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Crypto Winter Triggers Calls for Clear Bankruptcy Guidelines

July 15, 2022, 9:00 AM

The bursting of the cryptocurrency market is fueling calls for clearer guidelines on how to treat assets in crypto company bankruptcies.

Like the technology itself, uncertainties abound at the intersection of cryptocurrency and bankruptcy, stumping executives, attorneys, and traders.

Answers are still unclear on to what extent customers’ crypto holdings can be used to pay back other creditors and if a bankrupt exchange can still allow trades. There are also lingering discussions on whether crypto assets should be considered commodities—as opposed to securities—in a bankruptcy case, a distinction that can confer some benefits to both crypto companies in Chapter 11 and their customers.

“In any bankruptcy, regardless of the industry, predictability is key,” said Emanuel Grillo, a partner at Allen & Overy LLP’s restructuring practice.

A recent spate of Chapter 11 filings by crypto companies—including July filings from lender Celsius Network and broker Voyager—intimate more bankruptcies in the industry and will likely underscore advocacy for clearer rules.

In June, Wyoming Republican Sen. Cynthia Lummis and New York Democrat Sen. Kirsten Gillibrand introduced a bill that they tout will inject more clarity and consistent rules to the crypto market.

Crypto platforms are “highly vulnerable to deleveraging, fire sales, and contagion,” Federal Reserve Vice Chairwoman Lael Brainard said in a speech last week, highlighting a cryptocurrency hedge fund’s bankruptcy and recent freezes on withdrawals at some crypto exchanges and lending companies.

“The recent turbulence and losses among retail investors in crypto highlight the urgent need to ensure compliance with existing regulations and to fill any gaps where regulations or enforcement may need to be tailored,” Brainard said.

The Lummis-Gillibrand Responsible Financial Innovation Act is a wide-ranging bill that contains proposals on crypto tax treatment and stablecoin regulation. It also confers more authority to the Commodity Futures Trading Commission to regulate crypto coins and clarifies some issues that would linger in the event of crypto exchange bankruptcy.

“In order to have a safe and secure digital asset market, participants must have the same consumer protections as they do in securities and commodities markets. This should be an area of broad agreement,” Gillibrand said in a statement.

Crypto as Commodity

The bill would generally assume that cryptocurrencies are commodities, and apply existing statutes on commodity broker liquidation to digital assets.

The bill’s treatment of many crypto assets as commodities is one of the legislation’s major benefits, said Gabriel Benincasa, a partner at Holland & Knight LLP who was the SEC’s first chief risk officer.

“This would be one of the things that gives clear guidelines,” Benincasa said.

An existing bankruptcy “safe harbor” allows assets like commodities and securities to continue to be traded on an exchange, a rule meant to protect the financial markets.

The Lummis-Gillibrand bill would extend that safe harbor to digital assets. That likely means the automatic stay—a principle that largely bars creditors from collecting on their claims from bankrupt debtors—won’t apply to crypto holders that seek to trade or liquidate in a bankrupt exchange.

“They can continue, they can be concluded,” said Joanne Gelfand, a bankruptcy attorney at Akerman LLP. “The fraudulent transfer statutes in the bankruptcy code also will not apply to the crypto, because the crypto will be deemed to be a commodity.”

By subjecting customer’s digital property to the same rules applied to a futures commission merchant, debtors or trustees in a bankruptcy would already understand the ground rules and might be able to move more quickly, said Kenneth Aulet, a partner at Brown Rudnick LLP’s Bankruptcy & Corporate Restructuring Practice Group.

The same regime was used in the bankruptcy of the New York trading firm MF Global Inc., Aulet said.

“By reusing an existing system, it makes the first case of an exchange bankruptcy simpler—there’s already a roadmap and precedent on how to do it,” Aulet said.

“The winners are the customers of the broker that have digital assets in their accounts. They get protection,” George W. Kuney, a law professor of the University of Tennessee College of Law, said.

Customers as Creditors

The bill also takes a stab at sorting out how to pay back creditors. A crypto exchange filing Chapter 11, like other bankrupt companies, would likely have to face debtors’ rules on creditor recovery.

The bankruptcies of Voyager and Celsius may become test cases to better understand what happens to crypto assets, institutions and customers in a bankruptcy, said Alexandra Barrage, a former Federal Deposit Insurance Corporation official now in private practice at Davis Wright Tremaine. But in the absence of a uniform regulatory structure, uncertainties may continue, Barrage said.

“It may very well be that traditional rules and concepts apply to digital assets,” said Gabriella Kusz, CEO of the Global Digital Asset and Cryptocurrency Association. “However, without precedent, without testing these concepts in a court of law, or lacking a Congressional edict, questions about how the Bankruptcy Code applies to digital assets will persist.”

Currently, digital assets in some situations could be available to pay general unsecured creditors if an exchange goes bankrupt, according to Kuney.

The bill would expand the law to protect digital assets in customer accounts, essentially shielding them from other creditors and allowing those customers to eventually receive their property back by placing it outside of the bankruptcy estate.

Celsius had informed customers in its terms of service that the status of their digital assets in the event of an insolvency is “unsettled” and “not guaranteed,” which may result in customers being treated as an unsecured creditor.

Celsius had frozen access to accounts.

“Celsius is not requesting authority to allow customer withdrawals at this time. Customer claims will be addressed through the Chapter 11 process,” the company said in a press release.

The Lummis-Gillibrand bill would make it clear that customer property is clearly held in trust for the customers, said Adam Levitin, a law professor at Georgetown University.

“It means a customer property is not available to satisfy the claims of the exchange’s other creditors,” Levitin said.

It’s unclear how the bipartisan bill would fare in the year of midterm elections. But the crypto industry has seemed open to more regulations, as instability persists.

“I feel there is a gap with no regulations, leaving too much ambiguity and uncertainty for investors and retail traders,” Howard Greenberg, president of the American Blockchain and Cryptocurrency Association, said in a statement. “Therefore, there is a lack of safeguards such as basic protections and rights—something regulations should and would address.”

To contact the reporter on this story: James Nani in New York at jnani@bloombergindustry.com

To contact the editors responsible for this story: Roger Yu at ryu@bloomberglaw.com; Maria Chutchian at mchutchian@bloombergindustry.com