In Defense of Chapter 11 for Mass Torts
by | posted in: Bankruptcy, Chapter 11, Mass Torts, Texas Two-Step, Third-Party Releases, Valuation | 0

By Anthony J. Casey and Joshua Macey (University of Chicago Law School)

Anthony J. Casey
Joshua Macey

Recent high-profile bankruptcies involve the use of Chapter 11 proceedings to resolve mass tort claims. In these cases, debtors have employed controversial maneuvers to facilitate global resolution and to minimize operational disruptions that can result from bankruptcy filings. Most notorious among these maneuvers are the third-party release (a key feature in every mass tort bankruptcy) and the two-step bankruptcy (a recent innovation in asbestos cases, also known as the “Texas” two-step).

While most bankruptcy courts have blessed the use of Chapter 11 to resolve mass torts claims, scholars, policymakers, and media commentators have argued that bankruptcy proceedings provide an improper forum for resolving these cases. Critics have taken special aim at the use of the third-party release and the two-step bankruptcy.

In an Essay forthcoming in the Chicago Law Review, we argue that Chapter 11 proceedings provide an appropriate and often superior forum in which to resolve mass tort claims. We further argue that legal innovations such as the two-step bankruptcy and the third-party release can reduce bankruptcy costs and preserve value for all claimants. As a result, these maneuvers and others like them should be welcomed as long as courts are attentive to the potential for opportunistic abuse.

Bankruptcy law resolves the collective action problem that arises when creditors pursue their claims in a variety of separate proceedings. When creditors worry they will not recover the full value of their debt, they race to the courthouse—or courthouses—to collect what they are owed. The result is the destruction of value and potential dismemberment of viable firms. This leaves all claimants and stakeholders worse off. The Bankruptcy Code’s core provisions—the automatic stay, priority rules, prohibitions on fraudulent transfers, preference rules, and treatment of unpaid claims—are all designed to address these problems. This point has never been controversial.

Mass tort cases present this exact collective action problem. When a firm is unable to pay all its tort claims, claimants who file early, or who find themselves before a sympathetic jury, or whose injuries happen to manifest quickly, may receive a large payout. Late claimants risk being left with nothing if the firm’s resources are depleted. And the costs of a decentralized, lengthy resolution of mass torts claims can be large and value destructive for all stakeholders.

Chapter 11 proceedings can mitigate these problems and provide an appropriate and often superior forum in which to resolve mass tort claims. Despite the rhetoric surrounding recent cases, the bankruptcy community has recognized the resolution of mass tort claims as a widely accepted core function of bankruptcy courts for decades. And for good reason: Chapter 11 provides tools for dealing with holdouts and future claimants that are unavailable in conventional class actions or multidistrict litigation proceedings.

Moreover, bankruptcy tools that facilitate efficient, lower-cost resolution should be welcomed. The two-step bankruptcy and the third-party release are such tools, as long as courts guard against opportunistic abuse. Properly used, the third-party release prevents holdout behavior and incentivizes perpetrators of corporate misconduct to disclose their role in the company and to contribute assets to the bankruptcy estate. Similarly, the two-step bankruptcy allows a firm to quarantine mass tort liabilities from operations facilitating resolution in a single, streamlined bankruptcy proceeding without involving all nontort counterparties. These maneuvers thus further the Code’s purpose by providing a single forum in which to efficiently and fully resolve the firm’s mass tort liabilities.

Of course, debtors and managers can abuse the third-party release and the two-step bankruptcy. But given their potential to benefit all claimants, these tools should not be altogether prohibited. Instead, because the potential for abuse is identifiable, targeted procedures and reforms can mitigate it.

For example, courts should ensure bankruptcy proceedings do in fact mitigate collective action problems and do make tort claimants as a class worse off. Courts should be aggressive in demanding disclosures from the released parties, in requiring strong proof about the value of assets and liabilities, and in policing fraudulent transfers.

Perhaps a trickier issue is that unequal bargaining dynamics and information asymmetries may allow managers to use the reorganization process to take advantage of tort claimants. With full control of the bankruptcy proceeding, managers can pressure tort claimants with take-it-or-leave-it offers. They may also have private information about asset and claim values. Though these are serious concerns, we think that they, too, are best addressed through reforms to the bankruptcy process. To that end, we consider a menu of reforms that would inhibit insiders from taking advantage of their superior informational position.

Click here to read the full article.

And Another Lender Blocking Provision Bites the Dust, Texas Bankruptcy Court Rules
by | posted in: Bankruptcy, Chapter 11, Jurisprudence, Secured Lenders | 0

By Adam C. Rogoff and Ashland J. Bernard (Kramer Levin)

Adam C. Rogoff
Ashland J. Bernard

One feature commonly seen in commercial lending transactions is a waiver of the borrower’s authority to file for bankruptcy without the consent of the lender. While such “blocking” provisions are generally upheld where the equity interest holders are the parties with such rights, they are generally unenforceable as a matter of public policy when such protection is given to a creditor with no meaningful ownership interest in the corporate debtor.

In a recent decision issued in In re Roberson Cartridge Co., LLC, Case No. 22-20192 (RLJ), 2023 Bankr. LEXIS 588 (Bankr. N.D. Tex. March 7, 2023), the Bankruptcy Court for the Northern District of Texas denied a secured creditor’s motion to dismiss the corporate debtor’s Chapter 7 case on the grounds that the petition was filed without the requisite corporate authority. In doing so, the bankruptcy court held void as against public policy a blocking provision in the company’s governing documents, which purported to give the creditor — which held convertible debt of the debtor — the exclusive right to consent to the debtor’s bankruptcy filing. Through an analysis of the company’s governing documents under applicable provisions of the Texas Business Organizations Code, the bankruptcy court concluded that a pledge of equity by the debtor-LLC’s member did not divest the LLC’s manager from corporate authority to file for bankruptcy. Nor was the consent right enforceable with respect to convertible debt where, prior to the bankruptcy filing, the creditor had not exercised its right to convert the debt to equity (and therefore was only a creditor on the petition date). This ruling of a bankruptcy court in the Fifth Circuit joins the growing body of case law from other circuits that holds such bankruptcy-restrictive contractual provisions void as a matter of public policy.

Click here to read the full article.

Bankruptcy Overload
by | posted in: Bankruptcy, Bankruptcy Reform, Chapter 11, Mass Torts, Reorganization, Third-Party Releases | 0

By Laura Coordes (Arizona State University Sandra Day O’Connor College of Law)

Laura Coordes

Over the past few years, a growing number of scholars have sought to diagnose what is wrong with the U.S. bankruptcy system. Congress has held hearings in search of an answer. And many answers have emerged, ranging from lack of balance to outright lawlessness. In my article, Bankruptcy Overload, I contend that these problems are part of a larger issue: the bankruptcy system is overloaded. Those who use it, whether debtors or non-debtors, frequently seek to extract more out of a bankruptcy than the process can, practically and legally, provide.

We have always asked the bankruptcy system to do a lot—indeed, the system’s flexibility and adaptability to new challenges and situations are often described as features rather than bugs. As our current system approaches its 45th birthday, however, it has become increasingly clear that users of the bankruptcy system are putting enormous pressure on it to do more, to resolve more issues, and to satisfy the needs and wants of a growing number of players. In the face of this increasing pressure, the system is beginning to buckle—and this buckling results in many of the problems scholars have identified with modern bankruptcy practice.

The goals and boundaries of bankruptcy law have always been subject to debate, making the system particularly susceptible to taking on more than it can bear. Over the years, many have embraced the resulting uncertainty of the limitations of bankruptcy as a necessary byproduct of bankruptcy’s built-in flexibility. However, even a system with significant capacity can be overloaded, and this Article’s core claim is that the bankruptcy system has reached that point.

This Article defines and explains the concept of bankruptcy overload, illustrating that many of the problems currently plaguing the bankruptcy system derive from overloading it. In addition, although overloading the system may create problems in individual cases, this Article shows that bankruptcy overload is systemically harmful, and that failure to recognize and address it will undermine the system’s long-term utility. Those seeking changes to bankruptcy law must be aware of the system’s capacity constraints. In addition to defining bankruptcy overload and identifying its harms, the Article illuminates ways to address many of the issues present in bankruptcy today while being cognizant of the effect of changes to bankruptcy law on the system as a whole.

The full article is available here.

Generalized Creditors and Particularized Creditors: Against a Unified Theory of Standing in Bankruptcy
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, fraudulent transfer | 0

By Jeanne L. Schroeder and David Gray Carlson (Benjamin N. Cardozo School of Law)

Jeanne L. Schroeder
David Gray Carlson

Courts have struggled toward a unified theory to explain when the trustee has exclusive jurisdiction to sue a third party for harms done to a bankrupt debtor, and when creditors have exclusive jurisdiction to sue the third party. Courts have proclaimed that when every creditor can sue the third party, then none of them can, and the right belongs solely to the trustee. Creditor rights are “generalized.” If only a proper subset of creditors can sue the third party, then the trustee is not able to subrogate to the subset. Such creditors are “particularized.” This paper proclaims the test a failure. It announces the result rather than producing it. There are no generalized creditor rights or particularized creditor rights. There are only creditor rights and causes of action that are property of the estate. As for creditor rights, the trustee is subrogated to fraudulent transfer avoidance rights under Bankruptcy Code § 544(b)(1). Otherwise, the trustee is not subrogated. “Piercing the corporate veil” is not a generalized creditor right and not a cause of action at all. It is the assertion that two persons are the same person. If the corporate veil can be pierced, property of the apparent third person is actually property of the bankruptcy estate. For this reason, the trustee has control and the creditors are kept at bay by bankruptcy’s “automatic stay.” The article defends the recent settlement with the Sackler family in the historic Purdue Pharmacy opioid bankruptcy as entirely within the province of the bankruptcy estate.

Click here to read the full article.

The Excluded Asset Gap: Why Floating Charges Capture Realizations of Unsecured Assets
by | posted in: Bankruptcy, Bankruptcy Roundtable Updates, Secured Lenders | 0

By Matteo Clarkson-Maciel (Willkie Farr & Gallagher) and Paul Fradley (South Square Chambers)

Matteo Clarkson-Maciel
Paul Fradley

Will the proceeds of the sale of an asset, excluded from the scope of a floating charge governed by English law, be captured by that charge when sold after the crystallization of that charge? The answer turns upon the “Excluded Asset” definition found in the floating charge debenture and poses a key question with practical consequences for lenders, insolvency officeholders and other creditors. If the proceeds from the realization of an excluded asset are captured by the floating charge and distributed to the debenture-holder, the value of their security will be significantly enhanced, and the effect of the exclusion of assets from the charge will be reduced considerably in insolvency. A floating charge captures assets within a class of assets[1] (both present and future)[2] and allows the security provider to use those assets in the ordinary course of business.[3] A floating charge will cover property within a specified class even if assets within the class are acquired after the appointment of an administrator or where the charge has crystallized.

There is a poorly understood lacuna which, in principle, could entitle debenture-holders to the proceeds of assets, even where excluded from the scope of a floating charge, when sold by insolvency practitioners. We call this the “Excluded Asset Gap”. Professional advisers in England need to consider the Excluded Asset Gap when designing and drafting security packages under English law. The crux of the Excluded Asset Gap is the law of floating charges and the interaction between floating charges and company assets following (i) crystallization of that floating charge and (ii) an insolvency process in England & Wales.

An Excluded Assets clause, limiting the assets over which a floating charge applies, will not exclude the proceeds of a realization of assets from becoming subject to a floating charge unless specifically contemplated. This is the case regardless of whether the realizations were made before or after the initiation of an English administration process.[4] When charged assets are realized by the insolvency practitioner, they are not necessarily treated in the same way in the security package perimeter as was their progenitor. An asset not subject to a floating charge (because it falls outside the class of assets to which the charge applies) will, when converted or exchanged so that the new asset falls within the class of assets, fall within the scope of the floating charge. The initiation of administration does not change the nature of the sale of assets being realized.

Some ways of addressing the Excluded Asset Gap include specifying that Excluded Assets include: (i) the excluded assets specifically and their proceeds; and (ii) any Excluded Asset realizations are paid into a specific, designated bank account which is itself defined as an Excluded Asset.

Insolvency practitioners will need to make an assessment before the distribution of the estate. If an insolvency practitioner incorrectly assumes that the proceeds of an Excluded Asset remain excluded, their decision may give rise to a claim by secured creditors regarding the loss incurred by their actions. Lenders, too, should be weary of insolvency practitioners intuitively believing that proceeds of Excluded Assets remain excluded. This will likely result in material losses in recovery by the lenders.

Click here to read the full article, which first appeared in the September 2022 edition of Butterworth’s Journal of International Banking and Financial Law.

[1] Re Yorkshire Woolcombers [1903] 2 Ch 284

[2] See Holroyd v Marshall (1862) 10 H.L. Cas. 191 for floating charges over future property.

[3] See Ashborder BV v Green Gas Power Ltd [2004] EWHC 1517 (Ch).

[4] Ferrier & Australian Factors (Qld) Pty v Bottomor (1972) 126 CLR 597

 

Bankruptcy Amnesia
by | posted in: Bankruptcy, Bankruptcy Reform, Chapter 11, Legislation, Mass Torts, Statutory Interpretation, Third-Party Releases | 0

By Jonathan Lipson (Temple University Beasley School of Law)

Jonathan Lipson

[Editor’s Note: The author represented, on a pro bono basis, an individual claimant in the bankruptcy of Purdue Pharma.]

In late 2022, counsel for opioid-maker Purdue Pharma posted an essay on the Harvard Bankruptcy Roundtable (HBRT), “Please Don’t Forget the Victims: Mass Torts, Third Party Releases and the U.S. Bankruptcy Code” (“Forget”). Forget largely restated arguments they made to the Second Circuit Court of Appeals in their bid to reinstate controversial nonconsensual nondebtor “releases” (NDRs) of collateral civil liability arising from the OxyContin-maker’s confessed drug-marketing crimes. HBRT asked me to respond to Forget because I was pro bono counsel to one of those they would have us remember: Peter Jackson, whose daughter Emily died after taking a single OxyContin in 2006.

While the sentiment to “remember the victims” is laudable, the substance of Forget renders its title a cruel irony. Forget says almost nothing about the victims of a public health crisis that has taken over half a million lives and in which Purdue Pharma, and its wealthy and secretive owners, the Sacklers, apparently played a singular role. Instead, Forget would honor survivors of this crisis through the use of legally dubious NDRs.

Forget conspicuously omits or distorts problems in the Purdue Pharma case and precedent on which its NDRs would rest. It ignores the fact that nondebtor “releases” and “settlements” are contractual in nature, and cannot be forced onto the unwilling; that over 80% of creditors cast no vote on Purdue Pharma’s plan, so there was hardly “overwhelming” support for it; and that the precedent on which they rely—historic mass tort and Supreme Court cases—are readily distinguishable from Purdue Pharma.

Forget would have us forget just how problematic Purdue Pharma—and its quest to insulate the Sackler family—has been, thereby seeking to induce a kind of “bankruptcy amnesia.”

The full article is available here.

Financial Disequilibrium
by | posted in: Bankruptcy, Bankruptcy Reform, Distressed Debt Markets, Fiduciary Duties, fraudulent transfer, Reorganization | 0

By Samir Parikh (Lewis & Clark Law School)

Samir Parikh

Corporate bankruptcy cases have recently undergone a shift. After decades where creditors exercised outsized control, equity sponsors have now ascended the throne. This new group exploits contractual loopholes and employs coercive tactics to initiate creditor-on-creditor violence. The result is the ability to dictate outcomes in distress situations where equity sponsors would normally be idle passengers. The unwritten rules have been rewritten.

This new disequilibrium has the potential to fundamentally harm the financial ecosystem. Scholars have successfully chronicled the new tactics, but formulating the means to mitigate market distortion has been elusive. Most scholars have appealed to the judiciary to intervene. Unfortunately, the judiciary has rejected this call, arguing that sophisticated parties should address coercion through contracts. What if that is not possible? An efficient public debt market relies on some sort of check on outright exploitation. The inability to manage bad actors renders these markets more volatile and amplifies contagion risk for national and global economies. Further, coercive measures allow a company that should have sought bankruptcy protection or some other substantive restructuring to artificially limp along. There is a significant risk that this iniquitousness destroys value and there is little left to salvage by the time the company actually lands in bankruptcy.

This Article argues that a significant movement towards equilibrium is attainable by adjusting two aspects of this ecosystem. Primarily, I advocate for amendment of section 546(e) of the Bankruptcy Code to exclude leveraged buyouts from the fraudulent transfer safe harbors. My proposal aligns the section with its historical underpinnings and acts as a natural check on debt levels in overly aggressive acquisitions. This proposal reduces the need for coercive restructuring measures when a corporation experiences financial distress. On the backend, Delaware courts have limited creditors to derivative breach-of-fiduciary-duty actions, even when a corporation is insolvent and directors are actively attacking certain stakeholders. Delaware case law protects the mechanism by which equity sponsors implement coercion. I argue that when a corporation is insolvent, directors and officers who undertake hostile actions against specific creditors to whom they owe fiduciary duties should be subject to direct claims by those creditors. Unable to act with impunity, directors would be forced to properly consider all key stakeholders in formulating rehabilitation measures.

The full article is available here.

Appellate Review of a Bankruptcy Court’s Preliminary Injunction
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Jurisprudence | 0

Note: Last week the Roundtable concluded its series on crypto bankruptcies.  We will resume our regular posts beginning with this week’s post, featuring an article by attorney Michael L. Cook.

By Michael L. Cook (Schulte Roth & Zabel LLP)

Michael L. Cook

This essay shows why a bankruptcy court preliminary injunction should be reviewable on appeal by an Article III court.  District courts are split on the issue, often declining to review these rulings on the grounds that they are not “final” and that review is unwarranted.  Although the Third, Seventh and Eighth Circuits hold that the Judicial Code authorizes appellate review, only the Second Circuit disagrees, based on a blinkered reading of the Judicial Code and U.S. Supreme Court precedent.

A district court’s preliminary injunction ruling (granting or denying) is concededly subject to review by a court of appeals under the explicit terms of the Judicial Code.  Sound policy reasons, common sense and the obligation of the federal courts to hear cases within their statutory jurisdiction also show that bankruptcy court injunction rulings should not be insulated from appellate review.  No sound reason exists for treating these bankruptcy court rulings differently from an identical district court ruling.

The full article is available here.

[Crypto-Bankruptcy Series] Concluding Thoughts on the Series
by | posted in: Bankruptcy, Chapter 11, Crypto-Bankruptcy Series, Cryptocurrency, International and Comparative | 0

By Xiao Ma (Harvard Law School)

Xiao Ma

Note: This post is the concluding post in a series of posts on bankruptcies of cryptocurrency companies and the emerging issues they pose. Previous posts in the series include:

1. The FTX Bankruptcy: First Week Motions, Jurisdictional Squabbling, and Other Unusual Developments, by Megan McDermott

2. Quantifying Cryptocurrency Claims in Bankruptcy: Does the Dollar Still Reign Supreme?, by Ingrid Bagby, Michele Maman, Anthony Greene, and Marc Veilleux

3. The Public and the Private of the FTX Bankruptcy, by Diane Lourdes Dick and Christopher K. Odinet

4. Staking, Yield Farming, Liquidity Mining, Crypto Lending – What are the Customer’s Risks?, by Matthias Lehmann et al. (University of Vienna)

5. The Treatment of Cryptocurrency Assets in Bankruptcy, by Steven O. Weise, Wai L. Choy, and Vincent Indelicato

6. FTX Bankruptcy – A Failure of Centralized Governance in the Name of Decentralized Cryptocurrencies, by Vivian Fang

7. Roundup: Celsius Network LLC, by Jessica Graham

8. The Implications of CeFi and DeFi in Bankruptcy: A Hot Take on Celsius, by Kelvin FK Low and Timothy Chan

9. Crypto Volatility and The Pine Gate Problem, by Anthony Casey, Brook Gotberg, and Joshua Macey

This series is being managed by the Bankruptcy Roundtable and Xiao Ma, SJD at Harvard Law School, xma [at] sjd [dot] law [dot] harvard [dot] edu.

Check the HLS Bankruptcy Roundtable periodically for additional contributing posts by academics and practitioners from institutions across the country.

***

There is a new category of bankruptcies: crypto-bankruptcies. Although difficult to pinpoint the exact beginning of the recent wave of crypto winter (the common belief is that it can be traced back to the collapse of Terra/Luna in May 2022.) Since then, several crypto companies – such as Voyager, Celsius, FTX, BlockFi, and Genesis – have landed in U.S. bankruptcy courts. This trend has prompted our Roundtable to devote a special series to exploring these new developments. I appreciate the opportunity to have managed this series and enjoyed working with authors who contributed thought-provoking posts. While the crypto-bankruptcies will continue to unfold, we are concluding our series for now to feature other content on our forum. We hope that the series has provided some initial food for thought, and that discussions will extend beyond this series as we, the community of bankruptcy academics and practitioners, continue to learn and forge new thinking together about these novel crypto-bankruptcies. 

I would like to take this opportunity to add some concluding thoughts. First, the jurisdictional squabbling present in FTX’s bankruptcy, as highlighted by Megan McDermott, may signify a broader trend that the U.S. bankruptcy courts could become the leading venue in resolving crypto-related insolvencies. Cryptocurrencies are perhaps uniquely international, with no clear need for insolvency proceedings to take place in any particular jurisdiction. Indeed, other jurisdictions (most notably Singapore and London) have recently tried to increase their attractiveness as the home of major cross-border insolvencies, and cryptocurrency companies may have been a major test case for these efforts. Nevertheless, this wave of crypto-bankruptcies has taken place in the United States.

This new set of crypto-bankruptcy cases will put the efficacy and efficiency of Chapter 11 to the test. Crypto investors worldwide are closely monitoring the processes and carefully studying the rulings of U.S. bankruptcy judges (such as the critical Celsius opinion briefed by Jessica Graham). These opinions may have broad implications and global reach for the whole crypto industry. The ongoing crypto-bankruptcy proceedings also provide great insights into the business activities, financial condition, and commercial realities of major players in this fast-evolving industry. For example, the 600+-page Celsius examiner’s report not only detailed how Celsius struggled to generate enough yield to support its high reward rates and made terrible investment and asset deployment decisions, but also brought  public attention to its governance deficiencies and problematic representations made to the public. Diane Dick and Christopher Odinet reminded us of the need to investigate the causes of debtors’ failures and to craft appropriate laws and regulations safeguarding substantial public interests. On the other hand, they also highlight the dilemma of whether the limited resources of bankruptcy estates can support the type of independent management and fact-finding that might be essential to addressing the public concerns of crypto-bankruptcies, but which are not typically central to the chapter 11 model. 

Second, in reflecting on the cause of FTX’s massive failure, Vivian Fang noted how distressed companies’ financial positions have been inflated with illiquid assets and obscure instruments throughout corporate history. In FTX’s case, the related party transactions that are secured by FTTs, its own token, remind us of the SPVs of Enron that were solely financed by its own stock, and how a drop in the value of this stock led to Enron’s collapse. Investigations of fraudulent transactions and preferential payments are likely to be themes shared by the highly interconnected crypto-bankruptcies. Note that one essential (and as-yet-unanswered) issue that will greatly impact how these cases proceed is how to effectuate transaction avoidance law and enforce the clawback of payments that take place on the blockchain via nodes of anonymity. 

Another major theme, as predicted and discussed by Matthias Lehmann, Kelvin Low and Timothy Chan, and Diane Dick and Christopher Odinet, is how to characterize the crypto assets that the customers stake on the troubled crypto platforms. Steven Weise, Wai Choy and Vincent Indelicato’s memo analyzed the legal framework under which the crypto assets that are custodially held by a platform should be treated as customers’ assets, not the property of the bankruptcy estate. Whether such a custodial relationship exists would be a separate question, as many customer agreements provide otherwise (e.g., terms governing Celsius customers’ earn accounts were central to the opinion in that case). Crypto exchanges commonly comingle and rehypothecate crypto assets, making it even harder for customers to withdraw their staked cryptos during a chapter 11 case. This, in turn, makes the industry more susceptible to contagion (and such contagion has reached traditional banking where institutions have substantial ties to crypto, e.g., Silvergate Capital) as downward pressure on the value of crypto assets could quickly spread among a network of lenders and borrowers whose financial activities are linked to an identical set of collateral. The ongoing crypto-bankruptcy proceedings also revealed much interconnectedness among these distressed debtors through crypto-collateralized loans and cross-crypto-holdings.

In these evolving crypto-bankruptcies, judges are likely to set parameters around various substantive issues related to the valuation and recovery of crypto assets. Ingrid Bagby, Michele Maman, Anthony Greene, and Marc Veilleux considered the popular request for “payment-in-kind” distribution as prices of crypto assets are incredibly volatile and concluded that the USD continues to reign for now. The fluctuation of crypto assets’ value raises other concerns, such as the Pine Gate problem, as Anthony Casey, Brook Gotberg, and Joshua Macey noted. With the petition date serving as the artificial moment of reckoning, debtors in crypto-bankruptcies may effectively force customers into a bottom-of-market sale to finance the Chapter 11 process, and the liquidity generated may be redistributed to other creditors or managers. Relatedly, Kelvin Low and Timothy Chan discussed the fungible nature of crypto assets and how they do not have any inherent utility except for the ability to (potentially) make a profit upon alienation. 

This line of reasoning, in turn, gets to the heart of the heavily debated question of the nature of cryptocurrencies. Since the beginning of crypto-bankruptcies, a lingering question of mine has been – if these crypto exchanges and debtors’ business models bear significant similarities to banks, stock brokers, or commodity brokers, should they be excluded from filing under Chapter 11 in the first place pursuant to 11 U.S.C. § 109? Before Judge Wiles approved the Voyager-Binance deal, regulators raised objections stating that Voyager may be involved in unregistered offers and sales of securities, as well as illegal operations of virtual currency businesses without licenses. Once these crypto debtors’ business endeavors are better defined through the magnifying glass of bankruptcy proceedings and the governmental agencies settle on the regulatory framework for the crypto industry, future crypto debtors may not necessarily be eligible to seek chapter 11 remedies but will have to resort to chapter 7 liquidation or other proceedings that are specifically tailored to financial institutions. 

It is fascinating that U.S. bankruptcy courts, in addition to resolving mass torts, are now facing new challenges in navigating the ambiguities and uncertainties of U.S. crypto regulations. As they make rulings and decisions, these courts are essentially shaping the law for the entire crypto world, which was founded on the ideal of transcending centralized governance. While some jurisdictions, such as Singapore, have a manifested ambition to become a crypto hub, others, like China, have shown great animosity toward the industry. In contrast, the European Commission has recently launched a blockchain regulatory sandbox, which aims to facilitate dialogues between developers and regulators. Nonetheless, I find no dialogue more informative and soul-searching than the evolving crypto-bankruptcy cases happening here in the U.S. All eyes are on these cases, and questions are hammering at the doors of courthouses.

[Crypto-Bankruptcy Series] The Implications of CeFi and DeFi in Bankruptcy: A Hot Take on Celsius
by | posted in: Bankruptcy, Crypto-Bankruptcy Series, Cryptocurrency, International and Comparative, Jurisprudence, Priority | 0

By Kelvin FK Low and Timothy Chan (National University of Singapore)

Kelvin FK Low
Timothy Chan

Note: This post is the eighth post in a series of posts on bankruptcies of cryptocurrency companies and the emerging issues they pose. Previous posts in the series include:

1. The FTX Bankruptcy: First Week Motions, Jurisdictional Squabbling, and Other Unusual Developments, by Megan McDermott

2. Quantifying Cryptocurrency Claims in Bankruptcy: Does the Dollar Still Reign Supreme?, by Ingrid Bagby, Michele Maman, Anthony Greene, and Marc Veilleux

3. The Public and the Private of the FTX Bankruptcy, by Diane Lourdes Dick and Christopher K. Odinet

4. Staking, Yield Farming, Liquidity Mining, Crypto Lending – What are the Customer’s Risks?, by Matthias Lehmann et al. (University of Vienna)

5. The Treatment of Cryptocurrency Assets in Bankruptcy, by Steven O. Weise, Wai L. Choy, and Vincent Indelicato

6. FTX Bankruptcy – A Failure of Centralized Governance in the Name of Decentralized Cryptocurrencies, by Vivian Fang

7. Roundup: Celsius Network LLC, by Jessica Graham

This series is being managed by the Bankruptcy Roundtable and Xiao Ma, SJD at Harvard Law School, xma [at] sjd [dot] law [dot] harvard [dot] edu.

Check the HLS Bankruptcy Roundtable periodically for additional contributing posts by academics and practitioners from institutions across the country.

***

The difference between owning (i.e. having property rights in something) and being owed (i.e. having a right against a person by way of obligation) is at its most stark in bankruptcy. In the wake of multiple bankruptcies of crypto entities last year, the question of whether customers of these entities owned or were merely owed has come into sharp focus, especially when the entity has been engaged in what the industry has coined CeFi (centralized finance), which involves the lending and borrowing of crypto assets. In theory, the same questions are engaged in a DeFi (decentralized finance) transaction, where one of the roles is substituted by a peer (often pseudonymous) rather than a centralized intermediary. Determining whether property in “loaned” crypto assets belongs to a failed borrower (whether centralized intermediary or peer) who simply owes an obligation to the lender or remains with the lender throughout involves a question of characterization. Two recent motions in the Celsius litigation are instructive of how this characterization is undertaken by the courts and although the case involves CeFi rather than DeFi, there is no reason why the same reasoning does not extend to DeFi as well.

The first motion pertained to customers with assets in Celsius’ “Earn” accounts, who had been promised as high as 18% interest on sums deposited. Despite their strenuous arguments to the contrary, the bankruptcy court decided that those assets had become the property of Celsius, giving effect to Terms of Use stating that those customers had “grant[ed] Celsius … all right and title to such Eligible Digital Assets, including ownership rights”. This outcome in truth was always inevitable, perhaps even in the absence of such clear language. 

The arrangement mirrors exactly the traditional position relating to interest-bearing bank accounts, established since the mid-19th century in the common law world to entail an obligation owing to customers rather than ownership of money by customers. Cases like Thompson v Riggs 72 U.S. 663 (1866) and Foley v Hill (1848) 2 HLC 28, 9 ER 1002 decided that absent any special conditions, money deposited with a bank became the property of the bank, with the customer obtaining a claim to the return of the same amount of money (plus interest) on demand. The obligation is fungible (the bank need not return the same coins and notes deposited) and forms the basis for borrowing short and lending long that is the backbone of modern banking. This characterization is necessary because money, unlike some other property, does not have any inherent utility except by way of alienation. A bank uses deposited money as it pleases (usually by extending loans itself), makes what profit it can, and pays back to its customer the principal and agreed interest. How could a bank generate profits off the money were it otherwise? 

It is the same with most crypto assets such as Bitcoin. Whether described as staking, liquidity mining, or onward lending, all these processes involve committing the assets in a manner inconsistent with the continued ownership of the original owner of the assets. In the first motion, Celsius’s customers argued that the Terms of Use stated that they had “loaned” the Earn assets to Celsius, claiming this meant that they retained ownership of those assets. Terminology has never been conclusive in an exercise in legal characterization, but this argument was doomed to fail for a more basic reason. The term “loan” has two different meanings. The customers argued that they believed they had made a “loan” in the non-fungible sense of the term (the exact thing must be returned), as where one lends a chattel which possession itself has utility. Many examples abound. A book can be read and enjoyed; a car can be used to ferry passengers for a profit. Such “loans” can be, and are often structured, as not involving the transfer of ownership from lender to borrower. No library transfers ownership of library books to patrons in return for a mere obligation for their return. Likewise, hire agreements of cars are careful to spell out that ownership of said vehicles remains with the hire company throughout. 

However, most crypto assets are not suitable for non-fungible loans since, like money, they can only be enjoyed through alienation. As Warren Buffett famously explained in a CNBC interview, “If you said … for a 1% interest in all the farmland in the United States, pay our group $25 billion, I’ll write you a check this afternoon,” Buffett said. ”[For] $25 billion I now own 1% of the farmland. [If] you offer me 1% of all the apartment houses in the country and you want another $25 billion, I’ll write you a check, it’s very simple. Now if you told me you own all of the bitcoin in the world and you offered it to me for $25 I wouldn’t take it because what would I do with it? I’d have to sell it back to you one way or another. It isn’t going to do anything. The apartments are going to produce rent and the farms are going to produce food.” Without treading on the controversial question of whether all or most crypto assets are thus Ponzi schemes, the point holds that simply holding crypto assets doesn’t generate any returns so, unless a loan of crypto assets is characterized in the same way as a loan of money, it is difficult to see what the point of the loan is (from the borrower’s point of view) and how the borrower is supposed to generate the profits in order to pay the lender the interest it has promised. As a result, it is unsurprising that the court found that the customers had clearly made a “loan” of the fungible rather than non-fungible variety, where ownership of the property passed to Celsius in return for an obligation to return an equivalent sum plus interest.

More fortunate than the Earn customers were a group of customers who had placed crypto assets in Celsius’ “Custody” accounts. On 20 December 2022, Judge Glenn granted a motion authorizing their withdrawal of, among others, certain digital assets which had “only ever” been held in those accounts. The crucial difference was that the Terms of Use stated that ownership in crypto assets deposited in the “Custody Program” would “at all times remain with the [user]” and that Celsius would not “transfer, sell, loan or otherwise rehypothecate” such assets. The bankruptcy court agreed that assets in such “Custody Wallets” did not form part of the Celsius estate. This again is undoubtedly correct. Though the legal principles relating to ownership of crypto assets remain unsettled, in the absence of countervailing commercial indications and outside of the security context, the passing of title should be governed by the intention of the parties, such consensualism being consistent both with longstanding authority (see e.g. Cochrane v Moore (1890) 25 QBD 57; Metropolitan Trust Co of New York v McKinnon 172 F. 846 (1909)) and contemporary theories of justice in transfer. 

One theme that emerges from these two motions is the importance of the characterization process: intention is the starting point but the commercial nature of the transaction cannot be ignored. Yet, characterization is distinct from questions of actual segregation, which may pose independent obstacles to recovery. In the Celsius case it seems that customer assets were in fact segregated in the “Custody Wallets”. The “Custody” claimants were remarkably fortunate in this respect. Although ownership is superior to obligation in bankruptcy, its advantage is contingent on the customer’s ability to identify the property owned. Some crypto entities, such as FTX, are alleged to have been treated customer assets as belonging to them even though their terms of use indicate otherwise, in which case they would likely have been long dissipated or irretrievably commingled. In such cases, even if custody is taken to mean the retention of ownership, some aspects of crypto-systems may thwart customers’ claims. Given the pseudonymity and immutability of blockchains, establishing the ownership of property you are unable to identify or recover will likely prove to be cold comfort.

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