Are Cryptocurrencies True Currencies? Evaluating Cryptocurrencies Under § 550

           The “bitcoin.org” domain name was registered on Aug. 18, 2008.[1] Two months later, on Oct. 31, 2008, a link to a paper purportedly authored by Satoshi Nakamoto was posted on the website and distributed to a cryptography mailing list.[2] In the paper, Nakamoto “propose[d] a … peer-to-peer network … forming a record that cannot be changed … [a]s long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network[,]” eliminating the need for third-party authentication to prevent “double-spending.”[3] The following January, Bitcoin was released as open-source software,[4] implementing the first “open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way”[5] — i.e., the first blockchain —then became the first circulating cryptocurrency.

           Just one decade later, nearly 2,000 cryptocurrencies are now in circulation.[6] Given the exceptional growth in cryptocurrencies’ popularity, bankruptcy professionals will inevitably encounter “property of the estate” or “property of the debtor” in such form.[7] Indeed, the volatility of cryptocurrencies alone could force “holders” — i.e., cryptocurrency owners — into bankruptcy.[8] Cryptocurrencies held by the debtor on the petition date are plainly property of the estate, and pre-petition transfers of such property likewise fall within the ambit of avoidance actions.[9] But no court has decided how cryptocurrencies should be treated for purposes of § 550, and therefore, what a trustee[10] is entitled to recover from a successful fraudulent cryptocurrency transfer claim remains an open question.[11] This question matters because whether a cryptocurrency should be considered (1) a currency or (2) property could affect the trustee’s ability to obtain a judgment to recover fraudulently transferred cryptocurrency, or drastically alter the size of any such judgment entered.[12]

What Is a Cryptocurrency?

One industry expert has defined the term cryptocurrency as follows:

A cryptocurrency is a digital currency in which encryption techniques are used to control the generation of units of currency and verify the transfer of funds, operating independently of one single central unit.[13]

These digital currencies are only transmittable electronically and self-authenticate their value in any given transaction using cryptography involving an open ledger, the most common form, which is regularly referred to as the blockchain.[14]

The blockchain birthed the foundational concept on which all cryptocurrencies rely. As one commentator has explained:

The blockchain began life in the mind of Satoshi Nakamoto, the brilliant, pseudonymous and so far unidentified creator of bitcoin — a “purely peer-to-peer version of electronic cash,” as he put it in a paper published in 2008. To work as cash, [B]itcoin had to be able to change hands without being diverted into the wrong account and to be incapable of being spent twice by the same person. To fulfill Mr Nakamoto’s dream of a decentralized system the avoidance of such abuses had to be achieved without recourse to any trusted third party, such as the banks which stand behind conventional payment systems.

It is the blockchain that replaces this trusted third party. A database that contains the payment history of every bitcoin in circulation, the blockchain provides proof of who owns what at any given juncture. This distributed ledger is replicated on thousands of computers — [B]itcoin’s “nodes” — around the world and is publicly available. But for all its openness it is also trustworthy and secure. This is guaranteed by the mixture of mathematical subtlety and computational brute force built into its “consensus mechanism” — the process by which the nodes agree on how to update the blockchain in the light of bitcoin transfers from one person to another.[15]

          Understanding the blockchain helps explain the enthusiasm of cryptocurrency and blockchain proponents but provides little guidance with respect to the proper treatment of such assets under § 550.[16]

Should Cryptocurrency Be Deemed Currency or Property for Purposes of Fraudulent-Transfer Litigation?

         Sections 544 and 548 empower the trustee to avoid fraudulent pre-petition transfers of “property of the debtor.”[17] The Bankruptcy Code does not define “property of the debtor,” but the Supreme Court has interpreted the phrase to mean property that would have become “property of the estate,” for purposes of § 541, but for the allegedly avoidable transfer.[18] Accordingly, the trustee may avoid pre-petition transfers of cryptocurrencies that would have been held by the debtor on the petition date but for their transfer for actual or constructive fraud.[19]

         Section 550 provides that, where a transfer is avoidable under either § 544 or 548, “the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property.”[20] As one commentator has noted:

In cases where currency is transferred, the values are typically the same, but in the case of property, values can appreciate or depreciate drastically over time. For example, bitcoins have appreciated more than 1,000 percent in the last 18 months. Accordingly, whether a trustee is entitled to recover the value of the bitcoins transferred (i.e., the currency approach) versus the actual bitcoins (i.e., the property approach) is of paramount importance.[21]

Moreover, if classified as a currency, a cryptocurrency transaction would receive the protections provided to swap agreements under §§ 362(b), 546(g), 548(d)(2)(D) and 560.[22] Relevant here, §§ 546 and 548 prevent avoidance of currency swaps for constructive fraud.[23]

In the absence of authority directly on point, the opinions of federal courts and federal agencies in nonbankruptcy contexts are instructive.

Conflicting Approaches to Evaluating the Nature of Cryptocurrencies

         The Uniform Commercial Code (UCC) and federal regulators support the position that cryptocurrency should be considered property, not currency. Because they are not officially recognized as legal tender by any government, cryptocurrencies plainly fall outside the scope of the UCC’s definition of “money.”[24] Likewise, the Internal Revenue Service (IRS) and Commodity Futures Trading Commission (CFTC) each treat cryptocurrencies as property.[25] According to the IRS, “For federal tax purposes, [cryptocurrency] is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.”[26] Similarly, the CFTC has held that “Bitcoin and other [cryptocurrencies] are encompassed in the definition [of commodity under 7 U.S.C. § 1a(9)] and properly defined as commodities.”[27] Each of these approaches, at least on their face,[28] support classifying cryptocurrencies as property and, therefore, entitling the trustee to recover the appreciation in value of the cryptocurrency to the date of the judgment in order to restore the bankruptcy estate to the financial position it would have occupied but for the transfer.[29]

         In contrast to the approaches set out above, federal courts have treated cryptocurrencies as currency in criminal cases.[30] In perhaps the most well-known case involving cryptocurrency, prosecutors for the Southern District of New York indicted the creator of the “Silk Road” website,[31] among other charges, for conspiracy to launder money under 18 U.S.C. § 1956. Section 1956 of Title 18 provides that:

(a)(1) Whoever, knowing that the property involved in a financial transaction represents the proceeds of some form of unlawful activity, conducts or attempts to conduct such a financial transaction which in fact involves the proceeds of specified unlawful activity … shall be sentenced …

(2) Whoever transports, transmits, or transfers, or attempts to transport, transmit, or transfer a monetary instrument or funds from a place in the United States to or through a place outside the United States or to a place in the United States from or through a place outside the United States [for illegal purposes] … shall be sentenced … [or]

(3) Whoever, with the intent [to commit certain crimes] conducts or attempts to conduct a financial transaction involving property represented to be the proceeds of specified unlawful activity, or property used to conduct or facilitate specified unlawful activity, shall be fined under this title or imprisoned … or both.[32]

The Ulbricht court broadly construed the terms “financial transaction” and “monetary instrument” and held that “[o]ne can money launder using Bitcoin.”[33] This holding follows from the court’s conclusion that

the only value for Bitcoin lies in its ability to pay for things — it is digital and has no earthly form; it cannot be put on a shelf and looked at or collected in a nice display case.… Sellers using Silk Road are not alleged to have given their narcotics and malicious software away for free — they are alleged to have sold them. The money laundering statute is broad enough to encompass use of [b]itcoins in financial transactions. Any other reading would — in light of Bitcoins' sole raison d'etre — be nonsensical.[34]

        Like the court in Ulbricht, the court in United States v. Murgio held that cryptocurrencies were “funds.”[35] Section 1960 of Title 18 applies to “[w]hoever knowingly conducts, controls, manages, supervises, directs, or owns all or part of an unlicensed money transmitting business”[36] and it defines “money transferring” to include the transfer of “funds on behalf of the public by any and all means.”[37] According to the Murgio court,

The legislative history of § 1960 supports the conclusion that [cryptocurrencies] fall within the statute’s purview. Section 1960 was enacted to address the fact that money launderers with illicit profits had found new avenues of entry into the financial system. From its inception, then, § 1960 sought to prevent innovative ways of transmitting money illicitly. It appears that Congress designed the statute to keep pace with evolving threats, and this Court must accordingly give effect to the broad language Congress employed — namely, that § 1960 applies to any business involved in transferring funds ... by any and all means. Dictionaries, courts, and the statute’s legislative history all point to the same conclusion: bitcoins are funds.[38]

Thus, at least with federal law, [39] courts generally treat cryptocurrencies in a manner consistent with their construal as currency in criminal cases.

        When litigating fraudulent transfers involving cryptocurrencies, trustees will undoubtedly present arguments emphasizing the UCC, IRS and CFTC positions.[40] In opposition, defendants will highlight cases treating cryptocurrencies as money for purposes of federal criminal statutes.[41] At least one commentator has suggested that “whether [cryptocurrencies] are treated as currency or property, the Bankruptcy Code provides that the trustee … may recover … the appreciated value of the [asset]” because cryptocurrencies “should be treated in the same manner that one might treat a foreign currency.”[42] This analysis follows from the obvious conclusion that cryptocurrencies “are not U.S. dollars,”[43] but it discounts the protections provided to swap agreements under §§ 546(g) and 548(d)(2)(D), which would apply to cryptocurrency transactions if such assets were “treated in the same manner [as] a foreign currency.”[44] Therefore the viability of avoidance actions for constructive fraud under will depend on courts’ answers to the following question: Is cryptocurrency a currency of property for purposes of Bankruptcy Code § 550?

Conclusion

        Cryptocurrencies are alternately deemed “liquid money” — i.e., currency — or “capital assets” — i.e., property — depending on the applicable federal law. In the absence of on-point guidance, bankruptcy courts will likely be persuaded by one or the other way of thinking about cryptocurrencies. As the pervasiveness of cryptocurrencies in the modern economy increases, so too does the probability that fraudulent transfer litigation will involve cryptocurrency transactions. Because litigating these matters is inevitable and because a court’s decision to consider cryptocurrency “currency” or “property” may determine either (1) the viability of a fraudulent transfer allegation or 2) the extent of value that the trustee may recover, bankruptcy litigators should familiarize themselves with the competing approaches to assessing the nature of cryptocurrencies under federal law.