Vulnerability to customers’ crypto in bankruptcy; Is help on the way? | Greenberg Glusker LLP

The major cryptocurrencies have experienced significant declines in 2022; with the crypto market shedding $2 trillion of its peak $3 trillion market cap in November 2021. In the midst of this “crypto winter,” Terra Luna and its algorithmic stablecoin collapsed, triggering a domino effect of losses and illiquidity throughout the crypto industry. Hedge fund Three Arrows Capital was the first major domino to fall, defaulting on $1 billion in loans including $650 million to Voyager Digital (“Voyager”). To avoid the proverbial “run on the bank,” many crypto exchanges halted trading and froze customer accounts, and some have filed for Chapter 11 bankruptcy protection, such as Voyager and Celsius Network (“Celsius”).

The Voyager and Celsius Chapter 11 filings have allowed these crypto exchanges to use bankruptcy relief (eg the automatic stay) [1] to hopefully ride out the “crypto winter” and attempt to reorganize or pursue a different strategy to maximize returns for all stakeholders, perhaps at the expense of their customers.

The Voyager and Celsius bankruptcies raise a critical question: Are customers’ escrow crypto assets the property of the bankruptcy estate (which can be used to facilitate a reorganization and cover the debts of other creditors)? [2] In that case, customers will be left with a generally unsecured claim and stand to lose most, if not all, of the value of crypto-assets. If not, the customers should be entitled to exemption from the automatic stay and reclaim crypto-assets. While the Voyager and Celsius bankruptcy courts have yet to rule on this issue; their decisions will likely turn on the following factors: (i) the intent of the parties, as evidenced by the agreements between the crypto exchange and the customer, (ii) whether a customer’s crypto assets are commingled or easily traceable and (iii) who controls crypto assets.

Voyager customers have reason to be concerned. Voyager’s Customer Agreement provides that Voyager does not have crypto-assets held in custody in segregated accounts and is free to use those assets for its own account; only promises to make similar crypto available to its custodian clients when they seek to trade or withdraw.

Celsius customers have reason to be concerned too, although their situation is not quite as bad. Under pressure from regulatory authorities, Celsius earlier this year amended its customer agreement to ensure that customers retain ownership of assets held in custody; However, the agreement stipulates that crypto-assets held in custody are mixed with assets of other customers, and that the custody arrangement cannot be respected in the event of bankruptcy. [4] Why? Fungible crypto is virtually impossible to track; so customers cannot claim their crypto. Will the probate court provide any form of equitable relief; can it find grounds to impose a constructive trust on the commingled account for the benefit of the custodians? However, pending a decision from the bankruptcy court, escrow crypto remains with the exchange, unavailable to customers and subject to the volatility of the crypto market.

While it is too late to help Voyager and Celsius customers, efforts are underway at the state and federal level to address the uncertainty surrounding crypto custody arrangements.

The Uniform Law Commission and the American Law Institute recently approved and recommended for adoption in all states amendments to the Uniform Commercial Code (“UCC”) to address new technologies. The proposed changes include changes to Article 8 which provides that, as with traditional securities, if a “securities intermediary” – which would include a crypto exchange – agrees with a customer to treat the customer’s exchangeable crypto assets as “financial assets” those assets as a custodian, and the customer retains his property interests even if the exchange holds the assets out of an account for the customer’s benefit and is commingled. If an intermediary commingles a customer’s cryptoassets, the customer will have a proportional ownership interest in the commingled cryptoassets. It is important to emphasize that the proposed amendments to Article 8, if adopted by states, will only be useful if exchanges adopt the protocols and agree with customers to treat custodial crypto as “financial assets.” Notably, under SEC guidelines for publicly traded crypto exchanges, Coinbase recently updated its retail customer agreement to indicate that it is a “securities intermediary” under the UCC and has accepted that its customers’ cryptos are “financial assets.”

At the federal level, there are dozens of bills that have been introduced in Congress to regulate the crypto industry that would attempt to reign in the cowboy ways of the crypto industry and provide protection to customers. Two of the more prominent bills, the Responsible Financial Innovation Act (“RFIA”) and the Digital Commodities Consumer Protection Act (“DCCPA”), provide for fungible crypto-assets to be treated as commodities and empower the Commodity Futures Trading Commission to regulate the industry. They will require crypto exchanges to treat and handle all crypto assets of any customer as belonging to the customer and prohibit commingling (although a customer can opt out of the commingling protection). The RFIA and DCCPA will also amend the definition of “commodity broker” in the Commodities Exchange Act and the Bankruptcy Code to include crypto exchanges, [3] which will be subject to specialized winding-up provisions for commodity brokers where the customers’ crypto assets will effectively be excluded from the bankruptcy estate.

Whether the RFIA or DCCPA (or similar legislation) becomes law remains to be seen, but there is growing consensus among lawmakers that meaningful federal regulation of the crypto industry that includes escrow account protection is needed. Watch.