HLS Bankruptcy Roundtable: Concluding Thoughts on a Series on Crypto-Bankruptcy

By Xiao Ma (Harvard Law School)

There is a new category of bankruptcies: crypto-bankruptcies. Although difficult to pinpoint the exact beginning of the recent wave of crypto winter (the common belief is that it can be traced back to the collapse of Terra/Luna in May 2022.) Since then, several crypto companies – such as Voyager, Celsius, FTX, BlockFi, and Genesis – have landed in U.S. bankruptcy courts. This trend has prompted The Harvard Law School Bankruptcy Roundtable to devote a special series to exploring these new developments. I appreciate the opportunity to have managed this series and enjoyed working with authors who contributed thought-provoking posts. While the crypto-bankruptcies will continue to unfold, we are concluding our series for now to feature other content on our forum. We hope that the series has provided some initial food for thought, and that discussions will extend beyond this series as we, the community of bankruptcy academics and practitioners, continue to learn and forge new thinking together about these novel crypto-bankruptcies.

I would like to take this opportunity to add some concluding thoughts. First, the jurisdictional squabbling present in FTX’s bankruptcy, as highlighted by Megan McDermott, may signify a broader trend that the U.S. bankruptcy courts could become the leading venue in resolving crypto-related insolvencies. Cryptocurrencies are perhaps uniquely international, with no clear need for insolvency proceedings to take place in any particular jurisdiction. Indeed, other jurisdictions (most notably Singapore and London) have recently tried to increase their attractiveness as the home of major cross-border insolvencies, and cryptocurrency companies may have been a major test case for these efforts. Nevertheless, this wave of crypto-bankruptcies has taken place in the United States.

This new set of crypto-bankruptcy cases will put the efficacy and efficiency of Chapter 11 to the test. Crypto investors worldwide are closely monitoring the processes and carefully studying the rulings of U.S. bankruptcy judges (such as the critical Celsius opinion briefed by Jessica Graham). These opinions may have broad implications and global reach for the whole crypto industry. The ongoing crypto-bankruptcy proceedings also provide great insights into the business activities, financial condition, and commercial realities of major players in this fast-evolving industry. For example, the 600+-page Celsius examiner’s report not only detailed how Celsius struggled to generate enough yield to support its high reward rates and made terrible investment and asset deployment decisions, but also brought  public attention to its governance deficiencies and problematic representations made to the public. Diane Dick and Christopher Odinet reminded us of the need to investigate the causes of debtors’ failures and to craft appropriate laws and regulations safeguarding substantial public interests. On the other hand, they also highlight the dilemma of whether the limited resources of bankruptcy estates can support the type of independent management and fact-finding that might be essential to addressing the public concerns of crypto-bankruptcies, but which are not typically central to the chapter 11 model.

Second, in reflecting on the cause of FTX’s massive failure, Vivian Fang noted how distressed companies’ financial positions have been inflated with illiquid assets and obscure instruments throughout corporate history. In FTX’s case, the related party transactions that are secured by FTTs, its own token, remind us of the SPVs of Enron that were solely financed by its own stock, and how a drop in the value of this stock led to Enron’s collapse. Investigations of fraudulent transactions and preferential payments are likely to be themes shared by the highly interconnected crypto-bankruptcies. Note that one essential (and as-yet-unanswered) issue that will greatly impact how these cases proceed is how to effectuate transaction avoidance law and enforce the clawback of payments that take place on the blockchain via nodes of anonymity.

Another major theme, as predicted and discussed by Matthias Lehmann, Kelvin Low and Timothy Chan, and Diane Dick and Christopher Odinet, is how to characterize the crypto assets that the customers stake on the troubled crypto platforms. Steven Weise, Wai Choy and Vincent Indelicato’s memo analyzed the legal framework under which the crypto assets that are custodially held by a platform should be treated as customers’ assets, not the property of the bankruptcy estate. Whether such a custodial relationship exists would be a separate question, as many customer agreements provide otherwise (e.g., terms governing Celsius customers’ earn accounts were central to the opinion in that case). Crypto exchanges commonly comingle and rehypothecate crypto assets, making it even harder for customers to withdraw their staked cryptos during a chapter 11 case. This, in turn, makes the industry more susceptible to contagion (and such contagion has reached traditional banking where institutions have substantial ties to crypto, e.g., Silvergate Capital) as downward pressure on the value of crypto assets could quickly spread among a network of lenders and borrowers whose financial activities are linked to an identical set of collateral. The ongoing crypto-bankruptcy proceedings also revealed much interconnectedness among these distressed debtors through crypto-collateralized loans and cross-crypto-holdings.

In these evolving crypto-bankruptcies, judges are likely to set parameters around various substantive issues related to the valuation and recovery of crypto assets. Ingrid Bagby, Michele Maman, Anthony Greene, and Marc Veilleux considered the popular request for “payment-in-kind” distribution as prices of crypto assets are incredibly volatile and concluded that the USD continues to reign for now. The fluctuation of crypto assets’ value raises other concerns, such as the Pine Gate problem, as Anthony Casey, Brook Gotberg, and Joshua Macey noted. With the petition date serving as the artificial moment of reckoning, debtors in crypto-bankruptcies may effectively force customers into a bottom-of-market sale to finance the Chapter 11 process, and the liquidity generated may be redistributed to other creditors or managers. Relatedly, Kelvin Low and Timothy Chan discussed the fungible nature of crypto assets and how they do not have any inherent utility except for the ability to (potentially) make a profit upon alienation.

This line of reasoning, in turn, gets to the heart of the heavily debated question of the nature of cryptocurrencies. Since the beginning of crypto-bankruptcies, a lingering question of mine has been – if these crypto exchanges and debtors’ business models bear significant similarities to banks, stock brokers, or commodity brokers, should they be excluded from filing under Chapter 11 in the first place pursuant to 11 U.S.C. § 109? Before Judge Wiles approved the Voyager-Binance deal, regulators raised objections stating that Voyager may be involved in unregistered offers and sales of securities, as well as illegal operations of virtual currency businesses without licenses. Once these crypto debtors’ business endeavors are better defined through the magnifying glass of bankruptcy proceedings and the governmental agencies settle on the regulatory framework for the crypto industry, future crypto debtors may not necessarily be eligible to seek chapter 11 remedies but will have to resort to chapter 7 liquidation or other proceedings that are specifically tailored to financial institutions.

It is fascinating that U.S. bankruptcy courts, in addition to resolving mass torts, are now facing new challenges in navigating the ambiguities and uncertainties of U.S. crypto regulations. As they make rulings and decisions, these courts are essentially shaping the law for the entire crypto world, which was founded on the ideal of transcending centralized governance. While some jurisdictions, such as Singapore, have a manifested ambition to become a crypto hub, others, like China, have shown great animosity toward the industry. In contrast, the European Commission has recently launched a blockchain regulatory sandbox, which aims to facilitate dialogues between developers and regulators. Nonetheless, I find no dialogue more informative and soul-searching than the evolving crypto-bankruptcy cases happening here in the U.S. All eyes are on these cases, and questions are hammering at the doors of courthouses.

* This article was originally published on the Harvard Law School Bankruptcy Roundtable blog. It is the concluding post in a series of posts on bankruptcies of cryptocurrency companies and the emerging issues they pose.