The market for crypto assets has recently experienced significant tumult as evidenced by the bankruptcy filings of several key crypto players, including Three Arrows Capital, Voyager Digital, Celsius Networks, FTX and, most recently, BlockFi. These bankruptcy cases give rise to numerous issues for investors holding crypto assets, which can be mitigated with proper diligence and planning. In addition, there are several estate planning and trust-specific considerations that should be addressed when holding crypto assets (or determining whether to invest in crypto assets).
Risks to Customers of Bankruptcy Filing by Crypto Exchange
Investors in crypto assets face significant risk—particularly in the current marketplace—that the custodian or exchange on which they hold their crypto assets could file for bankruptcy. A number of major crypto exchanges have filed for bankruptcy in recent months—including FTX, which, until its shocking failure, was a darling of the crypto industry and a source of capital and bailouts for other crypto-related businesses. When a crypto exchange files for bankruptcy, its customers may be treated as unsecured creditors and repaid just cents on the dollar. Moreover, if a customer was fortunate (or prescient) enough to withdraw his or her crypto assets in the 90 days before the bankruptcy filing, those withdrawals may be subject to “clawback” claims by the bankruptcy estate. A number of issues underlie those risks.
Are crypto assets in a debtor’s custody property of the bankruptcy estate?
All property possessed by a debtor as of its bankruptcy filing is property of the bankruptcy estate unless an exception applies. A key exception is property held in trust for the benefit of a customer or other third party. The issue of whether crypto assets are estate property or customer property is critically important. When a crypto asset is property of the bankruptcy estate, the customer who deposited that asset is a creditor (generally an unsecured creditor), and that customer can expect to recover perhaps just pennies on the dollar. If the coins are not property of the estate, customers should be able to recover those coins in full, assuming they are still being maintained by the exchange.
The following considerations are relevant in determining whether crypto assets are the property of the bankruptcy estate:
- Applicable State Law. Bankruptcy law refers to state law to determine whether assets are property of the estate. Certain states have customer protection statutes that require custodied crypto assets to be held in trust for the customer or for crypto custodians to maintain surety bonds to backstop the custodian’s liabilities to customers. Laws applying to money transmitters (e.g., PayPal or Western Union) or other laws that govern the relationship between customers and exchanges/custodians may also bear on this analysis.
Can withdrawals of crypto assets be clawed back as preferences?
Bankrupt debtors (or trustees representing their estates) are permitted to seek to recover transfers made to creditors in the 90 days before bankruptcy filing as so-called “preferential transfers.” The preference laws are designed to ensure that all creditors of equal priority are treated equally and that no creditor is “preferred” to another shortly before a bankruptcy filing.
These preference claims have never been asserted in the bankruptcy case of a crypto exchange or custodian, so the law is unsettled. Customers have numerous defenses to these potential claims, all of which we assume will be litigated in the coming months and years.
- Withdrawal Not of Debtor Property. The bankruptcy estate can recover a transfer as preferential only if it was a transfer of estate property. As discussed above, whether a customer’s coins are property of the bankruptcy estate is a fact-intensive analysis. This issue is important to other aspects of the bankruptcy case as well, so it likely will be litigated even before preference suits are brought. Customers with potential preference exposure need to be careful in monitoring the bankruptcy cases to ensure they have a voice on this issue.
- Insolvency. Transfers are avoidable as preferences only if they were made when the debtor was insolvent. While there is a presumption of insolvency during the 90-day period before bankruptcy, customers can rebut that presumption by presenting evidence of solvency. The volatility in the crypto markets complicates the analysis because the daily swings could result in a shifting solvency picture. Challenging solvency is an expensive proposition involving expert witnesses, so customers seeking to challenge insolvency will likely want to pool their resources to the extent possible.
- Affirmative Defenses Apply. The bankruptcy code provides creditors with a number of other defenses to preference suits, including the “ordinary course” and “subsequent new value” defenses, as well as securities safe harbor provisions.
- Subsequent New Value Defense. A customer is entitled to a credit against a clawback claim to the extent the customer provided value to the debtor after receiving the withdrawal at issue. The subsequent new value defense may apply if, for example, the customer deposited additional assets after the subject withdrawal.
- Securities Safe Harbors. The Bankruptcy Code’s securities safe harbor provisions insulate certain transactions involving securities from preference exposure. One key open question regarding this defense is whether crypto assets are “securities” to which the safe harbor defenses would apply.
Tips for Mitigating Bankruptcy Risk
While bankruptcy is ravaging the crypto industry, investors can take some relatively straightforward preventative steps to protect transactions.
- Store Crypto Assets in Hardware Wallets or Other “Cold” Storage. Instead of maintaining crypto assets on an exchange, customers should consider a safer form of storage that will enable them to maintain their private keys (the “passwords” that verify ownership of crypto assets and authorize crypto transactions using that crypto). For example, a hardware wallet is a small “cold” storage device on which an investor can store crypto assets and that is connected to the internet only when effecting a crypto transaction. Not only does this type of device protect against bankruptcy risk, but it significantly reduces the risk of theft from hackers. Although certain risks are alleviated, there is a loss of convenience and risk of losing the wallet or private key, in which case the crypto may be impossible to recover.
Trust and Estate Considerations Relating to Crypto
As an asset class with a collective market cap of nearly $900 million (down from a nearly $3 trillion high in November 2021), crypto ownership gives rise to a number of traditional trust and estate issues as well, for both trustees and individuals. A few of those issues are discussed below.
Fiduciary Duty Considerations for Trustees
Given the volatility of the crypto marketplace and the bankruptcy risks identified above, trustees need to consider whether it is consistent with their fiduciary duties to invest in crypto assets at all. Many trustees will, as a matter of policy, determine that the answer is no, and that should be an acceptable answer.
However, if pressed by a beneficiary or otherwise to invest in crypto assets, trustees should carefully evaluate the nature of the proposed crypto asset investment. In evaluating the prudence of a crypto investment, it is important to understand that not all crypto assets are created equal. For example, while the prices of certain well-known crypto assets, including bitcoin, ethereum and certain popular “meme” coins, may fluctuate wildly, there is an entire class of crypto assets, called stablecoins, which are pegged to—and often backed by—fiat currency and which do not (or should not) fluctuate at all. Trustees should become familiar with the market for crypto assets and consider whether—if at all—a specific crypto investment is a suitable investment.
If trustees do determine to invest trust property in crypto assets, they also need to consider where and how to store the crypto assets securely. Not every trustee is sufficiently sophisticated to maintain crypto assets safely. As the market for crypto assets continues to grow, trustees will likely benefit from developing crypto-related capabilities or partnerships with trusted technology providers to enable the secure storage of crypto assets for their beneficiaries.
Succession Issues Relating to Crypto Assets
In order to access crypto assets not maintained on a centralized exchange, investors need to have access to both the wallet device on which the crypto assets are stored and the associated “private keys.” If either is lost, then the crypto investment likely will also be lost forever.
For that reason, a plan needs to be put in place to ensure transfer to heirs of not only the hardware wallets or other storage devices but also instructions for accessing those devices, including accessing potentially encrypted private keys. As part of this plan, the private keys must remain confidential and secure during the investor’s life. But a protocol also must be in place for heirs to know of the existence of the crypto assets and to access the hardware and the private keys upon death.
If the owner of crypto assets dies or becomes disabled without a plan in place for succession of those assets, the crypto assets will likely be lost. As of 2021, an estimated 20% of all bitcoins—worth more than $65 billion even at today’s somewhat depressed prices—have been lost forever because of missing private keys, misplaced wallets or similar avoidable circumstances.
Using Volatility to Assist in Gifting and Planning
The volatility of crypto values can create opportunities for more typical divestiture of assets used in estate planning transactions, including contributions to trusts and charitable donations. For example, when the value of crypto assets is low, it might be wise to contribute those assets to a trust for family members, including grantor retained annuity trusts, which are most effective with volatile assets. When the prices rebound—and historically they have, and then some—that growth will occur outside the estate. Conversely, when prices are high, it might be appropriate to donate some of the coins to charity.
Despite the issues currently plaguing the industry, crypto, in some form or another, seems to be here to stay. In addition to understanding the inherent risk of investing in this volatile asset class, investors need to be careful to store their coins safely and in a way that minimizes exposure to the custodian’s creditworthiness. Care must also be put into succession and estate tax planning. These issues are complex, and consultation with counsel and other trusted advisors (including technical advisors) is recommended.