Bankruptcy And Crypto

Over the past few years, many investors have used cutting edge financial products, like crypto exchanges, to make significant profits. Now, that the markets are turning, many are wondering how protected they will be in the event of collapse of a crypto exchange. We’re about to find out the hard way as those cutting edge financial platforms are being put on trial in bankruptcy courts for the first time. Although many of these products have been around for much of the past decade, in a booming market bankruptcy filings are few and far between.

Crypto has been around for more than a decade, but there is little to look at for guidance because things have generally gone well for crypto companies. Aside from crypto lending platform Cred, which filed for bankruptcy in 2020, the only other noteworthy precedent for a crypto bankruptcy case is Tokyo-based Mt. Gox – the largest exchange for Bitcoin
BTC
in 2010 that collapsed in 2014; that was a Chapter 15 case (where representatives of a corporate bankruptcy proceeding outside the U.S. obtain access to U.S. courts).

After the past few months of a crushing “crypto winter,” the avalanche of filings is on its way. First was Canadian crypto broker and lender Voyager Digital, which was recently forced to hastily file for Chapter 11 bankruptcy in New York, after having suspended account holders from withdrawing assets from their accounts. Voyager had lent $650 million worth of crypto to a hedge fund, Three Arrows, which also went under. Voyager hired the prominent law firm Kirkland & Ellis to represent it in its bankruptcy proceedings, which it filed under duress. In the papers Voyager submitted to the bankruptcy court Voyager argued that it already had a tentative plan of restructuring. According to its plan, account holders would be repaid in the form of crypto “coins” and “tokens”, in addition to proceeds from the litigation with Three Arrows, and some equity in a future reorganized Voyager.

Then, several days later, crypto lending platform Celsius, which refers to itself as “a crypto bank” – it charges interest when lending out crypto, and enables crypto deposits to earn their own interest – confirmed that it has initiated Chapter 11 bankruptcy proceedings as well. And if the Terra/Luna
LUNA
stablecoin crash a couple of months ago was not enough to signal that things are about to get ugly (like the Bear Stearns’ impending collapse in 2008 that regulators prevented by arranging for a distressed sale to J.P. Morgan Chase) the Celsius collapse has already been labelled by some as a “Lehman Brothers moment” for the crypto industry.

With more crypto firms becoming insolvent and filing for bankruptcy, it is now clear that many customers will face massive losses, as their rights to their funds and assets are not clear. This ownership issue was demonstrated in the Cred’s bankruptcy case, where customers did not retain ownership of their cryptocurrency following transfer to Cred. Instead, in that case, the CreditEarn transactions were treated similarly to any other loan in a fiat currency. The ownership issue is also a problem in Celsius’ case. For example, Celsius’ terms of use do not offer any guarantees that user deposits are actually protected in any way in the event of insolvency. The fine print of Celsius’ terms of use makes clear that depositors using its “Earn” accounts that pay interest rates of up to 18%, grant the “crypto bank” ownership of their funds as a condition of use. The consequences are that in the event of a bankruptcy, such account assets “may not be recoverable.” Similarly, although customers that opened Celsius’ “Custody” accounts that do not pay interest keep ownership of their funds, Celsius does not explicitly guarantee that these customers will get their money back in the event of a bankruptcy. Per the terms of use, a bankruptcy proceeding could result in the “total loss of any and all Digital Assets.”

But even if customers’ rights to get their money and assets back do exist, it is not clear that such customers will end up getting anything for two main reasons. First, while according to its bankruptcy petition Celsius says is interested in restructuring rather than liquidating (meaning that if there are funds available for distribution to unsecured creditors, customers can get something back), there is no promise that it will be successful. Second, once in bankruptcy, it is up to the bankruptcy process to determine: (i) the priority of creditors; and (ii) the valuation of assets – two novel tasks in the crypto world.

Priority of Creditors

In terms of priority of creditors, when an entity files for bankruptcy, and a trustee is appointed to determine all the assets of the debtor available to creditors, among the trustee’s tasks is to examine transfers made by the debtor to third parties within a certain period prior to the bankruptcy filing. If transfers are found to be improper or illegal the trustee can avoid them in order to recover the value of such transactions. For instance, “fraudulent transfer” actions seek to avoid or “unwind” certain pre-bankruptcy transactions that were made for little or no money. In a recent example of this, bankrupt cryptocurrency exchange Cred Inc., sought to claw back millions of dollars’ worth of bitcoin it argued the entity fraudulently transferred to an investor in return for a worthless bond.

There are other situations in which a trustee would seek to avoid transactions. In the Bankruptcy Code “avoidable preferences” are meant to prevent situations where the debtor’s assets are unfairly distributed to creditors. For example, when an aggressive creditor seeks to take a lion’s share of the available funds or assets in repayment of her claim right before the debtor files for bankruptcy, it does so to the detriment of all the other creditors. But the recovery of transfers that qualify as avoidable preferences is not automatic, and the burden of proof is on the trustee, who is required to show that all the elements required by the Bankruptcy Code have been met.

In Celsius’ case, the entity paid its debts to DeFi’s biggest lenders, reclaiming over $1 Billion in collateral. These payments will surely be carefully examined soon, as according to the Bankruptcy Code, the bankruptcy trustee may seek to avoid payments or transfers of interest made by the debtor to a creditor before filing for bankruptcy to recoup funds for the benefit of the bankruptcy estate and repayment of the estate’s creditors, including the unsecured creditors, such as Celsius’ customers. But in Celsius’s case there are several legal challenges. First, it needs to meet the burden of proof requirements, which might not happen based on reports regarding the overcollateralization of the loans that were repaid. Second, it might prove difficult to order transfers to be reversed when dealing with DeFi protocol. Indeed, DeFi protocols – unique programs that use computer code called smart contracts that run on the blockchain network– are decentralized, autonomous protocols, and are therefore harder to challenging to legally go after. A somewhat good illustration of this challenge of needing to deal with a DeFi protocol was recently demonstrated in a traders’ class action against Uniswap, a cryptocurrency exchange which uses a decentralized network protocol. The class action lawsuit was, therefore, brought against developers and venture capital backers of the decentralized digital assets exchange, and alleged that since the protocol allows users to freely list and also trade tokens, its creators should be the ones that are responsible for “rampant fraud on the exchange.”

Lastly, a different potential issue in Celsius’ case with regards to “avoidable preferences” could be what would happen to regular customers that pulled money out during the preference period – if the case converts to a chapter 7 bankruptcy case, a trustee go hypothetically go after those.

Valuation of Assets

As for valuation of assets, even outside the crypto space, disputes over valuations are challenging and could result in full blown legal battles where parties litigate the correct valuation using expert witnesses, evidence, and comparisons to comparable assets. But with digital assets being so volatile, and typically not tied to any external fixed prices or scales, the task of determining value is going to be much harder.

Additionally, in bankruptcy proceedings, valuations are usually determined as of the bankruptcy petition date. In cases such as Celsius’ and Voyager’s, this practice will complicate things. For example: if creditors state their proof of claims in U.S. dollars, and had 10 bitcoins (BTC) valued at $100,000 on the bankruptcy petition date, they should get assets based on the $100,000 amount. But if, by the end of the case, those same coins are worth $200,000, the creditors would want to be repaid in bitcoin, not cash. The issue of who should get the benefit of the increased value during the cases need to be resolved as well.

Yet these are not the only legal hurdles that customers of bankrupt crypto firms should expect.

Traditional brokerage firms are subject to SEC rules and laws, and if they collapse, they can use the Bankruptcy Code stockbroker liquidation proceeding, or the proceeding under the Securities Investor Protection Act of 1970 (SIPA). Therefore, although history does not include many instances in which brokerage firms collapsed, there are basic protections for investors if and when that does happen, including the: (i) “Net Capital Rule” of the SEC that makes it mandatory for brokerages to keep a minimum amount of prescribed capital in liquid form; (ii) “Customer Protection Rule” that requires brokerage firms to keep client assets in separate accounts from the brokerage’s assets in order to prevent confusion; (iii) protection of the Securities Investor Protection Corporation (SIPC)— a nonprofit, membership group that also functions as insurance for customers of brokerage firms that are registered under the Securities Exchange Act of 1934—specifically up to $500,000 of securities and $250,000 of cash held at a brokerage firm; and (iv) SIPC’s attempts to arrange the transfer of a failed brokerage’s accounts and assets to a different brokerage firm with little interruption, and if all attempts fail, the failed firm is typically liquidated.

But crypto firms are typically not registered with the SEC as a securities broker-dealer, and their deposits are not protected by SIPC insurance either. Coinbase and Kraken are good examples, which is why such firms are also not subject to other SEC and FINRA rules such as the “best execution” regulations and the SEC’s “national best bid and offer,” that are laws that ensure that investors receive the best buy or sell price for a security, no matter which broker was tasked with filling the order. This means that cryptocurrency prices can—and frequently do—vary across exchanges.

What will happen to the customers of bankrupt crypto firms? It is unclear, but my advice is to heed the European financial regulators’ warning from a few months ago: invest in crypto only what you are willing to completely lose.

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