A Primer on Avoidance Actions in the Context of Crypto Bankruptcies
In 2022, there were several high-profile crypto bankruptcy filings. A big question in these cases is whether there will be any money to satisfy unsecured creditor claims. If there are funds to distribute, then the creditors’ claims will become more valuable, and the cases will become even more interesting.
Because crypto companies do not have much physical inventory, real estate or other tangible assets to liquidate, it can be hard to imagine what assets will be available to help satisfy creditor claims. One way these debtors will bring value into their estates is through litigation. For example, Celsius has already brought millions of dollars of claims against Voyager Digital and Fabric Ventures Group, but these cases are just the start.
Many bankruptcy professionals expect the crypto bankruptcies to involve extensive avoidance action litigation. This article provides a primer on avoidance actions to help parties evaluate their potential exposure.
“Avoidance action” is an umbrella term for adversary proceedings that seek to unwind (or “avoid”) transactions that occurred before a bankruptcy filing. These actions are also referred to as “clawback claims” because, by undoing a transaction, some asset or value is being clawed back into the bankruptcy estate. The actions are typically brought by a trustee or the debtor, though other parties may be appointed to bring the case as representatives of the estate.
One type of avoidance claim is a fraudulent conveyance claim. A simple example of a fraudulent conveyance is an individual who sells his brand-new car to a friend for $1 one day prior to his bankruptcy filing. As a result, the car cannot be sold for its actual value in the bankruptcy, which reduces the money available for creditor recoveries. If the debtor’s intent to defraud creditors through this sale can be proven, then the trustee (or another appropriate party) may successfully bring an actual (or “intentional”) fraudulent conveyance claim against the friend in order to unwind the transaction.
However, intent is often hard to prove. Instead, a constructive fraudulent conveyance claim can be successfully litigated by showing the disparity between the sale price and the value of the asset. In these cases, the plaintiff must also show that the debtor (i) was insolvent, (ii) was left with unreasonably small capital, (iii) was unable to pay its debts as they became due, or (iv) made the transfer to an insider not in the ordinary course of business. Given these additional requirements, constructive fraud cases often hinge on expert testimony regarding asset valuation and the debtor’s solvency.
Another type of avoidance claim is a preferential transfer claim. A preferential transfer is a transfer made to or for the benefit of a creditor on account of an antecedent debt while the debtor was insolvent that allows the creditor to receive more than it would have in liquidation. The policy rationale for preference claims is to ensure that no creditor is treated better (or preferentially) to any other creditor because it received payment for its claim just before a bankruptcy filing.
Vendors are often defendants in preference cases because they often are paid after delivery of goods. One common defense available to vendors and other preference defendants is the ordinary course defense, which requires a showing that the transfer was made according to standard business practices. For example, if a vendor historically received payment 30 days after delivery, then a payment made according to that schedule is likely not avoidable. However, if the payment was delayed because the debtor was having financial difficulties or if payment was early because the vendor was pressuring the debtor to pay, then the payment is likely avoidable.
Another common defense to preference actions is the new value defense. This requires the defendant to show that, at the time of payment, there was a contemporaneous exchange of new value between the debtor and the preference defendant. In the context of a preference claim against a vendor, the vendor may prove that, even if the payment was for a prior delivery of goods, an additional shipment of goods was delivered at the same time as payment was made.
Fraudulent conveyance and preference claims are codified in sections 547 and 548 of the Bankruptcy Code, which also set out specific clawback periods. A transaction may be unwound if (i) with respect to fraudulent conveyance claims, it occurred within two years of the bankruptcy filing, and (ii) with respect to preference claims, it occurred (A) within 90 days of the bankruptcy filing or (B) within a year of the bankruptcy filing if the creditor was an insider.
However, Bankruptcy Code section 544(b) expands avoidance powers to include transfers that are avoidable under state law and other non-bankruptcy law by any creditor holding an unsecured claim. Therefore, depending on applicable law as well as relevant case law in the relevant jurisdiction, transactions that occurred much earlier than the Bankruptcy Code’s stated clawback period may be avoidable. In some cases, the clawback period could go back as far as 10 years. Parties that believe they may have avoidance action exposure should consult with bankruptcy professionals to determine the appropriate clawback period and to analyze possible defenses that might help defeat avoidance claims.
Avoidance claims are often brought after a bankruptcy plan is confirmed—a milestone that has not been reached yet in any of the major 2022 crypto bankruptcies. Individuals and companies that received any form of payment from a crypto company that has since filed bankruptcy should work now on evaluating their avoidance exposure while records are still fresh. Most notably, given the Celsius’ court recent ruling that digital coins deposited in Celsius’ interest-bearing accounts belong to the company, customers who withdrew funds from those accounts before the bankruptcy may find themselves as defendants in these cases.
