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Crypto Goes Bankrupt: What Do Lawyers and Investors Need To Know?

In an eerie case of foreshadowing for the crypto market, crypto exchange Coinbase Global disclosed in its first quarter 10-Q filing with the U.S. Securities and Exchange Commission that crypto held for its customers’ accounts potentially could become property of a bankruptcy estate—and its customers treated as unsecured creditors—should the exchange file for bankruptcy. SEC Chair Gary Gensler echoed this concern a few days later: “If the platform goes down, guess what? You just have a counterparty relationship with the platform. Get in line in bankruptcy court.”
 
Less than three months later, the crypto world was rocked by the Chapter 11 bankruptcy filings of two major platforms—Voyager Digital and Celsius Network. According to the Wall Street Journal, seven significant crypto-related companies, including Coinbase, have undertaken significant layoffs, suggesting that more crypto bankruptcies may be on the horizon. Vicky Ge Huang, Seven Crypto Companies That Laid Off Employees This Summer, Wall Street Journal (July 21, 2022).
 
Unique Issues in Crypto Bankruptcy Cases
There are a number of ways in which crypto cases are unique. Some of the differentiating issues are briefly summarized below.
 
(1) Are customers’ crypto assets in the debtor’s custody property of the debtor’s bankruptcy estate? Section 541(a)(1) of the Bankruptcy Code defines what constitutes property of the debtor’s estate to include “all legal or equitable interests of the debtor in property as of the commencement of the case.” Property in the debtor’s possession as of the filing date is thus property of the debtor’s estate unless certain exceptions apply—including that such property is held in trust for the benefit of another.
 
For most creditors in the Voyager Digital and Celsius cases, there does not appear to be much dispute that customers’ crypto assets are property of the estate. In those cases, most customers effectively loaned or transferred their crypto assets to the bankrupt exchanges, and the exchanges loaned out those assets to generate returns. These entities essentially operated like banks, albeit without the FDIC to backstop the customer deposits.
 
A subset of Celsius customers had a different arrangement. Those customers made deposits in Celsius’ “custody” program, which did not pay interest or rewards and had terms that were more protective of the customers’ rights in their crypto assets. The ownership of those “custody” deposits will likely be litigated in the near term.
 
Whether crypto assets are property of the estate will depend on a number of factors, including the terms of the customer agreement, the manner in which the crypto assets are held, and applicable state law. If the customer agreement provides that ownership of customer crypto assets is transferred to the exchange and that such assets will be commingled, the assets could be considered property of the estate. Conversely, if the agreement provides that the customer crypto assets are to be held in a segregated trust account for the benefit of the customer—and the assets are actually held in accordance with the agreement—the assets may be outside of the estate and remain property of the customer.

State law may also impact the determination. Bankruptcy law looks to state law to determine property rights. If the applicable state law provides for custodied crypto assets to be held in trust for the customer, it is possible certain crypto assets may be excluded from the bankruptcy estate. Certain states have money transmitter or other laws that govern the relationship between customers and exchanges/custodians as well, which also bear on this analysis.

(2) How are customers’ claims measured? Section 502(b) of the Bankruptcy Code prescribes a mechanism for measuring the amount of a creditor’s bankruptcy claim by providing that the court “shall determine the amount of such claim in lawful currency of the United States as of the date of the filing of the petition.”
 
In crypto cases, however, many customers will seek payment of their coin holdings in kind. Indeed, Celsius is on record noting that the majority of its customers will likely want to remain “long crypto.” Many complex issues surround how crypto assets might be distributed in a manner that is consistent with the bankruptcy code.

The issue will become even more complex if prices of the numerous crypto assets held by customers (e.g., bitcoin, etherium, stablecoins, etc.) fluctuate significantly from the bankruptcy filing date. Imagine a hypothetical Celsius investor holding $100,000 in bitcoin as of the bankruptcy filing date. What happens if the price of bitcoin goes up substantially after the bankruptcy filing date, potentially even enough to render Celsius able to satisfy all claims in full based on petition date amounts? Would the value from that increase be available to satisfy the claims of customers holding other coins, which may not have increased in value (e.g., stablecoins)? Could that investor even recover more than $100,000 in value, while other similarly-situated customers holding different coins receive less than the full amount of their petition date balance?

Anecdotally, the market appears to believe that claims denominated in different crypto assets will receive disparate recoveries. Claims denominated in bitcoin are currently trading for slightly more than claims denominated in stablecoins on the secondary market.
 
Because these are the first crypto-related U.S. bankruptcy cases, there is no direct precedent for how these questions will be resolved. But these and numerous other questions and potential intercreditor issues will need be resolved before the cases are concluded.

(3) Are withdrawals subject to clawback as preferences? Customers who withdrew their crypto assets in the 90 days before bankruptcy may be subject to suits seeking repayment of those withdrawals as preferential transfers pursuant to §547 of the Bankruptcy Code. The preference laws are designed to ensure that all creditors of equal rank are treated equally and that no creditor is “preferred” to another shortly before a bankruptcy filing.
 
To recover a preferential transfer, the debtor or trustee must establish that the transfer (1) was of the debtor’s property; (2) was made on account of an antecedent debt; (3) was made while the debtor was insolvent (i.e., the debtor’s debts exceeded its liabilities); (4) was made within 90 days before the bankruptcy filing; and (5) enabled the creditor to receive more than it would have received in a Chapter 7 case, if the transfer had not been made.

In the event a creditor is forced to repay a preference, that creditor will be granted an unsecured claim for the repaid amount pursuant to §502(h) of the Bankruptcy Code, which will effectively place the creditor in the same position it would have been in had there been no transfer.

The key issues in determining whether a creditor is liable for the return of a prepetition withdrawal as preferential in these cases are: (1) whether the withdrawal was of debtor property; (2) whether the debtor was insolvent at the time of the transfer; and (3) whether any affirmative defenses apply.

Debtor property. If the withdrawn crypto assets were not debtor property, then the withdrawal will not be a preference. Because this is an issue of broad importance, it likely will be litigated even before preference suits are even brought.

Solvency. The debtor must have been insolvent at the time of the withdrawal for the withdrawal to be avoidable. The Bankruptcy Code presumes insolvency, and rebutting that presumption is a costly undertaking that requires valuation experts and litigation. The volatility in the crypto markets complicates the analysis, since daily swings could result in a shifting solvency picture. Customers seeking to challenge insolvency likely would benefit from pooling their resources on this issue, given the complexity and expense associated with solvency-related litigation.

Affirmative Defenses. The bankruptcy code provides creditors with a number of affirmative defenses to preference suits. Potentially one of the most applicable here is that the transfers were made in the ordinary course of business of the debtor and the customer or made according to ordinary business terms. Customers will certainly argue that withdrawals made in compliance with the customer agreement constitute “ordinary course” transactions. The determination of ordinariness is fact-intensive, and likely considerations will include the language of the customer agreement, the length of the relationship the customer had with the debtor, and the nature and number of withdrawal transactions made by the customer.

Another defense results from the provision of new value to the exchange by the customer—most likely in the form of additional deposits into the customers’ accounts—after the subject withdrawal. The customers would be shielded from liability for the preferential transfers to the extent of the new value provided.
 
Finally, the Bankruptcy Code’s securities safe harbor provisions insulate certain transactions involving securities from preference exposure. The (yet unresolved) question is whether the provision could apply in the context of crypto transactions. The answer will turn, at least in part, on whether the crypto assets are “securities.” While certain regulators have suggested that some crypto assets are, in fact, securities, no court has weighed in on the issue in this context. Accordingly, and for other reasons, application of this defense is unsure.

Daniel Besikof, a partner with Loeb & Loeb in New York, represents debtors, secured and unsecured creditors, indenture trustees, landlords, equity holders, distressed investors and other stakeholders in connection with complex Chapter 11 bankruptcy proceedings, corporate restructurings and liquidations. Noah Weingarten, an associate at the firm, provides sophisticated advice on complex bankruptcy and restructuring matters to a wide range of clients, including debtors-in-possession, secured and unsecured creditors, landlords, board members and other key stakeholders.

Reprinted with permission from the September 16, 2022 edition of the New York Law Journal © 2019 ALM Media Properties, LLC. All rights reserved.

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