Crypto Winter Triggers Call for Clear Bankruptcy Guidelines

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The breakout of the cryptocurrency market is fueling calls for clearer guidelines on how to deal with assets in crypto company bankruptcies.

Like the technology itself, uncertainties abound at the intersection of cryptocurrency and bankruptcy, pinning down executives, lawyers, and traders.

The answers are still unclear on the extent to which customers’ crypto holdings can be used to pay off other creditors and whether a failed exchange can still allow transactions. There are also ongoing discussions about whether crypto assets should be considered commodities – as opposed to securities – in a bankruptcy case, a distinction that may confer certain advantages on Chapter 11 crypto companies and their clients.

“In any bankruptcy, regardless of industry, predictability is key,” said Emanuel Grillo, partner at the restructuring firm of Allen & Overy LLP.

A recent spate of Chapter 11 filings by crypto firms — including July filings from lender Celsius Network and broker Voyager — hints at more bankruptcies in the industry and will likely underscore the plea for clearer rules.

In June, Republican Senator from Wyoming Cynthia Lummis and Democratic Senator from New York Kirsten Gillibrand introduced a bill that they say will bring more clarity and consistent rules to the crypto market.

Crypto platforms are “highly vulnerable to deleveraging, fire selling, and contagion,” Federal Reserve Vice Chair Lael Brainard said in a speech last week, highlighting the bankruptcy of a cryptocurrency hedge fund and the recent withdrawal freezes at some crypto exchanges and lending companies.

“Recent turmoil and losses among retail crypto investors underscore the urgent need to ensure compliance with existing regulations and fill gaps where regulations or enforcement may need to adapt,” Brainard said.

The Lummis-Gillibrand Responsible Financial Innovation Act is a sweeping bill that contains proposals on the tax treatment of crypto and the regulation of stablecoins. It also grants more authority to the Commodity Futures Trading Commission to regulate cryptocurrencies and clarifies some issues that would persist if the crypto exchange fails.

“In order to have a safe and secure digital asset market, participants must enjoy the same consumer protections as in securities and commodities markets. This should be widely agreed upon,” said Gillibrand in a statement.

Crypto as a Commodity

The bill would generally assume that cryptocurrencies are commodities and apply existing laws on the liquidation of commodity brokers to digital assets.

The bill’s treatment of many crypto assets as commodities is one of the key benefits of the legislation, said Gabriel Benincasa, a partner at Holland & Knight LLP who served as the SEC’s first chief risk officer.

“That would be one of the things that gives clear guidelines,” Benincasa said.

An existing bankruptcy “safe harbour” allows assets such as commodities and securities to continue to trade on exchanges, a rule intended to protect financial markets.

The Lummis-Gillibrand bill would extend this safe harbor to digital assets. This likely means that the automatic stay — a principle that largely prevents creditors from collecting their claims from bankrupt debtors — will not apply to crypto holders seeking to trade or liquidate on a bankrupt exchange.

“They can go on, they can be done,” said Joanne Gelfand, bankruptcy attorney at Akerman LLP. “The fraudulent transfer laws of the bankruptcy code will also not apply to crypto, as crypto will be considered a commodity.”

By subjecting customer digital property to the same rules applied to a futures merchant, debtors or trustees in a bankruptcy would already understand the basic rules and may be able to act more quickly, Kenneth said. Aulet, partner at Brown Rudnick LLP’s Bankruptcy & Corporate Restructuring Practice Group.

The same regime was used in the bankruptcy of New York-based trading company MF Global Inc., Aulet said.

“By reusing an existing system, it simplifies the first case of exchange failure – there is already a roadmap and precedent for how to do this,” Aulet said.

“The winners are the broker’s clients who have digital assets in their accounts. They get protection,” said George W. Kuney, a law professor at the University of Tennessee School of Law.

Customers as creditors

The bill also attempts to determine how to repay creditors. A crypto exchange filing Chapter 11, like other failed businesses, would likely have to deal with debtors rules on creditor recovery.

The Voyager and Celsius bankruptcies could become test cases for better understanding what happens to crypto assets, institutions and customers in the event of bankruptcy, said Alexandra Barrage, a former Federal Deposit Insurance Corporation official now in private practice at Davis Wright Tremaine. But in the absence of a uniform regulatory structure, uncertainties can persist, Barrage said.

“It may very well be that traditional rules and concepts apply to digital assets,” said Gabriella Kusz, CEO of the Global Digital Asset and Cryptocurrency Association. “However, without precedent, without testing these concepts in court, or absent an executive order of Congress, questions about how the Bankruptcy Code applies to digital assets will persist.”

Currently, digital assets in certain situations could be available to pay general unsecured creditors in the event of an exchange going bankrupt, according to Kuney.

The bill would expand the law to protect digital assets in customer accounts, essentially shielding them from other creditors and allowing those customers to eventually recover their property by placing it outside the bankruptcy estate.

Celsius had informed customers in its terms of service that the status of their digital assets in insolvency is “unsettled” and “unsecured”, which may result in customers being treated as an unsecured creditor.

Celsius had frozen account access.

“Celsius is not requesting permission to allow customer withdrawals at this time. Customer complaints will be addressed through the Chapter 11 process,” the company said in a press release.

The Lummis-Gillibrand bill would make it clear that customer property is clearly held in trust for customers, said Georgetown University law professor Adam Levitin.

“It means that a client’s property is not available to satisfy the claims of other creditors of the exchange,” Levitin said.

It’s unclear how the bipartisan bill would fare in a midterm election year. But the crypto industry has appeared open to more regulation as instability persists.

“I think there is a void without regulation, leaving too much ambiguity and uncertainty for investors and retail traders,” Howard Greenberg, president of the American Blockchain and Cryptocurrency Association, said in a statement. . “Therefore, there is a lack of safeguards such as basic protections and rights – something that regulations should and should address.”

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