Unchartered Waters: Crypto Exchange Assets in Bankruptcy

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Nelson Mullins Riley & Scarborough LLP

A Securities Exchange Commission disclosure filed by popular cryptocurrency exchange Coinbase has shed light on the question of what would happen if Coinbase or a similar cryptocurrency exchange ever filed for bankruptcy protection. In an SEC Form 10-Q filed in May, Coinbase divulged that in a bankruptcy proceeding over $250 billion in custodial fiat currencies and cryptocurrencies that it holds on behalf of its customers could potentially be included in the bankruptcy estate, and its customers could be treated as general unsecured creditors. The disclosure further provides that some of Coinbase’s customer contracts do not limit its liability with respect to security breaches, and that insurance is limited and may not cover the extent of losses or the nature of certain losses, potentially resulting in Coinbase facing liability for losses that exceed its assets. If this were to happen, Coinbase customers who utilize Coinbase’s custodial services could be out of some or all of their cryptocurrency investments in the event of bankruptcy.

The disclosure is likely alarming to many Coinbase customers, especially at a time when the company’s financial results are in decline due to what the SEC filing described as “softer market conditions” and Coinbase’s commitment to invest heavily this year. In the same report, Coinbase announced a net loss of almost $430 million for the quarter. Coinbase CEO Brian Armstrong said in a tweet that Coinbase has no risk of bankruptcy and that the disclosures were in response to a new SEC Staff Accounting Bulletin, SAB 121. The bulletin advises holders of crypto assets to provide disclosure describing “legal ownership of the crypto-assets held for platform users, including whether they would be available to satisfy general creditor claims in the event of a bankruptcy. . . .”

In any case, both the SEC’s staff bulletin and Coinbase’s disclosure calls attention to the uncertain legal landscape surrounding cryptocurrency exchanges and how their assets would be treated in bankruptcy proceedings. Due to the novelty of the cryptocurrency market, bankruptcy priority laws do not contain certain carve-outs that exist for other financial markets, and federal regulation is lacking. Specifically, the issue of whether customer’s currencies held custodially by a cryptocurrency exchange has yet to be tackled by any bankruptcy court. With the monumental rise of cryptocurrencies and cryptocurrency services over the last several years, the possibility of a cryptocurrency exchange falling into bankruptcy in the near future does not seem impossible, even if crypto itself is here to stay.  

Sources:

  1. SEC Form 10-Q filing: https://www.sec.gov/Archives/edgar/data/0001679788/000167978822000048/coin-20220331.htm 
  2. SEC Bulletin: https://www.sec.gov/oca/staff-accounting-bulletin-121
  3. CEO Brian Armstrong’s tweet: https://twitter.com/brian_armstrong/status/1524233480040710144?cxt=HHwWgICsyceRlacqAAAA

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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