In the Estate, or Fake? How Cryptocurrency Impacts Bankruptcy

Popularized by Bitcoin billionaires such as Elon Musk, cryptocurrency is well known but not well understood. Seeing a need for more information on the subject, the Bankruptcy Law Section presented a cryptocurrency seminar featuring bankruptcy attorney Christopher Hughes and high-tech investigator Steve Konecny.

“What is a Bitcoin? There really is nothing there,” said Konecny, who is a partner at Forensic Security Solutions. “It’s just an electronic hash, a chain of digital signatures that’s tracked in a public ledger.”

New bitcoins are created by “mining,” Konecny explained. “You have your computers basically solving mathematical problems, like they’re breaking encryptions.”

If Bitcoin, and the roughly 3,000 other types of cryptocurrency such as Dogecoin and Ethereum, aren’t backed by the government and aren’t a tangible asset like a car or cash, are they even part of a petitioner’s bankruptcy estate?

Attorney Hughes says yes. He also believes cryptocurrency isn’t real currency, but a commodity.

“Just because you have one unit of bitcoin doesn’t mean you have that much in your pocket; it means you can exchange that for real actual dollars,” said Hughes, who is a partner at Nossaman LLP. “This is not the way a typical currency works. It would be almost idiotic to use this as currency.”

The U.S. Bankruptcy Court for the Northern District of California was faced with the question of whether Bitcoin constitutes a currency or a commodity in the case of In re HashFast Technologies LLC, but ultimately, the Court did not reach a determination.

The pair of presenters explained it’s common for practitioners to be confused how something that is “nothing” can be part of the bankruptcy estate and how cryptocurrency even has any value.

“It’s all imaginary in the heads of the people around us,” Hughes said. “When Elon Musk tweets Tesla will take Dogecoin, the value goes up, but nothing actually changed. The value changed because of the tweet of a billionaire.”

The value of cryptocurrency has fluctuated wildly. In 2011, one bitcoin was $0.30; then, on November 10, 2021, it reached an all-time high of $68,000 per coin.

There are a lot of different issues to consider when assessing a debtor’s cryptocurrency assets. First, is how to determine if the debtor has any cryptocurrency. Although Bitcoin is often mistakenly regarded as untraceable, there is in fact an electronic trail of these transactions.

“As long as you never cash out the money, you’re anonymous, but what good does that do if you can never get the money?” Konecny explained. “If you want to cash out the money, you have to move it to the system to cash it out.”

If the debtor isn’t forthcoming about owning cryptocurrency, their attorney should look at the debtor’s tax returns. Starting in 2020, Form 1040 asks filers to check a box if a crypto transaction has taken place.

The next step is to search the debtor’s credit card and PayPal statements as well as other trading platforms, such as Kraken and Gemini, for cryptocurrency exchanges. And if you’re not sure if you’re looking at a crypto exchange, look the entity up online to see if it’s a cryptocurrency exchange.

While this can be time-consuming for practitioners, the FBI has advanced software to determine every cryptocurrency transaction that may soon be available to the public.

Hughes also cautions attorneys to be wary of a debtor who admits to having cryptocurrency but claims they lost the key to access it. Federal money laundering statutes require that exchanges trading in cryptocurrency know who’s buying it. The Federal Rules of Bankruptcy Procedure allow both creditors and the trustee to petition the court for permission to serve subpoenas on any third party in order to recover an asset. In addition, the debtor can be subject to a Section 727 action under the Bankruptcy Code for failing to say why the asset was lost.

Hughes is optimistic that proposed regulations will be successful in requiring all the exchanges, even foreign exchanges, to be transparent and accessible.

So, if the debtor has cryptocurrency and wants to keep it, can he?

“As the laws are written now, there are no exemptions specific for cryptocurrency,” Hughes said. “The best you can do is argue a wildcard exemption, and there doesn’t seem to be any real change to that coming down the pipeline.”