Restructuring

In our last Bitcoin Bankruptcy post, we discussed some of the questions that Mt. Gox’s chapter 15 filing raises.  Today, we begin to consider what a bankruptcy of a hypothetical U.S.-based bitcoin exchange might look like. 
The U.S.-Based Bitcoin Exchange and Its Filing
Hypothetical debtor: Our hypothetical debtor is a Delaware corporation having its headquarters office in New York, New York.  It operates a website with a “.com” top-level domain, which it has registered through a U.S.-based domain name registrar.  The website offers two services to its users: (i) bitcoin wallet services and (ii) a bitcoin exchange.  Like Mt. Gox our hypothetical U.S. bitcoin exchange maintains both customer and proprietary bitcoin wallets.  Assume that our debtor has deposit accounts at banks within New York State.  And to keep matters simple, assume that all of our debtor’s obligations were issued in U.S. dollars.
Hypothetical distress event: Now, assume that our hypothetical debtor experiences the same distress event that Mt. Gox experienced.  One day, the company suddenly discovers that most or all of its customers’ and its own bitcoins have gone missing.  The bitcoins’ disappearance has put the company in default of its obligations, and customers have commenced a class action against the company.  Unable to find the bitcoins and cure its defaults, and in the midst of a crisis of confidence, the company voluntarily seeks the protection of the U.S. bankruptcy laws.
Bitcoin Exchanges and Eligibility
First, our debtor must determine whether it is eligible for relief under the Bankruptcy Code.  This question has two parts:

• Does it satisfy the requirements of section 109(a) of the Bankruptcy Code?
• Even if so, does another part of section 109 expressly render it ineligible for bankruptcy?  

Section 109(a) of the Bankruptcy Code requires that a corporate debtor in a U.S. bankruptcy case “resid[e] or ha[ve] a domicile, a place of business, or property in the United States.”  Here, our hypothetical bitcoin exchange has, among other things, a domicile in Delaware, a place of business in New York, deposit accounts in New York, and a domain name situated in the United States.  Our debtor easily meets the requirements of section 109(a) to be a debtor in bankruptcy.
The next question is whether another part of section 109 of the Bankruptcy Code expressly excludes the debtor from eligibility for relief under certain chapters of the Bankruptcy Code.  The answer largely depends on the debtor’s business model.
Bitcoin Exchanges: Four Sample Business Models
Bitcoin exchanges operate under several different business models.  Based on our research, the following four business models appear to be the most common among bitcoin exchanges currently in operation:

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.
Chapter 11 May Not Be Available for All Bitcoin Exchanges.
Not all of these bitcoin exchanges may be eligible to file a chapter 11 case.  Section 109(d) of the Bankruptcy Code provides that only the following types of entities are eligible for chapter 11 relief:

• Railroads;
• Certain banks that operate multilateral clearing organization businesses under section 409 of the Federal Deposit Insurance Corporation Improvement Act of 1991; and
• Persons that may be debtors under chapter 7, except stockbrokers and commodity brokers.  In general, companies that are not railroads, insurers, or most types of banks may be debtors under chapter 7.

So what types of entity is a bitcoin exchange?  There are a few types that we can rule out at a glance.  First, a bitcoin exchange obviously is not a railroad.  Second, a bitcoin exchange does not appear to be an insurance company.  Although the Bankruptcy Code does not define “insurance company,” the Supreme Court of the United States has explained that “[t]he primary elements of an insurance contract are the spreading and underwriting of a policyholder’s risk.”  Bitcoin exchanges generally are not in the business of underwriting risk, so they probably do not constitute insurance companies.
As such, it appears that a bitcoin exchange would be eligible for chapter 11 unless it is a stockbroker, a commodity broker, or a bank that is not a multilateral clearing organization.  Could a bitcoin exchange be a stockbroker or a commodity broker?  Based on its wallet business, could it be a bank?  If it’s a bank, could it constitute a clearing organization? 
Our hypothetical bitcoin exchange facilitates the trading (at least in some sense) of bitcoins, and it also maintains wallets in which it holds customers’ bitcoins.  Depending on the exchange’s business model, and despite the fact that bitcoin transfers are peer-to-peer transactions, there may be an argument that a bitcoin exchange performs a kind of clearing function.  Accordingly, we must consider whether any of the bitcoin exchange business models described above constitutes a stockbroker, a commodity broker, a type of bank, or a clearing organization.  Our upcoming Bitcoin Bankruptcy posts will look at eligibility under each of these categories in detail.
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.