Celsius users with stuck crypto security are turning to the bankruptcy process

Alan Knitowski has an MBA, has worked in technology and finance for over 25 years and is the CEO of a Nasdaq-listed mobile software company. That didn’t stop him from being scammed by a crypto firm.

Knitowski borrowed $375,000 from crypto lender Celsius over several years and posted $1.5 million in bitcoin as collateral. He didn’t want to sell his bitcoin because he liked it as an investment and thought the price would go up.

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It was the Celsius model. Cryptocurrency investors can essentially store their holdings with the firm in exchange for a loan in dollars that they can use. Knitowski would get the bitcoin back when he paid back the loan.

But that’s not what happened, as Celsius, which managed $12 billion in assets earlier this year, went bankrupt in July after a fall in crypto prices caused an industry-wide liquidity crisis. Knitowski and thousands of other loan holders had more than $812 million in collateral locked up on the platform, and bankruptcy filings show Celsius failed to return collateral to borrowers even after they repaid their loans.

“Every aspect of what they did was wrong,” said Knitowski, who runs an Austin, Texas-based company Phunware, said in an interview. “If my CFO or I actually did something that looked like this, we would be immediately charged.”

Creditors are now working through the bankruptcy process to try to reclaim at least some of their funds. They were provided with a measure of optimism on Friday, after Celsius announced the sale of its asset custody platform called GK8 to Galaxy Digital.

David Adler, a McCarter & English bankruptcy attorney representing Celsius creditors, said the money from the transaction must go toward paying legal fees. Beyond that, there may be funds left for former customers.

“The big question is – who is entitled to the money they get from GK8?” Adler told CNBC. Adler said he represents a group of 75 borrowers that hold roughly $100 million in digital assets on Celsius’ platform.

Later this month, more relief may come as bidding will open up Celsius’ loan portfolio. If another company buys the loans, customers will likely have a chance to repay them and then have their collateral released.

Knitowski told CNBC that he had chosen to take out his loans at an interest rate of 25%. That means if he took out a $25,000 loan, he would put up four times that amount as collateral, or $100,000.

The more security a borrower is willing to provide, the lower the interest rate on the loan. If the borrower fails to repay the loan, the lender can seize the collateral and sell it to recoup costs. It is just like a mortgage, where the borrower uses the home as collateral. In the crypto world, a borrower can request a loan and put up bitcoin as collateral.

Earlier this year, when the price of bitcoin fell, Knitowski paid down one of his Celsius loans to avoid getting margin and having to raise collateral. But after doing so, the company did not return the bitcoin that served as collateral for that loan. Instead, the assets were deposited into an account called “Earn”. According to the company’s terms and conditions, assets in these accounts are the property of Celsius, not customers.

“Imagine you pay off your car, but someone keeps it,” Knitowski said. “You pay off your house, but someone keeps it. In this case, it would be like paying off the loan. And instead, you don’t get the security back even if it’s paid off.”

That wasn’t the only problem. The crypto platform also failed to provide borrowers with full federal Truth in Lending Act (TILA) disclosure, according to former employees and an email sent to customers on July 4. The law is a consumer protection measure that requires lenders to provide borrowers with critical information, such as the annual percentage rate (APR), the term of the loan and total costs to the borrower.

The email to borrowers said, “the disclosures required to be made to you under the federal Truth in Lending Act did not include one or more of the following,” and then went on to list more than a dozen possible missing disclosures.

A former Celsius employee, who asked to remain anonymous, told CNBC that the company was retroactively trying to come into compliance with TILA.

“You don’t get to say, ‘Oh, whoops, we forgot about 25 items in the Truth in Lending Act, and as a result, we’re just going to redo them and pray,'” Knitowski said.

Jefferson Nunn, an editor and contributor to Crypto.news, took out a loan from Celsius and put up more than $8,000 in bitcoin as collateral. He knows that these assets are now unavailable to him even if he repays the loan.

Nunn, who lives in Dallas, said he got the loan to invest in more bitcoin after seeing a promotion for the platform. He said he heard about Celsius after doing a podcast with co-founder Nuke Goldstein. On the show, Goldstein said, “your funds are safe,” Nunn said. Alex Mashinsky, Celsius’ former CEO, made similar comments shortly before he halted withdrawals.

“It’s basically a mess, and my money is still locked up there,” Nunn said.

That theme has come up repeatedly in crypto, most recently with the failure last month of FTX. Sam Bankman-Fried, the founder and CEO of the exchange, told his followers on Twitter that the company’s assets were fine. A day later, he sought a bailout amid a liquidity crisis.

While Celsius’ implosion doesn’t carry the scale of FTX, which was recently valued at $32 billion, the company’s management has faced its share of criticism. According to a lawsuit in October, top executives withdrew millions of dollars in assets before the company stopped withdrawing customer funds.

A former employee, who asked not to be named, said it was a lack of financial oversight that led to significant holes in the company’s balance sheet. One of the biggest problems was that Celsius had a synthetic short, which occurs when a company’s assets and liabilities don’t match.

The former employee told CNBC that when customers deposited crypto assets with Celsius, it was meant to ensure that those funds were available whenever a customer wanted to withdraw them. However, Celsius took customer deposits and loans to risky platforms, so it did not have the liquidity to return funds on demand.

As a result, when clients wanted to withdraw funds, Celsius would try to buy assets on the open market, often at a premium, the person said.

“It was a huge lapse in judgment and operational control that really put a dent in the balance sheet of the organization,” the former employee said.

He also said Celsius was accumulating cryptocurrency tokens that had no value as collateral. On its platform, Celsius said customers could “earn compound crypto rewards on BTC, ETH and 40+ other cryptocurrencies.” But according to the former employee, the teams responsible for distributing these coins had nowhere to go with many of the more obscure tokens.

Ex-employees said he left Celsius after discovering the company was not careful with customer funds and was making risky bets to continue generating the high returns it promised depositors.

“Many individuals took all their money out of traditional banking systems and put their full faith in Alex Mashinsky,” the person said. “And now these individuals are unable to pay medical bills, pay for weddings, mortgages, pensions, and it continues to weigh heavily on me and my colleagues who have left the organization.”

Celsius did not respond to multiple requests for comment. Mashinsky, who resigned from Celsius in September, declined to comment.