Whose crypto is it anyway? | Troutman Pepper

On July 18, the “not your keys, not your coin” principle took on a whole new meaning for customers of bankrupt cryptocurrency exchange Celsius Network LLC, which had filed for Chapter 11 bankruptcy in the Southern District of New York bankruptcy court. At the first hearing, lawyers explained the debtor’s view that cryptocurrency deposited on the exchange belonged to Celsius, not the depositors. They cited the terms of use for Celsius’ “Earn Rewards” program (Earn Program) where retail customers could place cryptocurrency in interest-bearing accounts, which Celsius then pooled to fund lending, trading and other operations. According to Celsius’ Terms of Service, “all rights and title” to coins in the Earn Program are transferred to Celsius, and Celsius is free to use, sell, pledge and re-hypothecate those coins.

In other words, according to Celsius’ lawyers, coins in the Earn program are the property of the bankruptcy estate,[1] and depositors who thought they were still the owners of these coins are just general unsecured creditors. The extent to which this came as a shock to depositors is reflected in dozens of outraged and disbelieving letters that have been filed in Celsius’ bankruptcy case.

Coins in custody program

In particular, a very small subset of coins on the Celsius platform in the “Custody” service (about 4% of the total coins on the exchange, worth about $180 million at the time of filing) may be subject to differential treatment in the bankruptcy case. A little history is necessary for context: As explained in detail here, in 2021, Celsius was subject to multiple cease-and-desist actions by state regulators, each of which alleged that Celsius was illegally offering unregistered securities through its Earn program. After initial opposition, in April 2022, Celsius unveiled the new escrow program where depositors could store digital assets but would not earn rewards or financial compensation. New transfers made by non-accredited investors in the US on or after April 15 will automatically go into custody. (Coins deposited by non-accredited US investors prior to April 15 were transferred to the Earn program and could remain there until moved by the depositors.)

The terms of use for the depository service state that ownership of coins deposited there remains with the customer, and not grant Celsius the right to use, sell, pledge and re-hypothecate these coins. The terms of use are not perfect (or completely clear) and do not necessarily specify a slam dunk case for custodians. For example, they give Celsius a right to offset mutual debt against coins in the Custody, which is more consistent with a creditor relationship, and warn that Custodian Depositors may be treated as unsecured creditors in a bankruptcy. But at least the language is more favorable to depositors than the terms of use for the Earn program.

The status of coins in the escrow account is likely to come to a head in fairly short order, as hundreds of escrow depositors have organized into an ad hoc committee and retained counsel to pursue this matter. If they succeed in obtaining a judgment that their coins do not belong to the bankruptcy estate, they will be in a good position to demand the immediate return of those coins.[2]

Coins in the Earn program

So where does this leave depositors in the Earn program – particularly non-accredited investors who arguably should never have had access to unregistered securities in the first place? Should they join treatment as general unsecured creditors who must wait months or years for a distribution likely to be in fiat currency and (even worse) based on the diminished value of their crypto assets on the date of the bankruptcy filing?

Not necessarily.

First, the terms of use for the Earn program are somewhat ambiguous: while they talk about a transfer of title and ownership to Celsius, they also expressly say that depositors only enter into “open loans” of their digital assets to Celsius. A loan does not usually entail a change of ownership. If I lend my car to my teenager, she can use the car for a variety of things, but she doesn’t get ownership of it. Or, in a more closely analogous situation, I can enter into a hypothecation agreement for a margin account that allows the broker to lend my shares to short sellers, but that does not make him the owner of the shares. Earn Program depositors may be able to make similar arguments regarding the status of their coins in Celsius’ hands.

Similarly, New York law looks at the substance of a relationship; the words used to characterize it are not dispositive. Celsius expressly disclaimed any fiduciary duty to depositors in its terms of use, which would tend to preclude a finding that it held depositors’ coins as an agent or custodian. But “where a writing builds up the essential structure of an agency relationship, even an express disclaimer cannot undo it.”[3] As the New York Supreme Court has recognized, the existence of fiduciary obligations “does not depend solely on an agreement or contractual relationship between the trustee and the beneficiary, but is a result of the relationship.”[4] In other words, just because Celsius claimed it wasn’t acting as an agent or custodian for depositors in the Earn program doesn’t let it off the hook. A factual record must be developed to establish the true relationship between Celsius and Earn program depositors.

Alternatively, Earn Program depositors may seek to rescind their transfers of coins to Celsius based on either the securities laws applicable to non-accredited investors or on a theory of fraudulent inducement. (A cursory search of YouTube reveals numerous examples of statements by Celsius executives that appear to be inconsistent with Celsius’ terms of service.)

Depositors in the Earn program could also argue that the terms of use were verbally modified by public statements by Celsius executives, indicating that they would continue to own and control their coins. The terms of use, somewhat surprisingly, contain no integration clause or prohibition against oral modification; therefore, under New York law, a colorful argument can be made that the terms were verbally modified to retain title to the coins with the depositors.[5]

Conclusion

While escrow account holders are likely in a stronger position to exclude their coins from the estate of the estate, depositors in the Earn program may also have viable arguments to retain ownership of their crypto assets, although further fact-finding and legal analysis will be required.

[1] Filing a bankruptcy petition creates an “estate,” which consists of all legal or equitable interests of the debtor in property from the beginning of the case. See 11 USC § 541.

[2] Of course, many of them will likely face preference lawsuits down the road. Pursuant to 11 USC § 547, the debtor-in-possession may recover payments to creditors due to prior debts within 90 days prior to the bankruptcy filing. If coins in the Earn program are considered to be the property of the estate, or loans from depositors to Celsius, the transfer of coins to depository will be payment of debts to creditors. It is no coincidence that Celsius filed for bankruptcy on the 89th day after the escrow accounts were created – the company and its highly competent bankruptcy attorney ensured that any coins transferred from the Earn program to escrow would fall within the grace period.

[3] Veleron Holding, BV v. Stanley, 117 F. Supp. 3d 404, 452 (SDNY 2015).

[4] EBC I, Inc. v. Goldman, Sachs & Co., 832 NE2d 26 (NY2005).

[5] See e.g. Merrill Lynch Realty Assocs., Inc. v. Burr140 AD2d 589, 593, 528 NYS2d 857, 860 (1988) (explaining that New York’s law of general obligations does not “bar the enforcement of a subsequent oral agreement to modify or cancel a contract where . . . the contract does not contain an express prohibition against oral modification”).