On February 28, 2014, Mt. Gox, the oldest Bitcoin exchange, filed for bankruptcy reorganization under Japanese law, toppling from its place in the Bitcoin community to insolvency. This filing confirmed rumors of financial troubles spawned by Mt. Gox’s sudden suspension of trading on February 25 and focused increased legal scrutiny on Mt. Gox’s business practices.

Mt. Gox’s downward legal spiral began in May 2013, when the Department of Homeland Security seized $5.5 million in funds held in its U.S. subsidiary’s processing accounts for failure to register as a U.S. Federal Money Services Business. Until then, despite having experienced other losses due to security breaches and other technical failures, Mt. Gox had enjoyed a rapid rise in popularity to become the largest Bitcoin exchange in the world, at one point handling as many as 80% of Bitcoin trades worldwide. The negative press and loss of consumer confidence from the government seizure of Mt. Gox’s funds, combined with the rise of several strong market competitors cut down Mt. Gox’s market share significantly. However, despite its challenges, Mt. Gox continued to conduct approximately 34% of all Bitcoin exchange transactions in early February 2014.

On February 7, 2014, Mt. Gox suddenly suspended all Bitcoin withdrawals from user accounts. Three days later, it issued a statement blaming a design flaw in the Bitcoin protocol for the suspension and assured users that withdrawals would be resumed once the issue had been resolved. Many members of the Bitcoin community rejected Mt. Gox’s excuse, noting that the transaction malleability problem cited by Mt. Gox was not a flaw in the Bitcoin protocol, but rather a vulnerability in Mr. Gox’s own implementation of the protocol. Despite a statement on February 17 by Mt. Gox that it had found a workaround for its transaction malleability problems and would resume Bitcoin withdrawals soon, the damage to customer confidence in Mt. Gox as an exchange had been done: the price of Bitcoin on Mt. Gox tumbled, dropping below $100 on February 20, less than a fifth of the price on other exchanges.

On February 24, Mark Karpeles, CEO of Mt. Gox, resigned from the Bitcoin Foundation Board of Directors, and Mt. Gox removed all posts from its Twitter feed. On February 25, Mt. Gox halted all trading, prompting other Bitcoin exchanges and wallet providers to issue a statement condemning Mt. Gox for violations of the public trust, and reaffirming their belief that Mt. Gox’s problems were self-inflicted, and not resultant from some flaw in the Bitcoin protocol. Hours later, a “crisis strategy draft” purporting to be from Mt. Gox was posted on the Internet, exposing purported catastrophic losses caused by the transaction malleability problem. In the draft, Mt. Gox acknowledged its complete insolvency and laid out a strategy to rebrand and relaunch, using a combination of outside investment and future profits to cover its deficit, which was estimated at approximately USD $23 million in fiat currency, and 740,000 in bitcoin. Later the same day, the Mt. Gox website went dark.

On February 26, Karpeles issued a statement indicating that he was still working to find a solution to Mt. Gox’s issues, and confirmed the accuracy of the leaked “crisis strategy draft” in an informal online chat session. On February 28, Mt. Gox filed for bankruptcy protection under Japanese law. The bankruptcy filing appears to paint an even more dire picture than earlier estimates, placing Mt. Gox’s fiat debt at USD $63.6 million and its bitcoin deficit at 850,000.

So far, the regulatory response in Japan has been muted, perhaps reflecting the stance of Japanese and other central banks and financial institution regulators in many countries that Bitcoin does not fall within their regulatory authority. The Chief Cabinet Secretary of Japan reportedly announced that relevant authorities — including Japan’s Financial Services Agency (“FSA”), Finance Ministry and the police — are collecting information on the Bitcoin trade in Japan, with an eye toward potential regulatory action. Police involvement may also indicate that a criminal investigation and charges relating to Mt. Gox’s collapse are underway. In subsequent reports, the Senior Vice Finance Minister of Japan stated that regulation of Bitcoin will require international collaboration to prevent criminals from exploiting loopholes or weak points in international or comparative laws.

In the U.S., Senator Joe Manchin (D-W.Va) sent a letter to federal financial regulators seeking a ban on Bitcoin, and expressing concern about the negative effect Bitcoin could have on America’s economy if it remains unregulated and continues to be used for illicit activity. Recipients of his letter included Treasury Secretary Jacob Lew, Federal Reserve Chairwoman Janet Yellen, Acting CFTC Chairman Mark Wetjen, OCC Comptroller and FFIEC Chairman Thomas Curry, Acting FDIC Chairman Martin Gruenberg, and SEC Chairwoman Mary Jo White. Chairwoman Yellen subsequently stated at a Senate Banking Committee hearing that the Federal Reserve does not have authority to supervise or regulate Bitcoin in any way, calling upon Congress to “ask questions to what the right legal structure would be” for Bitcoin. Senator Tom Carper (D-Del.), who chaired the November Senate Bitcoin hearings, issued a statement that U.S. policymakers can and should learn from the incident to help ensure that it will not happen in the United States. He also indicated that the Homeland Security and Governmental Affairs Committee will continue to work with U.S. government entities to provide clear rules for financial actors and to protect consumers.

The Securities Commissioners of Texas and Alabama have issued separate statements warning of the risks associated with Bitcoin and other virtual currencies. New York State Department of Financial Institutions Supervisor Benjamin Lawsky commented in an interview that these events underscore the importance of regulation of participants in the Bitcoin industry but also expressed his view that Bitcoin would survive and continue to grow.

On the law enforcement front, the Manhattan U.S. Attorney has reportedly issued subpoenas to Mt. Gox and other Bitcoin businesses related to this matter. The U.S. Attorney’s office has so far declined to comment on the matter.

Meanwhile, on February 28, the first class action lawsuit against Mt. Gox, its holding company and Karpeles was filed in Northern Illinois district court on behalf of all persons in the United States who paid any transaction fees to Mt. Gox, or who had bitcoins stored with Mt. Gox on February 7, 2014.

More information is likely to come to light soon regarding Mt. Gox’s business practices, how 850,000 bitcoins were lost, and legal remedies for affected customers. This information will provide insights for the industry self-regulation and governmental regulatory efforts currently underway.

Timeline: The Rise and Fall of Mt. Gox

July 2010 Founded in Japan as Magic: The Gathering Online eXchange, a trading card forum.

October 2010

Begins trading Bitcoin

2011

Sold and renamed Mt. Gox. Thefts exploiting transaction malleability problem allegedly begin.

April 2013

Becomes world’s largest Bitcoin exchange, handling up to 80% of transactions worldwide.

May 2013

Department of Homeland Security seizes $5.5M of Mt. Gox funds held in Dwolla accounts.

Feb 7, 2014

All Bitcoin withdrawals from Mt. Gox user accounts suspended.

Feb 24, 2014

Mark Karpeles resigns from Bitcoin Foundation board, Mt. Gox removes all posts from Twitter feed.

Feb 25, 2014

All trading suspended on Mt. Gox; “crisis strategy draft” alleges insolvency and imminent shutdown; Mt. Gox website goes entirely offline.

Feb 26, 2014

Informal statements from Karpeles confirm accuracy of “crisis strategy draft” and suggest that Mt. Gox will attempt to rebrand and relaunch itself.

Feb 28, 2104

Mt. Gox files for bankruptcy reorganization in Japanese court.