Even if you haven’t purchased any bitcoin, you have likely heard about the cryptocurrency that was approaching $20,000 per coin late last year. The record high was quickly followed by a dramatic fall in value over 16 days in early 2018 — crashing to below $7,000. Since that time, bitcoin has been staging its recovery, and as of this writing, sits at slightly over $9,000 per coin. Not a bad place to be, considering bitcoin’s humble valuation of $.08 per coin back in 2010. It seems that despite its roller coaster persona, bitcoin is here to stay.
Bitcoin is a form of digital or virtual currency, also known as a cryptocurrency, which is created and held electronically. Bitcoin or digital currencies have an equivalent value in fiat currency (government-issued money, such as dollars and euros), and can act as a substitute for fiat currency in order to carry out a transaction without the use of a third-party intermediary, such as a government or central bank, and typically without the fees associated with traditional fiat money transactions.
Instead of a paper dollar issued by a central bank, bitcoin is a digitized unit of value used in electronic payments based on a complex mathematical system. Satoshi Nakomoto, the elusive founder of bitcoin, created a bitcoin protocol, which will only allow for 21 million bitcoin to ever be in existence, not dissimilar from the now abandoned gold standard. Under the gold standard, countries agreed to convert paper money into a fixed amount of gold. However, unlike paper money, bitcoins can be divided into parts, with the smallest divisible unit being 100 millionth of a bitcoin.
Bitcoin Valuation Outside of Bankruptcy
Traditionally, currency has been backed by precious metals such as gold or silver. Bitcoin, by contrast, is backed by mathematics. This poses the question — how exactly is bitcoin valued if there is no tangible currency and it is not backed by anything of intrinsic value?
Simply put, bitcoin’s value is determined by how much people will pay for it. Many bitcoin enthusiasts believe that the bitcoin value is derived from two sources: functional and speculative. First, from a functional perspective, bitcoin’s utility and use helps drive its value. The more places people can use bitcoin, the more functional the cryptocurrency becomes, and thus the more bitcoin people want to have at hand. For example, in 2017, companies such as Subway, Expedia, Dish Network, Etsy, Gap, J.C. Penny and Whole Foods started accepting bitcoin as a form of payment, either directly or through gift cards purchased with bitcoin. Similarly, bitcoin skyrocketed in value from approximately $1,000 per coin in early 2017 to almost $20,000 by late 2017. As individuals start trading bitcoins on exchanges, the speculative value of bitcoin increases, as more people want to “buy in” to an upward trending market.
It is no secret that the price of bitcoin has been volatile. Yet, that has not seemed to slow the trading of bitcoin on various exchanges. One exchange, Coindesk, publishes a constant Bitcoin Price Index that considers the weighted average price of bitcoin at exchanges that meet certain objective requirements, including criteria such as minimum volume of trade.
Even the New York Stock Exchange can no longer ignore bitcoin. In 2015, the New York Stock Exchange created the NYSE Bitcoin Index with the listing “NYXBT.” At the time of the NYXBT launch, Thomas Farley, NYSE group president, said in a statement published by Coindesk, “Bitcoin values are quickly becoming a data point that our customers want to follow as they consider transacting trading or investing with this emerging asset class.”
Bitcoin Goes Mainstream and is Subject to U.S. Regulation
Hundreds, if not thousands, of merchants, including many here in the United States, now accept bitcoin as a form of payment. Presently, there are a large number of bitcoin payment processors, including Coinbase (San Francisco), Bitpay (Atlanta) and Circle (New York). These services claim to eliminate the volatility risk by maintaining consistent exchange rates based on an objective value presented by various exchanges. For example, Coinbase advertises: “When your business makes a sale, you can instantly sell the bitcoin received to Coinbase to avoid exposure to bitcoin volatility.”
Bitcoin and other digital currencies are subject to extensive regulation in the United States. The U.S. Commodity Futures Trading Commission, the U.S. Department of the Treasury and the IRS consider bitcoin to be property and subject to capital gains taxes.
The Financial Crimes Enforcement Network and the Department of the Treasury regulate bitcoin exchangers and money transmitters through authority granted by the Bank Secrecy Act and other statutes. FinCEN requires money transmitters to be registered and implement know-your-client and anti-money laundering procedures. In addition to federal regulatory guidance and requirements, almost all states regulate money transmitters, and many of those state money transmitters regulatory requirements have been updated to include money transmitters that deal in cryptocurrency. For example, the state of New York recently adapted their money transmitter statutes to provide for cryptocurrencies, allowing for the receipt of digital currencies by merchants but requiring regulatory compliance for businesses selling to consumers.
Why Does Bitcoin Matter for Bankruptcy
The use of cryptocurrencies is increasing at a staggering pace. The Mortgage Bankers Association published an article, “Bitcoin Debuts on Real Estate Finance Scene,” which reported that sellers and homebuyers alike are beginning to use bitcoin to pay closing costs, or have indicated they will accept bitcoin as part of the purchase price. These developments demonstrate that cryptocurrency use in the housing market could start to gain traction. The article also states that reports by Schwab agents in Boston, Chicago, Houston, Philadelphia, Washington, D.C., and several cities in California have had “conversations with people about using cryptocurrency as part of their transaction.” In fact, one agent in San Francisco had recently worked with a client to write an offer on a luxury home in Silicon Valley that was contingent on the sale of cryptocurrency.
As cryptocurrency use becomes mainstream, its use as a form of payment and storage as an asset will increase across industries and among companies. In fact, it is already being used in our own profession (as attorneys). A recent Nebraska ethics advisory opinion published by the Lawyer’s Advisory Committee, an ethics council appointed by the Nebraska Supreme Court, found that (1) an attorney may receive digital currencies as payment from a client or from a third party on behalf of their client, and (2) an attorney may hold digital currencies in escrow for a client. The Nebraska opinion, based on the Nebraska Rules of Professional Conduct, acknowledged that the valuation of bitcoin, and its volatility, was an important consideration in allowing an attorney to accept payment. The Nebraska opinion stated, “To mitigate or eliminate the risk of volatility, it is possible to value or convert bitcoins and other digital currencies into U.S. dollars immediately upon receipt. The conversion rate would be market-based, such as from an exchange or based upon the New York Stock Exchange Price Index, for example. In this way, the bitcoins would serve to credit the client's account and there would be no risk to the client of value fluctuation.”
As the use of bitcoin becomes more prevalent in the marketplace, it is inevitable that bitcoin will begin to show up as an asset in bankruptcy cases. Bankruptcy courts will have to determine how such cryptocurrencies should be valued for bankruptcy purposes.
Valuing Bitcoin in Bankruptcy
To date, there is little guidance in bankruptcy case law as to how bitcoin and other cybercurrencies should be valued. In an unpublished decision, the U.S. Bankruptcy Court for the Northern District of California reviewed the question of how bitcoin should be valued for purposes of recovery as a fraudulent transfer/preference. In Hashfast Technologies LLC v. Lowe (In re Hashfast Technologies LLC), the bankruptcy trustee contended that bitcoin was a “commodity,” and therefore should be valued as of the time of recovery, which would include any increase in value since the avoided transfer. (In this case, the value of the bitcoin had increased since the transfer from approximately $363,000 to $1.3 million). The defendant-transferee contended that bitcoin was currency, not a commodity, such that the value of transferred bitcoin was the cash value at the time of transfer ($363,000).
While the bankruptcy court concluded that “bitcoin are not United States dollars,” the bankruptcy court failed to rule on the issue of valuation, stating, “If and when the Liquidating Trustee prevails and avoids the subject transfer of bitcoin to defendant, the court will decide whether, under 11 U.S.C. §550(a), he may recover the bitcoin (property) transferred or their value, and if the latter, valued as of what date.”
In determining the value as of a particular date, bankruptcy courts will likely look to the values set forth in sources such as the New York Stock Exchange or Coindesk. The bigger issue for bankruptcy courts will be addressing the value of bitcoin over the course of a bankruptcy case, given the highly volatile nature of bitcoin value, which can fluctuate substantially in a short period of time (even over the course of one day). This uncertainty as to the future value of bitcoin could impact bankruptcy cases in a couple of ways.
Bitcoin as Loan Collateral
One area that may be impacted by the fluctuating value of bitcoin is the determination of whether a lender is adequately protected when bitcoin is collateral for the loan. As noted above, bitcoin is beginning to be used in finance transactions. In future bankruptcy cases, bitcoin will likely be the collateral, or part of the collateral, for a secured creditor’s loan.
As collateral for a loan in bankruptcy, the value of the bitcoin during the bankruptcy case will be important in determining whether the creditor is adequately protected. Even if the secured creditor is oversecured at the time of filing, a sharp drop in the value of the bitcoin could result in the creditor becoming undersecured over the course of the case.
Given the volatility in the value of bitcoin, the bankruptcy court may find it difficult to rely on the value of the bitcoin in determining whether a lender is adequately protected, and instead focus on the value of the lender’s other collateral in determining adequate protection. However, if bitcoin is the primary collateral for the loan, the bankruptcy court may be required to determine whether the lender is adequately protected based upon the value of such bitcoin. In order to protect the lender, the debtor’s maintenance and use of bitcoin may be subject to strict reporting requirements to monitor the value of the bitcoin collateral and allow the lender to move quickly if that value drops. However, such protections may not be enough to protect the lender if the bitcoin value drops precipitously.
Another concern in relying on bitcoin value is the danger that such bitcoin could be stolen. Bitcoin has shown itself to be vulnerable to cybertheft. In 2014, one of the largest bitcoin exchanges, Mt. Gox, was forced to suspend trading and file for bankruptcy in Japan as a result of the theft of 650,000 bitcoins. In December of last year, a South Korean bitcoin exchange, Youbit, was forced into bankruptcy when it lost 17 percent of its assets as a result of a cyberattack. Unlike cash, there is no federal insurance to protect against the theft of bitcoin.
Given the uncertainty in projecting the value of bitcoin, and the danger of bitcoin theft at the hands of cybercriminals, the reliance on bitcoin to provide adequate protection to a lender for use of such lender’s collateral may prove difficult.
Bitcoin and the Payment of Creditors
Another area in which the value of bitcoin could significantly impact a bankruptcy case is in the repayment of creditors, either through the liquidation of the debtor’s assets in Chapter 7 or through a Chapter 11 plan.
To the extent that a debtor possesses a substantial amount of bitcoin, such bitcoin may be the primary way that creditors are paid through a bankruptcy case. Accordingly, the value of the bitcoin at the time of exchange will greatly affect the return to creditors. To the extent that bitcoin values are rising, it may be in the best interest of creditors to delay the liquidation of bitcoin in hopes of a higher value.
Some of the issues related to the value of bitcoin in payment of creditors arose in the Japanese bankruptcy case of Mt. Gox. At the time of its bankruptcy filing in 2014, Mt. Gox possessed approximately 202,000 bitcoins. Since the bankruptcy was filed, the value of bitcoin has skyrocketed such that the bitcoin currently in the possession of Mt. Gox’s bankruptcy trustee is worth approximately $1.5 billion. Accordingly, creditors of Mt. Gox have benefited as the value of bitcoin has risen sharply over the last three years. Interestingly, the trustee administering Mt. Gox’s bankruptcy case has valued the claims of those creditors that lost bitcoins based upon the market price of bitcoins at the time of the bankruptcy filing, which was substantially lower than the value of bitcoin today. Based upon the lower value of these claims, the trustee could liquidate the bitcoin at current values, pay all creditors, and end up with a surplus of $1 billion.
Mt. Gox shows the effect that the volatile value of bitcoin may have in a bankruptcy case. Typically, a Chapter 7 trustee will liquidate a company’s assets as quickly as possible. However, creditors may prefer that the liquidation be delayed if the value of bitcoin is on the rise. Given the Chapter 7 trustee’s duties (and the possibility that the value of bitcoin could decrease), a Chapter 7 trustee is unlikely to delay the liquidation of bitcoin based upon the potential for a future higher value.
However, if bitcoin is being liquidated to make payments to creditors pursuant to a Chapter 11 plan, such plan could propose terms that allow for a delayed liquidation of bitcoin and distribution to creditors to account for future value increases. However, such a plan that proposes for liquidation of bitcoin on a future date would have to be balanced against the risk that the value of bitcoin could drop.
Given the mainstream use of bitcoin and the “staying power” of this cryptocurrency, bankruptcy practitioners need to prepare to see bitcoin as part of the assets in future bankruptcy cases. The uncertainty and volatility of bitcoin value will require bankruptcy courts and other parties in a bankruptcy case to come up with creative solutions to ensure that the debtor and its creditors are protected against a loss in value, while at the same time maximizing the benefit to creditors as the value of bitcoin continues to rise.