Bankruptcy judges who oversaw the failure of cryptocurrency exchanges this year trumped regulators, outpaced prosecutors, and answered core questions about the legalities of digital currency.
The judges’ decisions could define the crypto industry for years to come, despite leaving thousands of customers without control of assets they thought they owned. The use of bankruptcy to help resurrect the crypto industry comes at a time when Chapter 11 is being used to address a wide range of societal ills, from the opioid crisis to asbestos exposure.
FTX Group, Celsius Network LLC, BlockFi Inc., and Voyager Digital Holdings, among others, filed Chapter 11 in 2022. If 2022 was the year of the crypto collapse, 2023 was the year of sorting through the rubble.
“2023 was sort of like, now what the hell do we do with this?” Robert Stark, a Brown Rudnick LLP partner who has worked on multiple crypto bankruptcies, said.
Bankruptcy courts became the primary venue for answering that question. Chapter 11 disclosures brought new transparency to the young industry, and bankruptcy judges clarified the relationship between certain crypto account holders and the companies.
All the activity amounted to a quasi-regulatory role for bankruptcy courts, Stark and others say. But the year also showcased the shortcomings of the venue as a fix-all, leaving thousands of customers facing slim recovery prospects and racking up tens of millions of dollars in legal fees that drained estate coffers, Stark said. Regulators have struggled to keep up with the innovative industry, and Congress has declined to step in.
“It can’t really fix the whole financial ecosystem; that’s not really what bankruptcy is for,” Stark said.
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‘Terrifying’ Ruling
Judge Martin Glenn of the US Bankruptcy Court for the Southern District of New York nearly a year ago issued a ruling that would echo throughout 2023. Crypto assets in Celsius’ so-called Earn accounts, which accumulated interest, belonged to Celsius, not to the customers who deposited them, he ruled on Jan. 4.
For thousands of customers, Glenn’s decision rendered them unsecured creditors and effectively wiped out any chances of getting all their money back.
“Suddenly you find yourself an unsecured creditor,” Vanderbilt University Law professor Yesha Yadav said. “That’s horrible, and that’s what the absence of regulation has done.”
But that doesn’t mean Glenn’s ruling was wrongly decided, Yadav said. The judge applied bankruptcy law to the facts of the Celsius case, and had “no choice” but to rule the way he did, she said.
The ruling points to the court’s awkward position, and the vulnerability of customers without regulatory backup, said Yadav, who co-wrote a paper with Stark on bankruptcy courts and crypto.
The Celsius decision sent ripples through the industry, Yadav said. Other crypto firms sought to once again assure customers that deposited assets are safe and experts encouraged crypto users to keep assets in accounts that operate differently from Earn accounts, she said.
“It feels like there’s definitely an attempt to maneuver around what the court decided in Celsius, because it’s terrifying,” Yadav said.
Customers won’t get all of their crypto back, as they’d hoped. But the recovery offered by the plan, with Earn account holders receiving 67%, is decent by bankruptcy standards.
“Most unsecured creditors in non-crypto cases would see that as a pretty good win,” said Dan Gwen, restructuring counsel at Ropes & Gray.
Transparency and Disclosure
Chapter 11 is generally a transparent process requiring debtors to divulge balance sheets, creditor lists, and more. In especially complex or controversial cases, a judge can appoint an independent examiner to probe potential wrongdoing.
In the Celsius bankruptcy, a court-initiated investigation outpaced federal prosecutors. The bankruptcy examiner accused founder Alex Mashinsky of consistently painting a rosy view of the exchange’s finances while it was floundering behind the scenes.
More than five months later, Mashinsky was charged with fraud in an indictment that made similar accusations as those in the bankruptcy report. He’s pleaded not guilty.
It’s “arguably no coincidence that the Justice Department decided to bring charges shortly after” the bankruptcy court report, Yadav said.
But crypto cases haven’t always provided complete transparency. FTX convinced Judge John Dorsey of the US Bankruptcy Court for the District of Delaware to let it hide the identities of its 50 largest creditors.
Judges Versus Regulators
Bankruptcy courts provided a venue for traditional regulators like the Securities and Exchange Commission to weigh in on restructuring plans.
In the Celsius case, Glenn effectively deferred to the SEC, declining to rule on whether the company’s CEL token is a security. Glenn in November approved the restructuring plan, urging the SEC to move quickly if it wanted to intervene. Celsius later changed its plan to focus solely on mining Bitcoin, abandoning a proposed crypto “staking” division that drew scrutiny from the SEC.
But in the bankruptcy of crypto company Voyager, Judge Michael Wiles of the Southern District of New York steamrolled the SEC when he approved a sale of the bankrupt firm to Binance.US. The SEC failed to provide adequate evidence the sale violated US securities laws, Wiles ruled in March. The SEC eventually reached an agreement with Voyager and dropped its opposition, but the deal fell apart shortly after.
The uneven regulatory environment points to the awkwardness of the bankruptcy venue and the absence of true oversight, Stark said. For companies like FTX, which operated a massive crypto exchange, using bankruptcy is a bit strange, he said.
“There’s not a lot of experiences where trading desks were able to resurrect themselves,” Stark said. “Lehman Brothers and Bear Stearns didn’t come back to life.”
There’s also a certain irony in the fact that many crypto companies marketed their appeal as cutting against the traditional financial system, but their collapses have laid bare the regulatory benefits behind the existing regime, Stark argued.
Regulators that encourage transparency and back up deposits help create consumer confidence in the system—something bankruptcy isn’t designed to do, he said.
“Bankruptcy can’t force people to lend, and they can’t force customers to continue to do business,” Stark said.
For now, though, bankruptcy judges’ expertise on complex financial issues and experience with a wide range of business types might be the best the industry can ask for.
“Until we find a better solution, bankruptcy remains the most viable option for a complex type of restructuring like the cases we’ve seen,” Ropes & Gray’s Gwen said.