Posted May 9, 2024 at 8:46 am EST.
This week, the FTX bankruptcy estate announced it would repay 98% of creditors and that creditors would recover between 118% and 142% of the value of their allowed claims (i.e. those creditor claims that are recognized by the US bankruptcy court as legitimate claims against the FTX bankruptcy estate). While many cheered this news, it belied a larger truth: Customers who held crypto assets on the platform will, in fact, receive a fraction of the value of their original crypto holdings.
Read more: 98% of FTX Creditors to Receive 118% Claims Payout
How can it be true both that creditors would be paid over 100% of their allowed claims and also that they are in a worse-off economic position? It has to do with a longstanding practice that, due to numerous crypto bankruptcies across the last decade, is now being called into question: setting the value of the bankruptcy assets at the dollar value on the day the petition was filed, a practice known as “dollarization.”
Because bankruptcies can take years to play out, and especially because the most popular crypto assets can fluctuate almost exponentially in value, this means that creditors actually receive back a fraction of the dollar value of what they would have if they had been able to keep their crypto asset.
In short, the legal framework governing traditional financial instruments and currencies generally does not work for digital assets.
This issue of dollarization has been the subject of much debate in light of the bankrupt FTX estate’s sale of locked Solana (SOL) tokens at around $60. Though FTX customers that held SOL had their claims dollarized at around US$14 per SOL as at the Bankruptcy Order, the price of SOL has rallied to more than US$200 (before correcting in line with the rest of the cryptocurrency market), severely impacting FTX customers who considered they had been effectively “forced to sell” at the bottom by the dollarization process. As explained by Matt Levine, a customer holding 10 SOL tokens worth US$143 in their FTX account at the time of bankruptcy would now receive around US$170, but the same 10 SOL tokens today are worth almost $1,500. Indeed, a commentator on X went so far as to describe the FTX dollarization process as “probably the greatest anti-meritocratic mass redistribution of wealth” they had ever seen.
The Rationale Behind Dollarization
In the context of traditional bankruptcy proceedings, the law is well settled. Under English law for example, the Insolvency Rules 2016, which set out the procedures for all company and personal insolvency proceedings in England and Wales, clearly mandate that debts in foreign currencies be converted to the local currency (GBP) at the exchange rate prevailing on the date the company went into liquidation or entered administration.
The rationale for this is simple — dollarization aims to simplify the administration of the estate by consolidating all claims into a single fiat currency at a specified date, thereby avoiding the complexities and costs of dealing with multiple currencies. It takes the impact of currency volatility on the group of creditors out of the equation and leaves individual creditors to make their own decisions on hedging: dollarization crystallizes currency risk as at a specific date.
It’s no surprise then that dollarization has either been codified in law or has become an accepted rule of practice for courts and insolvency practitioners in major bankruptcy jurisdictions, including the US and Singapore. But it also means that creditors could end up receiving a different “base currency” return on their claims due to fluctuations in exchange rates between the date of the bankruptcy and the date of payment. This risk may be tolerable for the most part given that the volatility of most major fiat currencies is low, barring a major global economic crisis. Most creditors and stakeholders are therefore prepared to accept such risks considering the costs involved for insolvency practitioners to preserve and pay their claims in the currency of the original debt.
All this has changed with cryptocurrency bankruptcies where dollarization is seen as unfair because it is not reflective of the realities of the digital asset base and digital creditor classes. While fiat currencies are generally unaffected by the bankruptcy of any one participant, the tight cryptocurrency ecosystem means that the failure of one major participant can lead to a sharp short-term decline in cryptocurrencies which the failing business is associated with. Dollarization has been hotly contested by creditors in the FTX Chapter 11 process, but Judge Dorsey, the presiding judge in the bankruptcy process has been clear: “the debtors’ use of the petition date for determining the value of the digital asset claims is appropriate. I have no wiggle on that. The [Bankruptcy] code says what it says and I am obligated to follow the code.”.
Interestingly, crypto creditors are not alone in challenging dollarization. In the Lehman Brothers International (Europe) (LBIE) administration in the UK, a sudden and significant depreciation in the Pound in the period between the administration order and payment dates resulted in creditors on the one hand receiving 100 cents in Sterling terms, but seriously shortchanged in terms of original claims in a foreign currency, even though there was a surplus in the LBIE estate.
The English Supreme Court, reversing the decisions of the lower courts, held that because the requirement for dollarization of claims was codified under the Insolvency Rules 2016, there was little scope for judicial intervention to enable these creditors to recover their base currency shortfalls. Notably, in his dissenting judgment, Lord Clarke acknowledged the unsatisfactory nature of this ruling because, in circumstances where there was a surplus (as was the case with LBIE), it in effect gave shareholders a windfall at the expense of creditors.
A Poor Fit for Cryptocurrency Bankruptcies
The LBIE case has shown the statutory limitations of dollarization even for fiat currency claims, but the application of traditional insolvency law and practices to a crypto environment makes these limitations even less appropriate.
First, cryptocurrencies, do not fit neatly within the definition of “currencies” as understood in the context of insolvency law. Recent case law in England and Singapore has recognized cryptocurrencies as a form of property, not currency. This distinction is crucial because it implies that creditors may have property related rights in the assets they hold on an exchange, rather than merely a claim for the return of a deposit in a certain currency.
Secondly, those rights could be in the form of a trust claim (a claim that the customer, not the exchange, is the owner of the asset and exclusively entitled to it) or a contractual entitlement to delivery of a similar asset. If a customer is “entitled” to 1 BTC, the question arises whether they are entitled to 1 BTC, which can be identified or traced, or to damages for non-delivery of 1 BTC, with the latter involving the assessment of damages.
These are live issues in the FTX bankruptcy where FTX’s terms of use, governed by English law, state that customers retain title to their assets, suggesting that customers retain beneficial ownership of the assets they deposit, akin to placing currency notes in a safety deposit box rather than depositing them into a bank account. This implies that customers may not be creditors of the estate but rather have a right to the in-kind return of the assets they deposited. Various FTX creditor groups have raised this before the US Bankruptcy Court.
Thirdly, the law needs to be able to address the realities of cryptocurrency business failure in terms of claims quantification and distributions to ensure equitable treatment of creditors, and in terms of orders of priorities to ensure there can be no windfall recoveries at the expense of more senior claimants.
A More Creative Solution
Bankruptcy administrations, whether in the nature of liquidation or reorganization, are run for the benefit of all stakeholders, including shareholders, but recognition of the rights of creditors as senior stakeholders, as well as creditor involvement in and support of the administration process are fundamental. Cryptocurrency bankruptcies are no different and this requires the unique nature of crypto as a “non-currency currency” to be acknowledged and engagement with the crypto community on issues ranging from interim digital asset management to tokenization of claims.
Even so, bankruptcy reorganization processes (such as a US Chapter 11 proceeding, an English Restructuring Plan, or an English or Singapore Scheme of Arrangement) offer some options for creativity. This is because the restructuring consideration offered in exchange for existing claims can take virtually whatever form creditors want, provided the debtor is in agreement and creditor class and fairness issues are respected.
The industry is already seeing the tokenization of reorganization claims and the options to allow for variable claim values, pegged to current and future digital asset market prices through the issuance of “recovery tokens” to creditors linked to different categories of assets, seem potentially limitless. For example, subject to resolving any creditor class and fairness issues, and debtor agreements, reorganization consideration could be structured as follows:
- Category A: Where there are creditor claims against the debtor for high market cap and more liquid crypto assets (e.g., BTC, Ethereum, Solana), recovery tokens could be issued to creditors which provide for primary recourse to these types of existing and subsequently recovered crypto assets. Periodic distributions would be made to proportionately “write down” the recovery token based on linked crypto asset value as at the time of each distribution.
- Category B: Where there are creditors with fiat currency claims or claims with respect to low market cap and less liquid crypto assets, a fiat currency instrument could be issued to these creditors, possibly with voluntary or mandatory equity conversion options, with primary recourse to other general assets of the debtor including existing and subsequently recovered, but low market cap and less liquid crypto assets. Interest would be payable (actual or Payment in Kind) and an amortization schedule agreed.
A reorganization plan structured like this, with appropriate distribution and redemption options, could go some way to addressing future fluctuating crypto asset valuation concerns. But as things stand, without a change in the law (and absent any accepted trust claims), any reorganization would still involve a dollarization of crypto asset claims in the first instance, followed by “conversion back” into a recovery token.
One potential solution for this (and there will be others) might be to stipulate a recovery token redemption premium determined by reference to the difference between the dollarization amount and the linked crypto asset value at the time the recovery token is issued. For instance, if 1 BTC is $100 at the time of dollarization, the restructuring documents could establish a future date at which a redemption premium would be set, which would be at or near the date the recovery token is issued. Thus, if the value of BTC was $150 at that future date, the redemption premium would be $50. A reorganization plan or scheme solution such as this could also ensure “true value” recoveries ahead of other more junior stakeholders (and this could also be applied to fiat currency conversions).
Conclusion
While courts have successfully been able to apply traditional legal principles to address many of the unique challenges posed by cryptocurrency in bankruptcy proceedings, the one area where there is still concern, and a deep sense of unfairness within the cryptocurrency community, is in the valuation of claims.
The continued adoption and evolution of digital assets, blockchain technology, and cryptocurrencies necessitates a re-evaluation of insolvency laws. Solutions such as issuances of recovery tokens, can allow for a distribution of assets that reflects the inherent volatility and liquidity of different cryptocurrencies.
Ultimately, jurisdictions that can provide a more flexible mechanism to balance these competing interests would likely benefit through increased investor confidence and investments.
Rishi Hindocha is a partner at Allen & Overy Shearman Sterling LLP with expertise on restructuring, insolvency and financing matters. Ian Chapman is a consultant at Allen & Overy Shearman Sterling LLP with expertise on restructuring and insolvency matters. Benjamin Foo and Michael Pek at Allen & Overy Shearman Sterling LLP also contributed to this piece.
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