Restructuring

This is the fourth post in our Bitcoin Bankruptcy series on the Weil Bankruptcy Blog. We began by summarizing broadly how Bitcoin works. Then we examined whether a hypothetical U.S.-based bitcoin exchange would be eligible for chapter 11 relief. (The answer depends on how its business operates.) We also concluded that our hypothetical exchange likely would not constitute a stockbroker under the Bankruptcy Code. So unless it is either a commodity broker or a bank that does not operate a multilateral clearing organization, it is probably eligible to be a chapter 11 debtor. Today we consider whether a bitcoin exchange could be a commodity broker.
Recap: Bitcoin Exchange Business Models
As we wrote previously, bitcoin exchanges operate using a variety of business models. We explained four of these models as follows:

1. The “Dealer” Model

The “Dealer” exchange is a classic market maker.  In every exchange of bitcoins for real currency, the “Dealer” exchange faces the customer.  Customers who buy bitcoins purchase directly from the exchange.  Customers who sell bitcoins sell them directly to the exchange.  This sort of exchange may earn revenue through fees collected upon the customer’s registration, upon each exchange transaction, or in other ways.

2. The “Order Book” Model

The “Order Book” exchange never faces customers.  Instead, it manages an order book.  It matches third-party buyers and sellers, provides a digital platform on which the parties can make the exchange, and earns a commission on each transaction.

3. The “Margin Trading” Model

Some bitcoin exchanges provide a margin-trading and bitcoin-lending platform in addition to one of the exchange services described above.  Like a traditional broker-dealer, the “Margin Trading” bitcoin company facilitates customers’ trading of bitcoins by establishing trading accounts in which they can deposit bitcoins as margin collateral.  Based on the amount of margin collateral they maintain in their accounts, customers are able to borrow bitcoins (either from the exchange itself or from other customers) to take leveraged positions in trades directly against other customers.  Customers’ trades may be based in bitcoins themselves or in bitcoin derivatives.

4. The “Escrow” Model

A fourth type of bitcoin “exchange” is not truly an exchange but rather an escrow service.  It is similar to the “Order Book” model, except that the seller’s bitcoins pass through the exchange before going to the buyer.  The “Escrow” exchange maintains an order book.  When it matches a buy order with a sell order, it notifies the parties and provides the buyer with a bank account number of the seller.  The seller transfers the requisite bitcoins to the exchange, and the buyer deposits cash into the seller’s bank account at a local branch.  The buyer then provides the exchange with proof of the deposit (such as a copy of the receipt).  When the seller confirms that it has received the deposit, the exchange releases the bitcoins from escrow to the buyer.
Statutory Analysis
Under section 109(d) of the Bankruptcy Code, an organization cannot be a chapter 11 debtor if it is a “commodity broker.” The meaning of the term “commodity broker” includes, among other things, a “leverage transaction merchant . . . with respect to which there is a customer . . . .” This raises two questions: what is a “leverage transaction merchant,” and what is a “customer”?
“Leverage Transaction Merchant”
A “leverage transaction merchant” is an entity that is “in the business of engaging in leverage transactions.” A “leverage transaction,” in turn, is “an agreement that is subject to regulation under section 19 of the Commodity Exchange Act, and that is commonly known to the commodities trade as a margin account, margin contract, leverage account, or leverage contract.”
In general, section 19 of the CEA permits the Commodity Futures Trading Commission to regulate “leverage contracts.” The CFTC interprets “leverage contracts” broadly:
Leverage contract means a contract, standardized as to terms and conditions, for the long-term (ten years or longer) purchase (“long leverage contract”) or sale (“short leverage contract”) by a leverage customer of a leverage commodity which provides for:
(1) Participation by the leverage transaction merchant as a principal in each leverage transaction;
(2) Initial and maintenance margin payments by the leverage customer;
(3) Periodic payment by the leverage customer or accrual by the leverage transaction merchant of a variable carrying charge or fee on the unpaid balance of a long leverage contract, and periodic payment or crediting by the leverage transaction merchant to the leverage customer of a variable carrying charge or fee on the initial value of the contract plus any margin deposits made by the leverage customer in connection with a short leverage contract;
(4) Delivery of a commodity in an amount and form which can be readily purchased and sold in normal commercial or retail channels;
(5) Delivery of the leverage commodity after satisfaction of the balance due on the contract; and
(6) Determination of the contract purchase and repurchase, or sale and resale prices by the leverage transaction merchant[.]
Under this definition, certain types of bitcoin transactions could be leverage transactions if bitcoins constitute “commodities” under the CEA. And as Jerry Brito and Andrea Castillo have written:
The Commodity Exchange Act defines commodities as all “goods and articles . . . and all services, rights, and interests . . . in which contracts for future delivery are presently or in the future dealt in,” except onions and motion-picture box-office receipts. Therefore, bitcoins could certainly qualify as a commodity because they are articles that can be traded and made subject to futures contracts.
In other words, bitcoins fall within the CEA’s definition of a commodity because they are “rights” or “interests” that can form the basis for “contracts for future delivery.” CFTC Commissioner Mark Wetjen recently affirmed this view: “It has not been tested, but I do believe we have the authority because bitcoin, by I think a very rational reading of our statute, classifies as a commodity and the definition of a commodity under the Commodity Exchange Act.” Moreover, the Internal Revenue Service has determined that bitcoins constitute property (as opposed to money), and Japan and Finland have determined that bitcoins constitute commodities.
Yet the classification of bitcoins as commodities, without more, would not automatically make bitcoin exchanges “commodity brokers” under the Bankruptcy Code. For example, CFTC regulations would not cover a bitcoin exchange unless it participates “as a principal in each leverage transaction,” but it is unclear whether a bitcoin exchange would actually fulfill such a requirement. The answer likely depends on the exchange’s business model.
“Customer”
Even if a bitcoin exchange were a “leverage transaction merchant” under the Bankruptcy Code, it still would not constitute a “commodity broker” unless it has “customers.” The Bankruptcy Code defines “customer” as, among other things, an “entity that holds a claim against such leverage transaction merchant arising out of . . . a deposit or payment of cash, a security, or other property with such leverage transaction merchant for the purpose of entering into or margining” a leverage transaction. In short, if a bitcoin exchange operates as a “leverage transaction merchant,” then a client with a margin account at the exchange would appear to constitute a “customer” under the Bankruptcy Code.
Some Bitcoin Exchanges May Be Commodity Brokers
Based on the analysis above, a bitcoin exchange that operates under the “Margin Trading” model may fall within the meaning of “commodity broker” in the Bankruptcy Code to the extent that it participates in “leverage transactions” in its business. A bitcoin exchange that operates under the “Dealer,” “Broker,” or “Escrow” models, however, would not appear to constitute a commodity broker because it simply exchanges or facilitates the exchange of currency for bitcoins.
Being a “commodity broker” has significant implications for a distressed company. Among other things, the company would not be eligible for chapter 11 relief and must instead be liquidated under subchapter IV of chapter 7. Relative distribution priorities would differ from those in chapter 11. Perhaps most significantly for a company based on a relatively little-known and legally uncertain technology such as Bitcoin, a chapter 7 trustee would supplant the board and conduct the liquidation.
Depending upon how digital-currency law develops, a commodity-broker liquidation is a potential legal framework for at least some types of bitcoin exchanges. But we still have not excluded other types of exchanges from chapter 11. In our next and final post on the bankruptcy eligibility of a hypothetical bitcoin exchange, we will consider whether a bitcoin exchange could constitute a type of bank or multilateral clearing organization under the Bankruptcy Code.
As a reminder, the Weil Bankruptcy Blog does not provide or purport to provide legal advice on bankruptcy, securities, or any other areas of law.  The discussion herein reflects the opinion of the author, not that of Weil, Gotshal & Manges LLP.  This discussion is strictly hypothetical and may not be relied upon for the purpose of trading bitcoins, securities, or any other instrument of value.