By Matthias Lehmann et al. (Universitat Wien)
Note: This post is the fourth post in a series of posts on bankruptcies of cryptocurrency companies and the emerging issues they pose. Previous posts in the series include:
2. Quantifying Cryptocurrency Claims in Bankruptcy: Does the Dollar Still Reign Supreme?, by Ingrid Bagby, Michele Maman, Anthony Greene, and Marc Veilleux
3. The Public and the Private of the FTX Bankruptcy, Diane Lourdes Dick and Christopher K. Odinet
This series is being managed by the Bankruptcy Roundtable and Xiao Ma, SJD at Harvard Law School, xma [at] sjd [dot] law [dot] harvard [dot] edu.
Check the HLS Bankruptcy Roundtable periodically for additional contributing posts by academics and practitioners from institutions across the country.
The consequences customers face in case a crypto exchange like FTX goes bankrupt are enormous, but they may be even more severe if they had previously staked their digital assets or engaged in a similar transaction. As a matter of fact, it is not a far-fetched to fret that a bankruptcy court may construe such a transaction as entailing an asset transfer to the exchange or a third party. In this case, the crypto assets – Bitcoin, Ether or token – would be considered as a part of the insolvency estate or as belonging to somebody else. Customer would have no propriety rights in them and be relegated to the status of mere creditors, with the prospect of receiving only a fraction of the asset’s value.
In this context, it is of paramount importance how the transaction in question is to be legally characterized. Characterization is the process by which an empirical phenomenon is attributed to a particular legal category. This exercise is not always easy, and it is particularly difficult with regard to the operations in the crypto space. There is hardly any literature on them, because they are in large part novel and unprecedented. The legal nature and effects of such operations depend in the first place on the terms and conditions to which they are submitted. But many of them use highly general notions and are legally unprecise. To achieve definite results, it is likely for a court to intuitively trying to associate the transactions described with a known category. This will be important in two respects.
First, the category chosen for a certain transaction will inform the conditions for its validity as well as its effects. In particular, it will decide whether the customer has transferred her rights fully and thus bears the full risk of the counterparty’s insolvency, or whether the transaction merely creates a more limited right in rem of the crypto exchange or a third party.
Second, characterization is also important to identify the national law governing these transactions. Conflict-of-laws rules will be applied by a bankruptcy court to determine, as a preliminary question, whether an asset forms part of the insolvency estate or whether it belongs to another person. There are different conflict-of-laws rules for different types of transaction, which point to different laws depending on the transaction’s characteristics.
Which category a transaction is shoehorned in will thus be decisive in several ways for the position of the crypto investor. But how can they be legally characterized?
Admittedly, this is not easy. To take just one example, the legal nature of staking is quite doubtful. Potentially, it could be considered as a secured transaction because it enables to ‘slash’ the investor’s crypto asset in case of manipulative activity or inactivity of a node. But it may also be compared to a deposit or a loan of cryptos. It is even not excluded to view staking through the lenses of a partnership that may exist between all nodes of a platform, or as being constitutive of a trust.
Similar problems arise for yield farming, liquidity mining and crypto lending. These operations must be distinguished from staking and from each other, even though the lines are often blurred. How they are to be legally characterized is highly relevant for the position of the crypto investor.
Any characterization needs to reflect the terms and conditions, the typical intention of the parties, and the economic purpose of the transaction. But above all, it should be informed by the consequences it has for investor protection. Unless clearly indicated in the agreement and absolutely indispensable for achieving the purpose of the transaction, it should not be assumed that the investor intended to part with her ownership or other rights of entitlement. Where the terms and conditions are equivocal or ambiguous about this point, they should be interpreted against the person that formulated them, according to the time honoured “contra proferentem” principle for constructing constructs. When and for which transactions a transfer of property or other rights can be presumed will be the decisive question. The debate about this problem has just begun. Felix Krysa, Emeric Prévost, Fabian Schinerl, Robert Vogelauer and I have examined different options and made suggestions for precise characterization in a new paper.
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