How Bitcoin Is Confounding Insolvency Law
Arthur C. Clarke famously observed: “Any sufficiently advanced technology is indistinguishable from magic.” Our regulatory, legislative, and judicial systems illustrate this principle whenever new technology exceeds the limits of our existing legal framework and collective legal imagination. Cryptocurrency, such as bitcoin, has proven particularly “magical” in the existing framework of bankruptcy law, which has not yet determined quite what bitcoin is—a currency, an intangible asset, a commodity contract, or something else entirely.
The answer to that question matters, because capturing the value of highly-volatile cryptocurrency often determines winners and losers in bankruptcy cases where cryptocurrency is a significant asset. The recently-publicized revelation that the bankruptcy trustee of failed bitcoin exchange Mt. Gox is holding more than $1.9 billion worth of previously lost or stolen bitcoins highlights the issue.
The Mt. Gox Case: Timing is Everything
In 2013, Mt. Gox was the world’s largest bitcoin exchange. By some estimates, it accounted for more than 80% of all bitcoin exchange activity. By February 2014, Mt. Gox had shut down its website, frozen customer accounts, and ceased trading. A leaked internal document indicated that hackers had gained access to Mt. Gox’s online wallets and stolen nearly 850,000 bitcoins, each then worth approximately $550. That same month, Mt. Gox commenced insolvency proceedings in Japan, and thereafter filed a corresponding chapter 15 bankruptcy in the United States. Mt. Gox eventually “found” approximately 200,000 bitcoins previously believed to be among those lost or stolen.
When it became clear that Mt. Gox could not reorganize and would proceed with liquidation, the Japanese court appointed a trustee over Mt. Gox’s assets. A former Mt. Gox exchange customer then filed a lawsuit against the trustee seeking the return of the customer’s purchased bitcoins. The Japanese court, however, ruled that the bitcoins at issue were not capable of ownership under Japanese law and dismissed the lawsuit. Article 85 of the Civil Code of Japan provides that an object of ownership must be a tangible “thing,” in contrast to intangible rights (like contract or tort claims) or natural forces (like sunlight or electricity). Bitcoin, the court ruled, does not meet the definition of a “thing” under the statute and, therefore, does not qualify for private ownership.
The ruling effectively left Mt. Gox’s customers with claims for damages in the insolvency proceeding rather than ownership claims for the return of their bitcoins. Accordingly, the value of each claim was fixed at an exchange rate of one bitcoin to ¥50,058.12 (approximately $483), the value of bitcoin shortly before Mt. Gox filed its insolvency proceeding in Japan.
At the time of this post, bitcoin is trading at more than $9,500. That constitutes a 17x increase over the April 2014 exchange rate fixed in the Mt. Gox bankruptcy. The Mt. Gox bankruptcy estate is holding 202,185 recovered bitcoins, currently worth approximately $1.9 billion. The value of the estate’s bitcoins exceeds the total claims against Mt. Gox by several hundred million dollars. That excess value is creating controversy.
Millions for Mismanagement: An Insolvency Sleight of Hand?
In bankruptcy, after all creditor claims are paid in full, surplus assets flow to the owners. In the Mt. Gox case, the owners of Mt. Gox— not the customers who purchased bitcoin and still await repayment—stand to benefit from the dramatic increase in the value of bitcoin over the last three years. The single largest potential beneficiary is Mark Karpelès, Mt. Gox’s former CEO and majority shareholder, who currently is on trial in Japan for embezzlement.
Customers have repeatedly accused Mr. Karpelès of mismanagement, breach of duties, and outright fraud. Unsurprisingly, the prospect of Mr. Karpelès’ enrichment through the bankruptcy process has galled Mt. Gox’s still unpaid customers, many of whom insist that the rise in bitcoin value should be paid to them rather than the owners of the failed exchange. To date, however, those customers have not articulated a recognized legal basis for their desired result, particularly in light of the Japanese court’s ruling that bitcoin is not legally susceptible of private ownership.
As Karpelès himself has noted, “Creditors, when filing with the bankruptcy, had to convert any amount to JPY – which makes sense in a purely legal term, as it’d be impossible for anyone to proceed with a bankruptcy if debts had to be re-calculated all the time and could change over time. . . . Nobody in this whole process could have predicted the way the price went, especially as its initial trend was downward, not upward.”
Although Karpelès may be technically correct, bankruptcy is fundamentally an equitable proceeding, and it seems patently unfair to award a windfall to the owners of a failed bitcoin exchange to the detriment of its customers, who have endured the freezing of their accounts and years of uncertainty in multi-national bankruptcy proceedings. It also makes little sense that bitcoin cannot be legally owned in the same way stocks, gold, Japanese yen, or U.S. dollars are privately owned under applicable civil law. Unfortunately, such results appear to be a reality in the Mt. Gox case, and they stem from the current legal framework’s shortcomings in addressing this revolutionary technology.
Cryptocurrencies are not going away. Absent an expansion of our existing legal doctrines to account for their unique nature and often volatile trading value, we likely will continue to see results at odds with the spirit and intent of existing bankruptcy law. The Mt. Gox case hopefully will spur discussion about the need to amend our bankruptcy statutes to account for crypto-assets and how the judiciary may need to expand the existing decisional framework to achieve the policies of insolvency law in cases involving such technologies.
 In a notable thematic coincidence, Mt. Gox is an acronym for “Magic: The Gathering Online eXchange.”
 In the Mt. Gox case, some creditors urged the trustee to provide them the option of receiving crypto-tokens, “Goxcoins,” representing the customer’s pro-rata share of the estate’s distributable bitcoins, rather than reducing their claim amounts to yen. The customers who chose this option would assume the risk of fluctuation of bitcoin exchange rates and ultimately receive bitcoins back, albeit fewer bitcoins than they purchased on the Mt. Gox exchange. Essentially, they would agree to take a pro rata share of a smaller pie, betting that each slice of that pie would increase in value. As it turns out, they were correct. The trustee did not adopt that approach in the Japanese insolvency proceeding, but in fairness, the court had ruled that customers did not own the bitcoins, and bitcoin’s value appeared to be on the decline in mid-2014. Although it may be difficult to impose such a structure in a U.S. chapter 7 bankruptcy case, it may be viable under a chapter 11 liquidating plan in certain cases.