Up until several years ago, cryptocurrencies were traded directly among counterparties. Cryptocurrencies as investments were initially viewed with skepticism by both Wall Street and Main Street as something only hard-core libertarians, criminal actors, or privacy evangelists utilized. With cryptocurrencies such as Bitcoin leading the charge, eventually the investing public warmed up to cryptocurrencies as a decentralized asset class. The advent of online cryptocurrency exchanges and lending platforms democratized trading and investing in cryptocurrencies. Now, anyone with a smartphone can trade cryptocurrencies.
Recently cryptocurrency exchanges and lending platforms have become the new trend in the cryptocurrency space, and even the topic of Super Bowl ads this past year. However, further bolstering cryptocurrencies’ wild-west ethos, numerous cryptocurrency exchanges filed for bankruptcy in 2022. For example, crypto trading and lending firms Celsius and Voyager Digital filed for bankruptcy in July 2022, with investors’ assets frozen inside the platforms. Bankruptcy court, a federal legal proceeding initiated when a business is unable to repay outstanding debts or obligations, is a place no investor ever wants to be.
These crypto exchange bankruptcies beg the question for investors—what happens to their funds in bankruptcy? For example, will an investor get the full value of their tokens/coins back, or will they just receive their claim as a pro rata distribution in U.S. dollar denominated currency as a general unsecured creditor? Unfortunately for investors it is likely the latter.
Risk to Investors
It is well known that investing in cryptocurrencies is risky and largely unregulated when compared to investing in traditional securities. While the SEC, CFTC, and state regulators have taken certain steps to protect the investing public, by and large, cryptocurrency issuers, exchanges, and lending platforms often operate at the edge of regulation. Investors in cryptocurrencies do not receive the same investor protections that funds held in a bank or shares of securities held at a brokerage firm receive. For example, the Securities Investor Protection Corporation (SIPC) insures investors up to $500,000 in cash and securities if a member broker firm encounters financial difficulties (not the loss in value of the underlying security). Similarly, the Federal Deposit Insurance Corporation (FDIC) insures depositors up to $250,000 per account if a member bank fails. Thus, there are no parallel laws governing cryptocurrency assets. Further, there are no guarantees for investors that they would be able to recover their crypto assets if an exchange were to freeze their account or collapse and go belly under.
Centralized cryptocurrency exchanges and platforms can often mix and comingle different clients’ funds together. This comingling may lead the platform to take the position that the frozen assets are the property of the company, not users.
The Bankruptcy Process
Celsius and Voyager have both filed for Chapter 11 bankruptcy protection (named after the section of the bankruptcy code). A Chapter 11 bankruptcy allows a company (i.e., the “debtor”) to restructure its debts as compared to a complete liquidation, with the ultimate goal to ensure the debtor emerges as a viable, newly restructured company at the end of the bankruptcy process. However, it is always possible that a bankruptcy that starts off as a Chapter 11 restructuring may eventually turn into a Chapter 11 liquidation.
Under the bankruptcy code it is likely that Celsius’ and Voyager’s users will become general “unsecured creditors,” in their respective Chapter 11 proceedings. As the name of the classification indicates, “unsecured creditors” are creditors who have a right to payment from the debtor that is not guaranteed by any collateral (i.e., thus it is “unsecured”). This classification under the bankruptcy code places investors in the same broad category of creditors as a company’s trade vendors/suppliers and even litigation creditors. By virtue of their last-in-line position under the bankruptcy code, unsecured creditors are often paid out last from the assets of the bankruptcy estate, behind higher priority creditor groups, such as secured creditors.
For example, in Coinbase Global, Inc.’s SEC Form 10-Q (Q1 2022), in the event of a bankruptcy, Coinbase’s users are to be treated as “general unsecured creditors.”
Moreover, because custodially held crypto assets may be considered to be the property of a bankruptcy estate, in the event of a bankruptcy, the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors. This may result in customers finding our custodial services more risky and less attractive and any failure to increase our customer base, discontinuation or reduction in use of our platform and products by existing customers as a result could adversely impact our business, operating results, and financial condition. (emphasis added).
General unsecured creditors often have their claims diluted by other unsecured creditor groups (trade vendors/suppliers, litigation claimants, etc.). General unsecured creditors are pro rata paid just pennies-on-the-dollar for their claims when compared to the actual amount of their claim. This means that investors who file a claim in a cryptocurrency bankruptcy will have to wait until the bankruptcy process is over before receiving their claim payment, which can often be de minimis. Variables such as the number of other general unsecured creditors who file claims and the amount of those claims will affect an investors’ ultimate claim distribution. As to timing, most bankruptcies typically last several years from the initial bankruptcy petition date to the ultimate claim distribution date, depending on numerous variables.
After a debtor files for bankruptcy there is little investors can do to recoup their money except file a claim and wait for the bankruptcy process to play out. Depending on the nature and amount of the claim an investor may even want to hire bankruptcy counsel to represent them, making recovering funds a costly endeavor. However, to prevent the scenario of becoming an unsecured creditor, industry experts have recommended that investors move their cryptocurrency assets off an exchange into self-custody wallets or “cold storage” on an external hard drive or USB drive. In these circumstances an investor is responsible for their own password/private key, required for gaining access to a “wallet” where their assets are stored.
Since the last place a cryptocurrency investor wants to be is in bankruptcy court behind a line of other creditors also looking to be paid, the deluge of crypto bankruptcies has resulted in investors taking a hard look not only at the types of coins and tokens they invest in, but where and how they store those assets. Moving those assets into self-custody wallets or “cold storage” may pay dividends down the road in the event of a bankruptcy.
Lowey Dannenberg has a 50+ year track record of successfully representing investors in numerous asset classes who are defrauded. If you wish to speak to a member of Lowey Dannenberg’s securities and financial litigation practice groups, please feel free to reach out to Christian Levis (firstname.lastname@example.org), Andrea Farah (email@example.com) or Anthony M. Christina (firstname.lastname@example.org).
 See https://celsius.network/terms-of-use.
 See In re: Celsius Network LLC, et al., Case No. 22-bk-10964 (S.D.N.Y.).
 See In re: Voyager Digital Holdings, Inc., et al., Case No. 22-bk-10943 (S.D.N.Y.).
 See Coinbase Global, Inc., SEC Form 10-Q (Q1 2022), available at https://www.sec.gov/ix?doc=/Archives/edgar/data/1679788/000167978822000048/coin-20220331.htm.