[Crypto-Bankruptcy Series] Crypto Volatility and The Pine Gate Problem
by | posted in: Bankruptcy Reform, Chapter 11, Collateral Stripping, Crypto-Bankruptcy Series, Cryptocurrency, Valuation | 0

By Anthony Casey (University of Chicago), Brook Gotberg (Brigham Young University), and Joshua Macey (University of Chicago)

Anthony Casey
Brook Gotberg
Joshua Macey

Note: This post is the ninth 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

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.

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When a crypto exchange such as FTX files for bankruptcy, crypto assets will often be treated as property of the estate and not as property of the individual or business that deposited coins with the exchange. Scholars have focused on the financial stability and consumer protection issues that arise as a result of this treatment.

In our opinion, there is an additional reason to treat crypto depositors as owners, not as creditors, of crypto assets, and to exempt holders of crypto assets from ordinary bankruptcy procedures such as the automatic stay. With some exceptions such as stablecoins, crypto assets are highly volatile. Claims against a crypto exchange, including claims submitted by customers who traded crypto assets on the exchange, are valued at the filing date. The failure of a crypto exchange is likely to occur when the crypto asset’s value has declined significantly. The fact that claims are valued at the filing date could lead to strategic bankruptcy petitions that redistribute value away from junior claimants. And even if crypto exchanges do not file with this purpose in mind, bankruptcy, by creating an artificial moment of reckoning, is likely to redistribute value from customers of a crypto exchange to the exchange’s other creditors or managers.

This is an extreme version of a familiar problem, which is that bankruptcy, by forcing a moment of reckoning, causes claimants who have invested in volatile assets to lose the option value of those investments. Imagine a company that has an asset that could appreciate significantly in the future but currently holds little value. If the firm files for bankruptcy, creditor claims are based on the value of the asset at the time the firm files for bankruptcy. If there is reason to think that the asset’s value will increase in the future, a bankruptcy filing allows the debtor to pay the relatively little and then benefit when the asset’s value goes up. That, in our opinion, offers another reason to think that customers of crypto exchanges should not be treated as unsecured creditors.

Click here to read the full article.

The Development of Collateral Stripping by Distressed Borrowers
by | posted in: Bankruptcy Roundtable Updates, Collateral Stripping, Distressed Debt Markets | 0

By Mitchell Mengden (Law Clerk, Delaware Court of Chancery)

Mitchell Mengden

In the past decade, private equity sponsors have taken a more aggressive stance against creditors of their portfolio companies, the most recent iteration of which has come in the form of collateral stripping. Sponsors have been using creative lawyering to transfer valuable collateral out of the reach of creditors. This Article delves deeper into the issue by examining the contract terms and litigation claims raised by these transactions.

The lack of protective covenants and ease of manipulating EBITDA and asset valuations are key conditions that permit collateral stripping. Each of these conditions were present in the past decade, primarily due to the protracted expansionary stage of the credit cycle. Lenders, however, can protect themselves from collateral stripping by negotiating stricter covenants and tighter EBITDA definitions, as well as pursuing ex post litigation for fraudulent transfers, illegal distributions, and claims for breach of fiduciary duty.

Contractual opportunism and creative lawyering will almost certainly continue to pervade credit markets. This Article provides a roadmap of ways that lenders can protect themselves from opportunism during contracting and throughout the course of the loan. As this Article concludes, ex post litigation claims are often an inadequate remedy, so lenders should seek to tighten EBITDA definitions and broaden protective covenants—even if to do so requires other concessions—to avoid litigation.

The full article is available here.