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

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For the first time in the short life of cryptocurrency, major crypto platforms have turned to US bankruptcy law to salvage their insolvent businesses. Now it’s largely up to bankruptcy courts to determine how to divvy up customers’ frozen crypto assets.

So far this year, crypto platforms Celsius and Voyager Digital filed for bankruptcy and in doing so stripped millions of crypto holders of assets they once controlled. The bankruptcies follow the November 2020 filing by crypto lending platform Cred about two years after the company’s 2018 debut.

All three platforms filed under Chapter 11, which is designed to help debt-laden companies legally shed a bulk of their financial obligations, reshuffle business operations, and emerge with a stable business.

Those claims have triggered major questions about whether customers can recoup their frozen funds. Bankruptcy lawyers who spoke with Yahoo Finance say the answer depends on a variety of unsolved legal issues, as well as how bankruptcy judges apply long-established rules to a relatively new business. The stakes are high for customers who entrusted significant sums of money in now-bankrupt businesses.

Thad Wilson, a partner with King & Spalding, explains that crypto holders designated as unsecured creditors might never recoup their crypto. “You’re at the bottom of the totem pole,” he said of unsecured creditors.

Currently, there’s no precedent for categorizing cryptocurrency as an asset in bankruptcy, Elie Worenklein, a corporate restructuring attorney with Debevoise & Plimpton, told Yahoo Finance. Still, judges presiding over such cases will first determine if crypto assets belong to the bankruptcy estate. If they do belong to the bankruptcy estate, the judge will rank them among a hierarchy of creditors.

“Different crypto customers may have different rights against different crypto entities,” Worenklein said. “It’s not necessarily going to be the same answer for different entities that filed for bankruptcy.”

What’s the best-case scenario for crypto holders? Howard University law professor Matthew Bruckner says arrangements that clearly segregate a customer’s crypto from the platform’s own assets benefit crypto holders the most. In that case, the crypto assets must be set aside from the bankruptcy estate and returned.

Stephen Ehrlich, CEO and Co-Founder Voyager Digital Ltd., speaks during the Piper Sandler Global Exchange and FinTech Conference in New York City, U.S., June 8, 2022. REUTERS/Brendan McDermid

“So the major issue facing any crypto holder that had assets on a now bankrupt platform is: How are their assets being held by the platform?” Bruckner said.

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

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

U.S. Corporate Bankruptcy Hierarchy of Creditors

“So if the [crypto assets] are mixed into a pool of assets…in a big account, then they’re likely treated as a general unsecured creditor which is bad for crypto holders,” Bruckner said.

That’s what happened in the bankruptcy proceedings for crypto lending platform Cred. Unbeknownst to many of its customers, the company’s user agreements specified that crypto deposited in exchange for interest on the idle funds was neither segregated nor collateralized, and a bankruptcy court designated their claims as unsecured debt. Voyager made a similar argument, telling a bankruptcy judge that it considered its customers’ crypto as pooled assets that it could use on the customer’s behalf, and that those assets should become part of the bankruptcy estate.

However, Wilson points out that some crypto holders may be able to prove their assets remained segregated from a bankrupt platform’s assets, or those of fellow customers.

“Unlike cash where you can literally commingle it in 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 crypto analytics 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 designated as unsecured creditors, there’s no guarantee of any payout at all. They’ll stand in line for what, if anything, is left of the bankruptcy estate, behind post-bankruptcy vendors and administrative expenses, employees, bankruptcy lawyers, bankers and other advisers, and secured creditors that hold collateral against the company’s assets.

Inevitable fluctuations in cryptocurrency prices add to that uncertainty, along with unsettled lawsuits, and the possibility that a bidder could buy up the bankruptcy estate — all of which could leave more or less crypto to go around.

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

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