BlockFi website on November 17, 2022.
Gabby Jones/Bloomberg via Getty Images
Cryptocurrency company BlockFi filed for bankruptcy on MondayLatest crypto domino crash after FTX crash two weeks ago threatens to destabilize companies in the broader crypto ecosystem.
BlockFi provides cryptocurrency exchange and interest-bearing custodial services for cryptocurrencies. The distressed company – which has said it has “significant exposure” to FTX – said on Monday that it there are more than 100,000 creditorswith liabilities and assets ranging from $1 billion to $10 billion.
The FTX crash is happening — and bankruptcies earlier this year for lenders Network degree C and digital travel — is teaching crypto investors a hard lesson about their protections compared to more traditional asset classes. The fate of their money now deceit in legal proceedings that could take years to work.
According to legal experts, cryptocurrencies like bitcoin, ethereum and others in the digital asset sector exist in the gray area of federal regulation.
That means they largely escape the same scrutiny as holdings like stocks and bonds. Furthermore, federal funds are not available to assist clients in the same way as for equity holders in a bankrupt brokerage firm or bank.
How do orange groves impact crypto protection?
Aldo Pavan | Image Bank | beautiful pictures
The reason largely revolved around a 1946 Supreme Court case against investors in Florida orange groves.
The judges heard that case — SEC v. WJ Howey Co. — established the so-called Howey test to determine what constitutes a security, or “investment contract”. (More information on how the Howey test works can be found below.)
Stocks are considered securities, regulated by the United States Securities and Exchange Commission.
Courts have used the Howey test to attract a number of non-traditional investments — such as animal programs, railroads, cell phones, and Internet-only businesses — under the “investment contract” umbrella, thus receiving the same protection and supervision as stock investors.
Here’s why it matters for crypto: In many cases, it’s unclear whether a digital asset is an “investment contract” according to the 76-year-old Howey test.
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Richard Painter, a professor of securities law at the University of Minnesota, said regulatory oversight is somewhat ambiguous.
Experts have questioned whether it might be more appropriate to treat cryptocurrencies as a currency or a commodity, for example, regulated by various federal regulators.
“It makes no sense to apply all of this to the Howey test in the case from the 1940s,” said Painter, a former chief ethics attorney for the White House under President George W. Bush.
“It’s an invitation to disaster,” he said. “Someone has to cover this up.
“We know what happens to unregulated markets – since 1637 tulip bulbs [mania] in the Netherlands“, added Painter, referring to an event in the 17th century that is widely considered to be the first recorded large financial bubble that bankrupted many investors.
Why is the ‘security’ distinction important?
United States Supreme Court
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Howey’s test has four parts to determine if something like bitcoin is an “investment contract”. A contract exists if each contract is true:
- There is an investment of money;
- in a joint enterprise;
- in which the investor expects a profit; and
- Profits are only obtained from the efforts of others.
For example, think of an investor holding a publicly traded stock. Investors do not do the work to generate profits for the company, but it is done by the employees and managers of the company. Investors, for their part, can reap profits in the form of dividends and/or higher stock prices.
But cryptocurrencies are different. Daniel Gwen, corporate restructuring consultant at law firm Ropes & Grey, said it is decentralized in many cases, meaning it may not be considered a “regular business”. It’s also unclear if its purpose is always to make a profit, as some people use it to transfer money across borders or as a “store of value,” for example, Gwen added.
The 1946 Supreme Court case centered on the Howey Company, culture orange orchards and attract investment from tourists staying at an adjacent hotel. An affiliate manages the forest on behalf of tourists. After the orange harvest, Howey divided a portion of the net profit to each buyer. Transactions that are “clearly related” to investment contracts, courts rule.
It was an invitation to disaster.
Painter Richard
professor of securities law at the University of Minnesota
If cryptocurrencies were also a well-defined security, the SEC would be able to police the companies, said Micah Hauptman, director of investor protection at the Consumer Federation of America, an advocacy group. The company does not comply with securities laws. Those enforcement measures can also work to deter bad guys, he said. There will be additional disclosures required for investors, among other safeguards.
Hauptman said of cryptocurrencies: “How regulated these assets are is not going to make a difference to investors, but it does.”
The SEC has attempted to assert its regulatory oversight on a number of occasions. For example, the agency sued Ripple Labs and its employees in 2020 for not registering the XRP cryptocurrency as a security service. That case is happening.
“I don’t think you can blame the regulators” for what happened at FTX, said Sheila Bair, former president of the Federal Deposit Insurance Corporation, told CNBC. “They want Congress to act because there’s not a lot of clarity, absolute clarity about what is a security, what is a commodity, what should happen to banking regulators.”
‘Law is everywhere’
Customers holding their crypto assets at FTX also does not seem to receive financial protection for defunct brokerage firms that sell stocks, bonds, and other securities.
The Securities investor protection joint stock company insurance for investors up to $500,000 in the event a brokerage firm liquidates and their shares are tied up in the company insolvent. Suppose a customer of Lehman Brothers owned shares of a publicly traded company stock when the company bankruptcy. Gwen said the goal of SIPC is to get the shares back in the hands of investors as quickly as possible.
There is a similar mechanism for bank customers who Insurance up to $250,000 by the FDIC if a bank fails.
However, FTX customers may not be protected by SIPC, Gwen said.
First, that protection applies to securities, meaning that the ambiguity of a cryptocurrency as a security or not can be an obstacle. FTX itself may not be classified as a brokerage in relation to securities products. Furthermore, the company is headquartered outside of the United States, in the Bahamas, which SIPC does not include, Painter said.
“It does the same things as a broker-dealer,” Gwen said of FTX. “But the law is everywhere when it comes to [crypto].”
FTX, once valued at $32 billion, file for Chapter 11 bankruptcy protection on 11.11. Cryptocurrency holders have to hope they can get some — if any — money back in bankruptcy court.
It can be a long and difficult process.
“Chapter 11 is not really designed to protect this situation, where you have an opaque digital asset that is managed almost like a security, without the same framework,” Gwen said. “That’s not to say investors aren’t protected; they have different protections.”
