AI, Crypto, and Fraud: Bankruptcy Court Limits Jurisdiction Over Nondebtor Claims

Bankruptcy practice is counter-cyclical. When the economy is strong, bankruptcy filings decline. During recessions, the bankruptcy bar is swamped. But gross mismanagement and fraud span all economic cycles. It was predictable that with the new technologies of artificial intelligence (AI) and cryptocurrency would come old fashioned fraud and the question of whether a bankruptcy court has jurisdiction to adjudicate claims arising out of an alleged fraudulent scheme involving nondebtors. The intersection of artificial intelligence and cryptocurrency was involved in a recent decision in In re Augustus Intelligence (Case No. 21-10744 (TMH) (Adv. No. 23-50370 (TMH), where the U.S. Bankruptcy Court for the District of Delaware dismissed claims against an alleged participant in a scheme that induced investors to fund over $30 million in an artificial intelligence company designed to generate revenue from enhanced cryptocurrency mining. The court concluded it lacked subject matter jurisdiction to adjudicate the investors’ claims that had been assigned to a post-confirmation litigation trust created under a Chapter 11 plan, and also dismissed an estate claim for breach of contract pursuant to the long-standing rules that contracts in furtherance of fraud are unenforceable and that parties to criminal acts may not assert equitable claims against the other party, also known as in pari delicto.

The Alleged Fraudulent Scheme to Procure Investments 

The opinion recites facts as alleged in the complaint which, for the purpose of a motion to dismiss, were accepted as true. According to the opinion, the debtor was conceived to develop artificial intelligence solutions in 2018. Its founder, Wolfgang Haupt, developed a relationship with Kevin Washington, the son of a billionaire. Washington had an indirect investment in a cryptocurrency mining company with assets that included two bitcoin mining data centers. Haupt and Washington discussed securing the cryptocurrency company’s below-market power purchasing agreements and utilizing the debtor’s AI capabilities for bitcoin mining. Haupt and Washington set out to raise over $80 million in new investments to implement the plan.
In order to attract investors, Washington was presented by Haupt as the lead investor in the debtor. Haupt believed that because Washington was the son of a billionaire, his investment would carry weight and favorably influence potential investors. Washington, however, was reluctant to invest in the debtor before other investors had committed. To resolve the issue, Haupt and Washington executed a series seed preferred stock investment agreement that provided for $50 million in investments from Washington. They also entered into a “side deal” whereby Washington’s investment was conditioned on a financing contingency. The seed agreement itself did not contain the contingency.
Haupt and Washington traveled across Europe and met with potential investors. Washington was introduced as the lead investor who had committed to investing over $50 million. When requested, Haupt, with Washington’s knowledge and consent, provided the seed agreement to potential investors as proof of Washington’s committed investment, but neither Washington nor Haupt disclosed the existence of the “side deal.” Ultimately, Haupt and Washington raised over $30 million for the debtor from investors, plus $60 million in promised subscriptions. The debtor hired employees and software engineers. However, Washington did not pay the $50 million to the debtor and the seed agreement never closed. The employees were terminated, and the debtor filed a Chapter 11 bankruptcy case in 2021.
In May 2022, the debtor filed its Chapter 11 plan. The plan provided for the transfer of all the debtor’s assets, including causes of action, to a litigation trust. The debtor’s causes of action were to be pursued by the liquidation trustee for the benefit of all the debtor’s creditors. The plan also provided that the debtor’s noninsider equity holders could elect to assign their litigation claims to the trustee to be pursued as well. The plan was confirmed by the Bankruptcy Court in July 2022.
In April 2023, the trustee initiated an adversary proceeding against Washington and others in two separate capacities. First, the trustee asserted bankruptcy estate claims in his capacity as post-confirmation trustee of the litigation trust. Second, he asserted the investor claims in his capacity as the assignee. Washington moved to dismiss all claims asserted against him in the complaint, including both the bankruptcy estate claim for breach of the seed agreement and the investor claims against Washington for common law fraud, aiding and abetting fraud, civil conspiracy, securities fraud, and control person liability.

All Claims At Issue Were Dismissed

The court began its analysis with the assigned investor claims. Washington asserted the court lacked subject matter jurisdiction because the investor claims were held by nondebtors against a nondebtor, and had no relation to the debtor’s bankruptcy case. The opinion states bankruptcy courts have subject matter jurisdiction over four types of matters, pending referral from the district court: cases under Title 11 of the U.S. Code, proceedings arising under Title 11, proceedings arising in a case under Title 11, and proceedings related to a case under Title 11. The parties acknowledged the court could not have jurisdiction over the investor claims under any of the first three types of proceedings. Therefore, the only issue was whether the claims were “related to” the debtor’s bankruptcy case.
The court explained that post-confirmation, a bankruptcy court’s jurisdiction over “related to” claims narrows and exists only if there is a close nexus of the claims to the bankruptcy case or the confirmed plan of reorganization. In order to have a close nexus post-confirmation to the bankruptcy case, the claims must affect the interpretation, implementation, consummation, execution, or administration of the confirmed plan.
The trustee first argued that the plan and order confirming the plan expressly provided for the court’s continuing jurisdiction. The court rejected that argument, noting the U.S. Court of Appeals for the Third Circuit had held that “neither the bankruptcy court nor the parties can write their own jurisdictional ticket … if there is no jurisdiction under 28 U.S.C. Section 1334 or 28 U.S.C. Section 157, retention of jurisdiction provisions in a plan of reorganization or trust agreement are fundamentally irrelevant.” See, Resorts International Financing v. Price Waterhouse & Co. (In re Resorts International), 372 F.3d 154, 161 (3d Cir. 2004). The court also distinguished a prior case where a bankruptcy court did retain jurisdiction but in that case the claims would be liquidated for the benefit of the estate’s creditors. In this case, the debtor’s creditors would not benefit from liquidation of the investors’ claims. While the trustee argued that the estate claims and investor claims could result in a combined settlement, the court reasoned that such a combined settlement was just a possibility and in any event logically would result in allocation of the settlement between estate claims and investor claims, so the investors would still likely be the only ones to receive proceeds of the assigned claims. The court dismissed the assigned investor claims for lack of subject matter jurisdiction.
Turning to the estate claim for breach of contract, Washington argued that the seed agreement was unenforceable under the doctrine of in pari delicto, which is Latin for “in equal fault.” The opinion explained the general rule is “courts will not extend aid to either of the parties to a criminal act or listen to their complaints against each other but will leave them where their own act has placed them.” A separate but related rule provides that “agreements made for the purpose of perpetrating a fraud are unenforceable.”
Washington argued that because the debtor, through Haupt, “was alleged to be at least equally responsible for the fraudulent scheme to use the seed agreement to attract investors, the trustee (who stands in the shoes of the Debtor) is now barred from enforcing it.” The court agreed, noting the facts alleged in the complaint showed the Seed Agreement was the cornerstone of the fraudulent plan. The court held the seed agreement was unenforceable because Washington and the debtor had entered into it for the purpose of perpetrating a fraud, and was “a tool created to lend legitimacy to and offer assurances about an otherwise risky investment proposal.” The court held the debtor, and therefore the Trustee, was barred from enforcing it, and dismissed the estate’s breach of contract claim.

Conclusion: New Technologies, Old Story 

Billions today are being invested in artificial intelligence technologies and AI support businesses. The world of cryptocurrency has had a roller coaster ride as an evolving sector. There will be winners and losers, and there will be schemes along the way that fail and land in bankruptcy that invite claims between and among the debtor, creditors, investors and other stakeholders. That being said, many of these claims may have to be litigated outside of bankruptcy court, if at all. Bankruptcy courts will be limited in what they can adjudicate, and this case is a reminder that nondebtor claims that only impact nondebtors and do not benefit creditors will need to be adjudicated outside the bankruptcy process. And courts will not enforce illegal agreements for the benefit of one of the contract parties. New technologies may dominate the headlines, but practitioners are well-advised to remember the old rules.