The Crypto Conundrum: Difficulties In Valuing Cryptocurrency Assets Held In Exchange Custody: Part Two – Fin Tech
Mayer Brown LLP; Charlotte, N.C.1
Part One of this two-part article reviewed custodially held
crypto assets as part of the bankruptcy estate. This installment
discusses intrinsic value as a proper valuation method for crypto
assets held in exchange custody, factors to consider when
calculating the intrinsic value of custodially held crypto assets,
and risk-mitigation approaches to preserve asset value.
Intrinsic Value as a Proper Valuation Method for Custodially
Held Crypto Assets
When a record owner of crypto assets held in exchange custody
files for bankruptcy, trustees and counsel must acknowledge the
risk of an exchange bankruptcy during the pendency of the
record-owner’s bankruptcy case. As discussed in Part One,
crypto assets held in exchange custody cannot be valued according
to face value due to the risk an exchange bankruptcy’s
automatic stay will prevent the record-owner from exercising its
directing interest over the assets.
While fair market value reflects the asset’s current market
price, intrinsic value reflects the asset’s true value based on
its “fundamental financial characteristics.” 2
Due to factors such as the risk of an exchange bankruptcy, a lack
of typical consumer and investor regulatory protections, limited
market liquidity, and price volatility, intrinsic value may be a
more accurate valuation for crypto assets held in exchange custody.
Trustees and counsel to a record-owner’s bankruptcy (as opposed
to the exchange bankruptcy), therefore, may need to estimate the
intrinsic value of custodially held crypto when calculating the
feasibility of a reorganization plan or estimating creditor
distributions in a liquidation to account for the practical risks
unique to custodially held crypto assets.
While many debtors may hold only de minimis crypto
assets, therefore rendering any risk discount inconsequential,
businesses and individuals with large balance sheets, or that are
particularly tech-savvy, might hold substantial crypto assets. In
these cases, the risk discount from the asset’s market value to
its intrinsic value could result in a substantial change, affecting
the record-owner’s bankruptcy case.
Risk Factors to Consider When Calculating a Crypto Asset’s
Intrinsic Value
First, trustees and counsel will have to estimate the likelihood
that the exchange holding custody will file for bankruptcy
protection during the pendency of the record-owner’s case. As
control over crypto assets will only divest from a record-owner if
the exchange files for bankruptcy, this estimation is essential to
determine the risk discount. Estimating the risk of bankruptcy is
difficult, but an exchange with a healthy balance sheet, reasonable
debt levels and steady revenue will present a lesser risk than an
exchange with consistently negative cash flow, security breaches
and an overleveraged balance sheet. Furthermore, trustees and
counsel will also have to judge the estimated length of time the
record-owner will be in bankruptcy, as a longer bankruptcy case
will present a wider window of opportunity in which an exchange may
also file bankruptcy. While an individual’s chapter 7 case may
only last a few months, chapter 11 and 13 cases can take years and
therefore present a greater risk of exchange bankruptcy
occurrence.
Second, trustees and counsel should investigate the liquidity of
the record-owner’s crypto assets. Liquidity in markets
generally refers to “[t]he characteristic of having enough
units in the market that large transactions can occur without
substantial price variations.” 3 While many crypto
assets may have millions or billions of outstanding units, a low
number of willing market participants can create an illiquid market
for any given asset. Crypto assets vary widely in their respective
market liquidity, with some, such as Bitcoin, proving very liquid
while many new “alt-coins” struggle to maintain value and
suffer from large bid-ask spreads. As a result, dozens of websites
now offer information on crypto arbitrage strategies, with some
focusing on less popular cryptocurrencies in the belief that they
will present wider arbitrage gaps.4 Less popular crypto
assets, therefore, can present liquidity issues that may play a
considerable role in ascertaining a crypto asset’s intrinsic
value.
Third, trustees and counsel should examine the volatility of the
crypto assets at issue. Volatility means an asset that has
“the quality of . . . sudden and extreme price changes.”
5 While related to liquidity (indeed, an illiquid market
can often create greater volatility), volatility refers only to the
variation in an asset’s market price. As crypto assets are
infamous for their extreme price fluctuations,6
record-owners holding crypto assets in exchange custody can be
subject to the risk of price depreciation when the exchange files
for bankruptcy, partially depending on whether the bankruptcy court
determines the claim to be “liquidated” or
“unliquidated” under § 502.7 The relative
volatility of the record-owner’s crypto assets, therefore, can
present a considerable risk depending on the court’s
determination of liquidated claims or its chosen date for §
502(c) estimation.
Fourth, counsel should look to the terms of the user agreement
of the exchange holding custody of the crypto assets. If the
agreement permits the exchange to pool crypto assets held in
custody or otherwise control the private keys for use in ventures
such as staking, 8 the record-owner has a greater risk
of loss in value, as the record-owner is more likely to be
considered a general unsecured creditor. If the agreement
specifies, however, that each customer’s crypto assets will be
held in separate custodial accounts, the value of the crypto assets
should not be discounted as severely, because the record-owner will
have a stronger argument to establish a constructive trust.
9
Based on these factors, trustees and counsel may discount the
face value of crypto assets anywhere from 10-90% depending on the
crypto asset, the exchange bankruptcy risk, and the terms of the
exchange’s user agreement. While a more widely accepted crypto
asset such as Bitcoin or Ethereum will likely have a smaller
discount due to lower liquidity risk, the risks of exchange
bankruptcy, asset-commingling and high volatility persist, and
require trustees and counsel to discount the asset’s market
value to determine its intrinsic value.
Risk-Mitigation Approaches
Given these various risk factors for a record-owner’s
custodially held crypto assets, counsel may seek to minimize the
risk of losing the assets’ current value. One option for the
recordowner’s counsel to consider would be to immediately
liquidate all crypto assets before filing the bankruptcy petition.
[10] This would not only ensure that the record owner will not lose
access to the crypto assets if the exchange files for bankruptcy
during the pendency of the record-owner’s case, but would also
provide a liquid cash source to pay creditors.
A drawback of this approach is the possible loss of value in a
large asset liquidation, especially if the particular crypto asset
has an illiquid market. Additionally, this approach will be more
difficult to implement if the record-owner is a business that
accepts cryptocurrency in exchange for its goods or services, as
the record-owner would then be required to seek court approval
under § 363 to sell crypto assets received post-petition.
Finally, if the record-owner must hold crypto assets to generate
revenue through staking, this strategy is likely unfeasible, as the
sale of these assets would eliminate the record-owner’s revenue
source.
A second option for counsel seeking to minimize risk is to move
the record-owner’s crypto assets to a cold storage wallet, an
offline electronic wallet that stores crypto assets’ private
keys in a physical format.11 This option would similarly
eliminate the risk of an exchange bankruptcy but would also
preserve the crypto assets in their current form, allowing the
trustee or counsel to distribute crypto assets as part of the
reorganization or liquidation. On the other hand, trustees or
counsel lacking experience with crypto storage or without
sufficient storage capabilities could lead to the loss of the
assets’ private keys, rendering the underlying assets
unrecoverable. Furthermore, if the record-owner is a business that
requires crypto assets for revenue or accounts receivable, the
trustee or counsel will have to continuously transfer crypto assets
to and from the cold-storage wallet, resulting in additional labor
and reduced business capacity. Even if the record-owner operates as
a debtor in possession and keeps crypto assets in its own
cold-storage facilities, transferring crypto assets from an
exchange to cold storage is both burdensome and
costly.12 Finally, retaining crypto assets before and
during a bankruptcy case bears the risk that the assets’ value
will decrease during the case.
A one-size-fits-all solution to maximize the value of a
record-owner’s crypto assets and minimize risks does not exist.
Trustees and counsel, therefore, will have to weigh the facts
before them to decide whether a risk-mitigation approach is
appropriate for the record-owner. The benefits of these
risk-mitigation strategies are magnified when exchange bankruptcy,
asset and liquidity risks cause a severe discount from a crypto
asset’s current market price to its estimated intrinsic value.
In that case, trustees and counsel may pursue these strategies to
preserve asset value and enhance the likelihood of success in a
record-owner’s bankruptcy.
Footnotes
1. on Schlotterback wrote this article during his tenure
as the 2021-22 term law clerk for Hon. Paul M. Black, Chief Judge
of the U.S. Bankruptcy Court for the Western District of Virginia.
The views expressed herein are those of the author and not of the
U.S. Bankruptcy Court for the Western District of
Virginia.
2. James M. Lukenda, Westlaw Practical Law, Valuation
Fundamentals in Bankruptcy: Overview (2022).
3. “Liquidity,” Black’s Law Dictionary
(11th ed. 2019)
4. Colin Dodds, “Crypto Arbitrage: How It Works
& Trading Strategies,” Sofi Learn (July 23, 2021), www.sofi.com/learn/content/crypto-arbitrage/
(“Investors can find bigger price spreads for the same
cryptocurrency digital assets among less-popular, less-frequently
traded forms of crypto.”).
5. “Volatility,” Black’s Law
Dictionary, supra n.3.
6. See Shaurya Malwa, “Terra’s LUNA Has
Dropped 99.7% in Under a Week,” CoinDesk (May 12, 2022), www.coindesk.com/markets/2022/05/12/terras-luna-hasdropped-997-in-under…
(reporting that cryptocurrency LUNA lost 96% of its value in one
day).
7. Record-owners are likely subject to greater risk if
their claims are considered liquidated because they bear most of
the risk of post-petition asset price depreciation but stand to
gain little from asset price appreciation until all secured and
priority creditors are paid in full. If the court considered the
record-owners’ claims to be unliquidated, however, the date of
a § 502(c) claim estimation would likely present the greatest
risk for record-owners due to the volatility of crypto asset
prices.
8. Staking is the process by which investors “lock
up” units of cryptocurrency to validate transactions and forge
new blocks on the blockchain. In exchange for “locking
up” their assets with exchanges, investors earn interest as
part of a “staking pool” (a pool of staked crypto assets
used to achieve required minimum asset levels). Sam Becker,
“What to Know About Staking,” Personal Fin., Bus. Insider
(July 12, 2022), www.businessinsider.com/personalfinance/staking-crypto.
9. A successful argument that an exchange holds crypto
assets in a constructive trust would assist the record-owner
because assets held in trust for another generally do not enter the
bankruptcy estate. 11 U.S.C. § 541(d); Begier v. IRS,
496 U.S. 53 (1990).
10. ] While counsel should be mindful of pre-petition
transfer restrictions such as those found in §§ 547 and
548, this strategy is likely viable if the record-owner sells the
crypto assets for market (i.e., reasonably equivalent) value and
maintains the cash proceeds for distribution to
creditors.
12. Transfers from exchanges to cold storage typically
require transaction costs.
Originally Published by American Bankruptcy
Institute
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