“Winter is coming. We know what’s coming with it."
— Jon Snow, Game of Thrones, A Song of Ice and Fire
Despite record-breaking heat waves setting wildfires across the globe this summer, it seems that nothing can thaw the iciness that is the “crypto winter.” Cryptocurrencies collectively have lost two-thirds of their value (approximately $2 trillion) since their 2021 peak. And, we are now beginning to see the impact of this nosedive on the multi-billion dollar ecosystem of crypto hedge funds, crypto lenders, and crypto brokerage firms that have unregulated digital money as their foundation (as well as the impact on their crypto customers who lack the SIPA and FIDC protections afforded to traditional brokerage firm and banking clients).
Three Crypto Giants File for Bankruptcy in Two-Week Span
On July 1, 2022, Three Arrows Capital (3AC) – a Singapore-based crypto hedge fund that had managed $10 billion in assets – filed for Chapter 15 bankruptcy protection. Just one week prior, a BVI court ordered 3AC to liquidate after it suffered heavy losses from the collapses of Luna and other cryptocurrencies and 3AC’s founders reportedly went missing. 3AC also defaulted on a $670 million loan owed to Voyager Digital Ltd., a crypto brokerage and lending firm, that at its height managed $5.9 billion in assets. The mountain of debt does not end there – as 3AC also owes $2.36 billion to another crypto lending firm.
On July 5, Voyager itself filed for Chapter 11 bankruptcy.
On July 13, after posting a blog post on a long night, crypto lender Celsius filed for Chapter 11 bankruptcy in no small part due to the $1.2 billion hole on its balance sheet. A month prior, when Celsius was managing $11.8 billion in assets and offered customers over 18% APY on crypto deposits, it froze all of its 1.7 million customers’ accounts.
SIPC Will Be MIA
Ordinarily, the Securities Investor Protection Corporation (SIPC), which Congress created in 1970 under the Securities Investor Protection Act (SIPA), steps in to oversee the liquidation of financially-troubled brokerage firms. Importantly, SIPC protects up to $500,000 worth of each customer’s securities and cash (with a limit of $250,000 for cash). But SIPC only steps in to protect the customers of SIPC-member broker-dealers. In turn, only SEC registered broker-dealers (which, by definition, engage in the business of transacting securities) can become SIPC members.
Here, the (S)tark reality is that Voyager and Celsius are neither SIPC-members nor SEC registered broker-dealers. Nor is it clear that any crypto companies can become SIPC members in the first place right now, as the issue of whether cryptocurrencies can in fact be securities is hotly contested. While the SEC called nine cryptos “securities” in a recent insider trading case, the SEC Chairman has also stated that Bitcoin is not a security, but there is a “strong case” to classify Ripple (XPR) as a security. This lack of clarity as to whether all or some cryptocurrencies are securities explains why Coinbase, for example, the largest U.S.-based crypto exchange, is not a member of SIPC. And Robinhood notes that while its customers’ “securities” and cash are protected by SIPC, cryptocurrency investments through Robinhood Crypto are not protected by SIPC.
In any event, even if a crypto company somehow became a SIPC member, currently SIPC only protects customers’ cash and “securities,” which expressly does not include “currency” or “any commodity or related contract or futures contract.” Bottom line, SIPC will likely not be stepping in to protect customers of bankruptcy crypto companies absent (1) an official pronouncement (from a court or appropriate government agency) that at least some cryptocurrencies can be “securities” or (2) congress deciding to fundamentally retool SIPC.
First Impression Legal Issues
These three bankruptcy proceedings and any bankruptcies that may follow will present novel legal questions for the bankruptcy court. Particularly absent express guidance from the Bankruptcy Code, lawyers and courts alike may hit a colossal wall trying to determine, for example:
- Who Owns the Crypto: Will customers’ crypto assets held on these debtors’ platforms be considered property of the debtors’ bankruptcy estate? Voyager argues that the $1.3 billion in users’ funds on its platform do belong to the bankruptcy estate because Voyager was authorized to use and hold the crypto assets in commingled accounts. If Voyager’s argument prevails, its customers may be left with an unsecured claim for the value of the crypto assets (and the court will have to determine how to value the crypto in the first place). Separately, challenges to a lender’s perfection of its security interest in crypto, for example, as a result of a pre-petition liquidation of collateral, will also implicate ownership issues.
- Can a Debtor “Claw Back” Crypto Transfers: The Bankruptcy Code permits debtors to “claw back” certain transfers made by the debtor prior to bankruptcy, subject to any defenses that the transferees may have It is unclear whether transfers of crypto can be clawed back, or whether such transfers are protected by certain “safe harbors” in the Bankruptcy Code that have existed since the Code’s adoption in 1979. For instance, Section 546(g) prevents a debtor from clawing back, inter alia, currency and commodity swaps. And Section 546(e) prevents the clawing back of certain “margin payment or settlement payments” made by or to the benefit of a “forward contract merchant.”
- Will the Debtor be Permitted to Assume Certain Contracts: A debtor’s ability to assume or reject “executory contracts” is typically a key component in a reorganization. To the extent they are “executory,” crypto debtors would likely seek to assume favorable lending arrangements with their customers to retain their benefits, but where agreements provide for the debtor to use the assets in its discretion, including as collateral for loans it receives from third-party lenders, the agreement may be viewed as a “financial accommodation.” In that case, the debtor may not be permitted to assume the contract with the customer. What happens next to the crypto, and the extent of the customer’s recovery in the bankruptcy, will depend in large part on whether it is considered property of the crypto debtor’s estate.
In the weeks ahead, more crypto companies may end up filing for bankruptcy. But the upshot is that these bankruptcies could create more opportunity for bankruptcy courts to make decisions on the above and other first impression legal issues. These decisions could deliver some welcome clarity in an area that remains essentially unregulated.
Given recent events, Congress may finally be inclined to get moving on comprehensive crypto regulation, particularly if customers end up losing a significant amount of their crypto and take this issue to the voting booth. The Lummis-Gillibrand bill, the most comprehensive proposed crypto legislation to date, defines most cryptocurrencies as commodities which are overseen by a new “Night’s Watch,” the Commodity Futures Trading Commission (CFTC). It also seeks to provide certain crypto companies with access to the Federal Reserve. The bill even sets forth some (but not nearly sufficient) guidance for the bankruptcy treatment of digital assets. This bill, however, is unlikely to get a senate vote this year.
In the meantime, the crypto industry remains the Wild(ling) West, and courts, debtors and customers will have no choice but to continue marching “beyond the wall” into unknown territory.
Though crypto bankruptcies are new, the issues to be resolved are not. Based on the Davis+Gilbert Insolvency + Finance team’s experience in actions related to:
- the liquidation of Bernard L. Madoff Investment Securities LLC, and
- other bankruptcies under SIPA and the Bankruptcy Code,
my colleagues and I possess the in-depth knowledge and skillset to manage the intricacies of these bankruptcies. If you have questions, don't hesitate to contact us to discuss your specific concerns.
Adam Levy, an associate in the Insolvency + Finance Group, contributed to this post.