“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).
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.
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.
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:
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:
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.