Crypto bankruptcies could put some customers at the ‘bottom of the totem pole’
For the first time in the cryptocurrency’s short life, major crypto platforms have turned to US bankruptcy law to save their insolvent businesses. Now it is largely up to the bankruptcy courts to decide how to divide up customers’ frozen crypto assets.
So far this year, crypto platforms Celsius and Voyager Digital have filed for bankruptcy, stripping millions of crypto holders of assets they once controlled. The bankruptcies follow the November 2020 filing of crypto-lending platform Cred roughly two years after the company’s 2018 debut.
All three platforms filed under Chapter 11, which are designed to help debt-laden companies legally shed a large portion of their financial obligations, restructure their business operations, and emerge with a stable business.
These claims have sparked major questions about whether customers can get their frozen funds back. Bankruptcy lawyers who spoke to Yahoo Finance say the answer depends on a number of unresolved legal questions, as well as how bankruptcy judges apply long-established rules to a relatively new business. The stakes are high for customers who have entrusted significant sums of money in companies that are now bankrupt.
Thad Wilson, a partner with King & Spalding, explains that crypto holders designated as unsecured creditors may never get their crypto back. “You’re at the bottom of the totem pole,” he said of unsecured creditors.
Uncharted waters
Currently, there is no precedent for categorizing cryptocurrency as an asset in bankruptcy, Elie Worenklein, a corporate restructuring attorney at Debevoise & Plimpton, told Yahoo Finance. Nevertheless, judges presiding over such cases will first determine whether crypto assets belong to the bankruptcy estate. If they belong to the bankruptcy estate, the judge will rank them among a hierarchy of creditors.
“Different crypto customers may have different rights against different crypto entities,” Worenklein said. “It’s not necessarily going to be the same answer for different entities that filed for bankruptcy.”
What is the best case scenario for crypto holders? Howard University law professor Matthew Bruckner says arrangements that clearly separate a customer’s crypto from the platform’s own assets benefit crypto holders the most. In that case, the crypto assets must be set aside from the bankruptcy estate and returned.
“So the biggest issue for any crypto holder who had assets on a now bankrupt platform is: How are their assets held by the platform?” Bruckner said.
Bankruptcy judges will make these decisions based on the terms set forth in each platform’s customer agreements, and the intentions they reveal between the platforms and their customers. Some agreements pool customer crypto, controlling assets in a joint account. Other agreements see platforms act as custodians of crypto held in a dedicated account on behalf of a customer.
Pooled assets are more vulnerable than assets in a customer-dedicated or segregated account, Bruckner explains, because judges are likely to treat them as part of the bankruptcy estate. And among the creditor hierarchy, these assets likely qualify as general unsecured debt — a category that ranks far from the top of the creditor business chain.
“So if [crypto assets] is mixed into a pool of assets … in a large account, then they are likely to be treated as a general unsecured creditor, which is bad for crypto holders,” Bruckner said.
That’s what happened in the bankruptcy proceedings for the crypto-lending platform Cred. Unbeknownst to many of its customers, the company’s user agreements specified that crypto deposited in exchange for interest on the idle funds was neither segregated nor pledged as collateral, and a bankruptcy court designated their claims as unsecured debt. Voyager made a similar argument, telling a bankruptcy judge that it considered its customers’ crypto as pooled assets that it could use on its behalf, and that those assets should become part of the bankruptcy estate.
However, Wilson points out that some crypto holders can prove that their assets remained separate from a bankrupt platform’s assets, or those of other clients.
“Unlike cash where you can literally shuffle it in a bank account, with crypto you have the ability to track it on the blockchain,” Wilson said. In the Celsius bankruptcy, he says, the creditors’ committee hired a forensic cryptanalysis firm to track the debtors’ crypto holdings over time, and the debtors recently agreed to a court-appointed investigator who will investigate similar issues.
However, for owners of cryptocurrency designated as unsecured creditors, there is no guarantee of any payout at all. They will queue for whatever is left of the bankruptcy estate, behind sellers and post-bankruptcy administrative expenses, employees, bankruptcy attorneys, bankers and other advisers, and secured creditors who have security against the company’s assets.
Inevitable fluctuations in cryptocurrency prices add to this uncertainty, along with pending lawsuits and the possibility of a bidder buying up the bankruptcy estate—all of which could leave more or less crypto floating around.
Alexis Keenan is a legal reporter for Yahoo Finance. Follow Alexis on Twitter @alexiskweed.
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