Until yesterday, only one significant cryptoasset player had filed for bankruptcy protection in the U.S., which was Cred, Inc. in 2020. The Cred case, however, was precipitated more by fraud than any systemic issues related to the assets that it dealt in. That has very recently changed, with Voyager Digital filing late in the evening on July 5, 2022. The Voyager filing, as well as any subsequent bankruptcy filings in the crypto space will place untested issues front and center, including how cryptoassets held on behalf of customers of a bankrupt crypto platform are treated.

Background: Coinbase Highlights Potential Bankruptcy Issue for Assets in Non-Segregated Accounts

In May 2022, Coinbase, the largest U.S. crypto exchange, disclosed in an SEC filing that “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.” While the inclusion of this language in its SEC filing was the result of an accounting comment by the SEC staff, it highlighted the fact that customer assets held in omnibus, non-segregated accounts (which generally include all assets held in client accounts) could, in the event of an insolvency, be treated as Coinbase’s property (rather than property of customers). Ultimately, such assets could be liquidated and shared pro rata among all customers (subject to the priority scheme of the bankruptcy laws), with no guarantee that there would be assets sufficient to pay all customers in full. This disclosure sent Coinbase’s stock tumbling and forced their customers, and the customers of other crypto platforms, to contemplate a potential result that they had likely never considered. Although Coinbase’s CEO soon after asserted that any bankruptcy risk is mitigated because its customer assets are held in segregated accounts, the public disclosure highlighted the uncharted waters that crypto-companies face in the event of a bankruptcy filing.

“Crypto-Bankruptcies” in the Spotlight

May 2022 also saw the eradication of billions of dollars in value related to TerraUSD, a purported stablecoin, and the cryptocurrency it was linked to, Luna. Investors started dumping TerraUSD, de-linking it from its peg and causing both TerraUSD and Luna to plummet. According to some sources, $60 billion was wiped out, and $500 billion in losses were felt across the broader crypto marketplace. This created severe liquidity constraints for major players. One was Celsius Network LLC, a cryptocurrency lender that boasted extremely high annual interest rates (upwards of 18% annually) on crypto deposits. Celsius reported in May that its asset base had decreased nearly $25 billion from October 2021. Due to this extreme volatility, in June, Celsius suspended withdrawals and transfers by its approximately 1.7 million customers. Celsius hired restructuring counsel and is reportedly considering a bankruptcy.

Crypto hedge fund Three Arrows Capital (“3AC”), however, beat Celsius to the bankruptcy punch. 3AC was the first domino to truly fall, filing for liquidation in the British Virgin Islands with an attendant chapter 15 proceeding in the U.S. 3AC’s woes started after the collapse of TerraUSD and Luna, which reportedly cost 3AC more than $200 million. 3AC received capital support from Voyager Digital in the form of a $350 million and 15,250 bitcoin loan. However, on June 27, 2022, 3AC reportedly failed to pay back the outstanding balance on that loan, which was due in its entirety. Now, Voyager Digital, a publicly-traded crypto platform that advertises a 12% yield on various tokens, has filed based in part on that default. Voyager has already filed a plan of reorganization, which appears to be a backstop for the restructuring while it markets its assets and looks for a lifeline. That plan (based on a preliminary review) provides that, subject to ongoing discussions with certain parties, customers with crypto in their account will receive a combination of the crypto that was held, proceeds from any 3AC recovery, common shares in the reorganized Voyager, and Voyager tokens. It is unclear precisely what the mix of consideration will look like, although it doesn’t sound like customers will be entitled to a full recovery of “their” crypto (for the sake of full disclosure, S&K has not reviewed the plan in its entirety, which has only been public for a few hours). If this is the case, however, it will make the Coinbase disclosure somewhat prophetic.

Takeaway

The volatility in the cryptocurrency market and the knock-on effects of the TerraUSD/Luna collapse have already had a massive impact in the market. The Voyager bankruptcy will be closely watched and likely precedential in the marketplace. How will customer assets be treated? The preliminary view seems to be customer crypto that is held in omnibus accounts and not segregated would likely be “estate property” (i.e., property of the bankrupt entity), leaving those customers with a shortfall. Other bankruptcies could follow shortly. Celsius, for example, has restructuring counsel and is reportedly in talks with Goldman Sachs to purchase its assets. Different cases could have disparate results, depending on the underlying loan or customer custody agreements. On a macro scale, it will be interesting to see if this is simply contagion related to a specific collapse working through certain industry players, and if it can be contained, or if this is an indictment of the broader crypto marketplace. We will continue to monitor the situation closely and report on significant updates. If you are an account holder at Voyager or Celsius and have any questions, please contact Bob Gayda (212-574-1490), John Ashmead (212-574-1366), or Anthony Tu-Sekine (202-661-7150).