FTX Collapses Into Bankruptcy System That Still Hasn’t Figured Out Crypto
Bankruptcy courts had made limited progress reorganizing crypto firms before FTX filed for chapter 11
The U.S. bankruptcy system will hash out the largest-ever collapse of a cryptocurrency exchange through a legal process that has barely begun to answer how holders of digital currencies will fare in an insolvency.
Bankruptcy courts haven’t had the chance to decide complex legal questions around crypto ownership when an exchange or lender goes bust. As FTX’s chapter 11 case gets under way, the question of who even owns digital currencies—the exchanges or the customers who made the deposit—remains unsettled.
FTX collapsed into chapter 11 Friday with no strategy for restructuring and without including basic disclosures about its customers, assets and liabilities. The exchange, led by new management after the sudden resignation of founder Sam Bankman-Fried, also lacks a clear precedent to follow for finding out how much customers are owed and settling those debts.
While chapter 11 is an established process, it has never successfully reorganized a major U.S. crypto firm. Celsius Network LLC and Voyager Digital Inc. tumbled into bankruptcy earlier this year and have yet to unfreeze their customers’ money or secure a restructuring that would unlock users’ assets.
Bankruptcy courts have only had those cases since July, not enough time to clarify crypto customers’ legal rights in an insolvency. Many of the same questions are expected to be put forth in FTX’s chapter 11 case still in its infancy.
That means it will likely be some time before customers of FTX have a clear picture of their likely recoveries and what, if any, legal recourse they may have against Mr. Bankman-Fried and others that reportedly knew of the use of FTX customer funds by sister firm Alameda Research.
“We haven’t seen a similar bankruptcy that has gone through to customers getting payment,” said Timothy Karcher, a restructuring lawyer at Proskauer & Rose LLP. “All of that stuff has yet to be worked out. We don’t have a good model yet with what happens with customer deposits.”
Policy makers and academics have recognized that customers of unregulated crypto companies lack the safety nets that kick in when banks and brokerages go under. Earlier this year, a bipartisan duo of U.S. senators introduced a bill that would aim to protect investors in the event that a cryptocurrency exchange files for bankruptcy by ensuring that their digital assets are held separately from the firm’s own assets.
But such legislation has scant chances of passing in a closely divided Congress, according to crypto industry experts. The task of cleaning up after crypto failures has largely fallen to the nation’s bankruptcy courts, which haven’t had sufficient time to decide key legal questions about crypto and chapter 11 before FTX’s filing.
Celsius, a crypto lender, has argued in court papers that most of the customer assets deposited into its flagship yield-earning program are property of the firm, rather than of the customers. If so, customer assets could be pooled into a bankruptcy estate and distributed to satisfy all company debts in a chapter 11 plan. Those could include the sizable bankruptcy legal fees and administrative expenses, followed by other secured or priority debts, leaving a potentially bleak recovery for these depositors.
A bankruptcy judge is expected to decide whether Celsius or its customers own the cryptocurrencies deposited into its flagship Earn program. Also up for debate are the rights of Voyager and Celsius preferred stockholders.
Celsius also has asked for a ruling on whether crypto posted by customers as collateral for loans now belongs to the chapter 11 estate. Another key question is whether Celsius could claw back customer withdrawals or loan liquidations completed in the 90 days before it filed for bankruptcy.
Terms of service for Celsius told users that if it went bankrupt, crypto deposited into its flagship yield-earning program “may not be recoverable, and you may not have any legal remedies or rights in connection with Celsius’ obligations to you” other than as an unsecured creditor. Voyager returned $270 million in cash held in custody accounts to depositors, but the company said the most of customers’ $1.3 billion of digital coins belong to the chapter 11 estate.
FTX’s terms of service appear to go further than other crypto exchanges in clarifying that it doesn’t acquire title to customer assets in its user accounts and doesn’t treat customer property as its own. The Wall Street Journal has reported that FTX lent billions of dollars worth of customer assets to its affiliated trading firm, Alameda Research LLC, and that senior FTX officers were aware of it.
Celsius and Voyager both filed for chapter 11 in New York, while FTX chose another popular bankruptcy hub in Wilmington, Del. Decisions from the court in Delaware aren’t binding on the court in New York, raising the possibility that crypto bankruptcies could unfold differently depending on venue.
Another issue that lawyers are disputing is whether customer claims’ should be valued based on prices at the beginning or the end of the chapter 11 process. If customers of a troubled firm eventually regain access to their funds, they still could suffer big losses if the market turns against them while the bankruptcy plays out.
It isn’t clear if chapter 11 can offer an effective solution for crypto failures. Bankruptcy is expensive, no matter the outcome for customers, and patching up the firms and taking them out of chapter 11 is no easy feat. It also remains unclear who may be willing to make a bet on the future of these firms, or whether their intangible assets still hold value after subjecting their customers to a bankruptcy.
If any of these firms exit bankruptcy on their own, they face the risk that customers will simply withdraw their crypto as soon as they can, bringing back the danger of the kinds of massive withdrawals that led them to file for bankruptcy in the first place.
Even though customers’ money remains frozen and Celsius has curtailed its lending operations, the costs of navigating the chapter 11 process are adding up as it racks up legal fees and pumps money into a startup bitcoin mining operation. The firm’s lawyers said in court papers Friday that it faces another possible cash crunch in early 2023.
Customers of Voyager Digital, meanwhile, must now wait longer for a resolution to its chapter 11 case after its deal to be acquired by FTX fell apart.