What is the current regulatory landscape in the U.S. crypto industry?

Despite its prevalence, Congress has not introduced any cryptocurrency-specific legislation. Laws and regulations that were designed for traditional financial instruments do not translate easily to cryptocurrency, but regulators and courts have been forced to apply these ill-fitting rules to crypto instruments and platforms. To begin with, it is unclear how cryptocurrencies should be classified and, therefore, which regulations are applicable to companies in this sector. In the landmark SEC v. Shavers case in the U.S. District Court for the Eastern District of Texas in 2014, the traditional Howey test, derived from the 1946 Supreme Court case SEC v. W. J. Howey Co., was applied to classify cryptocurrencies — in this case, bitcoin tokens — as "securities" and therefore subject to SEC regulations. However, in a subsequent case before the U.S. Commodity Futures Trading Commission — In re: Coinflip Inc. in 2015 — cryptocurrency was classified as a commodity under the Commodity Exchange Act. The classification of digital assets also affects which regulatory agencies have jurisdiction over a crypto issue. Classification as a security puts crypto within the realm of the SEC, but classification as a commodity gives the CFTC oversight. Other agencies may also have jurisdiction — the Public Company Accounting Oversight Board, Internal Revenue Service, Financial Crimes Enforcement Network or the U.S. Department of Justice, as well as state authorities. This multiplicity of regulatory authorities only adds to confusion and unpredictability in the industry. Many companies operating in the crypto industry are private companies and are therefore not subject to more onerous rules and reporting requirements applicable to publicly held companies. Private companies are not required to produce audited financial statements or file reports with the SEC. Some crypto companies have published audited financials including proof-of-reserve reports, but the stringency of such audits has been called into question. Famously, FTX was audited by not one but two accounting firms before its collapse. The SEC has since brought charges against one of the audit firms for hundreds of auditor independence violations.

Aggressive SEC enforcement is pushing crypto issues into the bankruptcy courts.

Heightened scrutiny and enforcement have cultivated an environment of uncertainty and increased risk for cryptocurrency companies, and coincided with major bankruptcy filings in the industry. In May 2022, the SEC announced that it was nearly doubling the staff in its enforcement unit for cryptocurrency and renaming it the Crypto Assets and Cyber Unit to reflect its increased focus on cryptocurrency. Following that, it initiated 26 enforcement actions against companies in the crypto space in 2023 alone, including the January 2023 action against Genesis Global Capital LLC and Gemini Trust Company LLC alleging unregistered securities offerings in connection with the Gemini Earn program. The SEC action was the last straw for Genesis, which filed for bankruptcy a week later, owing creditors over $3.4 billion. Genesis recently settled with the SEC for $21 million. The SEC then sued Bittrex Inc. and its co-founder, William Shihara, for operating an unregistered national securities exchange, broker and clearing agency. Just three weeks later, the company filed for bankruptcy in Delaware bankruptcy court. Bittrex settled for $24 million. Actions were also taken against many other well-known companies such as Kraken, Binance and Coinbase Global Inc. Perhaps the most spectacular crypto bankruptcy to date, FTX, is still playing out in the courts and the media. The Securities Commission of The Bahamas, where FTX was based, froze the company's assets, suspended its registration, and applied for provisional liquidation amid concerns of mismanagement of assets and potentially unlawful behavior. Over just 10 days, the company collapsed. There is no sign that the campaign to increase oversight of the crypto markets will abate. In the aftermath of the FTX collapse, the SEC was criticized for not doing more to protect U.S. investors, and it has since aggressively pursued other cryptocurrency companies and executives. In announcing the Gemini and Genesis action, SEC Chair Gary Gensler stated:

Today's charges build on previous actions to clarify to the marketplace and the investing public that crypto lending platforms and other intermediaries must comply with our time-tested securities laws. Doing so best protects investors. It promotes trust in markets. It's not optional. It's the law.

Lawmakers are also pushing forward. Multiple legislative proposals relating to cryptocurrency regulation are working their way through the U.S. House of Representatives and the U.S. Senate, with politicians on both sides of the aisle generally supporting increased oversight.

Bankruptcy courts are making the law in cryptocurrency.

As cryptocurrency issues are pushed into the U.S. bankruptcy courts, often in Delaware, the judiciary is forced to fill the regulatory gaps and be both arbiters and lawmakers in this field. Seemingly inconsistent decisions and conflicting interpretations of ill-fitting regulations have only led to more questions for practitioners and stakeholders in the cryptocurrency industry.

How will crypto-assets be classified?
Currently, the classification of cryptocurrency assets is unclear. The Shavers case applied the Howey test to determine that bitcoin tokens were investment contracts and therefore securities. By ruling that bitcoin tokens were securities, they were brought within the regulatory framework of the SEC. However, in a subsequent July 2023 blow to the SEC, the U.S. District Court for the Southern District of New York ruled in SEC v. Ripple Labs Inc. that Ripple's XRP token was not a security and therefore was not subject to the requirement to register a securities offering. Rather than accepting the SEC's position that all cryptocurrency assets are securities, the court in Ripple applied the Howey test to each type of transaction, looking at the totality of circumstances for each one. It determined that only one of the four types of Ripple transactions met the Howey test for securities. It is therefore difficult for practitioners to predict how courts will evaluate and classify crypto-assets in future cases, especially given the nuances of the technology and the rapid pace of its evolution.

How and when should cryptocurrency be valued?
In its short history, the value of cryptocurrency has proven to be extremely volatile.
The U.S. Bankruptcy Code does not state when crypto-assets should be valued, so courts are using their own discretion. Some have chosen the petition date, some the date on which the debtor transferred the assets, and some the date of the recovery action. In November 2022 when FTX filed for bankruptcy, bitcoin was valued at $16,871. As of March 13, it had increased to $73,083. This volatility combined with the surge in litigation and bankruptcies in the aftermath of a so-called crypto winter makes valuation determinations critically important. In the FTX bankruptcy, the U.S. Bankruptcy Court for the District of Delaware determined that FTX's digital assets — including bitcoin and other digital currencies — should be valued at November 2022 prices, resulting in significant losses for FTX customers who have not had access to their crypto-assets since the company filed for bankruptcy. Outside the bankruptcy sphere, courts are forced to value crypto-assets to determine damages, debts and even inheritance decisions. Crypto-asset valuation can also affect the strategy or viability of litigation or arbitration in this sector. It is expected that the law, like the technology, in this area will continue to develop as companies, creditors, customers and investors continue to battle for the most advantageous valuation.

Will the automatic stay protect assets from civil or criminal forfeiture?
At the moment a bankruptcy petition is filed, Section 541 of the Bankruptcy Code creates an estate comprising all of the debtor's assets, and an automatic stay is enforced that protects these assets and prevents litigation against the debtor or its estate during the bankruptcy. Limited exceptions to the automatic stay include criminal activity and governmental enforcement of police or regulatory power. However, the DOJ has seized crypto-assets under its powers of criminal and civil forfeiture in multiple high-profile crypto cases, prompting disputes about whether crypto-asset ownership lies with the debtor or the users, whether or not crypto-assets can legally be seized while the automatic stay applies, and who has jurisdiction over these issues — the criminal courts or the bankruptcy courts. In the BlockFi case, the DOJ seized assets of the company pursuant to criminal and civil forfeitures, arguing that the automatic stay did not apply. In FTX, the DOJ seized approximately $150 million in cryptocurrency held in FTX bank accounts, as well as cash deposits and other assets following the criminal indictment of Bankman-Fried. Crypto companies cannot assume that the automatic stay will protect them in bankruptcy, and crypto customers must be vigilant about the risks associated with holding crypto-assets in an unpredictable industry.

Will creditor anonymity survive in cryptocurrency bankruptcies?
Pursuant to Section 107(a) of the Bankruptcy Code all documents filed in a bankruptcy are public records and open to inspection, however, anonymity is a fundamental tenet of cryptocurrency transactions. Bankruptcy courts have been given the unwelcome task of reconciling these conflicting positions, and, unfortunately, are not in agreement on the issue. Multiple court decisions, such as In re: FTX Trading in the U.S. Bankruptcy Court for the District of Delaware last year, have protected the anonymity of crypto customers in bankruptcy. However, some have not, like the Southern District of New York in In re: Celsius Network LLC in 2022. In Celsius, the court found that customer addresses, telephone numbers and email addresses should be kept confidential but that customer names should be disclosed. The court found that names did not constitute commercial or personally identifiable information under the Bankruptcy Code and did not qualify for an exception to the policy of disclosure in bankruptcy cases. Once again, crypto companies and customers must be prepared for unpredictability in this industry. '

Conclusion
Some have described the cryptocurrency industry as the Wild West. Lacking regulation — and featuring ambitious and sometimes crooked characters — it is easy to see why. The aggressive stance of the SEC reflects a growing awareness of the risks in this burgeoning sector. However, the resulting confusion, inconsistent court rulings and increased bankruptcy filings underscore the urgent need for a comprehensive regulatory framework. It is clear that a harmonized approach involving regulators, legislators and industry participants is essential to foster a cryptocurrency industry that can evolve beyond its current Wild West image into a well-regulated and thriving frontier of the financial world.

Originally Published on Law360