By Michael Rosella (Katten Muchin Rosenman LLP) and Dan McElhinney (Stretto)
The crypto winter has arrived! Among many other issues of first impression for bankruptcy courts is the question of how the increased due diligence standards for preference actions set forth in the Small Business Reorganization Act of 2019 (the “SBRA”) will play out in a crypto case. The SBRA raised the bar on the due diligence needed to pursue preference litigation, requiring the debtor or trustee to assess “known or reasonably knowable affirmative defenses” before moving forward.
This article first assesses lingering disagreements related to the “heightened” pleading standard as applied to preference causes of action set forth in In re Valley Media and its progeny. Next, we delve into the cases interpreting the new due diligence standard set forth in the SBRA, as there is already disagreement on how to interpret the SBRA. Certain courts suggest the new due diligence standard constitutes an element of a preference claim that must be specifically pled in a complaint in order to avoid dismissal; others do not. Yet courts in this latter group, while eschewing the idea of a new element, do consider any information regarding pre-complaint due diligence efforts in the complaint, nonetheless. We then consider the issues unique to the opaque world of a cryptocurrency debtor that may impact the debtor or trustee’s ability to satisfy a heightened due diligence standard. Questions relating to the potential differences in assessing cash vs. crypto transfers and whether debtors or trustees will have access to key demographic and transaction data are considered. For example, whereas a debtor dealing in cash transfers would likely have bank statements, canceled checks, and access to accounting systems with basic transferee information, debtors transferring cryptocurrency to the independent digital wallet of a customer or counterparty would be less likely to have access to basic information necessary to satisfy a heightened due diligence standard.
We also provide key takeaways that highlight measures that cryptocurrency debtors should take to comply with the pleading and due diligence requirements. For example, a debtor in a cryptocurrency case should include in the complaint a recitation of its efforts to conduct reasonable due diligence — including efforts to obtain information needed to consider affirmative defenses, as well as reference to demand letters sent inviting the transferee to assert such defenses—to minimize any dismissal risk.
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