DeFi participants should prepare to confront the unknown as bankruptcies loom

Ferris wheel at night

Restructuring Alert

Financial Services Alert

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Recent turmoil in in the cryptocurrency markets has left investors and blockchain projects wondering about what will come next and how to address the potential fallout.  Many facts about the failures of these projects remain unknown.  What is certain, however, is that there are many open questions related to how the laws will operate in the event of a US-based bankruptcy filing.       

Background

Most of the discussion on bankruptcy and cryptocurrencies has focused on centralized exchanges, the custodial status of assets held by centralized exchanges, and how depositors would be treated in the event of bankruptcy.  Less attention has been paid to the recent growth of cryptocurrency lending platforms that have developed under the umbrella of decentralized finance (DeFi).

DeFi platforms conduct transactions through the creation and maintenance of a “lending protocol” that exists on a blockchain.  The lending protocol is a self-executing computer program on the blockchain that algorithmically (i) determines the terms on which the lender accepts capital from investors and issues loans to borrowers and (ii) automatically executes on contracts between the parties.  DeFi loans are typically collateralized, requiring borrowers to maintain minimum collateral values – similar to traditional margin loans – and include automatic provisions for the liquidation of collateral after certain thresholds are met.

The recent crash in the cryptocurrency markets and potential failure of Celsius, a leading cryptocurrency lending platform, has placed these DeFi platforms in the spotlight.  Participants should not assume that a bankruptcy involving a DeFi platform would operate in a manner similar to other financial institution bankruptcy cases.

DeFi platforms raise difficult issues because of the uncertain nature of the regulatory regimes applying to the digital loans as well as the global nature of the users of the DeFi platforms.  For DeFi platforms in distress in the US, it will be critical to assess the unique risks associated with the cryptocurrency-based “smart contract” transaction structure through which DeFi platforms execute and manage their loan portfolios.

Most significantly, there is uncertainty about the scope of protections under the “automatic stay” and its various exceptions.  Whether DeFi loan transactions fall into one of those exceptions will turn upon the particular terms of relevant agreement of the DeFi platform and the classification of the nature of the DeFi loan for bankruptcy purposes as being a currency, security, or commodity transaction.

The Bankruptcy Code and DeFi

Under the US Bankruptcy Code, filing a petition for bankruptcy relief automatically enacts a worldwide stay, known as the automatic stay, of efforts to collect against the debtor outside of the bankruptcy case.  This protection also generally prevents contract counterparties from exercising contractual rights to the detriment of the debtor. 

The automatic stay, however, is not impermeable.  Congress created a series of exceptions to the automatic stay intended to protect the financial market system.  Under these provisions, certain counterparties to securities contracts, commodities contracts, forward contracts, repurchase contracts, swaps, and master netting agreements gain special protections.  Such contractual counterparties may exercise rights to liquidate, terminate, or accelerate an agreement, and may also offset or net out any obligations under such contracts, notwithstanding the existence of the automatic stay.

These provisions are not limited to exchange-traded contracts, and a number of them may apply to DeFi transactions, most notably the provisions applicable to currency swaps, security contracts, and commodities forward contracts.  If a bankruptcy court determines that the DeFi loan is a securities transaction, then contracts with a limited set of entities would be exempt from the automatic stay: stockbrokers, banks, investment companies, clearing agencies, and “financial participants” (defined as entities with over $1 billion gross in outstanding positions or $100 million in mark-to-market positions).  See 11 U.S.C. §§ 555 (securities contracts exception), 101 (22), 101 (22A), 101 (53A) (relevant definitions). 

By contrast, if a bankruptcy court determines that the DeFi loan is a swap or commodities transaction, then a far broader range of transactions would likely be exempt from the automatic stay.  Under the swaps exception, essentially any swap transaction would be exempt from the automatic stay.  See 11 U.S.C. §§ 560 (swaps exception), 101(53B) (defining swap agreements), 101 (53B) (defining swap participants as anyone who enters into a swap agreement).

The “forward contract merchant” exception, which applies to commodities, is also quite broad (although not as broad as the swaps exception).  The forward contract merchant exception applies when (i) the counterparty is a “forward contract merchant” and (ii) the contract is a “forward contract.”  11 U.S.C. § 556.  The former is defined as any “entity the business of which consists in whole or in part of entering into forward contracts as or with merchants” in a commodity or “any similar good, article, service, right, or interest.”  11 U.S.C. § 101(26).  The latter is defined as a contract “for the purchase, sale, or transfer” of a commodity or “any similar good, article, service, right, or interest” with a maturity date “at least two days after the contract is entered into.”  11 U.S.C. § 101(25).

There is a split of authority on the scope of this provision, with some courts holding that “merchant” status applies only to only entities that enter into forward contracts for financial profit or as an intermediary, as opposed to entry into the contract as the end-user of the commodities acquired.  See In re FirstEnergy Sols. Corp., 596 B.R. 631, 641-42 (Bankr. N.D. Ohio 2019) (describing the split in authority).

Currently there is no roadmap for how bankruptcy courts will evaluate DeFi transactions.  And although bankruptcy courts are not compelled to adopt a position held by one of the federal regulatory agencies (such as the SEC or CFTC) – as a court of equity, the bankruptcy court is ultimately empowered to determine the true nature of a transaction before it – it is reasonable to expect them to consider the non-bankruptcy regulatory landscape.  In doing so, they could find support for classifying these loan transactions as having currency, security, or commodity status.

In the non-bankruptcy context, the news has focused on the SEC’s and CFTC’s rival enforcement actions concerning market manipulation and fraud in markets for the crypto itself. 

The SEC applies the Howey test to evaluate whether a cryptocurrency product is an “investment contract” subject to SEC regulation, which considers four elements: (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profit, that (4) is to be derived from the efforts of others. See Securities and Exchange Commissioner Hester M. Peirce, Remarks at the Securities Enforcement Forum, May 9, 2019, available here.

The SEC also applies the Reves test to determine whether a cryptocurrency product, and particularly a DeFi product, is a “note” subject to the securities laws.  At a high level, the Reves test evaluates whether an instrument is a note that strongly resembles certain categories of debt instruments (eg, mortgage notes, consumer financing notes, notes evidencing character loans to a bank customer), and further includes consideration of the motivations of the buyer and seller, the plan of distribution, the reasonable expectations of the investing public, and risk considerations that suggest application of the securities laws is unnecessary.  And the CFTC has successfully argued that all virtual currencies are “commodities” under the Commodities Exchange Act because at least some virtual currencies are traded in futures contracts.  See Commodity Futures Trading Comm’n v. My Big Coin Pay, Inc., 334 F. Supp. 3d 492 (D. Mass. 2018).

Although it has attracted less media attention, there is support for the treatment of cryptocurrency transactions as currency based on actions of other federal agencies, as well as indirect support from bankruptcy case law.  Both DOJ and FinCEN[1] have treated cryptocurrency as money when it is used as the medium of exchange.  See United States v. Harmon, 474 F. Supp. 3d 76 (D.D.C. 2020) (holding that Bitcoin was money under the District of Columbia’s money transmitter laws); Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, No. FIN-2013-G001 (March 18, 2013) (holding that exchanges of virtual currency are money transmitters under FinCEN regulations and are subject to Bank Secrecy Act regulations). 

Furthermore, there are a series of cases under the Bankruptcy Code concerning the definition of “money,” the reasoning of which arguably could also apply to cryptocurrency in a bankruptcy-specific context.  See Tamm v. UST-United States Trustee (In re Hokulani Square, Inc.), 776 F.3d 1083 (9th Cir. 2015) (defining “money” as “some form of generally accepted medium of exchange”); Staiano v. Cain, 192 F.3d 109 (3d Cir. 1999) (holding that money is a broad term that could encompass a variety of methods of exchange and therefore a transaction must be evaluated within the statutory context to determine whether a transaction involves money). 

Given the growth of the use of certain cryptocurrency in the marketplace, not to mention the growing number of states accepting payments in certain cryptocurrency (particularly Ether and Bitcoin), it is arguable that while cryptocurrency may not have been considered currency in the past, its emergence into the mainstream today could provide a basis for a bankruptcy court to treat a cryptocurrency loan no different from a loan in ordinary currency if the loan is denominated in these widely used cryptocurrency. 

Case study: stETH

Any attempt to evaluate a transaction’s treatment under the Bankruptcy Code will require a case-by-case analysis considering the specific nature of the cryptocurrency, terms of the transaction, statutory framework, and regulatory overlays.  Some of these cases will be very challenging. 

Consider the example of Staked Ether (known as stETH) cryptocurrency on the Ethereum blockchain, which is one of the most prominent assets (and current focus of stress) in the cryptocurrency lending markets.  The stETH cryptocurrency was developed because the Ethereum blockchain is in the middle of an upgrade that will fundamentally change how transactions are processed and validated by moving the “consensus protocol” of the network from proof of work to proof of stake. 

In connection with this change, the holders of Ether (the cryptocurrency of the Ethereum blockchain) dedicate their Ether to the validator pools and render it unusable for transactions until the change is completed and Ethereum uses the proof of stake consensus protocol (this lockup is referred to as “staking,” although staking has different meanings in other cryptocurrencies).

In exchange for staking, holders receive an interest rate on the amount staked.  Staking, however, requires a minimum of 32 Ether.  As a result, companies started offering intermediary services so that smaller holders could aggregate for staking purposes (known as “pooled staking”).  Because staked Ether is unusable for transactions, one of these companies created stETH to help facilitate transactions and offered one unit of stETH for each unit of Ether dedicated to its staking pool.

Accordingly, stETH can be viewed as a commodity-linked derivative because the value is based on the underlying Ether and it facilitates a future transfer of the staked Ether coins when the upgrade is complete.  But it also can be viewed as a security because it represents a share of ownership in a common investment with the expectation of a return from the efforts of the Ethereum developers.  It is also arguable that stETH is a note since it represents a debt owed to the users who staked Ether through the developer.  Finally, stETH could be viewed as a currency given its prominent role as a medium of exchange.  The results will likely turn on the detailed nature of the implementation of the staking.

Going forward

As this example shows, the only thing we know now is that there will be no clear answers.  Participants in the DeFi space should pay close attention to case law as it develops and consult with counsel before taking any actions.

Learn more about the implications of these developments by contacting any of the authors.



[1] The Financial Crimes Enforcement Network (FinCEN) is the bureau of the Treasury Department responsible for implementing, administering, and enforcing federal financial crime and anti-money laundering laws and related regulations governing financial institutions under the Bank Secrecy Act.