Crypto bankruptcy plunges the industry into uncharted territory

Celsius and Voyager Digital’s bankruptcies could force courts to weigh difficult questions about how to prioritize customers and value digital assets.

Kolin Burges, a Mt. Gox customer, holds a placard in front of a building housing the company operating the Mt. Gox Bitcoin exchange in Tokyo, Japan, on Thursday, Feb. 27, 2014. The Bitcoin Foundation, an advocacy group for the nascent digital currency, provided information to federal prosecutors this week that aided a probe into Mt. Gox, a shuttered exchange in Tokyo. Photographer: Tomohiro Ohsumi/Bloomberg via Getty Images

Mt. Gox's collapse led to crypto's most infamous bankruptcy, but the proceedings mostly played out outside U.S. court and started when the industry was much smaller.

Photo: Tomohiro Ohsumi/Bloomberg via Getty Images

The first day in bankruptcy court for crypto lender Voyager Digital came with a warning, from the company's own attorney, that this could get tricky.

“I think for many of us, this is unchartered territory,” said Joshua Sussberg, an attorney with Kirkland & Ellis. “There will be many potential legal issues of first impression.”

The U.S. bankruptcy courts have never dealt with an insolvency proceeding of a crypto company on the scale of Voyager Digital or Celsius. Both companies, which operate lending businesses, are entering Chapter 11 bankruptcy with billions in both assets and liabilities. The filings came just a week apart: Voyager on July 6 and Celsius on July 13.

The uncharted nature of the proceedings means they will be watched closely by policymakers and within the industry, and especially by customers seeking their crypto back.

Many questions, few answers

There are established rules and insurance for customer funds if a broker-dealer or bank goes under that have not been established for crypto. And that type of bankruptcy is relatively rare, said Nizan Geslevich Packin, a professor of law at the Baruch College Zicklin School of Business.

“We don't really have any precedent for crypto firms in the U.S.,” Packin said. “We have an international case from almost a decade ago. But that was early on: a different continent, different rules, with the size of the market significantly smaller."

Packin was referring to Mt. Gox, the most infamous crypto bankruptcy. Mt. Gox customers, along with those who purchased creditor claims, are just now preparing to get some of their crypto back, eight years after the exchange collapsed into bankruptcy and lost 850,000 bitcoins total, valued at $500 million at the time. While the bitcoin that customers receive back will be worth significantly more than when it was stolen, creditors are receiving only a fraction of their initial claims.

Both Voyager and Celsius have offered plans to restart their businesses and are not in "free fall," as Voyager's filing described it. Still, bankruptcies can be years-long proceedings, said Packin, who specialized in Chapter 11 cases at Skadden, Arps, Slate, Meagher & Flom.

One major question, Packin said, is the priority of the creditors: who gets paid back, how much and in what order.

Voyager, for instance, has promised to pay back customers with a combination of their crypto, Voyager’s token, stock in the company and proceeds from its efforts to recover a loan to the bankrupt hedge fund Three Arrows Capital. But that plan would require court approval.

Coinbase sent a scare into the crypto world in May by warning in an SEC filing that customers could be considered unsecured creditors if the exchange went bankrupt. That would mean customer funds are considered part of the bankruptcy estate and those customers are the lowest priority as far as getting paid back.

CEO Brian Armstrong quickly assured customers that Coinbase was not at risk of bankruptcy and the company was only following new federal guidance with the disclosure. But he acknowledged that a court could pool customers' funds as part of the bankruptcy estate, whereas customer accounts have to be kept separate in a stockbroker bankruptcy.

In a smaller-scale crypto bankruptcy case, the lending platform Cred classified its customers as unsecured creditors in its November 2020 Chapter 11 filing, where it reported liabilities in excess of $160 million. The court approved a liquidation plan for the company that started last year amid allegations of fraud and mismanagement. Rick Hyman, a partner with Crowell & Moring, told Protocol that the small size of the company meant the case did not garner nearly the attention of the Coinbase disclosure, but nonetheless offered a cautionary tale.

"I would expect that many of the customers dealing with Cred probably didn't recognize that they will be entitled to nothing more than a general unsecured claim [in bankruptcy],” Hyman said.

Volatile valuations

There is also the question of valuing volatile digital assets. Bankruptcy proceedings take time, and crypto prices change quickly.

In 2016, nearly two years into the bankruptcy of crypto miner HashFast, a trustee sought to claw back payments to a promoter of about 3,000 bitcoin, paid three years earlier. The value of bitcoin had climbed from about $360,000 to more than $1 million in that time. This caused a dispute: The promoter said the courts should consider bitcoin a currency, which would leave HashFast on the hook for only the value of the bitcoin at the time of the transaction. The trustee, meanwhile, contended that bitcoin is a commodity and therefore must be returned at its current market value, according to bankruptcy laws. Ultimately, the case was settled before the court came down in either direction.

The same questions of classification for crypto could come up in the Voyager or Celsius cases. Robert Honeywell, a restructuring partner at K&L Gates, questioned in an interview with Axios whether crypto customers could claim to be securities holders to improve the priority of their claims.

"The real question is even if they filed as a Chapter 11, will customers who have yield-bearing accounts with Voyager say, 'I’m not just a normal unsecured creditor, I’m a securities holder,' even though no regulator has said they are that," Honeywell said, acknowledging that it is an untested proposition.

Regulation coming

The crypto regulation bill from Sens. Cynthia Lummis and Kirsten Gillibrand includes a section that aims to safeguard customer assets in the case of a crypto bankruptcy and treat digital assets similar to commodities in proceedings. But it remains to be seen whether that legislation can garner the support to become law.

In the meantime, the bankruptcies are just the latest fallout from crypto's crash, one that experts say is prompting even greater urgency for regulation. SEC Chair Gary Gensler indicated on Thursday in an interview with Yahoo Finance that the agency has authority to tailor parts of securities law to help bring crypto companies into compliance, potentially increasing investor protections in the process.

Gensler, who has been accused by some in the industry of regulating only by enforcement, said he has said to “the industry, to the lending platforms, to the trading platforms: ‘Come in, talk to us.’”

The current crash should leave more crypto companies open to accepting stronger oversight and regulation, said Diogo Mónica, co-founder and president of Anchorage Digital, the first federally chartered crypto bank.

"People are going to remember this: What happens if the company fails? How are you running risk management?" Mónica said. "All of a sudden those questions are being asked again that, to some extent, get forgotten during bull markets.”


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