[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] 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.

***

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.

[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.

[Crypto-Bankruptcy Series] Roundup: Celsius Network LLC
by | posted in: Bankruptcy, Chapter 11, Crypto-Bankruptcy Series, Cryptocurrency, Priority | 0

By Jessica R. Graham (Harvard Law School)

Jessica R. Graham

Note: This post is the seventh 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

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.

***

On January 4th, 2023, the U.S. Bankruptcy Court for the Southern District of New York issued its opinion regarding digital assets held by Celsius Network LLC (“the Debtor”). In a decision that arguably could have lasting implications for crypto bankruptcies and the crypto industry more generally, the Court held that the assets deposited with Celsius in one of its programs, the “Earn” rewards program, had been relinquished to the Debtor and thus are to be considered assets of the Debtor’s bankruptcy estate. For customers with assets in the Debtor’s “Earn” program, this decision means that they will not be entitled to an immediate return of their invested assets. Instead, “Earn” customers will be treated as general unsecured creditors and receive payment at the end of the Debtor’s bankruptcy.  Such payments will be made only after payment to any other priority creditors, and “Earn” customers will receive payments proportionate to the amount of their investments out of whatever money may be left at the end of the bankruptcy.

The Debtor offered three types of accounts: (1) “Earn”; (2) “Custody”; and (3) “Borrow”. This holding only applies to the “Earn” accounts because of the nature of the accounts. Assets deposited through the “Earn” program were comingled across consumers, and the Debtor had the right to invest these assets or use them for other purposes. In registering for one of these accounts, the Terms of Use dictated that customers were transferring ownership of assets deposited in the account to the Debtor, “in every sense and for all purposes.” Thus, the Court reasoned, these assets must be considered the property of the estate.  In interpreting the Terms of Use as an enforceable contract, the Court rejected the claim that these agreements were merely clickwrap. The Court also rejected the claim that the terms of use were ambiguous, stating that nothing in the agreement suggested customers would retain a lien on the assets they deposited. The Court did, however, leave the door open for customers to challenge the possession of their specific assets with individual defenses—the Court only articulated an assumption that the assets were the estate’s property.

The overarching theme is the importance of digital asset holders to carefully read the terms of use when opening accounts. Assets held in the other two types of accounts—“Custody” and “Borrow”—will need to be addressed in separate litigation, as they are governed by different customer agreements and management standards.

Several law firms have taken note of this decision, providing takeaways and analyses of impact. Sidley stresses the importance of carefully reading (for investors) or drafting (for market participants) the terms of use agreements and their related marketing materials. Morrison Foerster emphasizes the special nature of the decision, reasoning that it is unlikely to be determinative for other crypto cases because of the reliance on specific terms of use. Husch Blackwell highlights the importance of the Court’s imminent decisions regarding the other types of accounts, noting that the implications of those decisions could alter the landscape of crypto in the future.

[Crypto-Bankruptcy Series] FTX Bankruptcy – A Failure of Centralized Governance in the Name of Decentralized Cryptocurrencies
by | posted in: Bankruptcy, Corporate Governance, Crypto-Bankruptcy Series, Cryptocurrency, Valuation | 0

By Vivian Fang (University of Minnesota)

Vivian Fang

Note: This post is the sixth 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

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 fall of the once mighty crypto exchange FTX is sometimes mythologized, but what led to its bankruptcy may be simpler than you think. In a nutshell, FTX transferred a large amount of its native tokens to a closely affiliated trading firm Alameda Research. Using these tokens as collateral, Alameda borrowed real assets, made risky bets, and lost huge sums of money. Then, to cover up mounting losses, FTX and Alameda arranged obscure transactions between themselves. In the end, they went bankrupt for the same reason many other companies do: assets were insufficient to offset liabilities.

So, what lies at the crux of this mess? Let me start with FTT, which is FTX’s native token. It is not uncommon for a crypto exchange to issue a utility token to provide users with a convenient means of accessing features and benefits on the platform, such as discounted trading fees, early access to token sales, and voting rights. By offering such a token, a crypto exchange can create an integrated ecosystem and promote growth.

While FTT may have proven valuable to platform users as a utility token, it differed from open-source cryptocurrencies especially Bitcoin, being the first and most prominent, in two important aspects. First, FTT was issued and centrally controlled by FTX, while Bitcoin is generated and governed by a decentralized community. This means that FTX—a centralized exchange—could freely move large quantities of FTTs to affiliated entities like Alameda. This also means that FTX and Alameda should not have recognized FTT tokens as assets, just like stock should not be booked as assets by the issuing company or its subsidiaries. Second, supply and demand, which ultimately determine an asset’s value, are distinctly different between the two tokens. With FTT, the demand was tied to the performance and popularity of FTX platform, and the supply was tightly controlled by FTX, through its release of tokens, regular repurchases, and token burning. With Bitcoin, the demand comes from its perceived investment value and other utilities by a broad base of investors and users, while the supply is rigidly set by its open-source algorithm. This difference explains why FTT tended to be much riskier and less liquid than Bitcoin and why the announcement of a block sale by Binance, a competing crypto exchange, triggered a sharp decline in FTT’s price.

Unfortunately, the core issues that resulted in FTX’s bankruptcy—the use of illiquid and complicated financial instruments to inflate assets, excessive risk-taking leading to huge debts and losses, and engagement in shady non-arm’s length transactions with affiliated entities—are nothing new in U.S. corporate history. For example, mortgage-backed securities (MBS), another illiquid and complicated financial instrument that packages mortgage debts into bond-like securities, played a key role in driving the 2007–2008 financial crisis. Major financial institutions’ involvement with MBS made it possible for them to inflate assets and take risks, which fueled a real estate bubble and resulted in the largest corporate bankruptcy in U.S. history (Lehman Brothers). Take Enron as another example. The company was a dominant player in the global market for energy derivatives, which are financial contracts that enable transacting companies to manage exposure to energy prices. This market was highly obscure, and Enron assumed huge risks from its counterparties. When Enron’s energy trading business turned unprofitable, it attempted to cover up by creating a network of special purpose entities (SPEs) to raise debt and hide losses.

There are, of course, unique lessons to learn from every epic corporate downfall. Three aspects of FTX’s bankruptcy warrant emphasis. First, FTX is a case of regulator shopping facilitated by the status quo of the U.S. crypto regulation. The U.S. lacks a workable regulatory framework that guides exchange platforms on how to provide crypto-based financial services and store customer funds in a transparent manner. As such, many crypto exchanges set up operations offshore where regulation and enforcement are weaker, and customer protection is likely compromised. Second, FTX is a case of an accounting scandal facilitated by the lack of crypto accounting and disclosure requirements. In the U.S., the Financial Accounting Standards Board (FASB) is reportedly working on finalizing an authoritative rule that would require the use of fair-value accounting for crypto assets. It, however, remains a question as to how well this approach will apply to illiquid tokens like FTT, the value of which could evaporate overnight. It also remains a challenge as to how to consolidate accounting for deeply intertwined crypto entities. Third, FTX is a case of failed centralized governance in the name of decentralized crypto assets. Bitcoin, which is emblematic of decentralization, was created with the mission to circumvent centralized control. However, when decentralized assets are traded on a centrally controlled platform like FTX, the platform itself is no different from a traditional financial institution. To that end, proper governance measures must be implemented to prevent problems like conflicts of interest, excessive risk-taking, and misappropriation of customer funds.

[Crypto-Bankruptcy Series] The Treatment of Cryptocurrency Assets in Bankruptcy
by | posted in: Bankruptcy, Chapter 11, Crypto-Bankruptcy Series, Cryptocurrency, Priority, Statutory Interpretation | 0

By Steven O. Weise, Wai L. Choy, and Vincent Indelicato (Proskauer Rose LLP)

Steven O. Weise
Wai L. Choy
Vincent Indelicato

Note: This post is the fifth 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)

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 cryptocurrency market has experienced significant liquidity events, accelerating an industrywide sell-off and leaving the value of cryptocurrencies at historic lows—what many call a “crypto winter.” The idea that participants in the cryptocurrency industry, namely exchanges that operate platforms that allow users to transact in cryptocurrency, may resort to chapter 11 bankruptcy has created questions as to how such assets would be handled during a bankruptcy.

In “The Treatment of Cryptocurrency Assets in Bankruptcy,” Proskauer partners Steven O. Weise, Wai Choy, and Vincent Indelicato explore the question of whether crypto assets deposited by customers in a cryptocurrency exchange may be considered property of the bankruptcy estate and therefore not recoverable by the customer.  While some commentators have suggested that crypto assets might be considered property of the bankruptcy estate, existing common law, current provisions of Uniform Commercial Code (UCC) Article 8, and proposed amendments to the UCC recognize that if the arrangement and relationship between the exchange and its customers is one that is characterized as “custodial,” the crypto assets held by the exchange should remain property of the customers and, hence, not subject to dilution by general unsecured claim holders.  However, the analysis of when a custodial relationship exists will depend on the agreements and other facts of a particular relationship.

Click here to read the full article.

[Crypto Bankruptcy Series] Staking, Yield Farming, Liquidity Mining, Crypto Lending – What are the Customer’s Risks?
by | posted in: Bankruptcy, Bankruptcy Roundtable Updates, Crypto-Bankruptcy Series, Cryptocurrency, International and Comparative, Priority | 0

By Matthias Lehmann et al. (Universitat Wien)

Matthias Lehmann

Note: This post is the fourth 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, Diane Lourdes Dick and Christopher K. Odinet

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 consequences customers face in case a crypto exchange like FTX goes bankrupt are enormous, but they may be even more severe if they had previously staked their digital assets or engaged in a similar transaction. As a matter of fact, it is not a far-fetched to fret that a bankruptcy court may construe such a transaction as entailing an asset transfer to the exchange or a third party. In this case, the crypto assets – Bitcoin, Ether or token – would be considered as a part of the insolvency estate or as belonging to somebody else. Customer would have no propriety rights in them and be relegated to the status of mere creditors, with the prospect of receiving only a fraction of the asset’s value.

In this context, it is of paramount importance how the transaction in question is to be legally characterized. Characterization is the process by which an empirical phenomenon is attributed to a particular legal category. This exercise is not always easy, and it is particularly difficult with regard to the operations in the crypto space. There is hardly any literature on them, because they are in large part novel and unprecedented. The legal nature and effects of such operations depend in the first place on the terms and conditions to which they are submitted. But many of them use highly general notions and are legally unprecise. To achieve definite results, it is likely for a court to intuitively trying to associate the transactions described with a known category. This will be important in two respects.

First, the category chosen for a certain transaction will inform the conditions for its validity as well as its effects. In particular, it will decide whether the customer has transferred her rights fully and thus bears the full risk of the counterparty’s insolvency, or whether the transaction merely creates a more limited right in rem of the crypto exchange or a third party.

Second, characterization is also important to identify the national law governing these transactions. Conflict-of-laws rules will be applied by a bankruptcy court to determine, as a preliminary question, whether an asset forms part of the insolvency estate or whether it belongs to another person. There are different conflict-of-laws rules for different types of transaction, which point to different laws depending on the transaction’s characteristics.

Which category a transaction is shoehorned in will thus be decisive in several ways for the position of the crypto investor. But how can they be legally characterized?

Admittedly, this is not easy. To take just one example, the legal nature of staking is quite doubtful. Potentially, it could be considered as a secured transaction because it enables to ‘slash’ the investor’s crypto asset in case of manipulative activity or inactivity of a node. But it may also be compared to a deposit or a loan of cryptos. It is even not excluded to view staking through the lenses of a partnership that may exist between all nodes of a platform, or as being constitutive of a trust.

Similar problems arise for yield farming, liquidity mining and crypto lending. These operations must be distinguished from staking and from each other, even though the lines are often blurred. How they are to be legally characterized is highly relevant for the position of the crypto investor.

Any characterization needs to reflect the terms and conditions, the typical intention of the parties, and the economic purpose of the transaction. But above all, it should be informed by the consequences it has for investor protection. Unless clearly indicated in the agreement and absolutely indispensable for achieving the purpose of the transaction, it should not be assumed that the investor intended to part with her ownership or other rights of entitlement. Where the terms and conditions are equivocal or ambiguous about this point, they should be interpreted against the person that formulated them, according to the time honoured “contra proferentem” principle for constructing constructs. When and for which transactions a transfer of property or other rights can be presumed will be the decisive question. The debate about this problem has just begun. Felix Krysa, Emeric Prévost, Fabian Schinerl, Robert Vogelauer and I have examined different options and made suggestions for precise characterization in a new paper.

Click here to read the full article.

[Crypto-Bankruptcy Series] The Public and the Private of the FTX Bankruptcy
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Chapter 11, Corporate Governance, Crypto-Bankruptcy Series, Cryptocurrency, Priority, Reorganization | 0

By Diane Lourdes Dick and Christopher K. Odinet (University of Iowa)

Diane Lourdes Dick
Christopher K. Odinet

Note: This post is the third 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

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.

***

Bankruptcy has a public and a private side. The reorganization of a private company in chapter 11 has implications for the public, and, in some reorganizations, the public interest is quite substantial. The recent bankruptcy of the third largest crypto exchange in the world, FTX, represents just the kind of corporate restructuring where the public interest is front and center. Yet the public priority embedded in these proceedings has the potential to be overlooked. In this work, we aim to change that by shining light on the stakes, the costs, and the allocative decisions to be made in what will no doubt be described as one of the most consequential legal proceedings to happen in the world of crypto. Specifically, the outcome of these proceedings will help clear up what it means to hold crypto as a form of property, as well as the custodial v. proprietary nature of the relationship between crypto exchange companies and their customers as to rights in crypto assets. The answers to these questions will not only help resolve this bankruptcy but they will also guide lawmakers and regulators as they seek a way to regulate and police the crypto market in the future. As such, we question whether the private value capturing model that is chapter 11 is the right framework—particularly when it comes to the allocation of who bears the costs—for these largely public-oriented matters.

Click here to read the full article.

[Crypto-Bankruptcy Series] Quantifying Cryptocurrency Claims in Bankruptcy: Does the Dollar Still Reign Supreme?
by | posted in: Bankruptcy, Chapter 11, Claims Trading, Crypto-Bankruptcy Series, Cryptocurrency, Reorganization, Valuation | 0

By Ingrid Bagby, Michele Maman, Anthony Greene, and Marc Veilleux (Cadwalader Wickersham & Taft LLP)

Note: This post is the second post in a series of posts on bankruptcies of cryptocurrency companies and the emerging issues they pose. The first post can be read here (by Megan McDermott).

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.

***

Ingrid Bagby

Michele Maman

Anthony Greene

Marc Veilleux

Crypto-watchers and bankruptcy lawyers alike have speculated how customer claims based on digital assets such as cryptocurrencies should be valued and measured under bankruptcy law. However, a crypto-centric approach to valuing claims raises a number of issues.  For example, measuring customer claims in cryptocurrency and making “in-kind” distributions of these assets could lead to creditors within the same class receiving recoveries of disparate USD value due to fluctuation in cryptocurrency prices. Moreover, the administrative burden associated with maintaining, accounting for, and distributing a wide variety of cryptocurrencies as part of a recovery scheme or plan may prove costly and complex.  Equity holders also might challenge the confirmability of a plan where valuations and recoveries are based on cryptocurrency rather than USD, as a dramatic rise in cryptocurrency values may  allow for a return of  value to equity.

A recent dispute in the Celsius bankruptcy proceedings as to whether a debtor is required to schedule claims in USD, or whether cryptocurrency claims can be scheduled “in-kind,” may serve as a preview of things to come on these issues. In Celsius, each Debtor’s schedule of unsecured creditors’ claims (Schedule E/F) listed customer claims by the number of various forms of cryptocurrency coins and account types, rather than in USD. Subsequently, a  group of Celsius preferred shareholders filed a motion directing the Debtors to amend their Schedules to reflect customer claims valued in USD, in addition to cryptocurrency coin counts.

Ultimately, the Debtors and the Series B Preferred Holders were able to consensually resolve the motion by the Debtors agreeing to amend their schedules by filing a conversion table reflecting the Debtors’ view of the rate of conversion of all cryptocurrencies listed in the Debtors’ schedules to USD as of the petition date.  However, it remains to be seen whether scheduling of claims in cryptocurrency and providing conversion tables will become the norm in similar cases involving primarily crypto-assets.  Practitioners and creditors should expect further issues to arise in the claims resolution process in crypto-related  cases as claimants and liquidation trustees (or plan administrators) wrestle with how to value claims based on such a volatile asset, subject to ever-increasing regulatory scrutiny.  For now, the bankruptcy process continues to run on USD.

The full article can be read here, and the memo is also republished by National Law Review, Lexology and Mondaq.

 

[Crypto-Bankruptcy Series] The FTX Bankruptcy: First Week Motions, Jurisdictional Squabbling, and Other Unusual Developments
by | posted in: Avoidance, Bankruptcy, Chapter 11, Chapter 15, Crypto-Bankruptcy Series, Cryptocurrency, International and Comparative, Priority | 0

By Megan McDermott (University of Wisconsin-Madison School of Law)

Megan McDermott

Note: This post is the first post in a series of posts on bankruptcies of cryptocurrency companies and the emerging issues they pose.  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 FTX bankruptcy isn’t just significant for its size and scope, but also for some extraordinary procedural wrinkles.  Here are a few notable developments from the first six weeks of the FTX bankruptcy:

  • Unusual delays. Most Chapter 11 bankruptcies are the products of weeks, if not months, of behind the scenes planning.  As a result, the typical debtor is able to file a flurry of first day motions that ensure a high degree of debtor control – at least during the early stages of bankruptcy, while creditors are scrambling to find representation and determine strategy.  Not so with FTX, due to the fact that current CEO John Ray took over from Sam Bankman-Fried immediately before the Chapter 11 filing.  Ray has testified that FTX’s abysmal record-keeping and absence of corporate controls have made it extremely difficult to get an accurate picture of FTX’s assets and liabilities.  As a result, the traditional first day motions were heard a week into proceedings, and second day motions were postponed to January 11. The delay makes it easier for individual creditors to organize push back to the debtors’ plans, which could in turn impact overall creditor recovery.
  • Jurisdictional squabbling. Bahamian regulators are mounting a spirited fight to retain control over the liquidation of FTX Digital Markets, one of the many entities in FTX’s global web of related businesses.  The Bahamian regulators backed off their initial strategy of asking the Southern District of New York to open a parallel Chapter 15 proceeding.  Nonetheless, they are currently arguing that the Delaware Bankruptcy Court lacks authority to halt liquidation under Bahamanian law.  Given the rumors that Bahamanian authorities encouraged (or possibly compelled) Bankman-Fried to give Bahamanian customers preferential treatment in withdrawing frozen funds, there is a lot at stake in this jurisdictional skirmish.  In his testimony to Congress, Ray mentioned this “extraordinary pushback” but expressed confidence that these efforts would be rejected in favor of the transparency and clarity that Chapter 11 promises to all stakeholders.
  • Sealed submissions. Despite this commitment to transparency, FTX has asked to file a variety of court submissions under seal, including creditor lists.  FTX’s lawyers argue that revealing creditor names would make them a target for hacking or, at the very least, poaching by competitors of FTX.  The U.S. Trustee has objected strenuously to sealing these records, on the grounds that these risks are the trade-offs of a public and transparent proceeding.  In addition, Dow Jones, Bloomberg, and other media interests have moved to intervene in order to oppose the debtor’s efforts to avoid disclosing creditor identities.  In the Celsius bankruptcy, the Southern District of New York decisively rejected efforts to keep parts of the docket under seal.  Judge Dorsey hasn’t taken a clear position yet but has agreed to keep creditor lists under seal – for now.
  • Preferential transfers. During Congressional questioning, Ray was asked about rumors of looting in the months preceding the Chapter 11 filing, as well as some dubious post-petition maneuvers.  There are also likely to be a number of insider transfers, especially since at least one of Bankman’s Fried’s parents (Stanford Law Professor Joseph Bankman) has reportedly received payments from FTX.  Transfers between FTX and Bankman-Fried and his family may be in the billions.  Expect some bombshells as FTX seeks to use Chapter 11 to avoid these transfers.
  • Property of the estate. Major stakeholders are already wrangling to have their assets returned on the ground that these assets should not be considered property of the estate.  Of particular note are two motions filed by committees representing U.S. and non-U.S. exchange customers.  The customers are arguing that they are entitled to have their crypto assets returned rather than having to wait in line for a pro rata recovery alongside other unsecured creditors.  Although some commentators have suggested that FTX’s terms of service may support these arguments, the legal authority for how to treat these assets is far from clear.  Another early mover is crypto lender BlockFi, which is staking its claim to 56 million Robinhood shares that Alameda Research had pledged as collateral shortly before FTX’s Chapter 11 filing.  These shares have lost around 40% of their value since early November, which is part of the reason BlockFi has filed its own Chapter 11 bankruptcy in the District of New Jersey.  Bankruptcy courts across the country will likely see many similar ripple effects before FTX’s creditors see any recovery.
  • Executory contracts. Given FTX’s lavish public relations spending and celebrity co-branding, many FTX partners are undoubtedly eager to extricate themselves from the now-disgraced company.  For example, the publisher of the League of Legends video game filed an early motion for relief from the automatic stay, asking the court’s permission to halt their contractual obligation to promote FTX at various events.  Right before the new year, FTX granted their wishes, moving to reject that cobranding deal alongside a long list of other executory contracts.  FTX’s motion details almost two dozen sponsorship deals, ranging from the Golden State Warriors to Berkeley Athletics to an international cricket competition.  FTX also hopes to cast aside paid celebrity endorsements from the likes of Gisele Bundchen and Shohei Otani.  In the motion, FTX explained that “the Contracts are not integral to the Debtors’ Chapter 11 efforts, are not otherwise beneficial to the Debtors’ estates and present burdensome liabilities.”  Accordingly, FTX requested that the contracts be deemed terminated immediately.  That means the Miami Heat Arena may soon be in the market for a new naming rights partner.  (See photo.)  [Editor’s Note: On January 11, 2023, the bankruptcy court approved the termination of FTX’s naming rights: https://www.nba.com/news/miami-dade-coun…]