Crypto Clawbacks: Preference Claims Based on Customer Withdrawals

By Sam Ashuraey (May 22, 2024)*

One long-lasting effect of the crypto exchange bankruptcies is the large number of preference “clawback” actions that have been threatened or filed against customers who withdrew from their accounts in the 90 days before the bankruptcy filing.  Over the past few months, for example, customers who withdrew funds above a certain threshold from the Celsius and Voyager exchanges received preference demand letters.  As of July 2024, several thousand adversary complaints have been filed against those who did not settle.

For many customers, the decision of whether to settle or litigate is not an easy one.   In addition to account-specific considerations, many broader legal considerations in this context have not been addressed by the courts, meaning the outcome of litigation is uncertain.  This article aims to identify and clarify some of these considerations, with a focus on the common defenses customers have available to them.

Background

A preference claim is a cause of action unique to the Bankruptcy Code.  Section 547 allows a debtor, trustee, or other party with standing to avoid (i.e., claw back) transfers of the debtor’s property that were made in the 90 days before the bankruptcy filing (or one year in the case of insiders).  The other elements necessary to prove a preference cause of action are that the transfer (1) was to the benefit of a creditor, (2) was on account of an antecedent debt, (3) was made while the debtor was insolvent (presumed to be the case in the 90 days before the filing), (4) enabled the creditor to receive more than in would in a liquidation.

Even if the plaintiff can establish all these elements, there are multiple defenses to preference actions.  One of the most common and perhaps the most widely applicable in the crypto context is the “ordinary course” defense.  In addition, certain types of transactions are exempt from being preferential under the Bankruptcy Code’s so called “safe harbor” provisions.

Below are brief discussions of factors influencing how courts will ultimately value a preference claim, whether account deposits are property of the debtor, the ordinary course defense and the bankruptcy safe harbor provisions, all of which are likely to be addressed in preference litigation arising out of withdrawals from a crypto exchange.

I. Preliminary Valuation Issues

Before evaluating the merits of a preference claim, customers deciding whether to settle or defend the threatened claims must first value their ultimate exposure in dollars.  Two issues are worth considering in this regard.  The first is the value of the customer’s replacement claim under Bankruptcy Code section 502(h).  The second is whether the judgement will require the return of the property itself (e.g., the Bitcoin withdrawn) or the value of the property (e.g., the value of the Bitcoin, and if so, on what date).

1. 502(h) Replacement Claims

If a plaintiff establishes that a withdrawal was preferential, the Bankruptcy Code provides that the creditor-transferee may assert a claim against the debtors for the full amount recovered.  This is sometimes called a “replacement claim” and is meant to turn the transferee into a bankruptcy creditor with a claim on par with other similarly situated creditors who did not withdraw their funds.

How 502(h) claims will be applied in practice remains to be seen, but presumably means the creditor may setoff the claim against the awarded damages, rather than pay the full award and await distributions.[i]  Courts in the past have used the recovery rate provided in the disclosure statement to determine the amount of the setoff.[ii]  For example, assuming a plan provides for a 50% recovery rate, the total damages against the preferential transferee after the 502(h) offset would be 50% of the total transfer.  Some chapter 11 plans have provided a somewhat straightforward method of calculating the setoff amount.  For example, the Celsius plan specifies a preemptive setoff in the case of a successful avoidance action that was based on the recovery in the disclosure statement.[iii]  However, a transferee could theoretically argue that a different percentage should be used if, for example, recoveries have turned out to be greater than what was originally projected in the disclosure statement.

2. Recovery of Property or Value of Property

Under Bankruptcy Code section 550, the plaintiff may recover the property transferred or the value of the property.   The Bankruptcy Code does not provide courts with guidance on which is appropriate or, in the case of the return of value, as of what date the property should be valued.  This has potentially enormous implications for customers who withdrew digital assets in 2022.  A return of digital assets in, for example, May 2024 that were withdrawn in May 2022 could mean the customers are being asked to purchase assets that have gone up significantly in value.

Courts have not addressed whether a digital asset transferee should return the digital asset in the context of an avoidance action.  However, equitable considerations would seem to weigh strongly against a return of the digital assets themselves.  A customer asked to return Solana in May 2024 that it withdrew in May of 2022 would potentially be required to spend 4x or more the value of what it withdrew.  Moreover, any 502(h) replacement claim would be dwarfed by the preference award if it is of digital assets in today’s value.  Nevertheless, a plaintiff will likely attempt to make this argument and defendants should consider the risk of a court ultimately ordering the return of the digital assets themselves or their significantly appreciated value.

II. The Debtor’s Interest in Property

One gating issue the plaintiff must prove is that the alleged preferential transfer out of the customer account was a transfer of the debtor’s property.   A defendant could defeat this element by demonstrating that the debtor was only holding the customer’s property in trust.[iv]  Accordingly, the debtor can not claw back that amount since the debtor never owned it.

As a general matter, attempts to use the constructive trust doctrine have been met with “mixed success” and may implicate tracing requirements.[v]  Further, there is little guidance on whether amounts held in crypto customer accounts are property of the customer or of the debtor.  Although this question has implications for many other aspects of crypto bankruptcies, there has only been one decision on point.  In Celsius, the court held that amounts in customer “Earn” accounts were property of the estate.[vi]  However, the decision was based on the terms of service, and was therefore a fact-specific inquiry that will not automatically apply to all crypto customer accounts.  Future rulings may be influenced by this opinion, but they will ultimately depend in large part – if not entirely – on the terms of service in question.

III. Ordinary Course

A defendant can defeat a preference claim (partially or completely) by demonstrating that a withdrawal was made in the ordinary course of business.  For this defense to apply, (A) the underlying debt on which payment was made must have been “incurred by the debtor in the ordinary course of business or financial affairs” of both parties and, (B) that the transfer itself was either (1) “made in the ordinary course of business or financial affairs” of both parties (the subjective test), or (2) “made according to ordinary business terms” (the objective test).

Once again, whether this defense applies will depend on a highly fact-specific analysis.  Regular customers who opened and used their accounts on standard terms have solid arguments that withdrawals fall under the ordinary course exception.  In addition to satisfying this objective test, some customers may have established regular withdrawals that satisfy the subjective test.  However, plaintiffs may try to rebut this defense by arguing that any withdrawal that was made during a so-called “run on the bank” are not ordinary course, and by arguing that the debt was not incurred in the ordinary course in the first place because the exchange was, in effect, a Ponzi scheme.[vii]

IV. Safe Harbor

Even if a transfer is otherwise avoidable under the Bankruptcy Code (as a preference or otherwise), it can not be unwound if it falls under the so-called “safe harbor” provisions of 546(e) and (g) of the Bankruptcy Code.  In order for the safe harbor provisions to apply the following must be established:

1. Transfers “in connection with” a Qualifying Agreement. Among other possible types of transfers, the transfer must have been made “in connection with” particular types of agreements or contracts.  These agreements include “commodities contracts,” “swap agreements” or “securities contracts.”  The Bankruptcy Code’s definitions of these terms are broad.  Further, a number of opinions have interpreted the phrase “in connection with” broadly, meaning almost any transfer made under the customer agreements is arguably captured by the phrase.[viii]
2. Qualifying Property. Relatedly, in order for the agreement in question to be covered by the safe harbor provisions, underlying property governed by the agreement must include either a commodity or a security.  Cryptocurrency may be classified as a commodity, as has been previously held by some courts and the CFTC in the case of bitcoin, for example.[ix]  The SEC and other parties have argued that certain cryptocurrencies are securities, but this view is less tested.  In particular, some tokens that could be traded on the exchanges pursuant to the customer agreements, such as the exchanges’ own tokens or tokenized securities, arguably share many characteristics with securities.
3. Qualifying Participant.  The transfer must have also been made by or to a qualifying participant. The safe harbor provisions list several entities that would be deemed qualifying participants.  The most relevant in this context will likely be a “financial participant.” A financial participant is an entity that enters into certain types of agreements (including the qualifying agreements above) with a value in excess of $1 billion. While crypto exchanges likely meet the dollar threshold, whether they qualifying participants will also depend also on whether a court finds they entered in the qualifying agreements.

Courts have not ruled on whether the safe harbor provisions would protect withdrawals from crypto accounts.  However, given the breadth of the definitions, defendants can assert strong arguments that the withdrawals are safe harbored.

Conclusion

While preference actions can — understandably — feel unjust, defendants in the crypto context can take at least some comfort in the defenses available to them.  Similarly, defendants that choose to settle have many arguments as to why an initial settlement offer should be reduced.

Have you received a preference demand or an adversary complaint and are considering your options?  Please contact Sam to discuss or learn more here.

*Updated July 2024.

[i] Tronox Inc. v. Kerr McGee Corp. (In re Tronox Inc.), 503 B.R. 239, 336 (Bankr. S.D.N.Y. 2013)

[ii] Id.

[iii] Modified Joint Chapter 11 Plan of Reorganization of Celsius Network LLC and its Debtor Affiliates, In re Celsius Network LLC, Case No. 22-10964 (MG), ECF No. 4289, Section VI.L.

[iv] E.g., In re Miss. Valley Livestock, Inc., 745 F.3d 299, 305 (7th Cir. 2014)

[v] 5 Collier on Bankruptcy P 547.03 (16th 2024)

[vi] Mem. Op. & Order Regarding Ownership of Earn Account Assets, In re Celsius Network LLC, Case No. 22-10964 (MG), ECF No. 1822.

[vii] See In re Southern Industrial Banking Corp., 159 B.R. 224, 227 (Bankr. E.D. Tenn. 1993) (“The [ordinary course] exception applies to payments by a real business, not to payments by a fake business set up to defraud people.”).

[viii] See, e.g., In re Bernard L. Madoff Inv. Sec. LLC, 773 F.3d 411 (2d Cir. 2014)).

[ix] See CFTC v. McDonnell, U.S. Dist. LEXIS 146576 (E.D.N.Y. Aug. 23, 2018).

This article is intended for general informational purposes only.  It does not constitute legal advice, is not meant to be a substitute for advice of counsel, and its distribution does not create an attorney-client relationship.  While every effort has been made to ensure the accurateness of this publication, its contents is not guaranteed to be correct, complete or up-to-date, and may contain inaccuracies and/or typographical errors.  No party, including Ashuraey Law PLLC or the author, assumes any liability in connection with this publication.  Any opinions contained herein do not necessarily reflect the opinions of Ashuraey Law PLLC or any of its clients or employees.  Please feel free out to reach to Sam Ashuraey if you have any questions about this publication.  The contents of this publication may not be quoted or attributed without the express consent of Ashuraey Law PLLC.