Gone Baby Gone — Recovery of Stolen Bitcoins in Mt. Gox Bankruptcy

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Because customers did not own identifiable bitcoins themselves due to Mt. Gox’s pooled holdings, customers will face an uphill battle arguing priority to recovered bitcoins over Mt. Gox’s other creditors...

Mt. Gox filed for bankruptcy protection in Japan alleging that nearly all of the exchanges’ 850,000 bitcoins worth half-a-billon dollars had been looted by hackers. Customers were left asking whether any of their bitcoins are recoverable.

Unfortunately, none of the financial regulations applicable to banks and broker-dealers under U.S. or similar law protect bitcoin customers. U.S. securities law requires that brokers keep customers’ securities and cash in segregated accounts apart from those of the broker so that customers’ assets will be safe if the broker fails. Further, the Securities Investor Protection Corporation (SIPC) insures customers’ securities accounts up to $500,000 against theft, fraud or loss. Similarly, while banks pool customers’ deposits to fund loans, the Federal Deposit Insurance Corporation (FDIC) insures cash deposits up to $250,000 per customer.

Most customers were likely aware that their bitcoins were not insured by any governmental agency. But many did not know that Mt. Gox pooled and did not segregate their bitcoins in individual customer accounts. Mt. Gox’s pooling of its customers’ bitcoins, and its failure to hold those bitcoins in “cold storage” offline from its “hot wallet” buying and selling bitcoins in the market, made Mt. Gox susceptible to the massive theft.

With liabilities ($64 million) substantially exceeding assets ($38 million), Mt. Gox’s customers will receive little, if any, payment from the bankruptcy unless stolen bitcoins are recovered. Though somewhat notorious because of its anonymous nature, all bitcoin transactions are, in fact, tracked and become embedded in the bitcoin’s blockchain digital code. Theoretically, Mt. Gox’s stolen bitcoins can be traced and its thieves identified when they cash out through an exchange. While tracing is complicated by laundering efforts to exchange stolen bitcoins with clean ones, sophisticated forensics (regularly employed by bankruptcy professionals of failed financial institutions, LBOs, frauds, and Ponzi schemes) may be capable of tracking down the plundered digital currency. With the filing of a U.S. customer class action lawsuit and the substantial amount at stake, an intensive investigation is likely. If theft of almost 7% of all outstanding bitcoin is unrecoverable, that raises serious questions about the value of bitcoin as a currency going forward.

Because customers did not own identifiable bitcoins themselves due to Mt. Gox’s pooled holdings, customers will face an uphill battle arguing priority to recovered bitcoins over Mt. Gox’s other creditors. Instead, the value of recovered bitcoins is likely to be paid out based on the priorities set forth in Japanese bankruptcy law, including the potentially senior claim of secured lenders and equitable sharing amongst unsecured creditors.

Absent the addition of government regulations to protect customers’ bitcoins similar to those discussed above, a prudent buyer should consider holding their bitcoins directly in an individual wallet or at an exchange that both segregates customers’ bitcoins in individual accounts protected from hackers in cold storage and grants ownership to customers of identifiable bitcoins and wallets through clear contract language.

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[Timothy Durken focuses on Bankruptcy & Corporate Restructuring, Finance, Litigation and Transactions at Jager Smith P.C. in Boston and New York. He can be reached at tdurken@jagersmith.com and followed on Twitter at @TDurken.

JD Supra's new Law Matters series asks experts for their quick take on popular news of the day, and specifically how such matters affect people in their personal or professional lives. Stay tuned for other posts in the series.]

 


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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