Crypto bankruptcies shed light on who owns the assets to be recovered

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The dramatic downturn in cryptocurrency has led to several recent bankruptcy filings, including those of FTX Trading and Celsius Network. For customers impacted by these deposits, recovering their deposits can be difficult.

Crypto exchanges allow customers to buy, sell, and trade digital assets. Clients can choose to leave their assets in the custody of the exchange or transfer their assets to personal wallets.

Meanwhile, crypto lenders offer loans in cryptocurrency or fiat currency, which is government-issued currency not backed by any commodity such as gold. These lenders often offer customers the ability to deposit cryptocurrency on their platforms, which the lender will then deploy to make a profit by lending, mortgaging, staking, or selling the assets.

With limited industry regulation, these firms operate with little government oversight and no uniform guidelines regarding the management of customer deposits. Often, each lender or exchange must impose its own safeguards in the management and protection of customer deposits.

This uncertain landscape contributes to confusion over the disposition of customers’ digital assets when lenders and exchanges fail.

Nonetheless, several common threads emerged, including:

Who owns the digital assets that customers deposit with a crypto business may depend on the contractual relationship between the customers and the crypto business. Even if a customer owns the digital assets, many failed crypto businesses may not be able to return client assets in kind Who owns the crypto assets?

The default under the Bankruptcy Code is to fix the value of a debt as of the date a debtor files for bankruptcy. But if customers own their assets, those assets can be returned in kind, allowing customers to benefit from any increase in value of their digital assets during bankruptcy.

The Southern District of New York in the Celsius case ruled that customer deposits in certain accounts constituted ownership of the bankruptcy estate and not the property of the customer. The court determined that the terms of use constituted a binding contract transferring ownership of the deposits to Celsius.

The ruling does not bind courts in other Chapter 11 crypto cases, but it represents a major shift in the law relating to the ownership and handling of digital assets. Parties have applied similar logic to arguments in other cases.

For example, various FTX client groups have recently argued that because the terms of service provide that clients retain ownership of their assets, those assets did not become the property of FTX’s bankruptcy estate upon filing. .

The Celsius case provides a roadmap for arguments that may soon apply in similar bankruptcy cases.

Property recovery

Even if a court determines that digital assets held by a bankrupt exchange or lender are the property of the customer and not the property of the estate, many bankrupt crypto businesses may not be able to return customer assets. in nature.

In some cases, once deposited with an exchange or lender, a client’s assets are co-mingled in a centralized wallet with other client assets, or the assets of the exchange or lender. This makes tracing ownership of digital assets difficult, if not impossible.

Additionally, crypto firms often manage billions of dollars of exposure to digital asset exchanges and loans, but often hold only a fraction of those assets in their accounts.

Thus, clients in crypto bankruptcies face serious hurdles in recovering from the risks posed by the rapid and unregulated growth of crypto lenders and exchanges.

For example, FTX recently disclosed $5.5 billion in various assets. Although substantial, this number is far from sufficient to cover all customer deposits.

Similarly, an interim report from the court-appointed examiner in Celsius’s bankruptcy found that Celsius held about $50 million less in crypto assets than deposited clients.

Following the rapid fall of FTX, allegations of fraud and mismanagement emerged. This includes allegations that founder Sam Bankman-Fried used client deposits to, among other things, purchase personal real estate and contribute to political campaigns.

Similarly, according to the court-appointed examiner in the Celsius bankruptcy, customer deposits were mixed without sufficient accounting and operational controls or technical infrastructure.

To lend

These circumstances complicate the ability of customers to recover their assets from insolvent crypto businesses, making it clear that establishing ownership of digital assets is only the first step in a potentially long battle to regain ownership of digital assets. clients.

Without sufficient digital assets to cover all customer claims, customers may fight to recover a pro rata portion of the assets they can legally own. Additionally, crypto bankruptcies involving fraud or Ponzi schemes may subject commingled client assets to government orders for confiscation or restitution, further complicating client recoveries.

Insolvencies among lenders and crypto exchanges have revealed a lot about the industry and the disposition of troubled crypto assets. Ownership of crypto assets in the event of bankruptcy may depend on the contractual relationship between customers and crypto businesses.

But even if customers own their assets, failures in risk management and, in some cases, outright fraud, complicate the process for customers to recover their assets.

As these crypto insolvencies continue, the landscape of troubled crypto assets may soon become even clearer.

This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Author Information

Jessica Liou is a partner in the Restructuring department of Weils. She represents and advises debtors, creditors, shareholders, investors and other interested parties in all aspects of distress and insolvency situations.

John Marinelli is a partner in the restructuring department of Weils.

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