High-profile scandals have plagued the cryptocurrency industry. Recently, these cases have drawn attention to financial institutions’ ethical and legal responsibilities in the digital finance sector. In March 2024, the U.S. District Court for the Southern District of California heard a case in the cryptocurrency industry, Bhatia v. Silvergate Bank. The court addressed the extension of third-party liability for banks in the crypto sector, and set a distinct precedent for how courts might handle the liability of financial institutions and, more importantly, a new standard for fiduciary duties.
FTX, once a leading cryptocurrency exchange, and Alameda Research, its affiliated trading firm, were both founded by Sam Bankman-Fried. Their 2022 collapse, driven by alleged fraud and mismanagement, resulted in billions of dollars in losses and became one of the most significant scandals in cryptocurrency history. Following their bankruptcy, plaintiffs sued Silvergate Bank (the “Bank”), despite not being direct customers of the Bank, contending that Bank administrators allowed the improper transfer of funds to accounts controlled by Alameda without their consent as customers of FTX. The plaintiffs argued that despite multiple red flags, the Bank turned a blind eye to these irregularities, enabling the loss of billions in customer deposits. Specifically, the plaintiffs pointed to unusually large and frequent transactions between FTX and Alameda, the rapid movement of customer funds without adequate explanation, and the commingling of customer deposits with Alameda’s operational funds. These irregularities suggested potential misuse of funds, which, if addressed, might have prevented the misappropriation and subsequent financial collapse of FTX. The plaintiffs’ argument was that by ignoring these warning signs, the Bank enabled the loss of billions in customer deposits.
Traditionally, under California law, banks do not have a duty of care to non-customers. For instance, in Casey v. U.S. Bank National Association, the court held that banks generally don’t have a legal obligation to investigate or intervene in the transactions of their account holders when those transactions involve third parties who are not direct customers of the bank. In that case, the court reasoned that imposing such obligations could burden banks with extensive oversight responsibilities, potentially hindering their operational efficiency.
However, in this case, the court applied factors from Biakanja v. Irving to assess whether a duty of care should exist without a direct contractual relationship. These factors assessed the foreseeability of harm, the intent of the transaction, and the connection between the bank’s actions and the plaintiffs’ injury. The Bhatia court concluded that the nature of the Bank’s involvement with FTX and Alameda created circumstances where the foreseeability and direct connection of harm justified a broader scope of responsibility. This shift significantly broadens the scope of responsibility for financial institutions and implies that banks cannot process transactions without considering the consequences for non-customers. Therefore, this decision could establish a new standard of due diligence for cryptocurrency clients, ensuring that banks take proactive measures to monitor and mitigate risks associated with high-volume and high-velocity crypto transactions.
This case questions the corporate governance practices of financial institutions involved in cryptocurrency and exemplifies the evolving nature of fiduciary duties. The court found that FTX’s Terms of Service suggested a fiduciary relationship between FTX and its customers because FTX promised to segregate customer assets and protect them from misuse. It found that the Bank had facilitated the transactions that diverted these funds, thus contributing to FTX’s breach of fiduciary duty. This increased liability incentivizes banks to require stricter covenants and terms and conditions with their crypto clients to ensure proper safeguards. This decision could have significant implications for corporate governance in the crypto industry, which operates with less regulatory oversight than financial institutions. But, if fiduciary duties can be established by contracts or public representations, as asserted in the case, crypto platforms could face heightened liability, prompting them to adopt more rigorous compliance and governance standards.
Moreover, Bhatia v. Silvergate Bank comes at a time when the collapse of high-profile scandals put the cryptocurrency industry under increased scrutiny. If banks can be held accountable for their role in facilitating financial transactions within the cryptocurrency sector, many may distance themselves from the cryptocurrency sector. This distancing could reduce banking services available to crypto companies, making them difficult to operate.
A fringe implication of Bhatia is the potential new crypto industry regulations. After this case, companies with minimal oversight from regulators and financial partners could face greater scrutiny. Financial institutions could be required to enhance their monitoring systems and to report suspicious transactions more frequently. These regulations would raise business costs, potentially slowing the growth of crypto-focused banks and platforms because of increased operational expenses and regulatory burdens. Additionally, these regulations would provide greater protection for investors and customers.
The Bhatia case presents a critical lens into the responsibilities of financial institutions in the digital evolution. As technology evolves and the cryptocurrency industry continues to grow, regulators will have to re-examine how fiduciary duties should apply to banks facilitating crypto transactions. As the court broadens the scope of third-party liability and explores the application of fiduciary duties to financial institutions, it sets a precedent that could reshape the relationship between banks and crypto platforms. While economic efficiency remains an important key of the industry, Bhatia shows the need for fairness, stronger corporate governance, and enhanced safeguards in digital finance. Looking ahead, the crypto industry may face increased regulatory scrutiny and corporate reforms aimed at upholding fiduciary duties and preventing future collapses like FTX.