NOVEL LEGAL ISSUES RELATING TO CRYPTO BANKRUPTCIES –

WHAT’S BEEN DECIDED AND WHAT’S TO COME?

By Daniel B. Besikof1

The so-called “crypto winter” has given rise to numerous bankruptcy filings. Major cryptocurrency2 exchanges such as Voyager Digital, Celsius Networks, BlockFi, Genesis and even FTX, once a provider of bail-outs to distressed crypto companies, have all succumbed to chapter 11. The contagion has begun to affect ancillary businesses as well. Crypto ATM provider Cloud Coin, digital asset mining companies Core Scientific and Compute North and others have also recently filed, and the news is filled with other crypto-related businesses that have shuttered or are in (or are rumored to be in) economic distress.

While the market cap for all crypto currencies has trended up to approximately $1 trillion3 since its nadir at the depths of the crypto winter, the market cap is still down significantly from approximately $3 trillion as of November 2021.4 Crypto companies, and thosewho dobusiness with them,continueto faceeconomicdistress and layoffs,5 suggesting that additional bankruptcy filings may be forthcoming. Meanwhile, millions of customers, both institutions and consumers, have seen their crypto assets frozen and are awaiting repayment. They likely will continue to wait for months or even years.

1 Daniel Besikof is a partner in the Restructuring and Bankruptcy Department at Loeb & Loeb LLP. Mr. Besikof represents debtors, secured and unsecured creditors, indenture trustees, landlords, equity holders, distressed investors and other stakeholders in connection with complex chapter 11 bankruptcy proceedings, corporate restructurings and liquidations. Mr. Besikof also represents clients in bankruptcy avoidance litigation, including fraudulent transfer and preference litigation, and other commercial litigation matters.

2 Cryptocurrencies are digital currencies. Transactions using cryptocurrencies are tracked on encrypted, immutable distributed ledgers called blockchains. For an easy-to-follow overview of cryptocurrencies, the author recommends the following article: https://www.moneycontrol.com /msite/wazirx-cryptocontrol-articles/a-beginners-guide-to-cryptocurrency-article/#:~:text=What% 20Is%20Cryptocurrency% 3F,controlled%20by%20a%20central%20authority.

3 https://coinmarketcap.com/charts/

4 Id.

5 https://www.coindesk.com/business/2023/01/05/crypto-layoffs-heres-the-grim-count-since-april/.

Before customers will receive final distributions in connection with these bankruptcy cases, courts will need to determine (or parties will need to resolve by agreement) a number of novel legal issues. This article will examine two of those issues: (i) whether the crypto assets maintained by the bankrupt crypto exchanges belong to the exchanges or their customers, and (ii) the extent to which withdrawals by customers from their crypto accounts can be “clawed back” as preferential transfers pursuant to section 547 of the Bankruptcy Code.6

A. Who Owns the Coins?

Pursuant to section 541(a)(1) of the Bankruptcy Code, “the commencement of a [bankruptcy case] creates an estate.”7 That estate “is comprised of . . . all legal orequitableinterests ofthedebtorin propertyas ofthecommencementofthe case.”8 There are, however, a number of exceptions, including, most significantly, assets held by the debtor “solely for the benefit of an entity other than the debtor.”9

Whether crypto assets are, or are not, property of the estate is a threshold issue in every crypto bankruptcy case, and determination of the issue will affect every facet of the bankruptcy cases. If the coins are not property of the estate, then theyshould bereturned to thecustomerswhorightfully ownthosecoins. Ifthecoins are property of the estate, then the crypto debtors can use those coins to fund their operations and administrative expenses, and customers will be left with claims likely unsecured claims.10 The issue is also relevant to determine whether crypto assets withdrawn by customers can be “clawed back” as preferential transfers, since, as discussed in greater detail below, if coins withdrawn by customers were not property of the debtors, then they cannot be recovered as preferential transfers.11

6 11 U.S.C. § 547

7 11 U.S.C. § 541(a) i. Coins deposited in the Celsius “Earn” program are determined to be estate property.

8 Id.

9 11 U.S.C. § 541(b)(1).

10 Bankruptcy Code section 363 permits the use of estate property, either in the ordinary course of business without court order or out of the ordinary course of business with the bankruptcy court’s blessing. 11 U.S.C. §§ 363(b) (authorizing use of estate property out of the ordinary course of business after notice and a hearing); 363(c) (authorizing use of estate property in the ordinary course of business without hearing).

11 11 U.S.C. § 547(b) (trustee may avoid “any transfer of an interest of the debtor in property”).

The issue of coin ownership first reached the public consciousness back in May 2022, when Crypto exchange Coinbase Global filed a 10-Q report with the Securities and Exchange Commission that included the disclosure that customers’ crypto assets maintained on the Coinbase platform could be property of a Coinbase bankruptcy estate in the event of a Coinbase bankruptcy. That disclosure sent shockwaves through the crypto community, and SEC Chair Gary Gensler, amplified these concerns at an industry conference few days later when he said in a nowwidely reported statement: “If the platform goes down, guess what? You just have a counterparty relationship with the platform. Get in line in bankruptcy court.”12 Of course, Mr. Gensler’s prediction was correct; millions of customers are currently “waiting in line” to recover perhaps just a portion of their coins.

A recent decision from Chief Judge Martin Glenn of the Bankruptcy Court for the Southern District of New York was the first to consider the issue of coin ownership, ruling under the specific facts of that case that coins deposited by customers in Celsius’s “Earn” program (the “Earn Program”)13 were, in fact, property of the estate and therefore could be sold by the Celsius debtors to fund the administration of their bankruptcy cases.14

Under Bankruptcy Rule 7001, determinations regarding ownership of property generally are to be determined in an adversary proceeding.15 An adversary proceeding is formal litigation, initiated by the filing of a complaint,16 separate from the main bankruptcy case, which provides litigants the procedural safeguards afforded under the Federal Rules of Civil Procedure.17

12 https://www.wlrk.com/webdocs/wlrknew/AttorneyPubs/WLRK.28224.22.pdf.

13 The Earn Program was the primary service offered by Celsius. It enabled customers to earn yield on their deposits of crypto assets. https://celsius.network/earn

14 In re Celsius Network LLC, 22-10964, 2023 Bankr. LEXIS 2 (Bankr. S.D.N.Y. Jan. 4, 2023)

15 Fed. R. Bankr. P. 7001 (“The following are adversary proceedings: . . . (2) a proceeding to determine the validity, priority, or extent of a lien or other interest in property”) (emphasis added).

16 Fed. R. Bankr. P. 7003

17 See Fed. R. Bankr. P. 7002 to 7087.

In Celsius, however, the process for determination of whether the coins maintained in the Earn Program were property of the estate was short-circuited to some degree. Rather than commencing an adversary to determine this issue, the Celsius debtors filed a relatively simple motion sell approximately $18 million of stablecoins18 and to use the proceeds of that sale to fund the Celsius debtors’ administrative liabilities.19 The filing of that motion created a contested matter a more limited proceeding initiated by the filing of a motion within the main bankruptcy case which was the subject of Judge Glenn’s ruling.

As of its bankruptcy filing, the Earn Program had approximately 600,000 accounts containing cryptocurrency assets with a total market value of approximately $4.2 billion, of which stablecoins accounted for just $23 million.20 Accordingly, while the motion was purported to affect only a modest percentage of the total coins maintained in the Earn Program, the consequences of the decision are far reaching, potentially affecting all customers of the Earn Program.

A number of customers many of them represented pro se objected to the motion, arguing that the stablecoins at issue were owned by the customers, not the Celsius debtors. The United States Trustee and multiple state securities regulators opposed the motion, arguing that the stablecoin sale should not be approved because the Celsius debtors currently had sufficient liquidity and did not need the liquidity to be generated by the sale. The Official Committee of Unsecured Creditors contended that the proposed sale would not be in the ordinary course of business under section 363(c)(1) but instead should be approved under section 363(b)(1) because the Celsius debtors have shown a good business reason for the sale funding ongoing administrative expenses.

On January 4, 2023, Judge Glenn concluded that when the cryptocurrency assets, including the stablecoins, were deposited into the Earn Program, those coins became Celsius’s property and, as a result, became property of the Celsius debtors’ bankruptcy estates upon the Celsius bankruptcy filing.21

18 “Stablecoins are cryptocurrencies whose value is pegged, or tied, to that of another currency, commodity, or financial instrument. Stablecoins aim to provide an alternative to the high volatility of the most popular cryptocurrencies, including Bitcoin (BTC), which has made crypto investments less suitable for common transactions.” https://www.investopedia.com/terms/s /stablecoin.asp.

19 Celsius Network, 2023 Bankr. LEXIS 2, at *15.

20 Id. at *3-4.

21 Id. at *59.

Judge Glenn’s decision was based heavily on the Earn Program’s terms of use, and his analysis had two steps. He first considered whether the terms of use formed a valid, enforceable contract between Celsius and each account holder who accepted the terms of use. Those terms were part of a “clickwrap” agreement, which required users to click on a button confirming that they accepted the terms, or a button that implies that they have accepted the terms. Although the users were not necessarily required to view the terms at that time, Judge Glenn concluded the account holders understood that they were agreeing to a contract governed by the terms of use even if the they chose not to read any of the provisions and, on that basis, determined that the terms of use constituted a binding contract.22

Having determined that an enforceable contract did exist, Judge Glenn considered whether the terms of use unambiguously transferred title and ownership of the Earn Program assets from the account holders to Celsius upon the deposit of those assets by customers. Here too, Judge Glenn ruled in the affirmative, noting that the relevant transfer language in the terms of use was clear that no ownership interest or lien in favor of the account holders was intended.23 He therefore ruled that the account holders granted Celsius “all right and title to such Eligible Digital Assets, including ownership rights.”24

22 Id. at *43 (“The law in the Second Circuit is clear that clickwrap contracts such as the Terms of Use are valid and binding. TheDebtors have sufficiently shown the mutual assent element of contract formation” and the numerous updates to the terms of use constituted valid modifications of the contract).

23 Id. at *55.

24 Id. at *57.

ii Consequences of “Earn” Coins being Estate Property.

Because the Earn Program stablecoins were deemed to be estate property, the judge determined that the customers were left with unsecured claims, to be determined through the claims resolution process.25

Moreover, the Celsius debtors were permitted to sell the stablecoins and use the proceeds of that sale. Judge Glenn determined that the Celsius debtors had established a good business reason to permit the sale outside of the ordinary course of business providing liquidity to fund the bankruptcy cases.26

iii Ownership of Coins May Vary.

While this opinion is the first of its kind, it will almost certainly not be the last. As noted above, Judge Glenn determined the ownership of the coins on deposit in the Celsius Earn Program based on the language of the particular terms of use at issue. He was careful to point out that the decision did not determine ownership of coins deposited in other Celsius products.27

Each crypto exchange has different sets of terms for each of its products. Accordingly, not only may the ownership of coins be different depending on which exchange a customer had his or her crypto, the ownership of coins may vary by product even within a single exchange. For example, while the Celsius debtors argued, successfully, that the coins on deposit in the Earn Program were property of

25 Id. at *39 (“To be clear, this finding does not mean holders of Earn Assets will get nothing from the Debtors. Account Holders have unsecured claims against the Debtors in dollars or in kind (depending on the terms of any confirmed plan). The amount of allowed unsecured claims is subject to later determination in this case (through the claims allowance process) and may potentially include damages asserted by Account Holders, including breach of contract, fraud or other theories of liability.” the estate, they have conceded that the products on deposit in its “Custody” product (the “Custody Product”) were not property of the estate.28

26 Id. at *60 (“A rare point of agreement among all parties is that the Debtors’ liquidity is precipitously running out The Debtors need to generate liquidity to fund these Chapter 11 cases and continue down the path either of a standalone plan reorganization, a section 363(b) sale, or even a liquidation plan. The Debtors project that additional liquidity will be needed in early 2023. The Debtors demonstrate a sound business justification for selling stablecoins, and the Court agrees that it is appropriate to grants [sic] authority to do so.”).

27 Id. at *39-40 (The “Court’s decision does not determine the ownership of assets in the Debtors’ Custody Program, Withhold Accounts, or Borrow Program”).

Ultimately, if the customer agreement provides for commingling of assets with the assets of the exchange or for the customer assets to be transferred to the exchange for further use or investment by the exchange, the coins may be treated as estate property. In contrast, if the customer agreement requires crypto assets to be held in trust, or provides for the crypto assets to be held in trust for the customer’s benefit, the assets are more likely to be determined to be the customer’s property and to be excluded from the estate particularly if the coins were actually held in trust or segregated as contemplated by the agreement. These ownership issues will be critically important and likely hard-fought, and each such determination will be based on its own unique facts.

C. Clawback Considerations

The Bankruptcy Code permits the trustee or a bankrupt debtor in possession to seek to avoid and recover certain payments made to creditors within the 90-days before a bankruptcy filing as so-called “preferential transfers.”29 These provisions are designed to ensure that all creditors of like priority are treated equally and that no creditor is “preferred” to another shortly before a bankruptcy filing. If a creditor is forced to repay a preferential transfer, the creditor will be granted an unsecured claim for the repaid amount pursuant to section 502(h) of the Bankruptcy Code,30 which effectively places the creditor in the same position it would have been in had there been no transfer.

Whether withdrawals of crypto assets from customers’ exchange accounts in the 90-day period before an exchange bankruptcy filing can be “clawed back” as preferential transfers, pursuant to section 547 of the Bankruptcy Code, is a novel issue that will need to be determined.

Section 547 permits a trustee or debtor in possession to avoid any transfer of an interest of the debtor in property

(1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) made . . . on or within 90 days before the filing of the petition . . . ; and (5) that enables such creditor to receive more than such creditor would receive if – (A) the case were a case under chapter 7 . . . ; (B) the transfer had not been made; and (C) such creditor received payment of such debt to the extent provided by the provisions of this title.31

28 In re Celsius Network, LLC, et al., Case No. 22-10964 (MG) ECF No. 670.

29 11 U.S.C. §§ 547 (permitting avoidance); 550 (providing for recovery of avoided transfers).

30 11 U.S.C. § 502(h).

In practice, there will be three key issues to consider in determining whether withdrawals from customer crypto accounts can be avoided as preferential transfers.

First, the customer withdrawal must be of debtor property for it to be avoidable as a preferential transfer. Withdrawal of coins that were owned by the customers, not the debtors, would not give rise to a potential preference claim.32

Second, the debtor must have been insolvent when the transfer was made.33 Insolvency is presumed for transfers made in the 90-day period before the bankruptcy filing,34 but that presumption can be rebutted, generally with the use of valuation expert testimony.35 Because the crypto markets are volatile and can fluctuate rapidly, the solvency analysis may be more complex than with a more typical business and could shift from day to day. A challenge based on solvency is generally expensive because of the significant amount of discovery costs and expert fees associated with this type of challenge.

Third and finally, courts will need to determine whether any affirmative defenses will apply to protect withdrawals from avoidance. There are several affirmative defenses to preference suits provided for under the Bankruptcy Code.

31 11 U.S.C. § 547(b).

32 Id.

33 Id.

34 11 U.S.C. § 547(f)

35 In re Koubourlis, 869 F.2d 1319, 1322 (9th Cir. 1989) (“This presumption . . . requires the party against whom the presumption exists . . . to come forward with some evidence to rebut the presumption, although the burden of proof remains on the party in whose favor the presumption exists[.]”).

For example, transfers made in the ordinary course of business of the debtor and the customer or that were made according to ordinary business terms are not subject to avoidance.36 “Thepurposeoftheexceptionis to leaveundisturbed normal financial relations, because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or [its] creditors during the debtor’s slide into bankruptcy.”37

There are two tests for whether a transfer was made in the ordinary course of business. First, under section 547(c)(2)(A) is the subjective test, which “requires the creditor to establish a baseline of past practices between itself and the debtor,’ and that the transfer was ‘ordinary in relation to [these] past practices.”38 “Among the factors courts consider in determining whether transfers are ordinary in relation to past practices are: (1) the length of time the parties were engaged in the transactions at issue; (2) whether the amount or form of tender differed from past practices; (3) whether the debtor or creditor engaged in any unusual collection or payment activity; and (4) whether the creditor took advantage of the debtor's deteriorating financial condition.”39

Second, section 547(c)(2)(B) provides for an objective test, which “requires the creditor to show that the transfer comports with ‘terms employed by similarly situated debtors and creditors facing the same or similar problems.”40 To establish that a preferential transfer was made according to ordinary business terms, the creditor must introduce competent evidence of the practice in the industry.41

Determining whether a transfer was made in the ordinary course is factintensive and frequently requires expert testimony, particularly regarding the objective “industry” test. However, the ordinary course of business defense seems like it will have broad applicability in this context. Customers, by and large,

36 11 U.S.C. § 547(c)(2)

37 Pereira v. United Parcel Serv. of Am., Inc. (In re Waterford Wedgwood USA, Inc.), 508 B.R. 821, 827 (Bankr. S.D.N.Y. 2014).

38 Faith v. Inline Distrib. Co. (In re Newton Enters.), Nos. 9:13-bk-12388-PC, 9:14-ap-01127-PC, 2015 Bankr. LEXIS 1831, at *6 (Bankr. C.D. Cal. June 3, 2015) (quoting Sigma Micro Corp. v. Healthcentral.com (In re Healthcentral.com), 504 F.3d 775, 790 (9th Cir. 2007)).

39 Sulmeyer v. Pacific Suzuki (In re Grand Chevrolet, Inc.), 25 F.3d 728, 732 (9th Cir. 1994)

40 In re Kaypro, 218 F.3d 1070, 1074 (9th Cir. 2000) withdrew funds in accordance with their rights under the various user agreements. Those agreements, which were, in relevant part, similar across the crypto industry, permit withdrawals on demand. That alone would seem to protect a large majority of customer withdrawals.

41 Newton Enters., 2015 Bankr. LEXIS 1831, at *9.

The “subsequent new value” defense under section 547(c)(3) may also provide a defense to the avoidance of certain customer withdrawals.42 To invoke the subsequent new value defense, customers will need to show that they advanced new value to the debtor on an unsecured basis after receipt of a potentially avoidable withdrawal and that they were not repaid for that advance (or that if it was repaid, it was repaid with a potentially avoidable transfer).43

The new value defense is designed “to encourage creditors to work with companies on the verge of insolvency.”44 It is also intended to “ameliorate the unfairness of allowing the trustee to avoid all transfers made by a debtor to a creditor during the preference period without giving any corresponding credit for advances of new value that benefitted the debtor.”45

This defense is a bit more clear cut. Customers who made deposits after making potentially avoidable withdrawals from their crypto exchange accounts should get a credit against any potential preference liability in the amount of such deposits. This result makes perfect sense, since the subsequent deposit already effectively repaid the potential preference.

Finally, the Bankruptcy Code’s securities “safe harbor” provisions of Bankruptcy Code section 546(e) may also insulate withdrawals from avoidance. That section insulates certain types of payments from avoidance, other than as an “actual” fraudulent transfer under Bankruptcy Code section 548(a), including “margin payments” or “settlement payments” (as defined in the Bankruptcy Code) “made by or to . . . a . . . stockbroker, financial institution, financial participant, or

42 11 U.S.C. § 547(c)(3).

43 Burtch v. Revchem Composites, Inc. (In re Sierra Concrete Design, Inc.), 463 B.R. 302, 307 (Bankr. D. Del. 2012) securities clearing agency,” as well as transfers by or to those same parties “in connection with a securities contract.”46

44 Halperin v. Moreno (In re Green Field Energy Servs.), 585 B.R. 89, 103 (Bankr. D. Del. 2018).

45 Id.

There is a lot to unpack regarding the applicability of section 546(e) to the circumstances present in these crypto cases. Indeed, that topic could fill an entire article and may well be the subject of hundreds of pages of briefing at the Bankruptcy Court and appellate levels. But the issue will turn, at least in part, on whether crypto assets are securities and whether the customer agreements with the bankruptcy crypto exchanges constitute “securities contracts.”

All of these avoidance issues are novel. To date, no preference actions have been asserted in any of the crypto bankruptcy cases. Because the Bankruptcy Rules require that preference claims be asserted in an adversary proceeding,47 one would expect that these issues would not be litigated until preference actions are asserted and parties have an opportunity to submit briefs and evidence on their claims and defenses.

In the crypto cases, however, the issue of whether transfers are avoidable as preferences have become relevant in the context of what happens to coins that were transferred from a product, like the Earn Product, where those coins were Celsius property, to a different product, like the CustodyProduct, where the coins are owned by the customers. Celsius has argued (and others will certainly argue in other cases incomparablecircumstances)thatthetransfersfromtheEarnProducttotheCustody Product within the 90-day preference window were preferences, such that those coins cannot be withdrawn from the Custody Product, even if withdrawals from Custody are otherwise authorized.

Inorderto facilitateissues relating to withdrawals from theCustodyProduct, the Celsius bankruptcy judge has approved a scheduling order requiring briefing on the merits of preference defenses again well before a single preference action has been commenced. Accordingly, these preference issues may be resolved sooner than later potentially without the involvement of some of the larger potential litigation targets. Customers, therefore, will need to be vigilant in monitoring these proceedings, even before preference suits are commenced in order to ensure their rights and defenses are preserved.

46 See 11 U.S.C. §§ 101, 741 and 761 for the Bankruptcy Code’s definition of those terms.

47 Fed. R. Bankr. P. 7001.

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