In June of 2023, Prime Trust, a regulated trust company that was widely regarded as a reliable custodian for digital assets, abruptly shut down. Over the following years, thousands of people and companies whose assets were held by Prime Trust were prevented from accessing their property. As the saga unfolded, it became apparent that Prime Trust had perpetrated a massive fraud for almost a year. Regulators at the Nevada Financial Institutions Division, whose mandate had been to prevent such scams, did not step in until it was too late.
Although the size of the fraud was large, with over 80 million dollars’ worth of assets having been lost, Prime Trust still possessed many millions of dollars of property belonging to its account holders. Investigations revealed that only some assets had been affected by the fraud, with others left largely untouched. Nonetheless, because all of these assets had become subject to bankruptcy proceedings, account holders were prevented from accessing their property until the case could be resolved.
Bankruptcy cases are primarily concerned with resolving one key question: How should assets be distributed to creditors? Because Prime Trust was a trust company, a more fundamental question had to be answered first: Of the property in Prime Trust’s possession when it shut down, what belonged to the company, and what belonged to the account holders? After years of waiting, a decision was made this month by Judge J. Kate Stickles of the District of Delaware’s U.S. Bankruptcy Court: All of the property in Prime Trust’s possession belonged to the estate.
When a Custodian Is Not a Custodian: Our Prime Trust Example
As a builder of Coinbits, I’ve had the dubious privilege of watching this play out up close. (Coinbits is a website that helps everyday people buy bitcoin. For a while, Coinbits members relied on Prime Trust to custody the bitcoin that they would purchase until they withdrew it to their own self custody.) Prime Trust’s own public statements, end-user agreements and status as a regulated state-chartered trust company clearly indicated that the property that Prime Trust held on behalf of account holders belonged to those account holders at all times. Yet, in the Court’s decision, we see a different view.
Attorneys representing the estate claimed that “comingling” of digital assets was so extensive, and contractual language so flexible, that they must treat bitcoin and other assets in the accounts of Prime Trust customers as property of the estate. Under that theory, such property can be used to pay legal fees to the attorneys themselves before account holders ever see a single satoshi of their property.
The motion supporting that position rests on the assertion that digital assets were inextricably mixed together, and that there would be no feasible way to trace which property belongs to which customers; therefore, there is no alternative but to put all of it in one “pot.” From there, much of it would find its way into the personal bank accounts of the attorneys, with Prime Trust account holders getting what is left.
Prime Trust Comingled Bitcoin with Other Digital Assets
As you may have already noticed, different types of digital assets held by the estate couldn’t technically be comingled, since it would be impossible to mix assets across different blockchains. However, the Court asserted that these assets have a legal status of having been commingled.
This unnecessarily complicates what should be a straightforward process of counting how much bitcoin Prime Trust had and distributing it to bitcoin owners. To appreciate how bitcoin has a physical existence independent of any legal construct, it helps to understand how the network works. Bitcoin is recorded on a public ledger using an unspent transaction output (UTXO) model, which is more transparent than a typical financial ledger. Unlike dollars in bank accounts, bitcoin UTXOs are partitioned and follow a strict chain of custody.
This chain of custody is enforced by the expenditure of more energy per day than that of many small countries. The well-known and oft-maligned energy consumption of the bitcoin network is what makes this possible. Whether or not one believes the bitcoin network is a worthwhile use of energy, it is inarguable that it allows you to be very sure about the chain of custody of bitcoins on the blockchain. If officers at Prime Trust falsified internal records, that would not have been a function of Bitcoin’s ledger, but rather an accounting layer placed on top of it. Strip it away, and the physical reality of the Bitcoin ledger could be seen clearly.
Many of the above points were introduced at the evidentiary hearing in the case. However, since that time, the Court has decided differently. In her decision, Judge Stickles agreed with the Plan Administrator that bitcoin has been “hopelessly comingled” with other assets. She noted that my testimony about how UTXOs work was not relevant because I had not seen the blockchain analysis performed by the Plan Administrator’s team. (Unmentioned was that I had requested to see the blockchain analysis reports. They were never shared; neither was a justification for why they weren’t.)
As I watched the Prime Trust case unfold, I became curious about bankruptcy. Is this how it is supposed to work? Or is bankruptcy just another example of a broken institution that needs to be reformed? I’m a technologist, not an attorney, so my ignorance allowed me to study the bankruptcy system with beginner’s eyes.
Years ago, Lynn LoPucki wrote a book entitled Courting Failure. It documented how competition among bankruptcy venues, particularly in Delaware and New York, creates incentives that favor powerful insiders, including top law firms and management teams. LoPucki noted that mega-cases often yield staggering professional fees, yet courts tend to approve these requests with minimal pushback because they seek to position themselves as an attractive venue for future cases. Large debtors pick the forum that offers the most flexible rulings, which indirectly encourages courts to approve bankruptcy outcomes that maximize the fees that attorneys are able to extract from the bankrupt estate.
In other words, a district that allows attorneys to collect windfall fees is also a district that will attract future bankruptcy filings by attorneys who are looking for the most lucrative venue they can find.
Although judges themselves do not necessarily directly benefit from having large bankruptcy cases filed in their jurisdictions, local politicians and business interests have a strong incentive to keep the bankruptcy filings flowing. These power players have a variety of tools at their disposal to ensure that this interest is known. The judiciary may or may not feel overt pressure, and there is no evidence of which I am aware that it did in the Prime Trust case. However, if you are trying to understand why so many cases end up with attorneys making millions of dollars while account holders get little of their property back, it would be foolish to ignore LoPucki’s expert analysis about how incentives affect outcomes.
It turns out that several bankruptcies involving digital asset custodians — most notably Celsius and FTX — have followed a similar path. A subset of users of those services reasonably believed they were interacting with a fiduciary, only to discover that the estate may treat them as general unsecured creditors. And both cases yielded windfall fees for the attorneys working on the case.
The Prime Trust fraud harmed thousands of people, but it offers a lesson for everyone who participates in an economy increasingly intertwined with digital assets. When trouble comes, phrases like “qualified custodian,” “regulated,” “trust,” “fiduciary,” and “bankruptcy remote” could be worth little more than the paper they are printed on.
Some might dismiss this as a result of digital assets being too new — a Wild West. However, this is an outdated view. Bitcoin has been around for 15 years. If we use the launch of Netscape Navigator in 1994 to mark the beginning of the internet era, this would be like saying the internet was still a Wild West in 2009. The digital asset industry has matured, and we should be able to expect that the judicial system possesses the background knowledge required to engage with it — especially now that digital assets are set to play a prominent role in the American economy.
If the bankruptcy system continues to operate in an unpredictable and inefficient manner, it will curtail economic growth. History offers a parallel. In the early modern era, entrepreneurs faced immense personal risk when launching new ventures; a business failure could mean ruin. The introduction of a new corporate structure called a limited liability company allowed entrepreneurs to safely take more risks. By insulating individuals from financial devastation, LLCs lowered the stakes of failure and kickstarted the modern capitalist economy as we know it.
In our new era of intense global competition in the sectors of AI, energy, robotics and digital assets, we must ensure that the bankruptcy system likewise supports innovation, risk-taking, and growth. The outcome of the Prime Trust case demonstrates that bankruptcy reform is sorely needed.
