February 28, 2014

Bankruptcy and Bitcoin

by Kim Schmittel

I am fascinated with Bitcoin. For the uninitiated, Bitcoin is a digital currency protocol and payment network developed in 2008 by an individual or group using the name "Satoshi Nakamoto." A very good (albeit increasingly dated) primer on the early history and mechanics of Bitcoin can be found here (courtesy of Wired). A more recent introductory piece, aimed specifically at bankers, can be found here (courtesy of American Banker).

Generally, the way it works is that, instead of having a central authority keep track of who owns what amounts of currency (i.e., like a bank or a government), all of that ownership information is contained in a ledger called the "blockchain," which is maintained by a decentralized peer-to-peer network of computers. As owners of bitcoins trade and transact with one another, the ownership records within the blockchain must be continually validated and updated. This process is done by the solving of cryptographic puzzles (to prevent counterfeiting) by computers within the network.

Those attempting to solve the puzzles to maintain the ledger are referred to as "miners," because the act of solving a puzzle is rewarded by the issuance of new bitcoins. This "block reward" diminishes over time, and only 21 million bitcoins will ever be issued by the protocol. As more and more miners join the network, the processing power of the network grows. At the end of November 2013, Forbes reported that the collective processing power of the network was 256 times faster than the world's top 500 supercomputers combined! In order to keep transaction confirmation times at 10 minute intervals, however, the difficulty of the cryptographic puzzles that miners must solve increases. This dynamic has created a hardware arms-race among miners such that a cutting-edge piece of specialized mining hardware today is likely to be rendered obsolete in the very near future by the increasing network difficulty.

Bitcoin is an extremely popular topic these days, likely thanks to its surging (but extremely volatile) market value. A year ago, 1 bitcoin was had a market value of approximately $12. Right now, 1 bitcoin has a market value of over $500. New Bitcoin-related business ventures are emerging with increasing frequency. For example, see World's First Bitcoin ATM Exceeds $1 M in Transaction Volume in First Month (courtesy of GeekWire). Earlier this year, Bitcoin was under consideration by two senate subcommittees. Just in the past month, Bitcoin was discussed by Jon Stewart and Fed Chair Janet Yellen. Bitcoin evangelists have praised it as an extremely elegant solution to a set of vexing problems, and its critics have decried it as a ponzi scheme and/or tulip bubble.

However we look back on this mania, Bitcoin raises a seemingly inexhaustible array of legal issues to consider and sort out right now, ranging from banking regulation to securities law to tax law. Commercial law and bankruptcy are very unlikely to be immune to Bitcoin-related legal issues, particularly if interest in Bitcoin continues to proliferate. Just yesterday, one of the largest bitcoin exchanges, Mt. Gox, filed for bankruptcy protection (via WSJ) in Japan after apparently losing millions of dollars worth of the currency.

How will Bitcoin be handled by U.S. Bankruptcy Courts? One potential test case was underway in Seattle, WA with the case of CLI Holdings, Inc. This WSJ piece (warning: paywall ahead) by Robin Siedel and Katy Stech contained some good early coverage. The Debtor in CLI Holdings was a bitcoin-mining business that entered into what I can best describe as forward-sales contracts with its customers. That is, the customers paid an up-front amount of money in exchange for the Debtor's agreement to supply the customers with bitcoins that the Debtor would mine in the future using its own mining platform. In part due to increasing mining difficulty and the hardware arms-race described above, the Debtor was unable to perform. It is sought to reject the contracts under Section 365 of the Bankruptcy Code, but several of the customers objected, arguing that the contracts were not executory. The case was recently dismissed voluntarily after a settlement between the major players.

As Bitcoin-related startups continue to launch, a certain percentage are going to fail. I'm sure we'll be seeing Bitcoin issues pop up in U.S. Bankruptcy Courts with increasing frequency, and there will continue to be tough issues to tackle by practitioners and judges alike.