We have seen a tsunami of cryptocurrency exchange bankruptcies—FTX, Celsius, and Voyager, to name a few. Often, disputes arise among stakeholders in these bankruptcy cases regarding whether cryptocurrency maintained by a customer with an exchange in a pure custody relationship is property of the customer or property of the bankruptcy estate. Usually the litigation turns on the account agreement, including what are often referred to as the “Terms of Service,” entered into between the customer and the exchange, and the application of nonstatutory common law contract and property law principles. Given the uncertainty evidenced by this litigation and out of concern for customer protection, federal and state regulators have called for greater clarity on the issue through new regulation or, given the lack of clear regulatory authority, legislation. Yet many customers, exchanges, regulators, and legislatures seem to be unaware of an already existing statutory tool for addressing and resolving the issue: Article 8 of the Uniform Commercial Code (“UCC”).
The UCC, promulgated by the American Law Institute and the Uniform Law Commission, has been enacted in substantially uniform form by every state of the United States and the District of Columbia. Article 8 of the UCC provides a statutory scheme for the holding and transfer of investment securities, whether held directly by an investor from an issuer (so-called directly held securities) or held indirectly by an investor through a bank, broker, or other custodian acting for its customers, including the investor (so-called indirectly held securities). Of relevance here is the system for holding indirectly held securities (“indirect holding system”).
While the primary focus of Article 8 is generally on investment securities, Article 8’s indirect holding system provisions, contained in Part 5 of Article 8, can apply more broadly to any so-called financial assets as defined under Article 8. “Securities,” as defined in Article 8 (which may not coincide with the definition of securities under securities and other laws), are by definition financial assets. However, any other asset that the securities intermediary and its customer agree to treat as a financial asset is also a financial asset under Article 8 and is therefore within the scope of Article 8’s indirect holding system provisions. The agreement by which the exchange and the customer agree to treat an asset as a financial asset under Article 8 is referred to herein as a “financial asset election.”
Once the financial asset election is made and the financial asset is credited to the customer’s “securities account” at the securities intermediary, the customer (referred to in Article 8 as the “entitlement holder”) obtains a proprietary interest in, and contractual and statutory rights against the securities intermediary with respect to, the financial asset. That proprietary interest and contractual right are, together, referred to in Article 8 as a “security entitlement.”
A securities intermediary has a duty under Article 8, among other duties, at all times to maintain sufficient financial assets of each type to satisfy security entitlements to financial assets of that type. And, of chief importance here, financial assets to which the entitlement holder has a security entitlement are generally not property of the securities intermediary and are generally not subject to the claims of the securities intermediary’s creditors under Article 8.
A cryptocurrency exchange could be a securities intermediary under Article 8, with the cryptocurrency held for the customer being treated as a financial asset credited to a securities account of the customer at the exchange under a financial asset election included in the account agreement. If that were the case, the cryptocurrency would generally not be property of the exchange and generally not be subject to the claims of the exchange’s creditors. If the exchange became a debtor under the Bankruptcy Code, absent contrary terms in the account agreement, the financial asset election under Article 8 would reduce, if not entirely eliminate, the need to litigate the terms of the account agreement over whether the cryptocurrency is customer or exchange property. This is because Article 8 states so clearly that financial assets maintained by a securities intermediary for its customer are generally not the securities intermediary’s property and are generally not subject to the claims of the securities intermediary’s creditors. In other words, in this circumstance, the cryptocurrency would be property of the customer rather than property of the exchange.
A securities intermediary is a person that in the ordinary course of its business maintains securities accounts for others and is acting in that capacity. It is true that the most common examples of securities intermediaries are clearing corporations holding securities for their participants, banks acting as securities custodians, and brokers holding securities on behalf of their customers. But nothing in the definition of the term securities intermediary as used in Article 8 limits securities intermediaries to clearing corporations, banks, or brokers. In addition, because a securities account is an account to which a financial asset is or may be credited in accordance with an agreement under which the person maintaining the account undertakes to treat the person for whom the account is maintained as entitled to exercise the rights that comprise the financial asset, and the definition of financial asset is not limited to “securities” as defined in Article 8, a person may be a securities intermediary even if that person does not credit securities to the account. Rather, the securities accounts that a securities intermediary maintains may consist exclusively of assets that the securities intermediary has agreed to treat as financial assets—even if the financial assets are not securities.
The assets could, indeed, be cryptocurrencies. In 2022, the American Law Institute and the Uniform Law Commission promulgated amendments to the UCC providing rules for digital assets, referred to in a new Article 12 of the UCC as “controllable electronic records.” Controllable electronic records include most cryptocurrencies. The Official Comments to the 2022 amendments, including amendments to Article 8, confirm that a cryptocurrency exchange can be a securities intermediary under Article 8. Furthermore, under the 2022 amendments, a controllable electronic record maintained by a customer with an exchange can be a financial asset if there is a financial asset election under Article 8.
Examples of other assets treated as financial assets that are sometimes credited to a securities account and that are not securities include negotiable instruments, banker’s acceptances, certificates of deposit, and cleared swap agreements. It is not necessary that the cryptocurrency be considered a security or commodity under other law for the asset to be a financial asset under Article 8.
Moreover, the indirect holding provisions of Article 8 are technologically neutral. To obtain financial asset status, it would not matter whether the cryptocurrency is maintained by the exchange on-chain or off-chain or whether the customer has its own private keys to any wallet maintained by the exchange for the customer but with the exchange having ultimate control over the cryptocurrency.
The policy rationale for this broad and flexible interpretation of Article 8 in the context of the indirect holding system is explained in Article 8 itself. The Prefatory Note to Article 8 states, “Rapid innovation is perhaps the only constant characteristic of the securities and financial markets. The rules of Revised Article 8 are intended to be sufficiently flexible to accommodate new developments.” And the Official Comments to Article 8 provide, “That question [of the scope of Part 5 of Article 8] turns in large measure on whether it makes sense to apply the Part 5 rules to the relationship.” Here, the rules of the indirect holding system fit well when the financial asset election is made. The customer obtains the benefits of the duties of a securities intermediary, set forth in Part 5 of Article 8, owed to the customer by the exchange—including the duty of the exchange to maintain sufficient cryptocurrency of each type to satisfy all customer security entitlements to the cryptocurrency of that type. The exchange assumes the Part 5 duties with the ability to modify those duties, to the extent permitted by Part 5 of Article 8, with the agreement of the customer. And, as is the case with indirectly held investment securities, cryptocurrencies held as financial assets credited to the securities accounts of customers generally are not subject to the claims of the exchange’s creditors. There is no obvious policy reason not to permit the exchange and the customer to agree to the benefits and burdens of the indirect holding provisions of Article 8.
Of course, some cryptocurrency exchanges may commingle their proprietary cryptocurrency with cryptocurrency of customers as part of a single fungible bulk. An exchange doing so does not in any way alter the result under Article 8 if there is a financial asset election. Article 8 contains no provision that requires a securities intermediary to segregate proprietary financial assets from customer financial assets. The key is for the books and records of the securities intermediary to reflect what quantity of financial assets of which type is subject to security entitlements and which customers hold the respective security entitlements. If there is a shortfall in the cryptocurrency necessary to satisfy security entitlements to the cryptocurrency of any type, the customers’ rights under their security entitlements will generally be superior to the proprietary interests of the exchange in the cryptocurrency of that type.
Although there is so far no bankruptcy case addressing the issue, there is no reason why Article 8’s protections for customers’ cryptocurrency should not be recognized if the exchange were to become a debtor under the Bankruptcy Code. Based on the holding from the U.S. Supreme Court in Butner v. United States, the extent of a bankruptcy debtor’s interest in property is determined under applicable non-insolvency law, absent a compelling federal interest to the contrary—and there is no compelling federal interest why the applicable nonbankruptcy provisions of Article 8, after giving effect to financial asset election under Article 8, should not apply to determine the limitations of the exchange’s interest in the cryptocurrency maintained by the exchange for the customer. The interest of any creditor of the exchange would generally be similarly limited.
At most, the exchange’s interest would be limited to mere nominal title, which should not be problematic in the exchange’s bankruptcy case. Under Bankruptcy Code §§ 541(a)(1) and (d), the exchange’s nominal title is includable in the bankruptcy estate of the exchange. However, the bankruptcy estate’s nominal title in the cryptocurrency would remain subject to the limitations on the rights of the exchange as a securities intermediary, described above. The customer as the entitlement holder would have a security entitlement with respect to the cryptocurrency. Despite the exchange’s nominal title to the cryptocurrency, under Bankruptcy Code §§ 541(a)(1) and (d) the security entitlement itself remains the property of the customer and would not be included in the exchange’s bankruptcy estate. The customer may need relief from the automatic stay, and the assistance of the bankruptcy court in the bankruptcy case, for the cryptocurrency to be delivered out to another exchange or to the customer directly. If there is a shortfall in the cryptocurrency of the same type available to satisfy the security entitlements of all customers to cryptocurrency of that type, the customers would bear the shortfall ratably, and each customer would be treated as a general unsecured creditor of the exchange to the extent of the customer’s ratable share of the shortfall.
To be sure, a cryptocurrency exchange and its customers making a financial asset election is not a panacea for what many see as the risks of owning cryptocurrency, or for the lack of regulation of cryptocurrency exchanges. A financial asset election under Article 8 in and of itself cannot prevent fraud, self-dealing, or even poor record-keeping by an exchange—or be a substitute for regulation of cryptocurrency as a security, commodity, or otherwise or for regulation of a cryptocurrency exchange as a money transmitter or other licensee. Moreover, the Article 8 protections, even with a financial asset election, may not apply under choice-of-law rules contained in Article 8 or in the Hague Securities Convention, when the customer permits the exchange to use the cryptocurrency for the exchange’s own benefit (including where the customer is promised a return from the exchange’s use of the cryptocurrency), or in exceptional circumstances referred to in Article 8.
Article 8 is clear and flexible, built to practically accommodate areas of expanding economic activity such as the emergence of cryptocurrency exchanges. Cryptocurrency exchanges and their customers should seriously consider the benefits of a financial asset election, and regulators and legislators should seriously consider requiring cryptocurrency exchanges to build a financial asset election into their Terms of Service or other account agreement provisions. An example of a statute requiring a financial asset election is the Uniform Law Commission’s proposed Supplemental Commercial Law for the Uniform Regulation of Virtual-Currency Businesses Act. The comments to that proposed supplemental act go into greater detail on the substantive provisions of Article 8 and related choice-of-law rules applicable to a financial asset election.
The views expressed in this article are the personal views of the authors and not of their respective organizations.
