The Japanese insolvency and chapter 15 bankruptcy filing of bitcoin exchange Mt.Gox raise a host of questions about parties’ rights to bitcoins—assets that defy neat analysis under existing legal frameworks. How would a bitcoin exchange be restructured or liquidated? What assets does it have, and where are they situated? And what are those assets in the first place?
Bitcoin Bankruptcy
The Weil Bankruptcy Blog is pleased to announce a new series titled “Bitcoin Bankruptcy.” We will explore the legal questions that a hypothetical bankruptcy of a bitcoin exchange might pose under the Bankruptcy Code. We will also consider the implications of such a bankruptcy on the debtor exchange, its customers, its creditors, the bitcoin market and its infrastructure, and regulatory authorities. Today, we provide some background on Bitcoin and consider some of the questions raised by Mt. Gox’s chapter 15 filing.
What Is Bitcoin and How Does It Work?
Bitcoin is a digital payment system that functions as money among those who attribute value to it. To finance professionals, Bitcoin is a hybrid form of asset that straddles the line between currency and commodity. For example, the following are some of Bitcoin’s currency-like properties:
- Bitcoin is a medium of exchange used to purchase goods and services.
- Bitcoin has exchange rates against government-sponsored currencies.
- Bitcoins can be taken offline and converted to tangible form.
- A searchable record of all Bitcoin transactions (called the “block chain”) is maintained.
- Bitcoins appear to have no nonmonetary value (unlike things like oil, wheat, or gold).
Yet Bitcoin also has the following commodity-like properties:
- Bitcoin is not backed by a government and has no centralized regulatory authority.
- Bitcoins are scarce: a maximum of only 21 million bitcoins will ever exist.
- Bitcoins are released into circulation gradually (through a process known as “mining”).
- Bitcoin prices are extremely volatile and may not be susceptible to stabilization by a government.
At a high level, transacting in Bitcoin is similar to transacting in any other currency. A prospective Bitcoin market participant opens an account with a Bitcoin “wallet” service—an Internet company that holds one’s bitcoins in what is essentially a deposit account. The participant visits a Bitcoin exchange, which works like any other type of currency exchange, selling bitcoins for other currencies at various exchange rates that fluctuate over time. The exchange matches a buyer with a seller and earns the bid-ask spread on the transaction. The participant pays for the Bitcoins using PayPal, wire transfer, or another payment system and deposits those bitcoins in his or her wallet.
The market participant might be a consumer. A consumer can spend his or her bitcoins wherever bitcoins are accepted, such as the websites for Overstock.com or the Sacramento Kings basketball team. But the market participant might instead be an investor. An investor might buy bitcoins at one price and sell them at a higher price; use them to hedge transactions in other currencies; or use them for other types of financial transactions.
Bitcoins can also be converted from digital form into physical form. Market participants can perform these conversions at bitcoin ATMs and store physical bitcoins in wallets. A number of market participants have in fact converted their bitcoins into physical form and stored them in safe-deposit boxes at banks.
Most governments and companies do not presently accept Bitcoin as a medium of exchange, but Bitcoin’s acceptance has been growing in most parts of the world since Bitcoin’s introduction in 2009. Bitcoin prices are extremely volatile, though. Bitcoins traded around $5 in March 2012; over $1,200 in November 2013; and between $600 and $700 on most major exchanges over the past week.
Transaction Mechanics and Market Infrastructure
At a more granular level, Bitcoin’s transaction mechanics differ markedly from other forms of payment. These differences may raise significant questions regarding how bitcoin-based transactions should be analyzed under the Bankruptcy Code and other restructuring frameworks.
For a frame of reference, suppose a buyer purchases goods from a seller via PayPal. PayPal serves as a third party escrow-type agent that both parties trust will clear the transaction properly. As an intermediary, PayPal is also a means by which a buyer can initiate a chargeback—i.e., reverse the transmission of funds where the buyer disputes the transaction. For most purposes, this is a typical online payment structure.
Bitcoin transactions are fundamentally different. A Bitcoin transaction occurs between a buyer and a seller, each of which is identified only by a unique publicly available code called an “address.” The transaction occurs on a peer-to-peer basis, and that is Bitcoin’s most significant innovation: it does not require a bank or other trusted third party to clear transactions. Instead, Bitcoin relies on what one might call “crowdsourced market infrastructure.”
When a Bitcoin transaction takes place, a signal announcing the transaction is sent out to the Bitcoin market. The signal is received by thousands of computers with specialized hardware called “miners.” Miners perform calculations (called “mining”) that verify that the transaction they have received is, in fact, a valid transaction involving unique bitcoins. When a critical percentage of miners have verified the transaction, the transaction is considered valid and is recorded in the block chain, a public ledger. No third party clears transactions, and so transaction costs are generally low. Chargebacks are difficult or impossible for buyers to perform.
A word about miners: Miners’ incentive to verify transactions is that they receive bitcoins for doing so. The more effective a miner is at mining, the more bitcoins it receives. The bitcoins are distributed to miners by the Bitcoin network, and mining gets more difficult as more bitcoins are mined. The Bitcoin network will stop distributing bitcoins once 21 million bitcoins have been distributed.
This is just an overview of Bitcoin, but much more writing is available online for those interested in more detail.
The Mt. Gox Crisis
Mt. Gox is a bitcoin exchange headquartered in Tokyo, Japan. It was once the world’s largest bitcoin exchange. Mt. Gox operated two related businesses—an exchange and a wallet system—for both its own accounts and its customers’ accounts. It managed both hot wallets and cold wallets. A “hot” wallet is a bitcoin wallet that is maintained on a computer connected to the Internet. A “cold” wallet is maintained on an offline computer.
Mt. Gox has asserted that, in early February 2014, unidentified hackers may have broken into its wallet system—apparently both hot and cold, and both its own accounts and its customers’ accounts—and stolen approximately 850,000 bitcoins. Following its discovery of the bitcoin losses, Mt. Gox stopped permitting customers to make withdrawals from their wallets. On February 28, 2014, Mt. Gox commenced a bankruptcy-like civil rehabilitation proceeding in Tokyo. Yesterday, Mt. Gox petitioned the United States Bankruptcy Court for the Northern District of Texas for chapter 15 relief.
Chapter 15 for a Non-U.S. Bitcoin Exchange
Generally, a debtor’s decision whether to file under chapter 15 is a strategic or practical one. Chapter 15 facilitates the debtor’s foreign proceeding (i.e., its proceeding outside of the United States) by granting judicial recognition of that proceeding in the United States. A debtor in a foreign proceeding can use chapter 15 to protect assets situated in the United States; to establish U.S. procedures for filing claims in the foreign proceeding; to facilitate asset sales approved in the foreign proceeding; and for certain other purposes. In its case, Mt. Gox asserts that it has sought chapter 15 relief to avoid “expend[ing] substantial monetary and personnel resources” to defend itself in litigation pending in the United States.
Mt. Gox may be the next debtor to raise the question whether section 109(a) of the Bankruptcy Code applies to debtors seeking chapter 15 relief. Section 109(a) requires, among other things, that a debtor in a bankruptcy case have “a domicile, a place of business, or property in the United States.” The United States Court of Appeals for the Second Circuit recently held that section 109(a) applies to debtors in foreign proceedings seeking relief under chapter 15. By contrast, the United States Bankruptcy Court for the District of Delaware recently held in an oral ruling that section 109(a) does not apply to a debtor in a foreign proceeding. In Mt. Gox’s case, no one seems to know what, if any, property Mt. Gox has in the United States. And for that matter, it is unclear what kind of property a foreign-based bitcoin exchange would be expected to have in the United States.
Where in the World Is Property of the Estate? (And What Is That Property?)
In general, the kinds of property a foreign bitcoin exchange could have in the United States might include a website, servers, data, bitcoins, and other intellectual property, among other things. Yet there may not be clear answers on where certain of these intangible assets are situated. For example: where is data situated? Is it on a physical server; in the owner’s principal place of business; in the owner’s jurisdiction of incorporation; or somewhere else? Does it depend on what kind of data is at issue? Do bitcoins in digital form constitute data or some other kind of property?
Further, it is unclear whether customers’ bitcoins constitute property of the debtor’s estate or custodial property held in trust for the debtor’s customers. (In other words, do customers constitute creditors?) In the context of a typical (fiat) currency, a deposit of funds into a bank account generally creates a debtor-creditor relationship between the bank and the depositor. Yet it is unclear whether the same would be true for the deposit of a bitcoin into a wallet. The commodity-like property of bitcoins may weigh in favor of considering the bitcoin-wallet relationship one of custody rather than of debt.
Notice and Service Procedures May Be Antiquated.
Bitcoin exchange bankruptcies also raise the question whether currently applicable service and notice procedures are obsolete. For example, when a typical debtor commences a bankruptcy case, it generally provides notice of the case to known creditors by mail and to unknown creditors by newspaper publication. But these methods may not work for a bitcoin exchange. Parties transacting in bitcoin are identifiable only by their public pseudonyms, and they may be located anywhere in the world. Their mailing addresses likely are all unknown, and there may be no way to determine which newspaper would most effectively reach creditors. Thus, traditional methods of giving notice—and, for similar reasons, of serving process—may not apply in the bankruptcy of a bitcoin exchange. It may be that the bitcoin exchange’s website itself constitutes the most effective forum for providing notice and serving process in the case. Moreover, the involvement in bitcoin exchanges by parties located all over the world may implicate novel questions of the statutory and constitutional reach of bankruptcy courts’ in personam jurisdiction.
More to Come
These issues are just the tip of the Bitcoin Bankruptcy iceberg. In future posts, we will explore the issues that may arise in a hypothetical bankruptcy of a U.S.‑based bitcoin exchange. We are excited to discuss what may be the next new frontier of restructuring law.
