Delaware Bankruptcy Judge Dorsey Issues Bench Ruling in Cryptocurrency Fraudulent Transfer Litigation

By Kina Thornton Frazier on October 27, 2022

As the 2022 “Crypto Winter” continues its grip on the cryptocurrency industry, more and more companies in the space are turning to bankruptcy courts for relief.[1] The inevitable litigation that arises out of those cases requires courts to apply familiar legal frameworks to unavoidably novel fact patterns. A prime example of this can be seen in a recent bench ruling (the “Ruling”) by Judge Dorsey in the Cred Inc. Liquidation Trust v. Strong (In re Cred Inc.), Adv. No. 22-50134 (Bankr. D. Del. Jul. 11, 2022) (D.I. 55) adversary proceeding, currently pending in the United States Bankruptcy Court for the District of Delaware (the “Court”). In that litigation, the defendant (“Defendant”) moved the Court under FRCP 12(b)(6) to dismiss claims brought against him by a post-confirmation liquidating trustee (“Trustee”); the claims were brought under state and federal law to avoid the alleged actual and constructive fraudulent transfer (“Transfer”) of 516 Bitcoin made by the Debtors to a party Plaintiff designates in the complaint (“Complaint”) as a “cryptocurrency whale.” Defendant’s rationale for dismissal turned in part on the assertion that the claims at issue were based on an antecedent debt (and thus were non-avoidable) and that the transfer was conducted at arm’s length without the ability to control the Debtors for purposes of actual fraud. The Court rejected the former argument but agreed with the latter.

The Parties’ Positions

According to the Complaint, the Debtors were comprised of a cryptocurrency “yield earning” platform, whereby customers lent their cryptocurrency to the Debtors and the Debtors agreed to repay the loaned cryptocurrency with interest. Ultimately, the Debtors filed for bankruptcy when they could not repay those customers, a scenario brought on in part by cryptocurrency’s “COVID Crash” of 2020, in which a substantial portion of the Debtor’s leveraged positions were liquidated.

Per the Complaint, approximately ten months prior to the bankruptcy, Defendant, a high net worth investor in cryptocurrency ventures, loaned the Debtors 500 Bitcoin (“BTC”). Shortly thereafter, the nature of the transaction changed, in that the loan was converted into Defendant purchasing a bond (the “Bond”) issued by a foreign-based third party (the “Third Party”); the 500 BTC were transferred to the Third Party as consideration for the Bond. Approximately four months before bankruptcy (on or about the Bond’s maturity date), the Transfer occurred, whereby Debtors purchased the Bond from Defendant in exchange for 516 BTC (the 16 additional BTC constituting the interest accrued on the initial 500 BTC). The Trustee argued that the Bond was worthless at the time of purchase and that the Debtors never received any benefit from it. The Complaint thus seeks to avoid the Transfer as constructively and actually fraudulent, and require Defendant to convey under section 550 “the greater of the following at the time of actual recovery (i) 516.39344262 BTC, and (ii) cash in an amount equal to the greatest value of 516.39344262 BTC at any time since the Bond Purchase.”

Defendant argued in his motion to dismiss the Complaint that the Bond documentation required the Debtors to pay Defendant both BTC principal and interest, ergo the Transfer was in satisfaction of an antecedent debt. Defendant likewise argued that the requisite badges of fraud were missing, with the Complaint limited to an assertion that the Debtors made the Transfer solely to appease Defendant. Next, Defendant argued that the Complaint did not adequately assert insolvency, undercapitalization, or an intent to incur debts beyond the Debtors’ ability to pay. Finally, Defendant argued that the Complaint’s pursuit of recovery under section 550—i.e. awarding the Debtors an amount equal to the “greatest value” of the BTC since the time of the Transfer to the end of the litigation—was inappropriate and would constitute an impermissible windfall.

The Court’s Findings

In the Ruling, the Court found that the Bond documentation contemplated two steps—first, the Third Party would deliver the principal and interest to the Debtors, then the Debtors would remit the same to Defendant. The Court found no evidence that the Debtors “had any direct liability under the [Bond] in the event of a default by [Third Party].” Moreover, the Court found that other Bond documentation expressly states that the Bond is “the obligation solely of [Third Party] and do (sic) not constitute a liability or obligation of . . . [the Debtor].” As a result, the Court concluded that the Debtors “purchased the [Bond], rather than made a repayment under the [Bond] and that, at the time of the purchase, the [Bond] were (sic) worthless, therefore, there was no repayment of an antecedent debt owed to [Defendant] by [the Debtor] that would necessitate dismissal of the complaint.”

As to the actual fraud allegations, the Court analyzed the allegations of closeness between Defendant and the Debtors and whether Defendant may constitute a non-statutory insider. In so doing, the Court found that the allegations in the Complaint did not demonstrate any level of control by Defendant or that negotiations between the parties were not conducted at arm’s-length. To the contrary, the Court found that the allegations “merely show that [Defendant] was considered an important client.” Accordingly, the actual fraud counts were dismissed without prejudice. As to the Complaint’s purported lack of insolvency allegations, the Court denied the same, finding the existing pleadings to be sufficient. The Court did not rule on the section 550 dispute as to what measure of recovery is appropriate.

Conclusion

Given the burgeoning and fast-developing cryptocurrency insolvency space, the Ruling provides a helpful window into how bankruptcy courts will apply traditional concepts of bankruptcy litigation to disputes involving such novel asset classes. It is notable that the Ruling turns in large part on the language underpinning the Bond, notwithstanding the use of BTC as the collateral base. In light of cryptocurrency’s volatile reputation, however, it will be especially interesting to see how the Court ultimately addresses the section 550 dispute and what, if the Trustee succeeds, the appropriate remedy should be to make the estate whole.

A copy of the Ruling can be found on the Court docket for Case No. 22-50134 at D.I. 55.

[1] Cases include those filed under Chapter 11 such as In re Voyager Digital Holdings, Inc. (S.D.N.Y. Case No. 22-10943 (MG), filed July 5, 2022), In re Celsius Network LLC (Case No. 22-10964 (MG), filed July 13, 2022), In re Compute North Holdings, Inc. (S.D. Tex. Case No. 22-90273 (MI), filed September 22, 2022), and the Chapter 15 case In re Three Arrows Capital, Ltd. (S.D.N.Y. Case No. 22-10920 (MG), filed July 1, 2022).

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