Crypto Bankruptcy Preference Considerations | Practical Law The Journal

Beginning in 2022, many of the largest retail-facing crypto platforms, including Celsius, Voyager, FTX, Genesis, and BlockFi, filed for Chapter 11 bankruptcy protection. Several of these cases were precipitated, at least in part, by “runs on the bank” in which retail customers withdrew substantial amounts of crypto from each platform.

In several cases, insiders of the crypto debtors also engaged in misconduct relating to the management of crypto assets. For example, in the weeks and months leading up to Celsius’s bankruptcy filing, Celsius insiders withdrew tens of millions of dollars’ worth of their own crypto assets that had been deposited on the platform. Further, several FTX insiders commingled, misused, and misappropriated billions of dollars of customer crypto deposits.

In addition to providing retail trading and lending services, Celsius, similar to many other crypto platforms, had significant borrowings under DeFi loans. DeFi loans are dollar-denominated loans collateralized by pledged crypto assets that are often governed by self-executing smart contracts and recorded on the blockchain. In the month before its bankruptcy filing date, nearly $650 million of Celsius’s DeFi loans were repaid, freeing up excess crypto that had previously served as collateral for these loans.

In light of these events, the Celsius, Voyager, FTX, Genesis, and BlockFi debtors (or the respective statutory committees that sought to act as fiduciaries on behalf of the estates) have explored avenues for maximizing value, including by considering whether customer withdrawals and repayments or liquidations of DeFi loans in the lead-up to the bankruptcy filings might be deemed preferential and avoided for the benefit of the estates.

Various crypto exchange debtors have engaged in litigation related to the recovery of such funds or have negotiated settlement agreements with the recipients of potentially avoidable transfers. The Chapter 11 plans for several crypto debtors also provided for the establishment of a liquidating trust or similar structure to pursue, among other things, avoidance actions (including preference actions) on behalf of the debtors’ estates.

Although the authority relating to these exact issues is in its infancy, recent precedent reflects that those seeking to augment creditor recoveries through avoidance of crypto withdrawals and DeFi loan repayments face several obstacles, including:

(For more on issues that may arise in crypto-related Chapter 11 proceedings, see Crypto Chapter 11 Proceedings in the March 2023 issue of Practical Law The Journal.)

Section 547 of the Bankruptcy Code allows a trustee or debtor-in-possession to avoid as preferential any transfer of a debtor’s interest in property to a creditor for a pre-existing debt if the transfer:

In other words, if a creditor receives payment on a pre-existing debt within 90 days before the bankruptcy filing, at a time when the debtor was insolvent, that payment potentially may be clawed back to the extent it allowed the creditor to receive more than their pro rata share of the bankruptcy estate. This is generally understood to serve two purposes:

(For more on the elements of a preferential transfer and the application of preference law, see Preferential Transfers: Overview and Strategies for Lenders and Other Creditors on Practical Law.)

The seven elements needed to prove a preference are:

Some of these elements are more easily satisfied than others when applied to a potential avoidance of a crypto withdrawal or DeFi loan repayment or liquidation.

For example, the Bankruptcy Code defines transfer broadly to include “every conceivable mode of alienating property, whether directly or indirectly, voluntarily or involuntarily” (Cullen Ctr. Bank & Tr. v. Hensley (In re Criswell), 102 F.3d 1411, 1415 (5th Cir. 1997)). This definition encompasses either the voluntary repayment (or involuntary liquidation) of a DeFi loan by the debtor or a withdrawal by a customer from a debtor’s rewards program, such as Celsius’s Earn program or Voyager’s payable-in-kind (PIK) interest-bearing deposit accounts (see Rewards Programs below).

The Bankruptcy Code’s definition of creditor is similarly broad and includes any entity that holds a claim (that is, virtually any right to payment, whether fixed, contingent, disputed, or otherwise). An antecedent debt is merely “liability on a claim” that arose before the date of the challenged transfer. (§ 101(5), (10), (12), Bankruptcy Code.) Both DeFi lenders and customers hold a right to payment from a debtor, and that right to payment generally will have arisen before the time of the relevant repayment or withdrawal. In other words, any payment or withdrawal would be on account of an antecedent debt. That said, these parties may raise creative arguments regarding when a transfer was actually made, particularly where a smart contract governs the loan (see Establishing When the Transfer Occurred below).

Additionally, although a transfer can be preferential only if made while the debtor is insolvent, there is a rebuttable presumption that the debtor is insolvent in the 90 days leading up to the petition date (§ 547(f), Bankruptcy Code). If the preference defendant can introduce even “some evidence that the debtor was not in fact insolvent at the time of the transfer,” then the burden shifts back to the debtor to prove by a preponderance of the evidence that it was insolvent at the time of the challenged transfer (see Lawson v. Ford Motor Co. (In re Roblin Indus., Inc.), 78 F.3d 30, 34 (2d Cir. 1996)).

This ability to shift the burden regarding insolvency leaves the door open for individual defendants to raise solvency as a defense, particularly if a crypto exchange’s downfall was due to a sudden and precipitous drop in crypto prices that occurred immediately before the petition date (and after the transfer at issue).

The determination of whether a transfer was “of an interest of the debtor in property” (§ 547(b), Bankruptcy Code) is more complicated. Generally, a debtor has an interest in property only if that property “would have been part of the estate had it not been transferred” before the bankruptcy filing (see Begier v. IRS, 496 U.S. 53, 58 (1990)).

This again potentially elicits the metaphysical question of when a transfer under a smart contract is made (see Establishing When the Transfer Occurred below).

Property held in trust for the benefit of another is not considered the debtor’s property (and a transfer of that property, therefore, cannot be avoided as a preference). On the other hand, property to which the debtor has legal and equitable title, and which the debtor is free to use or spend in its own discretion, generally will constitute estate property.

In the context of a crypto debtor, a key issue is therefore determining who has title to the crypto held on the platform. While customers might assume that crypto assets deposited with crypto platforms remain the customer’s property, the reality is more complicated. The terms of use of the underlying crypto account bear a strong correlation to whether such funds are property of the customer or the crypto debtor. (For more on whether crypto may be property of a crypto platform’s estate, see Crypto Chapter 11 Proceedings in the March 2023 issue of Practical Law The Journal.)

Celsius’s Earn program was its most popular product, representing approximately 77% of the crypto deposited on the Celsius platform at the time of its bankruptcy filing (Tr. of Hr’g at 37:21-22, In re Celsius Network LLC, No. 22-109640 (MG) (Bankr. S.D.N.Y. July 18, 2022)). It allowed customers to enter into open-ended loans to Celsius of certain eligible crypto assets and earn rewards in the form of yield paid either in-kind (that is, Bitcoin (BTC) would earn yield denominated in BTC) or in Celsius’s proprietary token (Celsius: Terms of Use, § 4.D (last rev. Sept. 29, 2022)).

The terms of use for Celsius’s Earn program clearly and explicitly state that, in exchange for earning yield, customers “grant Celsius all rights and title” to the underlying crypto, which will become Celsius’s “property, in every sense and for all purposes.” After the transfer, Celsius “may lend, sell, pledge, hypothecate, assign, invest, use, commingle or otherwise dispose of” the assets in its sole discretion. (Celsius: Terms of Use, §§ 4.D, 10.) Based on Celsius’s “unambiguous terms of use,” the US Bankruptcy Court for the Southern District of New York held that any crypto enrolled in Celsius’s Earn program presumptively became property of the Celsius debtors’ estate and is potentially susceptible to avoidance, which presumption remains subject to any defenses that individual customers might raise (see In re Celsius Network LLC, 647 B.R. 631, 651, 660 (Bankr. S.D.N.Y. 2023)).

Voyager maintained a similar program, its PIK interest-bearing deposit account, which allowed customers to earn yield on deposited assets (Decl. of Stephen Ehrlich, Chief Exec. Officer of the Debtors, in Supp. of Ch. 11 Pets. and First Day Mots. at ¶ 24, In re Voyager Digital Holdings, Inc., No. 22-10943 (MEW) (Bankr. S.D.N.Y. July 6, 2022), Doc. No. 15). Under the terms of use, the customer granted Voyager the right to hold crypto in Voyager’s name and to subsequently sell, lend, or otherwise use such funds (Ex. A: Customer Agreement, § 5(D) (updated Jan. 7, 2022), In re Voyager Digital Holdings, Inc., No. 22-10943 (MEW) (Bankr. S.D.N.Y. Oct. 19, 2022), Doc. No. 567-1).

The Voyager debtors’ special committee of the board of directors (which was established to look into, among other things, potential avoidance actions to be brought against directors, officers, and other insiders) determined that, although the underlying terms of use appeared to grant Voyager title to the property, no “valid Avoidance Actions exist[ed] against Account Holders because any transactions with Account Holders were completed in the ordinary course of business consistent with past practices” (First Am. Disclosure Statement Relating to the Second Am. Joint Ch. 11 Plan at 60, In re Voyager Digital Holdings, Inc., No. 22-10943 (MEW) (Bankr. S.D.N.Y. Oct. 17, 2022), Doc. No. 540).

That a transaction was entered into in the ordinary course of business may provide a defense against a preference action brought to avoid the transaction. In other words, although the account terms reflected that the customer deposits were Voyager’s property, Voyager’s special committee concluded that actions to recover such assets would be subject to affirmative defenses (specifically, the affirmative defense that the withdrawal of crypto was largely done in the ordinary course of business, which provides a separate defense to a preference action) (First Am. Disclosure Statement Relating to the Second Am. Joint Ch. 11 Plan at 60). However, Voyager’s plan administrator for the wind-down debtor has since sought to pursue causes of actions against account holders that received net preference transfers of more than $350,000 (Notice Regarding Preference Claims Exceeding $350,000, In re Voyager Digital Holdings, Inc., No. 22-10943 (MEW) (Bankr. S.D.N.Y. May 17, 2024), Doc. No. 1684).

Further, neither Celsius nor Voyager establish individualized wallets or accounts for each customer. Instead, customers transfer crypto from external wallets to the exchange’s wallet. The crypto is then reflected on the blockchain as belonging to the exchange, and the customer’s rights regarding the crypto are reflected solely in the exchange’s own internal database. (Decl. of Alex Mashinsky, Chief Exec. Officer of Celsius Network LLC, in Supp. of Ch. 11 Pets. and First Day Mots. at ¶ 63, In re Celsius Network LLC, No. 22-10964 (MG) (Bankr. S.D.N.Y. July 14, 2022), Doc. No. 23.)

Similarly, under Gemini’s Earn program, customers who deposited their assets on Gemini’s crypto platform could choose to loan the digital assets they placed with Gemini to Genesis, with Gemini acting as custodian and agent for the funds that Gemini’s Earn program participants deposited (Gemini Earn Program Terms and Authorization Agreement). Arguably, crypto lent to Genesis under Gemini’s Earn program could be property of the Genesis bankruptcy estate. On November 21, 2023, the Genesis debtors filed an avoidance action against Gemini seeking the recovery of nearly $700 million based on this theory, which action remains pending (Adversary Compl., Genesis Glob. Cap., LLC v. Gemini Tr. Co. (In re Genesis Glob. Holdco, LLC), Adv. Pro. No. 23-01203 (SHL) (Bankr. S.D.N.Y. Nov. 21, 2023), Doc. No. 1).

In contrast to Celsius’s Earn program, Celsius’s Custody Accounts are more akin to a traditional deposit or custodial account. The terms of use for these Custody Accounts state that title to any deposited crypto remains with the customer and does not transfer to Celsius. The terms of use provide that Celsius may “not transfer, sell, loan or otherwise rehypothecate” this crypto without the customer’s consent (Celsius: Terms of Use, § 4.B).

Consistent with these terms of use, the Celsius debtors agreed that the customers retained title to funds in these Custody Accounts (Motion for Entry of an Order (I) Approving (A) The Settlement by and Among the Debtors, the Committee, and the Custody Ad Hoc Group and (B) the Election Form and (II) Granting Related Relief at ¶ 15, In re Celsius Network LLC, No. 22-10964 (MG) (Bankr. S.D.N.Y. Feb. 28, 2023), Doc. No. 2148). Custody Account holders could agree to opt into a settlement resulting in the recovery of 72.5% of the crypto that was held in their Custody Accounts as of the Celsius petition date (Order (I) Approving (A) The Settlement By and Among the Debtors, the Committee, and the Custody Ad Hoc Group and (B) the Election Form and (II) Granting Related Relief, In re Celsius Network LLC, No. 22-10964 (MG) (Bankr. S.D.N.Y. Mar. 21, 2023), Doc. No. 2291).

Customers of Celsius’s Earn program, by contrast, received their pro rata share of all liquid digital currency held by the Celsius debtors as of the plan effective date (Modified Joint Ch. 11 Plan of Reorganization of Celsius Network LLC and its Debtor Affiliates at Art. III.B.5, In re Celsius Network LLC, No. 22-10964 (MG) (Bankr. S.D.N.Y. Jan. 29, 2024), Doc. No. 4289). Whether Earn program customers or Custody Account holders ended up better off will largely be a function of the price of individual tokens at the time the Celsius plan became effective. As part of the settlement, the Celsius debtors also agreed to waive any preference claims against participating customers relating to the Custody Accounts.

After the effective date of the Celsius Chapter 11 plan, the litigation administrator (that is, the entity entrusted with pursuing litigation claims on behalf of the Celsius estates) announced a limited time offer to Celsius customers with net withdrawals in excess of $100,000 in the 90 days before the Celsius petition date (apparently without regard to which Celsius product they used) who had not participated in the prior custody settlement to settle any potential preference claims against them (Stretto: FAQs: Litigation Oversight Committee — Celsius Network LLC, et al., No. 22-10964 (MG) (Bankr. S.D.N.Y.)). Under this offer, customers can return 13.75% of the net crypto withdrawn in the 90 days before Celsius’s bankruptcy filing in exchange for a full release of preference liability.

Similar to the terms of use of Celsius’s Custody Accounts, FTX’s terms of use for depositing money onto their platform reflect that the title to the crypto is retained by the customer and “shall not transfer to FTX” (FTX: Terms of Service, § 8.2.6 (May 13, 2022)). This likely influenced the FTX debtors’ decision to propose a settlement framework to resolve potential customer preference exposure in the debtors’ proposed plan of reorganization on terms that appear customer friendly. In particular, under the proposed settlement, customers may elect to return (through a cash payment or set off against other claims against FTX) 15% of net withdrawals that had been made within ten days before FTX’s bankruptcy filing (a substantially shorter look-back period than the standard 90 days established under section 547 of the Bankruptcy Code).

The FTX settlement proposal does not address how customers’ resulting net claims will be treated, though the debtors have indicated their intention to satisfy customer claims in full based on the petition date token prices (Fourth Mot. of Debtors for Entry of an Order Extending the Exclusive Periods During Which Only the Debtors May File a Ch. 11 Plan and Solicit Acceptances Thereof at ¶ 1, In re FTX Trading Ltd., No. 22-11068 (JTD) (Bankr. D. Del. Mar. 5, 2024), Doc. No. 8621).

Under the proposed settlement, the FTX debtors also will not pursue any preference exposure less than $250,000 (Notice of Proposed Settlement of Customer Property Disputes, In re FTX Trading Ltd., No. 22-11068 (JTD) (Bankr. D. Del. Oct. 16, 2023), Doc. No. 3291; Disclosure Statement for Debtors’ Joint Ch. 11 Plan of Reorganization of FTX Trading LTD. and its Affiliated Debtors and Debtors-In-Possession at 97, In re FTX Trading Ltd., No. 22-11068 (JTD) (Bankr. D. Del. Dec. 16, 2023), Doc. No. 4862). The proposed settlement remains subject to court approval and will be reflected in a Chapter 11 plan to be filed with the court.

The terms of use for BlockFi’s custodial Wallet Account state that the title to crypto held in the Wallet Account “shall not transfer to BlockFi” (BlockFi: Wallet Terms, § F (Aug. 22, 2022)). Consistent with these terms, the BlockFi debtors agreed that such funds were not property of their estate and are currently in the process of returning such funds to customers (Order (I) Authorizing the Debtors to (A) Honor Withdrawals from Wallet Accounts, (B) Update the User Interface to Properly Reflect Transactions and Assets as of the Platform Pause, and (C) Conduct Ordinary Course Reconciliation of Accounts, and (II) Granting Related Relief, In re BlockFi Inc., No. 22-19361 (MBK) (Bankr. D.N.J. May 17, 2023), Doc. No. 923). Therefore, it would be surprising if any preference claims were pursued against customers in the BlockFi Chapter 11 cases.

To be avoidable as a preference, a transfer must have allowed the recipient to receive more than it would have received in a hypothetical liquidation under Chapter 7 of the Bankruptcy Code. This requirement reflects the key policy advanced by avoiding preferences, which is to ensure equal treatment of similarly situated creditors and prevent a race to the courthouse. In the absence of more favorable treatment of specific creditors, there is no benefit to the estate to avoiding transfers.

This avoidance requirement quickly eliminates liability for oversecured creditors who are entitled to receive the value of their collateral in a Chapter 7 liquidation. Because of this entitlement, no distribution to these creditors covering the value of their collateral before the petition date could allow them to recover more than they would have received in a Chapter 7 liquidation.

Most institutional DeFi loans are overcollateralized by a significant margin (for example, by crypto assets that have a value well above the nominal fiat value of the loan). Assuming that lenders have properly perfected their security interests in the crypto assets serving as collateral, lenders that liquidate (or otherwise receive repayment of) the loans before a bankruptcy filing should generally be safe from preference actions. (For more on how security interests in crypto assets can be perfected, see Security Interests: Bitcoin and Other Cryptocurrency Assets on Practical Law.)

The same will not necessarily be true with, for example:

In these cases, the preference defendant must show that they were not rendered better off by the prepetition transfer.

To demonstrate that a creditor received more from a preferential payment than it would have received in a Chapter 7 liquidation, the preference plaintiff must reconstruct the bankruptcy estate as it existed on the petition date and then show the amounts of the hypothetical distributions absent the challenged transfer.

Ordinarily, this is a straightforward analysis that involves looking at the assets in the estate on the petition date (adding back the amount of the challenged payment and subtracting out any accrued administrative expense claims) and comparing the value of those assets to the dollar amount of claims existing on the petition date (again, adding back the amount of the challenged payment). If the creditor would have received a distribution of less than 100% for its claim in the hypothetical Chapter 7 liquidation, then the payment is clearly preferential. (See In re AFA Inv. Inc., 2016 WL 908212, at *2 (Bankr. D. Del. Mar. 9, 2016).)

Customers with potential preference exposure to debtors such as FTX that have projected an ability to satisfy customer claims in full may argue that their withdrawals did not allow them to recover more than similarly situated creditors, and, therefore, there can be no preference. The estate would likely take the position that because assets and distributions are to be valued as of the petition date for purposes of determining whether a creditor would have received less in a Chapter 7 liquidation, any appreciation of estate assets (such as an increase in crypto prices or in the value of investments made by FTX’s venture arm) should be disregarded.

On the other hand, the analysis regarding crypto withdrawals, DeFi loan repayments, and liquidations might not be so simple, such as in a scenario where each of the following occurred:

Under these facts, a trustee might contend that Customer A received a preference (assuming all other elements of a preference are met), arguing that:

But if these distributions are converted to fiat currency value, there is a different result. Before the petition date, Customer A received one BTC that was worth $15,000. In a hypothetical Chapter 7 liquidation, they would have received a distribution worth $15,025 at the petition date (0.835 BTC × $18,000). Therefore, Customer A could argue that they were in fact worse off from their prepetition withdrawal.

This argument is not entirely without support. To the extent that BTC is considered a currency, most commentators seem to agree that a transfer of BTC to a creditor would be valued as of the date of the transfer (see, for example, Money for Nothing: The Treatment of Bitcoin in Section 550 Recovery Actions, 20 U. Pa. J. Bus. L. 485, 505 (2017); The Bankruptcy Estate and Cryptocurrency, 15 No. 01 WL J. Bankr. 01 (May 17, 2018); see also In re Waterford Wedgwood USA, Inc., 500 B.R. 371, 383 n.8 (Bankr. S.D.N.Y. 2013) (explaining that the valuation of a purportedly fraudulent transfer is obtained by converting foreign currency to US dollars based on the exchange rate at the time of the transaction)).

If BTC is considered a commodity, some case law supports the proposition that the transfer should be valued as of the transfer date (see In re Int’l Ski Serv., Inc., 119 B.R. 654, 658-59 (Bankr. W.D. Wis. 1990) (collecting cases holding that, when determining the value of property transferred for purposes of section 550(a) of the Bankruptcy Code, value is determined by reference to “market price at the time of the transfer”)).

The question of whether BTC is a currency or a commodity was raised in a California bankruptcy case, but the parties settled before the bankruptcy court determined the issue (Order Approving Stipulation to Dismiss Adversary Proceeding with Prejudice, Kasolas v. Lowe (In re Hashfast Techs. LLC), Ch. 11 Case No. 14-30725 (DM), Adv. No. 15-AP-03011 (DM) (Bankr. N.D. Cal. June 17, 2016), Doc. No. 52).

By contrast, under section 547(b)(5) of the Bankruptcy Code’s Chapter 7 liquidation test, the value of a creditor’s claim and the distribution on the claim are to be determined as of the petition date (see, for example, In re Connolly N. Am., LLC, 398 B.R. 564, 580 (Bankr. E.D. Mich. 2008) (holding that “the Court must assess the value of the claim as it existed on the bankruptcy petition date”); In re AFA Inv. Inc., 2016 WL 908212, at *2 (explaining that “[w]hether a transfer meets the test of section 547(b)(5) requires the formulation of a hypothetical chapter 7 distribution of a debtor’s estate as it existed on the petition date” and “[b]ecause the Defendant received 100% of what it was owed for the Transfers, the Court need only find that the Defendant would have received less than 100% in a hypothetical chapter 7 liquidation”) (citation omitted); In re CIS Corp., 195 B.R. 251, 262 (Bankr. S.D.N.Y. 1996) (“§ 547(b)(5) analysis is to be made as of the time the Debtor filed its bankruptcy petition”); see also § 502(b), Bankruptcy Code (providing that claim amounts shall be determined “in lawful currency of the United States as of the date of the filing of the petition”)).

Therefore, when considering the analogous question of whether a secured creditor(generally one whose collateral is subject to volatile price swings) has received a preference, courts will compare the amount received prepetition to the value of the collateral as of the petition date.

In the hypothetical scenario above, if Customer A had received $15,000 worth of property before the petition date and bore the risk or reward that this property would subsequently decrease or increase in value, Customer A should not be penalized by having to provide the bankruptcy estate with a windfall merely because that property increased in value. Conversely, if the BTC received by Customer A had instead decreased in value, Customer A would have been liable to the estate.

This will strike many as unjust, and for good reason. For one thing, it relies on an arbitrary bifurcation of the valuation process, where the respective recoveries of Customer A and their fellow customers are valued as of completely different dates. In that sense, it also runs contrary to the stated policy undergirding the preference provisions of the Bankruptcy Code (that is, ensuring equal treatment and disincentivizing a scramble by creditors) by rewarding Customer A with a larger slice of the pie than similarly situated customers.

This approach also ignores the strong preference that crypto debtors, investors, and other stakeholders (at least so far) have toward making and receiving distributions of estate property in kind, as opposed to dollarizing claims (Tr. of Hr’g at 35:5-8, In re Celsius Network LLC, No. 22-109640 (MG) (Bankr. S.D.N.Y. Aug. 16, 2022) (Joshua Sussberg, counsel for Celsius: “The company is not seeking to dollarize claims on the petition date and give people back a recovery in fiat. That’s just not what we are going to do.”)). Despite customers’ preference to receive payment in kind, many debtors have, consistent with section 502(b) of the Bankruptcy Code, elected to dollarize claims based on their petition date values (for example, Order Granting Mot. of Debtors to Estimate Claims Based on Digital Assets, In re FTX Trading Ltd., No. 22-11068 (JTD) (Bankr. D. Del. Feb. 7, 2024), Doc. No. 7090).

Most customers and other market participants appear not to assess recoveries in terms of fiat value as of an arbitrary date. Rather, they are concerned with how much of the desired crypto the estate can distribute. There may also be adverse tax consequences for customers that receive a distribution in fiat currency because these customers potentially could be forced to realize a taxable gain on the underlying crypto asset.

Those taking the view that crypto appreciation should inure to the benefit of the bankruptcy estate may find support in a line of cases interpreting section 550(a) of the Bankruptcy Code (which permits a trustee to recover the value of property subject to a successfully avoided transfer). These cases hold that a trustee should be entitled to recover the greater of the value of the transferred property at the transfer date or the value at the time of the recovery. That is, where a party has received property in a subsequently avoided transaction, and the property has later decreased in value, courts taking this approach shift the risk of the depreciation to the transferee and away from the estate. Conversely, if the property appreciates in value, the estate will reap the benefit.

These policy arguments seem true in the context of section 547(b)(5) of the Bankruptcy Code, and it would not be surprising if plaintiffs (or possibly courts) apply this reasoning by analogy in valuing prepetition transfers of crypto.

(For more on the valuation of crypto in bankruptcy, see Crypto Characterization and Valuation in Chapter 11 in the January 2024 issue of Practical Law The Journal.)

The time at which a transfer is deemed to have occurred is relevant to multiple elements of a preference, particularly when determining if a transfer was made within the prepetition 90‑day preference window.

While this is often a straightforward analysis, smart contract counterparties that received payments in the lead-up to the bankruptcy filing may be able to argue that the relevant transfers actually occurred earlier in time, outside of the 90-day preference period. Specifically, because smart contracts are self-executing and irrevocable (in the sense that, once entered into and recorded on the blockchain, their terms cannot be altered or revoked by either party) (Smart Contracts: A Primer, 5 J. of Sci. & Eng’g Rsch. 538, 539 (2018)), one might argue that a transfer of property subject to a smart contract is made at the time the contract is entered into, as opposed to the time that the counterparty actually receives the property.

In the case of DeFi lenders whose loans are subject to a smart contract, the timing of the transfer likely will not matter to the extent that they have a perfected security interest in crypto. Again, as a rule, secured creditors cannot obtain preferences to the extent of their collateral (see Calculating Whether the Creditor Would Receive More Than in a Chapter 7 above).

Subject to exceptions not relevant here, section 547(e)(2) of the Bankruptcy Code provides that a transfer is deemed to occur when it is perfected. In the case of personal property (such as crypto), a transfer is perfected when “a creditor on a simple contract cannot acquire a judicial lien that is superior to the interest of the transferee” (§ 547(e)(1)(B), Bankruptcy Code), which is generally determined by reference to state law.

DeFi lenders and other smart contract counterparties would appear to have a good argument that, where liquidation of a loan occurs or payment is made under a smart contract, the underlying transfer should be deemed to have occurred at the time that the smart contract was entered into (and not at the time that the crypto, funds, or other property were released to the recipient). (For the complete version of this resource, which includes more on when title to property passes from a debtor to a third party, see Crypto Exchange Bankruptcies: Prepetition Crypto Withdrawals and Decentralized Finance (DeFi) Loan Repayments as Potential Avoidable Preferences on Practical Law.)

As discussed above, when dealing with ordinary contracts or negotiable instruments (such as checks), courts have held that the transfer does not occur until the property at issue is actually transferred because, until then, potentially superseding actions could occur. The same cannot be said for a smart contract.

Before a smart contract is uploaded to the blockchain, the parties must “reach an agreement on the contents” of the underlying “computer algorithms” contained in the blockchain. A smart contract is a “self-executable and self-verifying agent[] that cannot be changed once deployed in the blockchain,” and any associated crypto can no longer be transferred except in accordance with the smart contract’s terms. (Smart Contracts: A Primer, 5 J. Sci. & Eng’g Rsch. at 539.)

Based on this description, smart contracts function more like escrow arrangements than ordinary contracts or negotiable instruments. Similar to a debtor depositing funds into an irrevocable escrow, a debtor entering into a smart contract cannot retrieve associated crypto assets except in accordance with the contract’s terms. As a result, the debtor is left no worse off on the release of crypto to a creditor. Therefore, it could be argued that as much as the subsequent release of funds from escrow is treated as a disregarded transfer for preference statute purposes, so too should crypto released under a smart contract.

In the case of DeFi loans in particular, this treatment also would comport with the fact that the loans are secured transactions where the crypto posted in connection with the smart contract serves as collateral for the loan. This commercial reality is reflected in the approach that some state legislatures have taken to permit an interest in crypto to be perfected by control, including control through a smart contract created by a secured party (for example, Wyo. Stat. Ann. § 34-29-103(e)(i)(B)).

Even assuming that the seven elements of a preferential transfer under section 547(b) of the Bankruptcy Code can be met, section 547(c) also provides for several affirmative defenses against preferences (for more on defenses to a preference action, see Preferential Transfers: Overview and Strategies for Lenders and Other Creditors on Practical Law).

A preference defendant has the burden to prove these defenses by a preponderance of the evidence (§ 547(g), Bankruptcy Code). The most relevant defense for DeFi lenders or other crypto customers is likely the ordinary course of business defense. Individual crypto customers may also be able to avail themselves of the Bankruptcy Code’s statutory minimum threshold for asserting a preference claim, currently set at $7,575. Additionally, while not a statutory defense, there is a split in authority on the issue of whether the Bankruptcy Code’s avoidance provisions may be applied to extraterritorial transfers.

(For the complete version of this resource, which includes more on affirmative defenses against preferences and safe harbor provisions, see Crypto Exchange Bankruptcies: Prepetition Crypto Withdrawals and Decentralized Finance (DeFi) Loan Repayments as Potential Avoidable Preferences on Practical Law.)