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Crypto bankruptcies could put some customers at the ‘bottom of the totem pole’ [Video]

For the first time in the short life of cryptocurrency, major crypto platforms have turned to US bankruptcy law to save their insolvent businesses. It is now largely up to the bankruptcy courts to determine how to distribute customers’ frozen crypto assets.

So far this year, crypto platforms Celsius and digital travel filed for bankruptcy and in the process stripped millions of crypto holders of assets they once controlled. Bankruptcies follow November deposit 2020 by crypto lending platform Credit about two years after the company debuted in 2018.

The three platforms filed under Chapter 11which is designed to help indebted companies legally get rid of a large portion of their financial obligations, revamp their business operations and emerge with a stable business.

These claims have raised major questions about whether customers can recover their frozen funds. Bankruptcy attorneys who spoke with Yahoo Finance say the answer depends on a variety of unresolved legal issues, as well as how bankruptcy judges apply long-established rules to a relatively new business. The stakes are high for clients who have entrusted large sums of money to companies that are now bankrupt.

Thomas Wilson, a partner at King & Spalding, explains that crypto holders named as unsecured creditors might never get their crypto back. “You’re at the bottom of the totem pole,” he said of unsecured creditors.

Uncharted Waters

Currently, there is no precedent for categorizing cryptocurrency as an asset in the event of bankruptcy, Elie Worenkleincorporate restructuring lawyer with Debevoise & Plimpton, told Yahoo Finance. Yet judges presiding over such cases will first determine whether the crypto assets belong to the bankruptcy estate. If they belong to the bankruptcy estate, the judge will classify them in a hierarchy of creditors.

“Different crypto clients may have different rights against different crypto entities”, worenklein said. “It won’t necessarily be the same answer for different entities that have filed for bankruptcy.”

What is the best case scenario for crypto holders? Professor of Law at Howard University Matthew Bruckner says that arrangements that clearly separate a client’s crypto from the platform’s own assets benefit crypto holders the most. In this case, the crypto assets should be set aside from the bankruptcy estate and returned.

Stephen Ehrlich, CEO and co-founder of Voyager Digital Ltd., speaks during the Piper Sandler Global Exchange and FinTech conference in New York, U.S., June 8, 2022. REUTERS/Brendan McDermid

“So the main problem facing any crypto holder who had assets on a now bankrupt platform is: how are their assets held by the platform?” said Bruckner.

Bankruptcy judges will make these decisions based on the terms set out in each platform’s customer agreements and the intentions they reveal between the platforms and their customers. Some agreements pool client cryptography, controlling assets in a common account. Other agreements show that the platforms act as custodians of crypto held in a dedicated account in a client’s name.

Pooled assets are more vulnerable than assets in a dedicated or separate client account, Bruckner says, because judges will likely treat them as part of the bankruptcy estate. And among the hierarchy of creditors, these assets likely qualify as general unsecured debt — a category that ranks far from the top of the creditor food chain.

Hierarchy of creditors in business bankruptcy in the United States

Hierarchy of creditors in business bankruptcy in the United States

“So if the [crypto assets] are mixed in an asset pool…into a large account, then they’re probably treated like a general unsecured creditor, which is bad for crypto holders,” Bruckner said.

This is what happened in the bankruptcy proceedings of the crypto lending platform Cred. Unbeknownst to many of its clients, the company’s user agreements specified that crypto deposited in exchange for interest on unused funds was not segregated or secured, and a bankruptcy court named their claims. as unsecured debt. Voyager made a similar argument, telling a bankruptcy judge that it considered its clients’ crypto to be pooled assets that it could use on behalf of the client, and that those assets should be part of the pool of assets. bankruptcy.

However, Wilson points out that some crypto holders may be able to prove that their assets have remained separate from the assets of a bankrupt platform or those of other customers.

“Unlike cash where you can literally shuffle it into a bank account, with crypto you have the ability to trace on the blockchain,” Wilson said. In the Celsius bankruptcy, he says, the creditors’ committee hired a forensic cryptanalytics firm to trace the debtors’ crypto holdings over time, and the debtors recently agreed to a court-appointed examiner who will investigate similar issues.

However, for cryptocurrency holders named as unsecured creditors, there is no guarantee of payment. They will line up for what, if any, remains of bankruptcy assets, behind vendors and post-bankruptcy administrative expenses, employees, bankruptcy attorneys, bankers and other advisers, and creditors guarantees that hold security over the company’s assets.

The inevitable fluctuations in cryptocurrency prices add to this uncertainty, along with unsettled lawsuits and the possibility that a bidder could redeem the asset from bankruptcy, which could leave more or less crypto for everyone. .

Alexis Keenan is a legal reporter for Yahoo Finance. Follow Alexis on Twitter @alexiskweed.

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