If Crypto Platforms Go Bankrupt, What Happens to My Assets?
Voyager Digital, The Center Square, and Celsius Are in Bankruptcy-Protect Your Digital Currency Investments!
“Banks are not your friends,” said Alex Mashinsky, owner and CEO of Celsius, one of the largest U.S.-based crypto lending platforms. At the time, Mashinsky intended to pull consumers away from what he deemed were onerous and expensive traditional banking systems to decentralized crypto exchanges, like Celsius. That is, of course, before Celsius’ June 12 announcement it was pausing swaps, withdrawals, and transfers between accounts due to extreme market conditions, as Bitcoin lost more than half its value and Ethereum fell roughly 70%. As crypto prices continued to plummet, customers began to withdraw at much higher rates than the platform could handle, leading to Celsius’ freeze, and its decision’s ripple effect across the crypto industry as more and more platforms are announcing suspensions of withdrawals.
Despite Mashinsky’s distinction, Celsius operated much like a traditional bank – taking its customers’ deposits, lending them out or placing them in high-risk investments in hopes of generating high yields for those unsecured investors willing to invest in their platforms. The customers’ deposits become unsecured loans. Voyager, another U.S.-based crypto brokerage, operated on a similar model and collapsed alongside high-profile crypto hedge fund, Three Arrows Capital, after it defaulted on a $660 million loan from Voyager. Rightfully so, users are now wondering, “if crypto platforms go bankrupt, what happens to my assets?”
Mashinsky is right, regulated traditional banks may burden customers with additional expenses and processes that crypto exchanges alleviate, though unlike traditional banks, crypto exchanges lack the financial and legal protections of a regulated bank or a brokerage. For example, the U.S. Securities Investor Protection Corporation insures traders up to $500,000 in cash and securities if a member broker runs into financial difficulties. In addition, the Federal Deposit Insurance Corporation offers bank depositors protection of up to $250,000 if an insured lender fails. With no current laws governing crypto assets, there are no guarantee platform users will be able to recoup their funds once the exchange freezes their account — or, worse yet, files for bankruptcy.
And that’s what happened. Crypto trading and lending firms Celsius and Voyager filed for bankruptcy last month, leaving their users’ assets locked inside their platforms or dissipated in loans made to third parties with their clients’ assets which will never be repaid. Due to lack of federal regulation and therefore limited legal recourse, what happens next will largely depend on any existing, local, applicable laws, each Company’s terms of use agreements, and how customers held their crypto funds.
Since there are no federal laws that regulate crypto exchanges under these circumstances and no special treatment accorded to them under bankruptcy laws, users will need to consider if state law applies. Chances are that the users are parties to written agreements with their crypto exchange which identify the applicable law under their agreement. However, if there is a question regarding which state law applies, parties will likely argue over what the applicable law is depending upon whether the law of one state versus another favors the position of either party. New York, for example, has laws specifically addressing the custody of crypto that may offer specific protections, such as a requirement that a crypto custodian maintains a surety bond or trust account for the benefit of its customers in an amount that state regulators find acceptable. The determination of whether an asset is “property of the estate” in a bankruptcy case is one based upon applicable state law.
Next, outcomes will hinge on each Company’s terms of use, which they have a right to update and alter at any time. For example, Coinbase, the largest U.S. publicly traded, crypto exchange amended their User Agreement on June 6, after its 10Q filing in May, to offer the same legal protection that its institutional clients rely on to protect their assets in the event of a custodian bankruptcy. Though importantly, Coinbase’s User Agreement language now specifies that,
“All interests in Digital Assets we hold for Digital Asset Wallets are held for customers, are not property of Coinbase, and are not subject to claims of Coinbase creditors.”
What users should be wary of is that Coinbase is distinguishing between funds in “Digital Asset Wallets” and funds that are sitting on the Coinbase exchange itself. Coinbase has derivative products, the Coinbase Wallet and Coinbase Vault, each meant to protect user funds extracted off the exchange, though each is subject to its own terms of use which users should also be aware of. On the contrary, Celsius deliberately claims that “In the event that Celsius becomes bankrupt, enters liquidation or is otherwise unable to repay its obligations, any Eligible Digital Assets used in [its service] or as collateral […] may not be recoverable, and you may not have any legal remedies or rights in connection with Celsius’ obligations to you other than your rights as a creditor of Celsius under any applicable laws”, leaving users with no recourse when the platform froze their funds and filed for bankruptcy this past month. Under any circumstance, a user agreement is only as good as the performance and integrity of the crypto exchange involved-once the user’s assets are not in their account; all that the user becomes at that point is an unsecured creditor of the crypto exchange.
Where users keeps their funds can significantly manage their risk. Customers may not be aware that they have the ability to transfer their cryptocurrencies and digital assets to their own “cold” wallets, which are held separately from an exchange. In a personal wallet (i.e., a cold storage wallet), the owner gets a private digital key to control that digital wallet and only the holder can make withdrawals and activate payments (but make sure you don’t misplace the private digital key!). Anyone can send cryptocurrency to a cold wallet address, but only the owner can transfer cryptocurrency from his or her own address. Using a “cold” wallet will significantly protect users in the event of a subsequent bankruptcy filing because only the user will be able to control access to the content(s) of those account(s), though the language of the platform agreements would still be important in determining the parties’ rights.
In a bankruptcy case for a crypto company, at best, a user would be involved in litigation where the bankruptcy trustee and the creditors would be interested in seeing the assets in the custodial accounts sold and the proceeds used to pay the claims of all creditors, and such creditors would include the account holders. A user in this instance would be treated no differently than any other unsecured creditor. Therefore, users would need to litigate their entitlement to their own assets against parties who would be attempting to take those assets from them. But again, cryptocurrency as an industry still lacks the regulations and protections that traditional financial institutions have, though the recently introduced bipartisan Responsible Financial Innovation Act looks to change this, aiming to provide a comprehensive regulatory framework for the crypto industry. Unfortunately, the bill hasn’t garnered much attention, but it wouldn’t be surprising if recent events will encourage the government to prioritize the blatant hole in our financial regulatory framework.
Gai Sher is senior counsel in the Innovation and Technology practice group at Greenspoon Marder LLP. Ms. Sher concentrates her practice on representing and advising startups, emerging growth companies, brands, creators, and executives in media, technology, and consumer products in all aspects of commercial transactions. Ms. Sher has experience in deal-making and structuring rights, talent, and production agreements in the podcasting industry and other new media spaces.
Victor A. Sahn is a partner in the Bankruptcy & Reorganization practice group at Greenspoon Marder. With more than 40 years of experience, Mr. Sahn represents Chapter 11 Debtors and Creditors’ Committees, as well as secured creditors, equity committees, and individual unsecured creditors, in bankruptcy cases. He also works frequently with asset purchasers in Chapter 11 and Chapter 7 cases and with plan proponents in relation to Chapter 11 cases.
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