Cryptocurrency Meets Bankruptcy Law: a Call for Creditor Status for Investors in Initial Coin Offerings
| Publication year | 2020 |
Cryptocurrency Meets Bankruptcy Law: A Call for Creditor Status for Investors in Initial Coin Offerings
Miriam Albert
Maurice A. Deane School of Law at Hofstra University, miriam.r.albert@hofstra.edu
J. Scott Colesanti
Maurice A. Deane School of Law at Hofstra University, j.s.colesanti@hofstra.edu
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In 1973, experts Homer Kripke and John J. Slain published a seminal study titled The Interface Between Securities Regulation and Bankruptcy—Allocating the Risk of Illegal Securities Issuance between Securityholders and the Issuer's Creditors. That lengthy analysis, contributed by, respectively, a former Securities and Exchange Commission official and a professor of law, examined the status quo and concluded that investors were receiving unfair priority vis-a-vis creditors in bankruptcy proceedings administered under the federal Bankruptcy Code. Focusing on the traditional "absolute priority rule," the study pointed out that the Securities and Exchange Commission support for the investor priority was unfounded and urged deference to the notion of general creditors coming first.
Since then, a host of developments complicated both the analysis and the traditional view of Kripke and Slain. First, the pivotal determination of "rescinding shareholder" has been made complex by, among other things, an expanded notion of "sophisticated investor" occasioned by phenomena such as "crowdfunding." Second, stock swaps, hedges, repurchase agreements, and other hybrid responses to financier discomfort have clouded the definition of "investor." Finally, the explosive growth of cryptocurrencies (and
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the ventures that would sell, distribute, trade, or package them) highlighted the need for a new, softer line between creditor and investor.
Accordingly, the present authors revisit the absolute priority rule with a view towards historic SEC involvement with bankruptcy law and contemporary classification of some cryptocurrency-related entities as securities issuers. The article concludes that in light of the existing provisions and interpretations, the "absolute priority rule" examined through the lens of today's innovative securities should be rethought to give investors in initial coin offerings creditor status. Whether the reader agrees or not is likely subordinated to the need for a conversation on the most egalitarian response—under both the securities laws and the Bankruptcy Code—to the investor's claim for in pari passu treatment normally reserved for creditors, and likewise the general creditors' opposition to sharing a legally enforceable priority.
A. Crypto Among Us
In March 2019, close to $200 million worth of cryptocurrency was lost when the owner of a cryptocurrency trading platform died in sole possession of its digital key.1 The debacle foisted the trading platform into court protection, prompting calls for national legislation by the Canadian Securities Administrators.2
Indeed, such security problems are not unexpected. At year-end 2017, the meteoric rise of the price of Bitcoin (e.g., $17,900) posed a regulatory challenge to courts and government agencies alike.3
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Moreover, the first and largest Bitcoin exchange, Mt. Gox, remains protected by Japanese bankruptcy laws.4 These regulatory challenges are rife with difficulties, often chief among them the battle for prioritized status between creditors and depositors-investors—if such are even identifiable as distinct classes.5
A spinoff of the volatile, virtual investment craze arrived in recent years in the form of initial coin offerings (ICOs).6 In such ventures, fledgling companies with grandiose plans exchange future "tokens"
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in a unique digital enterprise for investment.7 These enterprises state plausible cases for securities law coverage, particularly in light of the great many federal court holdings urging expansion of the securities laws in favor of investor protection.8 For example, a company promising partial ownership of a purely cyberspace enterprise may accord digital tokens on a pro rata scale tied to the level of investment. Such tokens only carry value in the accompanying "blockchain" (i.e., digital ledger created by the enterprise).9
Compounding the regulatory challenge are the myriad definitional hesitancies: the United States (U.S.) Department of the Treasury has not declared Bitcoin or similar creations the equivalent of fiat currencies, instead simply insisting that cash exchanges for cryptocurrencies satisfy currency transaction requirements.10 The Internal Revenue Service (IRS) formally identified Bitcoin as "property," gains on which must be taxed like all other gains on properties.11 And via a 2015 disciplinary decision, the U.S. Commodity Futures Trading Commission (CFTC) proclaimed Bitcoin a "commodity," thus making the instrument subject to regulations promulgated under the Commodity Futures
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Modernization Act of 2000.12 The U.S. Securities and Exchange Commission (SEC) acknowledged the CFTC classification in December 2017; however, there still has been overlapping jurisdiction, as the SEC has taken repeated disciplinary actions against companies determined to invest in Bitcoin or other forms of cryptocurrency for misleading disclosures to shareholders.13 However, relatively unaddressed is the issue of classifying a Bitcoin investment (or any other cryptocurrency) for purposes of the federal securities laws enacted over seventy-five years before the advent of virtual and cryptocurrencies.
B. Brief History of the Federal Securities Laws
The federal securities laws of 1933 and 1934 were a drastic reaction to the Wall Street folly that almost bankrupted the nation. President Franklin D. Roosevelt and Congress were eager to restore investor confidence and reacted to profligate speculation by creating remedial laws with expansive reach.14 The purpose of these laws was to provide investor protection through mandatory disclosure and anti-
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fraud provisions.15 The first of these laws, the Securities Act of 1933 (1933 Act), is known as the "truth in securities" law and has two primary goals: to make sure investors have material information about possible investments and to prevent fraud in the purchase and sale of securities.16 Neither the 1933 Act nor the Securities Exchange Act of 1934 (1934 Act) was intended to provide a broad federal remedy for all fraud.17 Instead, these statutes apply only to those investments that are within their broad statutory definition of "security."18 Courts often reference a need for flexibility in applying the definition of security.19
Cognizant of the remedial goals of the 1933 Act, Congress tried to craft a broad definition that would "meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits."20 Thus, Congress included (but failed to define) in the list of kinds of securities the catchall phrase
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"investment contract" to give the courts flexibility in interpreting this important and far-reaching definition.21 The U.S. Supreme Court availed itself of that flexibility, aggrandizing jurisdiction in crafting a case law test that has come to be known as the "Howey test."22 The resulting common law standard (like so much of securities law) results in case-by-case determinations of the threshold question to any dispute.23
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Conversely, the U.S. Bankruptcy Code (the Code), adopted in its current form in 1978, contains statutory definitions of a much more definite character. Section 101(49) largely mirrors the securities law legislative definition, though § 1145 expressly exempts certain arrangements from those set categories (e.g., "note").24 The Code focuses on much more conventional securities products; moreover, a lack of certainty in discharging the debtor is the chief ill to be avoided.25
I. Statutory and Common Law Approaches to Defining a Security
A. The Securities Act of 1933
From its inception, § 2(a)(1) of the 1933 Act contained a veritable laundry list of arrangements that arise under American securities laws. In its current form, the statutory definition of security reads as follows:
The term "security" means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a "security[,]" or any certificate of
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interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.26
None of these examples expressly touch on bankruptcy estate assets. Of the definition's myriad possibilities, the SEC seized upon investment contract as a catchall, as explained below.27
B. The Howey Test
Although the SEC has rarely shied from an opportunity to expand its jurisdiction,28 the investing public can remain calm because any overreaching by the SEC would arguably be tempered by the modest remedy sought of registration under § 5 of the 1933 Act.29 A primary means of such expansion by the SEC is via an ever-expanding notion of an investment contract, a term included but not defined in...
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