By Sophie Knight and Nathan Layne

TOKYO (Reuters) - Two years before Mt. Gox filed for bankruptcy, a half dozen employees at the Tokyo-based bitcoin exchange challenged CEO Mark Karpeles over whether client money was being used to cover costs, according to three people who participated in the discussion.

The question of how Mt. Gox handled other people's money - the issue raised by staff in the showdown with Karpeles in early 2012 - remains crucial to unraveling a multi-million dollar mystery under examination by authorities in Japan.

A bankruptcy administrator and police are seeking to determine how a Tokyo start-up that shot from obscurity to dominate global trade in bitcoin managed to lose more than $27 million in old-fashioned cash held in a bank as well as bitcoins worth close to $450 million at today's prices.

The still-unresolved issue has thrown a spotlight on how Mt. Gox functioned as a hybrid between an online brokerage and an exchange. Essentially, the more than 1 million traders who used Mt. Gox at its peak had entrusted a 3-year-old firm to hold their money safely until they decided to cash out.

A court-appointed bankruptcy administrator on Friday said an initial examination of Mt. Gox - key to determining whether Mt. Gox's users will be able to recover some of what they had on deposit with the exchange - would not be complete until May, citing the involvement of authorities in the case.

GROWING STRAINS

In interviews with Reuters, current and former employees at Mt. Gox described the strains that emerged over the handling of customer money just as the firm was gearing up for expansion and bitcoin was edging out of the shadows as an investment and a means of online settlement.

By early 2012, a small group of Mt. Gox employees, all of whom worked on one-year contracts, began to worry that customer funds had been diverted to cover operating costs that they estimated to be rising. Those costs included rent in a Tokyo high-rise that also housed offices for Hulu and Google, high-tech gadgets such as a robot and a 3-D printer and a souped-up, racing version of the Honda Civic imported from Britain for Karpeles, people who have reviewed expenses said.

Unlike Karpeles, the employees say they did not have access to the financial records of Mt. Gox. They asked for a formal meeting with the then-26-year-old Karpeles in early 2012, those involved said, and asked him to respond to their estimate that Mt. Gox was spending more than it was taking in. They were also concerned that company expenses were being paid from the same bank account used for customer deposits.

Karpeles told the group that customer money was not being used to fund the business, but declined to provide details on how the business had covered any loss. The meeting broke off after about an hour, those who participated said.

Several of the staff say they left the inconclusive meeting frustrated that Karpeles would not share proof that client deposits had been protected. For his part, Karpeles believed he had thwarted a challenge to his leadership by staff who had no right to see the books of a firm he owned and was funding, a person familiar with his thinking said.

Mt. Gox referred questions to its lawyers who had no immediate comment.

The former Mt. Gox employees who spoke to Reuters asked not to be named because of potential legal complications. Tokyo police have taken evidence from Mt. Gox in recent days as part of an early-stage inquiry into what the company has described as possible theft.

It is unclear how Japanese law would treat any such diversion of customer funds as Mt. Gox was not regulated as a financial institution. As a private firm in which Karpeles held an 88 percent stake with no declared debt, Mt. Gox was under no obligation to share any details on its finances.

ACCOUNTING

Mt. Gox said in its February 28 bankruptcy filing that hackers may have exploited what it called "a bug in the bitcoin system" to steal virtual currency from the exchange. It has not offered an explanation for the missing $27 million in cash.

By 2012, from its offices in Tokyo's Shibuya neighborhood, Mt. Gox was handling at least $14 million in bitcoin trades per month, according to its estimates - equivalent to almost 90 percent of global trade in the digital currency at the time.

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