Recent Disclosure Guidance Highlights Growing Concern Surrounding The Risks Of User


Recent turmoil in the cryptocurrency market has brought issues
related to crypto-asset custody to the forefront of the
cryptocurrency discourse;1 in an enormous $1 trillion
crypto-asset crash between approximately May 6, 2022 and May 16,
2022, some coins lost up to 99% of their original
value.2 Many crypto-asset investors are now wondering
how their assets may be treated if their crypto-asset exchange of
choice were to file for bankruptcy.3 While this question
remains largely unanswered, new guidelines issued on April 11, 2022
by the U.S. Securities Exchange Commission (the “SEC”)
regarding platforms that safeguard or hold crypto-assets on behalf
of users may require additional disclosures on this topic.

SEC Guidance for Crypto-Asset Custody
Disclosures.
The SEC’s new Staff Accounting Bulletin
(“SAB 121”) added interpretive guidance “for
entities to consider when they have obligations to safeguard
crypto-assets for their platform users.”4 This
bulletin addresses three main risk concerns surrounding crypto
custodians:5 (1) technological risks, particularly with
respect to the safeguarding of customer assets and information; (2)
legal risks that arise due to the unique character and lack of
legal precedent with respect to crypto-assets; and (3) regulatory
risks, as there are no current clear regulations for crypto-asset
trading and custody.

SAB 121 states that crypto-asset custodians should make several
key disclosures to better inform its platform users of the various
risks involved, including:

  • The nature and amount of crypto-assets that an entity is
    responsible for holding for its platform users;
  • The fair value measurements of crypto-assets;
  • Who owns the crypto key information, maintains recordkeeping of
    crypto-assets and is obligated to protect crypto-assets;
  • Significant risks and uncertainties associated with an
    entity’s holding crypto-assets for platform users;
  • The potential impact that the loss of cryptographic key
    information would have on an entity; and
  • The risk mitigation steps an entity has taken in light of the
    concerns mentioned in SAB 121.6

The guidelines set by SAB 121 are intended to inform the public
about the uncertainties surrounding crypto-assets in custodial
possession on various crypto-asset exchanges. Pursuant to these
guidelines, popular crypto-asset exchange platforms must now
disclose specific risks related to their custody of user assets in
filings going forward.7

Liquidation of Crypto-Asset Exchanges. In a
recent filing, one exchange explained that custodial-held
crypto-assets may be considered property of a bankruptcy estate
and, thus, in the event of a bankruptcy, crypto-assets held by the
exchange on behalf of customers could be subject to bankruptcy
proceedings. In such an event, customers may be treated as general
unsecured creditors.8

With respect to potential liquidation, there are potential
differences between securities held by customers at SEC-registered
broker-dealers and digital assets held by cryptoexchanges.
Liquidations of registered broker-dealers are overseen by the
Securities Investor Protection Corporation (“SIPC”) under
the Securities Investor Protection Act (“SIPA”). With
liquidations overseen by SIPC, customer accounts are segregated
from those of the brokerage’s assets, meaning that customer
assets cannot be used to satisfy debts of other creditors in
bankruptcy proceedings.9 Since most crypto-exchange
platforms are not registered broker-dealers or members of a
securities exchange, their bankruptcies would not be overseen by
SIPC; instead, these crypto-asset exchange platforms would be
liquidated under the Bankruptcy Code.

Bankruptcy Considerations. If a crypto-asset
exchange were to be liquidated under the Bankruptcy Code, the
digital assets that are held on the crypto-asset exchange on behalf
of its platform users could, under certain circumstances, be viewed
by a bankruptcy court as the crypto-asset exchange’s corporate
assets in a bankruptcy proceeding. In such an event, customers may
be treated as unsecured creditors and, thus, potentially stand to
lose some or all of the value of their investment in the
crypto-assets.

Under the Bankruptcy Code, all of a debtor’s assets and
interests become property of the debtor’s
“estate,”10 which is generally available for
distribution to the debtor’s creditors in accordance with the
priorities set forth in the Bankruptcy Code. The question as to
what assets constitute property of the debtor’s estate is not
answered by the Bankruptcy Code. Rather, the nature of a
debtor’s interest in a particular item of property is generally
determined by applicable non-bankruptcy law. However, Congress
intended for property of the estate to be viewed broadly, and the
Bankruptcy Code provides that property of the estate includes
assets “wherever located and by whomever
held.”11

While property of the debtor’s estate is defined broadly,
the Bankruptcy Code explicitly excludes any property in which a
debtor holds only legal title and not an equitable interest, such
as assets held by the debtor under trust, escrow, agency or
bailment arrangements.12 Accordingly, it will be a
fact-based determination whether a customer’s crypto-assets are
property of the debtor, or whether they remain the customer’s
property under applicable non-bankruptcy law. Key factors that
courts would likely consider in making this evaluation include: 1)
the intent of the parties, as reflected in, for example, the terms
of any custodial or other agreements that exist between the
customer and the crypto-exchange; 2) whether the assets are
commingled with the debtor’s assets or can be readily traced
and identified; and 3) the debtor’s control over such assets.
Accordingly, the specific factual arrangement governing the
crypto-assets will be critical in determining whether a court would
view such assets as part of the debtor’s estate that could be
used to satisfy the claims of general creditors (to the detriment
of the individual customer), and such determination may not be the
same for all customers of a specific exchange.

Implications. Policymakers have increasingly
focused on crypto-asset custody; for example, SEC Chairman Gary
Gensler has repeatedly warned that investors who own cryptocurrency
through trading platforms may effectively be making unsecured loans
to those companies.13 Additionally, last November, the
President’s Working Group on Financial Markets released a
report highlighting the financial risks of stablecoins and
expressing concerns about custody issues in relation to
them.14 We note that potential uncertainties relating to
crypto-asset custody may be further complicated when considering
the impact of state laws, including money transmitter laws, which
may apply in such cases. U.S. crypto-asset exchanges are generally
formed as state trust companies, and relevant state trust company
laws may require the exchanges to hold customer assets as
fiduciaries.15

One crypto-asset exchange responded to concerns regarding
crypto-asset custody by claiming that the crypto-assets that it
protects are safe, as the exchange is currently not at risk of
bankruptcy.16 Further, the exchange noted its intention
to update user terms to offer some protections in the case of a
“black swan event” (i.e., an unpredictable event
that exceeds normal expectations and has potentially severe
consequences) and take additional steps to further protect customer
crypto-assets in the event of bankruptcy. 17

In conclusion, there remains potential uncertainty regarding the
treatment of cryptoassets in bankruptcy due to limited legal
precedent. As noted earlier, a determination regarding whether a
customer’s assets are property of a debtor’s estate in a
bankruptcy proceeding is a fact-specific analysis that is
determined by the arrangement governing the crypto-assets.
Accordingly, this is another important factor in determining what
account structure a customer will obtain from a crypto-exchange,
which could mitigate this uncertainty.

Footnotes

1. James Nani, “If a Crypto Exchange Goes Bankrupt,
What Happens?: Explained,” Bloomberg (May 19, 2022),
available at https://news.bloomberglaw.com/bankruptcy-law/if-a-crypto-exchange-goes-bankrupt-whathappens-explained.

2. See, e.g., Byungkwon Lim & Amy Aixi
Zhang, “Part 1: Luna, UST and the Future of Stablecoin,”
Debevoise & Plimpton Fintech Blog (May 16, 2022), available
at
https://www.debevoisefintechblog.com/2022/05/16/luna-ustand-the-future-of-stablecoin/.

3. For the purposes of this article, we will assume that
such crypto-asset exchanges would qualify to be debtors under
Section 109 of the Bankruptcy Code.

4. Staff Accounting Bulletin, 17 CFR 211.121
(2022).

5. The term “crypto custody” is used to
describe the process of securing digital assets from theft through
the use of third parties who act as safeguards of a user’s
assets (e.g., cash, securities or virtual assets). See Krisztian
Sandor, “What is Crypto Custody?,” CoinDesk (Feb. 18,
2022), available at https://www.coindesk.com/learn/what-is-crypto-custody/.

6. 17 CFR 211.121.

7. See Coinbase 10-Q at 83

8. See Twitter.com/brian_armstrong.

9. Under the Bankruptcy Code, a trustee must convert held
securities to cash and distribute that cash to customers. 11 U.S.C.
748. Whereas, under SIPA, the customer’s held securities are
transferred back to the customer in the event of a SIPA proceeding.
See U.S. Courts, available at https://www.uscourts.gov/servicesforms/bankruptcy/bankruptcy-basics/securities-investor-protection-act-sipa
(last visited May 17, 2022).

10. 11 U.S.C. § 541(a).

11. Id.

12. 11 U.S.C. § 541(d). See…



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