Friday, March 14, 2014

MtGox Chapter 15 Case Brings Japanese Insolvency Proceeding and Bitcoin Drama to Dallas Bankruptcy Court

Bankruptcy sometimes provides a window into unfamiliar worlds.   The recent chapter 15 filing by MtGox Co., Ltd. contains an interesting explanation of the bitcoin phenomenon as well as Japanese involvency proceedures.   In re MtGox Co., Ltd., No. 14-31229 (Bankr. N.D. Tx.).   Here are a few nuggets that I picked up from the initial filings.  

By way of introduction, MtGox Co., Ltd. is a Japanese company that operated a bitcoin exchange in Tokyo.  According to Wikipedia, MtGox is an acronym for “Magic:  The Gathering Online Exchange.”  Unforutnately for MtGox, the magic turned sour.   On February 28, 2014, it filed for reorganization in Japan after it found that it was missing bitcoins valued at $473 million which constituted about 7% of all of the bitcoins in circulation.   This raises the question of just what is a bitcoin and how does someone steal half a billion dollars’ worth of them.   

All About Bitcoin

According to the Declaration of Robert Marie Mark Karpeles (Dkt. #3), “Bitcoin is a form of digital currency that was first conceived of in 2008 by a person or group going by the name of Satoshi Nakamoto.”     Attributing the conception of bitcoin to a pseudonymous person or group suggests that this digital medium of exchange is to currency what Anonymous is to the internet, that is, a shadowy, disruptive force.    According to Wikipedia, Satoshi Nakamoto is probably not Japanese and is probably not an individual.   Whether he is an individual or a group, he launched the first Bitcoin software in 2009 and then handed it over to Gavin Andresen (an engineer with a degree from Princeton) in mid-2010.   For his or its troubles, “Nakamoto” ended up with a million bitcoins.   

Continuing on with the Declaration:
The first actual bitcoin was created, or "mined" in 2009. There are several ways in which a person can obtain bitcoin, including the following:

o Bitcoins are "created" through a computer software algorithm which, at any point in time, resides on thousands of computers on the Internet. Persons who accept to certify bitcoin transactions over the bitcoin peer-to-peer network are remunerated by the issuance of a fixed number of bitcoins which evolves over time. The certification is done by the solving of an "algorithm" with the use of ever-more powerful computers. These persons are called "miners" and the process of obtaining bitcoin in this fashion is called "mining."

o A person can also obtain bitcoins that have already been mined by buying them from another. These transactions can consist of "one-to-one" transactions between a buyer and seller. In addition, a person can buy or sell bitcoin through an online exchange, such as the exchange operated by MtGox on the website. In these exchange transactions, the buyer and seller create accounts at the exchange and then fund the account with currency funds, bitcoin or both. The user can then enter a buy or sell order online and the website will match the buy or sell order with one or more sell or buy orders. The buyer receives an increase in bitcoin in his/her account and the seller receives an increase in currency in his/her account. The bitcoin exchange receives a fee or commission for the transaction.

o A person can also obtain and use bitcoin through commercial or merchant transactions; that is, a person can use bitcoin in certain circumstances to pay for goods and services.

Users store bitcoins in a digital "wallet" using either the software provided as part of the bitcoin software or a wallet provided by various providers. MtGox provides a wallet feature. A wallet can be materialized on a piece of paper and bitcoins need not be stored on a computer.

The MtGox exchange allowed persons with MtGox accounts to buy and sell bitcoin among themselves. In this regard, a person was to first open an account at MtGox and was assigned an account number. Once a user wanted to start buying or selling bitcoin on the mtgox website, he or she would need to "fund" the account with currency, bitcoin, or both. In addition, the account holder would be subject to "anti-money laundering" ("AML") procedures.

Once the account was "funded," the account holder would have a "currency balance" in the account, corresponding to the amount of currency he or she had a right to withdraw; and, a "bitcoin balance" in the account, corresponding to the amount of bitcoin he or she had a right to withdraw.
 Declaration, pp. 2-4.

While the part about mining bitcoins by solving an algorithm using ever more powerful computers sounds really technical, I think it can be boiled down to this.  I think that what happened was that someone came up with the idea of bitcoin and persuaded other people to exchange currency or products in return for it.   This is basically the story of currency everywhere.   While we may have once relied upon coins made of precious metals, it still required an agreement that these shiny objects had value.  All money is based on the shared idea that it has value.    Once enough people agree that a thing has value, then it does—at least until people stop thinking it does.

Meanwhile, MtGox was founded in 2007 by Jed McCaleb as a site for trading cards like stocks.   In July 2010, McCaleb read about Bitcoin on Slashdot and decided to create an exchange for trading Bitcoin and regular currencies.   In March 2011, McCaleb sold MtGox to Mark Karpeles while retaining a 12% interest.   Karpeles is a software developer who was born in France in 1985 and moved to Japan in 2009.   

The problem with having something of value is that people who are not nice may try to take it from you.   This happened with MtGox.   Going back to the Declaration:
The website has been subject to numerous attempts by persons to breach its security, create denial of service ("DOS") situations, or to otherwise "hack" the system, and this has been the case since MtGox started operating the website in July 2011. In certain circumstances such attempts have led to the company shutting down the site for periods at a time.

On February 7, 2014, all bitcoin withdrawals were halted by MtGox due to the theft or disappearance of hundreds of thousands of bitcoins owned by MtGox customers as well as MtGox itself. The cause of the theft or disappearance is the subject of intensive investigation by me and others -- as of the present time I believe it was caused or related to a defect or "bug" in the bitcoin software algorithm, which was exploited by one or more persons who had "hacked" the bitcoin network. On February 24, 2014, MtGox suspended all trading after internal investigations discovered a loss of 744,408 bitcoins presumably from this method of theft.
 Declaration, p. 4.    This illustrates another peril of the digital world.   When your asset consists of computer code, there are going to be hackers who will want to breach your network and mess with your stuff, which is apparently what happened to MtGox.    While losing half a billion dollars of your customers’ non-corporeal assets to theft is embarrassing, it is not as bad as JP Morgan losing $5.8 billion from trading credit default swaps or MF Global losing $1.6 billion of customer funds from bad trades.

The Japanese Main Proceeding and the Dallas Chapter 15

While the internet does not exist within fixed borders, companies do.   MtGox was physically located in Tokyo, Japan.   While it is curious that the creator of bitcoin used a Japanese pseudonym, Mark Karpeles was already living in Tokyo when he acquired MtGox in 2011.   So what you have is a Frenchman living in Tokyo who acquires an exchange from an American for trading a digital currency developed by an anonymous person or collective using a Japanese name.    

Returning to the Declaration:
In order to protect the MtGox business as a going concern and retain its value while MtGox investigates the theft of the bitcoins under its control and addresses security defects in the bitcoin exchange, MtGox filed a petition (the "Japan Petition") for the commencement of the Japan Proceeding in the Tokyo Court pursuant to Article 21(1) of the JCRA on February 28, 20 I4, reporting that the company had lost almost 750,000 of its customers' bitcoins, and around 100,000 of its own bitcoins, totaling around 7% of all bitcoins in the world, and worth around $473 million near the time of the filing.

The Japan Proceeding is a civil rehabilitation. The purpose of a civil rehabilitation proceeding is to formulate a rehabilitation plan as consented to by a requisite number of creditors and confirmed by the court, to appropriately coordinate the relationships of rights between creditors and the debtor, with the aim of ensuring rehabilitation of the debtor's business or economic life.

In addition to the petition for commencement, MtGox also filed applications for a temporary restraining order and for a comprehensive prohibition order which were issued by the Tokyo Court on February 28, 2014. At the same time, the Tokyo Court issued orders for the appointment of a supervisor and examiner (collectively, the 'Tokyo Court Orders").

The Tokyo Court appointed Mr. Nobuaki Kobayashi, a Japanese attorney, as MtGox's supervisor and examiner. Under the Tokyo Court Orders, the Debtor cannot execute any agreement with any third party without the consent of the supervisor and examiner. The Debtor however remains free to initiate or pursue any legal proceeding provided that the costs of these proceedings be approved by the supervisor and examiner. On March 10, 2014, Mr. Kobayashi, pursuant to the powers conferred upon him by the Tokyo Court Orders, issued a consent allowing the Debtor to hire Baker & McKenzie to file this Chapter 15 case as counsel of Debtor, allowing the payment of Baker & McKenzie's fees and further acknowledging that this consent was granted at the condition that MtGox's sole Director and Chief Executive Officer, Mr. Karpeles, file this Chapter 15 case as the foreign representative of MtGox.

Under the current status of the Japan Proceeding, the supervisor/examiner does not have the powers to manage the assets of the Debtor. As a consequence, the current management of MtGox remains in place and is allowed to continue to operate its businesses as a debtor-in-possession. I understand that this is permitted under the JCRA and that MtGox has submitted the evidence legally required for the relief to be granted upon formal commencement.
Declaration, pp. 5-6.   In case you were wondering what a Japanese Insolvency order looks like, here is an image of one page:

From what I can discern, the JCRA allows something like our debtor-in-possession procedure with an independent supervisor and examiner who must approve certain actions but does not run the business.  According to a Brief filed by MtGox's American lawyers, Baker & McKenzie, the JCRA was modeled on Chapter X of the U.S. Bankruptcy Act of 1898. 

The Chapter 15 proceeding was filed in response to legal proceedings in the United States.    After Jed McCaleb sold his majority interest in MtGox to Mr. Karpeles, he founded a company named CoinLab, Inc. in the United States.    CoinLab filed suit against MtGox in the Western District of Washington in 2013.   Immediately after MtGox ceased operating, a class action was filed against it in the Northern District of Illinois.    When the Chapter 15 proceeding was filed, MtGox filed a Verified Petition for Recognition and Chapter 15 Relief in which it sought to have Mark Karpeles recognized as the “foreign representative” of MtGox.  It also requested that it be granted provisional relief pending recognition to have the automatic stay apply to MtGox in the United States.   

On March 10, 2014, Judge Harlin Hale entered an order providing that the automatic stay apply “to the Debtor and its assets until further order of this Court or as so ordered at the Recognition Hearing.    The Court scheduled a hearing on recognition of the foreign proceeding before Judge Stacey Jernigan to be commenced on April 1, 2014.    Somehow it seems fitting that the hearing for recognition of the bankruptcy for the exchange that had its digital crypto-currency pilfered will begin on April Fools’ Day.       


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Nate said...

Because I was one of their customers and they owe me money, I received an email from them with a bunch of legal stuff I don't understand. I live in the Austin area. Some where around the end of last year I sold my bitcoin for $221.24 of which they have yet to send to my bank account. Any chance I'm going to get my money back from them?

Steve Sather said...

@Nate, I would not hold your breath. With the main case being in Japan, that is where you would have to look to for any recovery. However, if you get the chance to file a claim with the Japanese administrator, you should do so. Filing a claim in bankruptcy is like buying a lottery ticket--you probably won't get anything but you never know.