The Proposed GENIUS Act Raises Concerns Over Insolvency Provisions

Much attention has been paid to the regulatory and customer protection provisions of the proposed Guiding and Establishing National Innovation of US Stablecoins Act, the so-called GENIUS Act, S. 1582 (the proposed Act). However, the proposed Act also contains provisions relating to insolvency, particularly in Section 11. While some of these provisions are straightforward, there are areas of concern that should ideally be addressed in any final bill.

In this LawFlash we discuss the insolvency provisions of the proposed Act[1] and highlight the areas of concern. These areas of concern raise questions of whether, in trying to protect holders of payment stablecoins in an insolvency proceeding of a stablecoin issuer, the proposed Act jeopardizes the likelihood that the insolvency proceeding will be successful.

SECTION 11 ESTABLISHES PRIORITY

The Priority of a Stablecoin Holder’s Claim to the Stablecoin Reserves If the Issuer Is a Debtor in a Case Under the Bankruptcy Code

Section 11(a) of the proposed Act establishes a general rule that the claims of holders of payment stablecoins to the reserves backing the stablecoins have priority over all other claims in the bankruptcy case. The general rule reinforces a stablecoin holder’s redemption right as creating a “hard promise” by the permitted stablecoin issuer to redeem the holder’s payment stablecoins for fiat currency at the election of the stablecoin holder. The effect of the general rule is to give to the stablecoin holders what is tantamount to a security interest in the reserves to secure the permitted stablecoin issuer’s redemption obligations to the stablecoin holders. 

However, the stablecoin holders are actually treated more favorably than secured creditors in a bankruptcy case. There is no possibility for the debtor issuer under Section 364 of the Bankruptcy Code to obtain credit based on the reserves even if the stablecoin holders are otherwise adequately protected. Not only is the debtor issuer prohibited from granting a security interest in the reserves under Section 4(a)(2) of the proposed Act but also, under Section 11(e)(3) of the proposed Act, the reserves are not considered even to be included in the debtor issuer’s bankruptcy estate. 

Likewise, because the reserves are not included in the bankruptcy estate, there is no possibility for the reserves to be surcharged under Section 506(c) of the Bankruptcy Code for any expenses of the estate representative in preserving the reserves.

These provisions raise concerns over whether the legal wall inserted around the reserves will be so thick as to inhibit a successful or efficient reorganization or liquidation of the debtor issuer in a bankruptcy case.

The Priority of a Stablecoin Holder’s Claim If the Issuer Is a Debtor in a Case Under the Bankruptcy Code and the Reserves Are Insufficient to Satisfy the Holder’s Redemption Claims

It is possible that, notwithstanding the regulatory scheme for permitted stablecoin issuers provided under the proposed Act, a permitted stablecoin issuer may not have sufficient reserves to satisfy all redemption claims of stablecoin holders in the bankruptcy case. In that case, the stablecoin holders are given, under Section 11(d) of the proposed Act, “super” priority claims over all other Bankruptcy Code Section 507 priority claims.

Because Section 507(a) includes administrative claims under Section 503(b) of the Bankruptcy Code, the super priority claims would be superior to general administrative claims relating to the estate representative preserving the bankruptcy estate as well as priority wage and tax claims, among other priority claims.

As with the priority claims of the stablecoin holders to the reserves, the provisions raise concerns over whether the super priority reserves shortfall claims of the stablecoin holders will inhibit a successful or efficient reorganization or liquidation of the debtor issuer in the bankruptcy case.

Of special concern is the priority of the stablecoin holders’ shortfall claim over administrative claims in the bankruptcy case. The subordination of administrative claims to the shortfall claims may increase the likelihood that the estate will become administratively insolvent or that a reorganization of the debtor issuer will not be feasible.

DUTIES OF THE ESTATE REPRESENTATIVE

Because the reserves are not included in the bankruptcy estate, it begs the question of whether the estate representative even has any duty to creditors to preserve the reserves and, if so, how far the duty extends. 

THE AUTOMATIC STAY

The automatic stay in a debtor’s bankruptcy case prevents creditors from enforcing their claims against assets of the bankruptcy estate while, in the interest of all creditors of the estate, the estate is being rehabilitated or liquidated in an orderly manner. It would normally follow then that the automatic stay would not apply to assets not included in the bankruptcy estate, such as the reserves not included the bankruptcy estate under Section 11(e)(3) of the proposed Act.

If so, the stablecoin holders should be free to look to the reserves to satisfy their redemption claims despite the issuer being a debtor in a bankruptcy case. Yet, Section 11(c) of the proposed Act applies the automatic stay to actions against the reserves. It then provides an accelerated procedure for stablecoin holders to obtain relief from the automatic stay even though the reserves are not part of the bankruptcy estate.

Indeed, it is questionable what is gained by the reserves not being included in the bankruptcy estate if they are in any event subject to the automatic stay.

BANKRUPTCY CODE ELIGIBILITY

The proposed Act expands the category of persons eligible to be a debtor in a bankruptcy case and does so without amending Section 109 of the Bankruptcy Code. The proposed Act   declares in Section 11(g)(2) that any permitted stablecoin issuer that is not a bank “may” be a debtor in a bankruptcy case.

Arguably, then, a common law trust, which is not a business trust, or a state insurance company not otherwise eligible to be a debtor in a bankruptcy case would be eligible if it is a stablecoin issuer. The provisions seem to incentivize a person not eligible to be a Bankruptcy Code debtor to opportunistically become eligible merely by issuing payment stablecoins to avoid otherwise applicable insolvency procedures.      

STANDING OF REGULATORS

Section 11(f)(1) of the proposed Act requires (the word in the subsection is “shall”) the Comptroller of the Currency or any applicable state stablecoin regulator to appear and be heard on any issue in a chapter 11 bankruptcy case of a permitted stablecoin issuer regardless of the issue or whether the issue is even of concern to the regulator. The provision seems to create an inefficient use of regulatory resources if no issue is presented in the case involving the protection of stablecoin holders.

OTHER ISSUER INSOLVENCY PROCEEDINGS

A permitted stablecoin issuer may be an insured depositary institution or a federal or state credit union. The insolvency procedures applicable in that case would, under Section 11(g)(1) of the proposed Act, be those applicable to the depositary institution or the credit union. It is also plausible that a stablecoin issuer could be subject to a federal or state court receivership or an assignment for the benefit of creditors.

In all of these insolvency proceedings the general rule of Section 11(a) of the proposed Act would apply: the claims of stablecoin holders to the reserves backing the payment stablecoins would have priority over all other administrative, priority, or general unsecured claims in the insolvency proceeding, whether federal or state. Presumably, the priority would apply even to federal priority claims under 32 USC Section 3713. Once again, the concern arises as to whether the insolvency proceeding will be unsuccessful or inefficient given the stablecoin holders’ priority claims.

PRIORITY OF CLAIMS AGAINST THE CUSTODIAN OF THE RESERVES

The reserves would presumably be maintained for the permitted stablecoin issuer by a custodian, usually a bank or other securities intermediary. Of interest in the proposed Act is Section 10(c)(3), which gives to stablecoin holders priority claims over other creditors of the custodian with respect to the reserves.

For example, if a bank whose deposits are insured under the Federal Insurance Deposit Act (FDIA) became subject to a receivership under the FDIA, the stablecoin holders’ claims to the reserves would have priority over other claims against the bank. The priority of the stablecoin holders’ claims should not be controversial to the extent that the reserves consist of securities; interests in securities would usually be protected in the receivership.

What might be controversial is the priority claims of the stablecoin holders to reserves consisting of free cash balances. Presumably these claims would have priority over depositor preference claims in the receivership, including any subrogation claims of the Federal Deposit Insurance Corporation, thereby upsetting established distribution schemes in federal bank receiverships protecting depositors.

SUBORDINATION OF PRIORITY OF CLAIMS, CARVEOUTS, ETC.

The proposed Act does not preclude stablecoin holders in any insolvency proceeding from contractually subordinating their claims where necessary to ensure a successful or efficient reorganization or liquidation of a stablecoin issuer. However, given the expected large number of stablecoin holders, obtaining subordinations from all relevant stablecoin holders in the insolvency proceeding would likely be highly impracticable absent a provision in the proposed Act, or contractual arrangement with the stablecoin holders as part of the issuance of the payment stablecoins, for a stablecoin holder representative to act for the stablecoin holders.

If there were such a provision or arrangement, it could provide for the representative to agree in an issuer insolvency proceeding, with certain guardrails protective of the stablecoin holders, to subordinate stablecoin holder claims to certain administrative expenses, permit post-petition financing based on the reserves, allow the use of cash collateral, and the like. These types of agreements are typically essential for any bankruptcy case to be successful, especially a chapter 11 bankruptcy case.

CONCLUSION

If there was a “blank slate” to structure the insolvency provisions of the proposed Act, a better approach might have been to treat the claims of stablecoin holders to the reserves in any insolvency proceeding on par with the treatment of claims of secured creditors generally in the proceeding. At this late stage it is not likely that Congress would have any interest in restructuring the insolvency provisions. Nevertheless, there still may be time for Congress to consider addressing the areas of concern expressed in this LawFlash to minimize the possibility of any unintended consequences.

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