Suppose bitcoin’s (BTC) price doubles over the coming months. Would the hundreds of thousands of customers whose cryptocurrency assets are frozen within stricken lending platform Celsius Network come out ahead, or just break even?
This is uncharted territory for a U.S. bankruptcy court.
The high volatility of cryptocurrencies created the extreme market conditions that saw crypto lender Celsius freeze customer withdrawals in early June and later confess to a $1.2 billion hole in its balance sheet. But an equally dramatic upswing in cryptocurrency prices could conceivably happen before the case – in the U.S. Bankruptcy Court for the Southern District of New York – is concluded.
The possibility of a thaw in the crypto winter was mentioned at the first bankruptcy hearing by Patrick Nash – a partner at Kirkland & Ellis, the law firm representing Celsius – who added that the majority of customers are expected to remain “long crypto.”
The strategy of waiting for an eventual change in the crypto climate was echoed by Vincent Indelicato, a partner at law firm Proskauer who is focused on corporate restructurings.
“Stakeholders may very well want to use the bankruptcy process to wait out the crypto winter and hibernate until it thaws a little bit so that they could then capture the upside of the rebound,” Indelicato said in an interview with CoinDesk.
The option to take recoveries in crypto sounds like it could be a boon for Celsius account holders, but much depends on what that means in practice, said Daniel Besikof, a partner at law firm Loeb & Loeb.
“The general rule is that creditors in bankruptcy have claims, denominated in [U.S. dollars], measured as of the date of the bankruptcy filing. It will be interesting to see how that rule is applied in this unique setting,” said Besikof in an interview.
Imagine a hypothetical account holder who has $1 million worth of bitcoin on the bankruptcy petition date of his or her exchange, Besikof suggested. In this example, if bitcoin goes down, recoveries on the claim will also likely go down. But if bitcoin doubles, would that creditor have a claim that’s now worth $2 million? Could he or she recover more than $1 million?
The courts will have to decide, Besikof said.
“I could see exchanges arguing that the account holder’s recovery is capped at $1 million, even if the exchange is flush with cash and crypto assets from the price increases,” he said. “That argument would create a potential windfall for the equity holders, but would be highly detrimental to account holders. This concern could be alleviated if the plan provided for the return of some or all of the customer’s crypto.”
The situation is somewhat analogous to certain oil and gas companies that filed at the bottom of that market, only to become solvent later on in the case as oil prices increased, Besikof said. “However, in those cases, creditors were actually paid in full – the value of what they were owed did not also increase with the price of oil.”
Go to rehab
It’s worth highlighting ongoing legal disputes involving cryptocurrency firms, such as the now infamous customer losses associated with collapsed exchange Mt. Gox, which entered bankruptcy proceedings in Japan back in 2014.
A ruling on the legal status of property of the crypto assets – approximately 200,000 BTC held by the Mt. Gox bankruptcy estate that kept appreciating in value until it eventually overtook the total legal claim value of all creditors – might have been useful. But the court punted on the issue by switching to civil rehabilitation, a type of proceeding in Japan that bears some similarity to U.S. Chapter 11 restructuring, where a debtor retains the power to continue to manage its business.
That said, Mt. Gox is only really an indication of how things have progressed within the slow-moving jurisdiction of Japan, and doesn’t provide a clear indication of what will happen under the U.S. bankruptcy code, noted Thomas Braziel, the founder of 507 Capital, a firm that has purchased Mt. Gox bankruptcy claims.
“The problem with talking about previous cases is that it’s not U.S. bankruptcy law, or even U.S. law at all,” Braziel said in an interview. “So while of course it’s interesting, I don't think that the U.S. bankruptcy court is going to consider this non-estate property, and it’s all held in trust.”
As it stands, the dispositive issue of whether the cryptocurrency assets are custodial (meaning their title and ownership remains the property of the customer) or those assets are now the property of the bankruptcy estate, is determined by the language in the firm’s customer agreements.
The terms attached to Celsius’ custody wallets, which were purely for storage and did not pay interest, seem to suggest the firm should give that property back to those customers, but those assets only make up 4% of the outstanding pie (about $180 million at today’s prices). The rest of the assets are locked up in Celsius’ high-yield Earn program. According to the firm’s terms and conditions, customers who elect to use this service will “grant Celsius all rights and title to such digital assets, for Celsius to use in its sole discretion while using the Earn Service.”
However, those terms of service aren’t the endpoint in a case like this; they’re more like the starting point, noted Braziel. “There are tons of contractual terms that are totally unenforceable in bankruptcy court, let alone any court of law,” he said. “And if the firm wasn’t following the rules within a given jurisdiction where something was offered, then the terms of service aren’t even applicable.”
Just one of the cans of worms to be opened further into the bankruptcy proceedings concerns those non-accredited investors (mom-and-pop investors, basically) who were grandfathered into the Earn program by Celsius as the firm fielded scrutiny from state regulators, but who would properly belong in the custodial wallet bucket if they were to remain on the platform.
“There are different pockets that are very interesting,” said Braziel. “Those guys who got grandfathered in should probably form an ad hoc group; basically a group of people with common interests that like an argument enough to foot the bill themselves.”
Rip it up and start again
Some of these questions may well become moot, or at least secondary, if the stakeholders can find the right conceptual framework for a reorganization plan that works for the customers, said Proskauer’s Indelicato.
Bankruptcy cases often become a tug of war between groups of stakeholders who may turn out to be the customers and the equity holders in this case, noted Indelicato. These parties will focus on who gets the biggest piece of the pie, and how you measure a piece of that pie, he said.
“If you’re an equity holder, you may want to assert a view that the crypto assets should be frozen and valued at the time of the filing, not as they appreciate over the life of the case – assuming that we see market appreciation of cryptocurrency prices.”
A crypto-market value appreciation, should it happen while the case rumbles on, will become an important driver for customers of Celsius, who already hold conviction in the technology and who may also want to avoid tax and other unintended consequences of cashing out, said Indelicato.
“This is very much uncharted territory, and because of that I think the conventional toolbox and ruleset really gets thrown out the window,” Indelicato said. “Just take the playbook and rip it up. For those reasons, the Celsius and Voyager Digital cases will require innovation, creativity and people who can think outside the box.”
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