Bloomberg Law
Jan. 27, 2023, 9:00 AM

Crypto Bankruptcies Shed Light on Who Owns Assets for Recovery

Jessica Liou
Jessica Liou
Weil, Gotshal & Manges
John Marinelli
John Marinelli
Weil, Gotshal & Manges

The dramatic cryptocurrency downturn led to several recent bankruptcy filings, including those by FTX Trading and Celsius Network. For customers who are impacted by these filings, recovering their deposits can be difficult.

Crypto exchanges enable customers to buy, sell, and exchange digital assets. Customers can choose to either leave their assets in the custody of the exchange or transfer their assets to personal wallets.

Meanwhile, crypto lenders offer loans in cryptocurrency or fiat currency, which is government-issued currency not backed by a commodity such as gold. These lenders often offer customers the ability to deposit cryptocurrency on their platforms, which the lender will then deploy to earn a profit by loaning, hypothecating, staking, or selling the assets.

With limited industry regulation, these firms operate with little government oversight and no uniform guidelines around managing customer deposits. Often, each lender or exchange must impose its own guardrails in managing and safeguarding customer deposits.

This uncertain landscape contributes to confusion about disposition of customers’ digital assets when lenders and exchanges enter bankruptcy.

Nevertheless, several common threads have emerged, including:

  • Who owns the digital assets deposited by customers with a crypto firm may depend on the contractual relationship between the customers and crypto firm
  • Even if a customer owns the digital assets, many bankrupt crypto firms may be unable to return customer assets in kind

Who Owns Crypto Assets?

The default under the Bankruptcy Code is to fix the value of a claim on the date a debtor files for bankruptcy. But if customers own their assets, those assets may be returned in kind, which would allow customers to benefit from any increase in value of their digital assets during the bankruptcy.

The Southern District of New York in the Celsius case ruled customer deposits in certain accounts constituted property of the bankruptcy estate and not customer property. The court determined that the terms of use constituted a binding contract transferring title of the deposits to Celsius.

This ruling does not bind courts in other crypto Chapter 11 cases, but it represents a major development in the law surrounding ownership and treatment of digital assets. Parties have applied similar logic to arguments in other cases.

For example, various groups of FTX customers recently argued that because the terms of service provided that customers retained ownership of their assets, those assets did not become property of the FTX bankruptcy estate upon filing.

The Celsius ruling provides a roadmap for arguments that may soon apply in similar bankruptcy cases.

Recovering Property

Even if a court determines the digital assets held by a bankrupt exchange or lender constitute customer property and not estate property, many bankrupt crypto firms may not be able to return customer assets in kind.

In some instances, once deposited with an exchange or lender, a customer’s assets are commingled in a centralized wallet with other customer assets, or the assets of the exchange or lender. This makes tracing title ownership of digital assets difficult, if not impossible.

Additionally, crypto firms often manage billions of dollars in exposure from trades and loans of digital assets, but often only hold a fraction of those assets in their accounts.

Thus, customers in crypto bankruptcies face serious hurdles to recovery from the risks posed by the rapid, unregulated growth of crypto lenders and exchanges.

For example, FTX recently disclosed $5.5 billion in various assets. Although substantial, this number is not nearly large enough to cover all customer deposits.

Similarly, an interim report by the court-appointed examiner in the Celsius bankruptcy revealed that Celsius held approximately $50 million less in crypto assets than customers deposited.

In the wake of FTX’s swift downfall, allegations of fraud and mismanagement emerged. This includes allegations that founder Sam Bankman-Fried used customer deposits to, among other things, purchase personal real estate and contribute to political campaigns.

Likewise, according to the court-appointed examiner in the Celsius bankruptcy, customer deposits were commingled “without sufficient accounting and operation controls or technical infrastructure.”

Moving Forward

These circumstances complicate customers’ ability to recover their assets from insolvent crypto firms, making clear that establishing who owns the digital assets is just the first step in a potentially long battle to recover customer property.

Absent sufficient digital assets to cover all customer claims, customers may find themselves fighting to recover a pro rata portion of assets they may legally own. Furthermore, crypto bankruptcies involving fraud or Ponzi schemes may subject commingled customer assets to government forfeiture or restitution orders, further complicating customer recoveries.

Insolvencies among crypto lenders and exchanges have revealed much about the sector and the disposition of distressed crypto assets. Ownership of crypto assets in bankruptcy may depend on the contractual relationship between customers and crypto firms.

But even if customers do own their assets, failures of risk-management and, in some instances, outright fraud, complicates the process for customers to recover their property.

As these crypto insolvencies proceed, the landscape for distressed crypto assets may soon become yet clearer.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Author Information

Jessica Liou is a partner in Weil’s restructuring department. She represents and advises debtors, creditors, equity holders, investors, and other interested parties in all aspects of distressed and insolvency situations.

John Marinelli is an associate in Weil’s restructuring department.