Understanding the Mt. Gox bankruptcy process by David Z. Morris @FortuneMagazine March 6, 2014, 5:45 PM EST E-mail Tweet Facebook Google Plus Linkedin Share icons FORTUNE — On Friday, Feb. 28, the bitcoin exchange Mt. Gox filed for bankruptcy under Japan’s Civil Rehabilitation (Minji Saisei) code, revealing that it was insolvent and seeking protection from creditors. On its website, the firm stated that it hoped to restructure and continue in business “in order to increase repayments to our creditors.” Almost immediately, the London-based firm Selachii LLP, which has provided services to many bitcoin businesses, began assembling a class action lawsuit against the management of Mt. Gox on the basis of suspected negligence and fraud. A similar fraud suit has been filed in the Illinois District Court in the United States. More cases will almost certainly be filed as the international legal system attempts to process the loss of nearly half a billion dollars in investments. The civil suits are necessary for a simple but not quite obvious reason: The tens of thousands of people whose bitcoin or fiat currency were held and then apparently lost by Mt. Gox are not creditors, and the bankruptcy process will not directly help them regain their property. MORE: Bitcoin blogger explains Mt. Gox leak As with most bankruptcy processes, civil rehabilitation will address only debt obligations including loans, outstanding service debts, and investments. In the absence of any FDIC-like backing, civil litigation is the only apparent path for depositor recovery. The path to civil rehabilitation The civil rehabilitation process has many commonalities with American Chapter 11 restructuring. According to Kazuaki Nagai of the Tokyo firm Anderson, Mori & Tomotsune, the immediate next step will be judicial approval of the filing for civil rehabilitation. “In the standard case, the decision is made one week from the date of petition,” which means it could come as quickly as Friday, March 7. However, Nagai warns, “In this case, it’s very complicated, [so] it may take more time.” There is also the chance that a judge may deny the application for civil rehabilitation — if, for example, there is patent evidence of fraud, or if it is judged unlikely that a voting body of creditors would approve a restructuring plan. The timing of any acceptance of Mt. Gox’s application for civil rehabilitation will have major implications because, according to Article 124 of Japan’s civil rehabilitation code, liabilities may be registered at market values when rehabilitation commences. This throws cold water on Mt. Gox’s delusional habit of valuing its obligations at its rock-bottom internal price (referenced in the leaked ‘Crisis Strategy Draft’ document). Moreover, the price of bitcoin has recovered by around 20% since the initial filing, vastly increasing Gox’s outstanding liabilities. However, Article 124 also allows the court to order that valuation of liabilities be made on a continuing basis as the company restructures. Given bitcoin’s volatility in recent years, this could leave a restructured Mt. Gox chasing an ever-mounting pile of obligations to bitcoin-denominated creditors – or it could mean those debts shrink to nearly nothing, if bitcoin collapses under the weight of failures like Mt. Gox’s own. MORE: Bitcoin’s digital tip jar: Microtransactions reborn Once the filing for civil rehabilitation is approved, Mt. Gox will be expected to assemble a proposal for restructuring, including proposed repayments for creditors. At the same time, creditors will need to file details of what they are owed, both to establish claims and to gain voting rights over the proposal. The proposal will need approval from a majority of creditors. Given the distrust directed at Mt. Gox and Mark Karpeles even before the revelation of insolvency, it seems entirely possible that creditors will reject any restructuring bid in favor of liquidation. However, Nagai warns, “In practice it’s difficult for international creditors to get information or to take part in the creditors meetings” in a civil rehabilitation case. Even leaving aside barriers of language and distance, Japanese legal processes are less public and transparent than those in the United States. For instance, bankruptcy documents are not generally available to the public, though interested parties, including creditors, can obtain copies by special request. Even if they are not able to vote on the restructuring plan, creditors and depositors skeptical of Mt. Gox management can be reassured that Mark Karpeles is unlikely to retain a meaningful role. Under civil rehabilitation, says Nagai, “It’s usual that management who have responsibility for [the] bankruptcy will quit or lose their ability to manage the company.” That responsibility devolves to their legal team, any sponsoring lenders, and members of management not directly responsible for the bankruptcy. The process of planning and approving a restructuring generally takes about six months in Japan, though again, the complexity of the Mt. Gox case may slow that. Another unusually high hurdle is the likely necessity and difficulty of Mt. Gox locating a sponsor organization willing to fund its restructuring — a role commonly taken by a bank. Given the very murky circumstances and lack of information surrounding its fall, Mt. Gox may have serious difficulty locating an institution willing to back its attempt to return to solvency. Civil suits for depositors But little of this is directly relevant for depositors who have may have lost dollars, euro, yen, or bitcoin held in trust by Mt. Gox, who will have to seek restitution through civil litigation. Numbers released by Mt. Gox seem to indicate that they are counting as assets all bitcoin and cash holdings that have remained intact. But Joe Gluxman, a bankruptcy specialist with the firm Scarinci & Hollenbeck, points out that this contradicts basic principles of international finance. “If I buy a share of stock and put it in a safe deposit box at a bank owned by UBS, it doesn’t belong to UBS.” In other words, cash or bitcoin linked to Mt. Gox customer accounts are not in any sense legal assets of Mt. Gox, and are not subject to recovery by debtors or depositors through bankruptcy. The Selachii class action suit is aimed both at recovery of Mt. Gox customer property, and discovery of where the assets went. (Applications for inclusion close at 4 p.m. GMT on Friday, March 7.) “The general consensus was that the way Mt. Gox went down was suspicious. Whilst they’re filing for bankruptcy, lots of people are asking a lot of questions and can’t get answers,” says the firm’s Richard Howlett. MORE: Cryptocalypse now: Bitcoin’s issue with ‘transaction malleability’ Mt. Gox has claimed that its loss was due to a hack or theft of an as-yet-unspecified nature, but the suit will put legal force behind widespread speculation about negligence and fraud. “All of the computers at Mt. Gox will need to be forensically examined,” says Howlett — including Mark Karpeles’s personal computer. The other major question looming over any civil suit is that of where the money for a settlement would come from, given Gox’s claims to have lost all but a fraction of deposits. But, says Howlett, “[if] there has been any element of negligence or wrongful trading … that’s when you can start looking at the directors” as a source of settlement funds. Howlett says reports of Mark Karpeles’s personal wealth have varied greatly, from near destitution to a personal fortune of up to $250 million, which could go a long way to making depositors whole. Another source of compensation could include Mt. Gox’s parent company, Tibanne, which holds assets such as the bitcoins.com domain name that could be liquidated. Finally, private deposit insurance is a legal requirement of doing business in many jurisdictions – but given the lack of any reassuring statements so far from Mt. Gox, Howlett thinks it’s a longshot. “I’m assuming they haven’t got insurance,” he says. “And that’s another reason to claim negligence.” Richard Howlett is at pains to emphasize that he wishes all this wasn’t necessary. “We want to reach out to Mt. Gox and Mark Karpeles and see if we can proceed with this matter without having to pursue a class action. But they’re impossible to reach.” Karpeles may come to deeply regret his habits of secrecy and obfuscation. Howlett points out that a finding of fraud or gross negligence in a civil case would almost certainly trigger a criminal investigation, most likely in Japan, that could end with the former CEO behind bars.