Bankruptcy and crypto

In recent years, many investors have used cutting-edge financial products, such as crypto exchanges, to make significant profits. Now, as the markets turn around, many are wondering how protected they will be in the event of the collapse of a cryptocurrency exchange. We are in the process of finding out the hard way as the groundbreaking financial platforms are brought before the bankruptcy courts for the first time. Although many of these products have existed for much of the last decade, there are few and far between bankruptcy applications in a thriving market.

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

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

Then, several days later, the crypto-lending platform Celsius, which describes itself as “a crypto-bank” – it charges interest on crypto-lending, and allows crypto-deposits to earn its own interest – confirmed that it has initiated Chapter 11 bankruptcy proceedings that we want. And if Terra / LunaLUNA
The Stablecoin crash a couple of months ago was not enough to signal that things are getting ugly (as Bear Stearns’ impending collapse in 2008 as regulators prevented by securing a distressed sale to JP Morgan Chase) The Celsius collapse has already been labeled by some as a “Lehman Brothers moment” for the crypto industry.

With several crypto companies becoming insolvent and filing for bankruptcy, it is now clear that many customers will face huge losses, as their rights to their funds and assets are not clear. This ownership problem was demonstrated in Cred’s bankruptcy case, where customers did not retain ownership of their cryptocurrency after transferring to Cred. Instead, in this case, the CreditEarn transactions were treated in the same way as all other loans in a fiat currency. The issue of ownership is also a problem in Celsius’ case. Celsius’ terms of use, for example, do not guarantee that user deposits are in fact protected in any way by insolvency. The fine print of Celsius’ terms of use makes it clear that depositors who use their “Earn” accounts that pay interest of up to 18% give the “crypto bank” ownership of their funds as a condition of use. The consequence is that in the event of a bankruptcy, such account assets may “not be recoverable.” Similarly, even if customers who opened Celsius’ “Depot” accounts that do not pay interest retain ownership of their funds, Celsius does not explicitly guarantee that these customers will get their money back in the event of bankruptcy. Under the terms of use, bankruptcy proceedings may result in “total loss of all digital assets.”

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

Creditors’ priority

In the case of priority for creditors, when an entity files for bankruptcy and an executor is appointed to determine all the assets of the debtor that are available to creditors, one of the executors’ tasks is to examine transfers that the debtor has made to third parties within a certain period before the bankruptcy petition. If transfers prove to be inappropriate or illegal, the trustee may avoid them in order to recover the value of such transactions. For example, “fraudulent transfer” actions try to avoid or “liquidate” certain transactions before the bankruptcy that was done for little or no money. In a recent example of this, the bankrupt cryptocurrency exchange Cred Inc., tried to recover bitcoin for millions of dollars, and it argued that the unit was fraudulently transferred to an investor in return for a worthless bond.

There are other situations where an executor will try to avoid transactions. In the Bankruptcy Act, “avoidable preferences” are intended to prevent situations where the debtor’s assets are unfairly distributed to creditors. For example, when an aggressive creditor seeks to take a majority of the available funds or assets as repayment of her claim just before the debtor files for bankruptcy, it does so to the detriment of all the other creditors. However, the recovery of transfers that qualify as unavoidable preferences is not automatic, and the burden of proof lies with the trustee, who is required to show that all the elements required by the Bankruptcy Act have been met.

In Celsius’ case, the unit paid off its debt to Defi’s largest lenders, demanding more than $ 1 billion in collateral. These payments are guaranteed to be scrutinized soon, as under the Bankruptcy Act, the trustee can seek to avoid payments or transfers of interest made by the debtor to a creditor before filing for bankruptcy to recover funds in favor of the bankruptcy estate and repayment of the estate’s creditors, including the unsecured creditors, such as Celsius’ customers. But in Celsius’ case, there are several legal challenges. First, it must meet the requirements for the burden of proof, which may not happen based on reports of excess collateral for the loans repaid. Secondly, it can prove difficult to order transfers to be reversed when working with the DeFi protocol. In fact, DeFi protocols – unique programs that use data code called smart contracts that run on the blockchain network – are decentralized, autonomous protocols, and are therefore more difficult to challenge to legally follow. A somewhat good illustration of this challenge of having to deal with a DeFi protocol was recently demonstrated in a class action lawsuit by traders against Uniswap, a cryptocurrency exchange that uses a decentralized network protocol. The class action lawsuit was therefore filed against developers and venture capitalists over the decentralized exchange of digital assets, arguing that since the protocol allows users to freely list and also trade tokens, its creators should be responsible for “widespread stock market fraud.”

Finally, another potential problem in Celsius’ case regarding “avoidable preferences” may be what would happen to regular customers who withdrew money during the preference period – if the case is converted into a Chapter 7 bankruptcy case, an executor hypothetically goes after those.

Valuation of assets

When it comes to valuing assets, even outside the crypto area, valuation disputes are challenging and can result in full-blown legal battles where the parties legalize proper valuation using expert witnesses, evidence and comparisons with comparable assets. But with digital assets that are so volatile, and usually not tied to any external fixed prices or scales, the task of determining value will be much more difficult.

In addition, in bankruptcy proceedings, valuations are usually determined from the date of the bankruptcy petition. In cases like Celsius and Voyagers, this practice will complicate things. For example: if creditors provide proof of claims in US dollars, and had 10 bitcoins (BTC) valued at $ 100,000 on the date of bankruptcy, they should receive assets based on the $ 100,000 amount. But if, towards the end of the case, the same coins are worth $ 200,000, creditors will want to be repaid in bitcoin, not cash. The question of who will benefit from the increased value during the cases must also be resolved.

Nevertheless, these are not the only legal obstacles that customers of bankrupt crypto companies should expect.

Traditional brokerage firms are subject to SEC rules and laws, and if they collapse, they can use the bankruptcy Code stockbroker’s liquidation procedure, or the procedure under the Securities Investor Protection Act of 1970 (SIPA). Therefore, although the story does not include many cases where brokerage firms collapsed, there is basic protection for investors if and when it happens, including: (i) the “Net Capital Rule” to the SEC which makes it mandatory for brokerages to retain a minimum amount of prescribed capital in liquid form; (ii) “Customer Protection Rule” which requires brokerage firms to hold client funds in separate accounts from the brokerage house to prevent confusion; (iii) Securities Investor Protection Corporation (SIPC) – a nonprofit that also serves as insurance for clients of brokerage firms registered under the Securities Exchange Act of 1934 – specifically up to $ 500,000 in securities and $ 250,000 in cash held by a brokerage firm ; and (iv) SIPC’s attempts to arrange the transfer of a failed brokerage house’s accounts and assets to another brokerage firm with little interruption, and if all attempts fail, the failed firm is usually liquidated.

However, crypto firms are not usually registered with the SEC as a securities broker, nor are their deposits protected by SIPC insurance. Coinbase and Kraken are good examples, and that is why such companies are also not subject to other SEC and FINRA rules, such as the regulations for “best execution” and the SEC’s “national best bids and offers”, which are laws that ensure that investors receive the best buy or sell price for a security, regardless of which broker was responsible for filling the order. This means that cryptocurrency prices can – and often do – vary across exchanges.

What will happen to the customers of bankrupt crypto companies? It is unclear, but my advice is to follow the warning of the European Financial Supervisory Authorities a few months ago: invest in crypto only what you are willing to lose completely.