“Hacked” insolvencies of crypto exchanges
Have you ever invested on crypto exchanges? Whether the answer is yes or no, it is worth following their development and learning from the unfolding dramas of their failures. Faced with the unknown terrain of the crypto world, insolvency rules are tested.
On 22 June 2018, the District Court of Tokyo issued an order commencing civil rehabilitation proceedings against MtGox Co. Ltd. (MTGOX). The previously ongoing insolvency liquidation proceedings were therefore stayed. This recent development signifies a crucial victory (although not final) for the creditors in the protracted and unusual insolvency proceedings of what was once the biggest crypto exchange.
MTGOX was the world’s largest Bitcoin trading exchange. Based in Japan, it handled around 70% of the world’s Bitcoin (BTC) trades in 2013. It allowed its users to buy, sell, convert and keep their Bitcoins and fiat currency in accounts deposited with the exchange. Following a massive hack, which led to the loss of around 850,000 Bitcoins worth USD 473 million at that time, MTGOX stopped all withdrawals and shut down its website early in February 2014. On 28 February 2014, it filed for insolvency protection in Tokyo under the procedure called civil rehabilitation (minji saisei), claiming that rebuilding MTGOX in a legally organised manner “will not be for the sole benefit of the company but for that of the whole bitcoin community.” The latter turned out to be problematic (as the crypto exchange users have not yet received anything) and the rehabilitation procedure soon grew into a full scale insolvency liquidation. Mr. Nobuaki Kobayashi, a Japanese attorney, was appointed as a bankruptcy trustee. As a defence from the multiple court proceedings launched against it, MTGOX filed petitions to have the Japanese insolvency proceedings recognised abroad. Such recognition was granted in the USA and Canada, giving the failed crypto giant the necessary breathing space and protection against asset seizure (e.g. computer servers and money in bank accounts).
Meanwhile the aggrieved crypto investors were left in a state of uncertainty, as the Japanese legal (and for that matter, insolvency) system was not geared towards resolving financial troubles involving hacked cryptocurrency exchanges. According to Japanese insolvency law and as confirmed by the trustee, in bankruptcy proceedings non-monetary claims, such as claims for the return of invested Bitcoins and other digital assets, are converted into monetary claims based on the valuation at the time of the commencement of insolvency proceedings. This means that MTGOX’s creditors could claim the value of the invested Bitcoins at the exchange rate as of April 24, 2014 (commencement of the insolvency proceedings), which was approx. USD 450 for 1 BTC. As is well known, the price of Bitcoins is extremely volatile and has dramatically risen since 2014, reaching record USD 19,000 in December 2017 (now trading at the level of ∼ USD 6,000). Please follow the link to see the graph accurately depicting the relations between the MTGOX’s creditor claims and the value of trustee holdings from 2015 till mid-2018.
It is clear that as a result of the insolvency proceedings, the creditors would lose out, should the surplus in the value of Bitcoins (∼ USD 5,500 per 1 BTC) bypass their pockets and end up in the hands of MTGOX’s shareholders, themselves accused of embezzling money from MTGOX and manipulating its data. This outcome not only lacks in fairness, but also contradicts one of the main principles of insolvency law – maximisation of the asset value for the benefit of creditors, whose interests override the interests of shareholders. However, in the case at hand, due to the increase in the price of BTC and the aforementioned specificity of Japanese insolvency law, the asset value has exceeded the amount of the claims, effectively pulling MTGOX out of insolvency. This situation is rather unprecedented and turns the insolvency process upside down. One can compare this rapid increase in the insolvency estate to the recent auction sale of the portfolio of technology patents owned by Nortel Networks, a Canadian telecommunications company. Originally estimated to be worth USD 900 million, its sale price went over USD 4.5 billion, primarily due to the fierce battle unfolding between Apple Inc., Google Inc. and Intel Corp. However, unlike with MTGOX, in the Nortel example the successful asset sale directly benefitted the creditors of the defunct telecom manufacturer.
In both scenarios, the asset price appreciation was determined by the growing demand. This is the law of supply and demand in action, demonstrating that low supply and high demand lead to price increase. As theoretical as it may sound, in practice it has turned into a real headache for Mr. Kobayashi as he was tasked to sell MTGOX’s Bitcoins. The amount managed by MTGOX surpassed 200,000 BTC or USD 1.2 billion (at today’s exchange rate). One of the major concerns was that a one-time or quick sale of BTC would cause a sharp decline in its price, ultimately hurting the creditors’ interests. In March 2018, the trustee confirmed selling Bitcoins worth approx. USD 400 million. Even though he argued that the sale was not through a BTC exchange but instead over the counter, a correlation between the sale and the BTC price drop was spotted. In my opinion, in the future, cryptocurrency price volatility and market sensitivity will be a recurring theme, requiring insolvency practitioners to cautiously approach its disposal and maybe even acquire the skills of a professional trader.
The unfairness of the ongoing “insolvency” proceedings in Japan has sparked anguish and discontent among MTGOX’s numerous creditors. “This mess is giving me anxiety”; “I wanna give up but I’m baked in so f**k it”; “There is no accountability there. You can “demand” all you want and they will just ignore you” – these are just a few recent comments left by the aggrieved investors in the special sub on Reddit. Some of them even started Mt.Gox Legal, a co-operative of over 900 creditors, “in order to share legal costs, advice and representation.” Apparently, the creditor’s activism has facilitated the replacement of the insolvency proceedings with the originally planned civil rehabilitation proceedings. This happened on 22 June 2018, when the Tokyo court made an order staying MTGOX’s insolvency proceedings. Most importantly, this meant that non-monetary claims no longer have to be converted into monetary claims, as would be the case if insolvency went on. Therefore, claims seeking a refund of Bitcoins will not be transformed into claims for the repayment of the monetary value of BTC calculated as per April 2014. When and how exactly the unfortunate crypto investors can receive their investments remains unclear, as Mr. Kobayashi now needs to prepare a rehabilitation plan, specifying the amount, timing and method of distribution. The problem is that such distribution lies relatively far in the future, i.e. not earlier than mid/end 2019. Nobody can predict what the BTC price will be next month, let alone next year.
While the failure of MTGOX is the most notable example of the insolvency of a crypto exchange, it is far from being the only one. In June 2018, a new chapter in the struggles around Italian crypto exchange BitGrail unfolded. Following the reported theft of approx. 17 million NANO (∼ USD 187 million), an altcoin almost solely traded on BitGrail, the court in Florence ordered seizure of its assets and appointment of a receiver to investigate its situation. Meanwhile, a group of crypto investors filed a class action suit in the United States District Court for the Eastern District of New York, alleging that they were misled into investing in BitGrail, advertised as a safe haven for crypto investors. Interestingly, the relief sought from the court includes an order requiring NANO to “rescue fork” the allegedly missing coins into a new cryptocurrency. Such forks are not new and have been used in the past to deal with the consequences of crypto collapses (e.g. the infamous debacle of The DAO, breaking Ethereum into two separate active blockchains, each with its own cryptocurrency). However, I am not aware of any cases in which hard forks have been a matter of a court order.
What can we learn from these examples of “hacked” insolvencies? First, they almost always involve a criminal element, i.e. a theft/embezzlement of crypto assets. Second, retrieval of such assets is oftentimes problematic and calls for close cooperation with (foreign) enforcement authorities. Third, the specificity of the crypto markets requires insolvency practitioners to have a special skill set, analogous to the one of a professional trader or a forensic investigator. And last, crypto exchanges are characterised by the dispersed creditor base leading to considerable collective action problems. However, technological progress has substantially mitigated such problems and made it easier for them to get together for the purposes of sharing information and costs, formulating legal strategies and exercising pressure on insolvency practitioners and courts. To a large extent, it is precisely this creditor activism that will define the fate of “crypto insolvencies”.