107157648 1669651423675 Gettyimages 1244848654 BLOCKFI BANKRUPTCY

As BlockFi files for bankruptcy, what to know about crypto protections

The BlockFi website on November 17, 2022.

Gabby Jones/Bloomberg via Getty Images

Crypto firm BlockFi filed for bankruptcy on Monday, the latest cryptocurrency domino to fall after the collapse of FTX two weeks ago threatened to destabilize companies in the broader crypto ecosystem.

BlockFi offers a cryptocurrency trading exchange and interest-bearing custody service for cryptocurrencies. The beleaguered company – which said it had “significant exposure” to FTX – said on Monday it had more than 100,000 creditors, with liabilities and assets ranging from $1 billion to $10 billion.

The ongoing FTX fallout — and bankruptcies earlier this year for lenders Celsius Network and Voyager Digital — are teaching crypto investors a harsh lesson about their hedging against more traditional asset classes. The fate of their money now lies in lawsuits that will likely take years to play out.

Crypto is facing a crisis of investor confidence

Cryptocurrencies such as bitcoin, ethereum and others in the digital-asset realm exist in a gray area of ​​federal regulation, according to legal experts.

This means that they largely escape the same oversight as holdings like stocks and bonds. Furthermore, federal money is not available to return clients in the same way it would be for those with ownership at a failed brokerage firm or bank.

How Orange Orchards Affect Crypto-Protection

Aldo Pavan | The Image Bank | Getty Images

The reason why depends largely on a 1946 Supreme Court case about investors in Florida orange groves.

The judges who heard that case – SEC v. WJ Howey Co. – established the so-called Howey test to determine what constitutes a security, or “investment contract”. (More on how the Howey test works can be found below.)

Stocks are considered securities, which are regulated by the US Securities and Exchange Commission.

Courts have used the Howey test to lasso some non-traditional investments—for example, animal breeding programs, railroads, cell phones, and Internet companies—under the “investment contracts” umbrella, thereby gaining the same protection and oversight as stock investors.

Here’s why it’s important for crypto: It’s unclear in many cases whether digital assets are an “investment contract” under the 76-year-old Howey test.

More from Personal Finance:
What to know about the latest student loan payment break
3 lesser-known ways to reduce your 2022 tax bill before year-end
Op-ed: Cryptocurrency hasn’t been a smart investment for a while

So regulatory oversight is somewhat ambiguous, said Richard Painter, a securities law professor at the University of Minnesota.

Experts have questioned whether it might be more appropriate to consider crypto a currency or a commodity, for example, governed by different federal regulators.

“It makes no sense to have all this spin on the Howey test in the 1940s-era case,” said Painter, a former White House chief ethics counsel under President George W. Bush.

“It’s an invitation to disaster,” he said. “Someone has to cover it.

“We know what happens to unregulated markets – since the 1637 tulip bulbs [mania] in Holland,” Painter added, referring to a 17th-century event widely regarded as the first documented case of a major financial bubble that bankrupted many investors.

Why the ‘security’ distinction matters

US Supreme Court

Rudy Sulgan | The Image Bank | Getty Images

The Howey test has four parts to determine whether something like bitcoin is an “investment contract.” A contract exists if each is true:

  1. There is an investment of money;
  2. in a common enterprise;
  3. in which the investor expects a profit; and
  4. the profit is obtained solely from the efforts of others.

Consider, for example, an investor who holds publicly traded stocks. The investor does not do the work to generate the company’s profit, rather it is done by the company’s employees and managers. On their part, the investor can get profit in the form of dividends and/or a higher share price.

But crypto is different. It is decentralized in many cases, meaning it may not be considered an “ordinary enterprise,” said Daniel Gwen, business restructuring attorney at law firm Ropes & Gray. It’s also unclear whether its intent is always to generate a profit, as some 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, which grew orange groves and solicited investments from tourists staying at an adjacent hotel. An affiliate managed the forest on behalf of the tourists. After the orange harvest, Howey allocated a share of the net profit to each buyer. The transactions “clearly” involve investment contracts, the court ruled.

This is an invitation to disaster.

Richard Painter

securities law professor at the University of Minnesota

If crypto were also a clearly defined security, the SEC would be able to police companies that don’t comply with securities laws, said Micah Hauptman, director of investor protection at the Consumer Federation of America, an advocacy group. Those enforcements could also have a deterrent effect on would-be bad actors, he said. Additional disclosures will be required for investors, among other protections.

“It shouldn’t make a difference to investors how these assets are regulated, but in fact it does,” Hauptman said of crypto.

In some cases, the SEC has tried to maintain its regulatory oversight. For example, the agency sued Ripple Labs and its officers in 2020 for failing to register the cryptocurrency XRP as a security offering. That case is ongoing.

“I don’t think you can blame regulators” for what happened at FTX, Sheila Bair, former chairman of the Federal Deposit Insurance Corporation, told CNBC. “They wanted Congress to act because there is not a lot of clarity, complete clarity, about what is a security, what is a commodity, what should be with the bank regulators.”

‘The law is everywhere’

Customers who keep their crypto assets with FTX also don’t seem to get the financial protection afforded to defunct brokerages that sell stocks, bonds and other securities.

The Securities Investor Protection Corporation insures investors for up to $500,000 in the event that a brokerage firm liquidates and their holdings are tied up in the insolvent firm. Let’s say a Lehman Brothers client owned shares of a publicly traded corporate stock when the firm went bankrupt. It will be SIPC’s aim to get shares back into investors’ hands as quickly as possible, Gwen said.

There is a similar mechanism for bank customers, who are insured by the FDIC for up to $250,000 if a bank fails.

However, FTX customers likely lack SIPC protection, Gwen said.

For one, that protection applies to securities, meaning that crypto’s ambiguity as a security or non-security can be a barrier. FTX itself may not be classified as a broker, which deals in securities products. What’s more, the company is based outside the US, in the Bahamas, which SIPC does not cover, Painter said.

“It does things similar to a broker-dealer,” Gwen said of FTX. “But the law is all over the place when it comes to [crypto].”

FTX, once valued at $32 billion, filed for Chapter 11 bankruptcy protection on Nov. 11. Customers with crypto holdings should hope they can recover some — if any — money in bankruptcy court.

This can be a difficult and long process.

“Chapter 11 is not really designed to protect this circumstance, where you have an obscure digital asset that’s administered almost security-like, without the same framework,” Gwen said. “That doesn’t mean investors don’t have protections; they have different protections.”

Related Posts