New York's guidance on crypto custodial accounts and its impact on a bankruptcy estate

The crypto winter has brought a flurry of bankruptcy filings into the digital asset space. As pioneering cryptocurrency platforms collide with the Bankruptcy Code, unprecedented questions of law have left customers asking a fundamental question: who owns my crypto?

This question—the answer to which is critical to customer recoveries in cryptocurrency platform bankruptcy cases—is especially prevalent in cases where the debtor company’s platform offered custodial accounts to customers. Custodial accounts are not new to the financial world; however, digital asset custodial accounts have unusual attributes (such as limited regulatory oversight) that have revealed cracks in customer protection when custodians have filed for bankruptcy.

To address these concerns, the New York Department of Financial Services (the “NYDFS”), the agency that supervises and regulates New York’s financial institutions (including, as of 2015, virtual currency companies conducting business in the state under a BitLicense), recently issued guidance that, if followed, could significantly impact customer recoveries in future bankruptcy cases of digital asset platforms.

WHAT IS A CUSTODY ACCOUNT?

Digital asset custody accounts operate differently from a typical custody account at a bank: digital asset custodians do not technically store any of the customer’s assets. This is due to the nature of cryptocurrency—the assets themselves actually exist on the blockchain (a quasi-public ledger). Instead, a crypto custodian holds a user’s “private key”—the part of a crypto wallet that grants access to the funds associated with it.

Crypto custody accounts became a popular method for customers to secure their assets from theft.

Unfortunately, many traits that attract investors to a groundbreaking and unregulated industry also attract individuals who are less scrupulous or conscientious, and cryptocurrency platforms have not all proven themselves to be hack-proof or otherwise vault-like. Moreover, unlike tangible assets secured by a traditional financial institution, once digital assets are stolen, it is difficult, and in some cases, impossible, to recover them. As customer concerns increased, platforms began offering custodial services to safeguard customers’ digital assets. These accounts also benefitted platforms—they offered customers a comprehensive place to hold all their digital assets, increasing the likelihood of attracting and retaining customers. And, notably, custodial accounts also generated substantial revenue.

As customers learned, however, there can be drawbacks to entrusting digital assets to a third-party custodian. One risk is that a custodian who holds the private key controls the assets and can freeze accounts, block access, or limit withdrawals.1 In more severe cases, cryptocurrency platforms essentially could be considered to have acted like unregulated banks, with few controls in place to ensure that custody account assets never were commingled with other types of assets.

Thus, when a company offering custodial services files for bankruptcy, customers can be left at the court’s mercy to determine whether digital assets meant for a custody account, but commingled with other funds, belong to the customer or the bankruptcy estate.

In such circumstances, there is a risk that bankruptcy courts could hold that the assets within the custody account belong to the bankruptcy estate, leaving customers, who thought they had mitigated the risk of loss of their digital assets by entrusting them to the custodian, as unsecured creditors of a bankrupt company.

OVERVIEW OF THE NYDFS GUIDANCE

On January 23, 2023, the NYDFS issued recommendations on policies and controls for digital asset custodians to prevent future governance and operational issues: an industry letter entitled “Custodial Structures for Customer Protection in the Event of Insolvency.

The NYDFS issued this guidance to emphasize “sound custody and disclosure practices to better protect customers in the event of an insolvency or similar proceeding,” stressing the importance of equitable and beneficial interest always remaining with the customer.

This letter sets forth best practices for digital asset custodians to follow. Not all the recommendations are in direct response to issues that have arisen during crypto-related bankruptcy cases; rather, the guidance also serves a preventative purpose. We provide a high-level summary overview of the guidance below:

Segregation of and Separate Accounting for Customers’ Digital Assets. To maintain appropriate books and records, the NYDFS expects that the custodian will separately account for and segregate customers’ digital assets from the corporate assets of the custodian and its affiliated entities, both on-chain and on the custodian’s internal ledger accounts.

Custodian’s Limited Interest In and Use of Customers’ Digital Assets. When a customer transfers possession of an asset to a custodian for safekeeping, the NYDFS expects that the custodian will take possession only for the limited purpose of carrying out custody and safekeeping services, and that it will not thereby establish a debtor-creditor relationship with the customer.

Sub-Custody Arrangements. A custodian may elect to arrange for the safe keeping of customers’ digital assets through a subcustody arrangement with a third party. The NYDFS views a third-party arrangement as a material change to a custodian’s business; as such, approval by the NYDFS is required before the implementation of any arrangement.

Customer Disclosure. A custodian is expected to (i) clearly disclose to each customer in writing the general terms and conditions associated with its products, services, and activities and (ii) obtain acknowledgment of receipt of such disclosure before entering into an initial transaction with the customer. Additionally, the guidance recommends that customer agreements clarify the parties’ intentions to enter into a custodial relationship rather than a debtor-creditor relationship.

Industry letters like these aim to clarify regulations and establish best practices for entities supervised by the regulator. Crypto companies are likely to follow this guidance if they want to stay in the regulator’s good favor and avoid the NYDFS’s enforcement powers—especially as the New York State Senate recently provided the regulator with an enhanced budget. If the guidance is followed, it could impact which assets are determined to belong to the customer and which are determined to belong to the bankruptcy estate.

In a chapter 7 liquidation, a bankruptcy trustee is appointed to administer the estate. In a chapter 11 case, unless a bankruptcy trustee is appointed for cause, the debtor’s management in a business bankruptcy case remains in control, and the debtor becomes a “debtor in possession” with most of the same rights and responsibilities as a bankruptcy trustee.

Determining whether an asset is property of the bankruptcy estate is critical for multiple reasons, including that estate property: (1) is subject to the automatic stay and thus not subject to creditor collection action absent leave of the bankruptcy court; (2) may be sold or used by the debtor-in-possession or trustee, subject to court supervision; and, perhaps most importantly, (3) is available for general distribution to creditors under a plan of reorganization. If a custodial customer’s digital assets are characterized as the property of the estate, that customer may never see those assets again or may receive mere cents on the dollar as an unsecured creditor under a plan of reorganization.

The NYDFS guidance aims to preemptively address this property characterization problem by requiring an express custodian-customer agreement from the beginning of the commercial relationship. Absent an ambiguity in the contract requiring looking beyond the document, New York (and most states’) law requires courts to look within the four corners of an agreement to determine the respective parties’ rights—and, in general, bankruptcy courts look to state law for purposes of determining property interests.

By requiring both parties to the agreement to acknowledge that the customer, rather than the custodian, maintains an ownership interest over the assets at all times, the NYDFS aims to increase the certainty that a bankruptcy court would determine that a custody account belongs to the customer and is not part of the bankruptcy estate.

Relevant to issues uncovered during recent bankruptcies, having distinct processes in place so that custody account assets are not comingled with other assets would help to define ownership interests. In some recent crypto-related cases, digital assets meant only for custody accounts may have been comingled with digital assets intended for other types of accounts. This comingling led to uncertainty for customers and the bankruptcy court regarding which digital assets (if any) belonged to custody customers at the time of bankruptcy filing.

If a future platform were to follow the NYDFS guidance by maintaining separate accounts and implementing controls to disable comingling, digital assets within custody accounts would provide more specific protection to customers wishing to have their digital assets excluded from the bankruptcy estate.

CONCLUSION

This NYDFS guidance was published to encourage non-bankrupt custodians to implement strict controls and clarify the scope of their customer relationships. While it may be too little, too late for some customers, this guidance provides a path for custodians to firm-up their policies and prevent headaches and uncertainty in the event of a digital asset platform’s future insolvency. Following this NYDFS guidance would likely increase the chances of custodial accounts being excluded from a bankrupt custodian’s estate.

Authored by David Simonds, Edward McNeilly and Kaitlyn Hittelman for The International Journal of Blockchain Law, Volume 5, March 2023.