquidating trustee sought to recover 3,000 bitcoin as a fraudulent transfer, arguing that he was entitled to the Bitcoin at its present value of $1 million because the cryptocurrency was a commodity and not currency. The recipient of the transfer argued that the Bitcoin was currency and were only worth the $363,000 that was the value at the time of the transfer. The bankruptcy court did not determine whether the Bitcoin was currency or commodities for purposes of the fraudulent transfer, and because the case was ultimately settled, the question of whether to value the Bitcoin as of the date of transfer or a later time was never decided. 

Other courts have reached differing conclusions. For example, one court determined that investments in Bitcoin constituted an investment of money. SEC v. Shavers, Case No. 13-cv-416, Docket No. 23 (E.D. Tex. Aug. 6, 2013). Another court in a case brought by the Commodity Futures Trading Commission found that cryptocurrencies are a type of commodity. In re Coinflip Inc., CFTC No. 15-29 (Sept. 17, 2015) (“Section 1a(9) of the act defines ‘commodity’ to include, among other things, ‘all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.’ ... Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.”).

Takeaways

 Read the fine print of any user agreement with an Exchange or subscription documents for an Investment Fund.

 Even if the fine print says you own the cryptocurrency, be aware of the risk that a bankruptcy court may find otherwise.

Consider placing cryptocurrency in a cold wallet to stay offline and in complete custody and control of the owner – but don’t lose the private key!

    Be suspicious of promises of regular or above market returns on cryptocurrency investments.

 If it sounds too good to be true, it probably is.