Crypto Bankruptcy Proceedings Highlight Regulatory Shortcomings

Celsius, BlockFi, Voyager, and, most recently, FTX — along with its roughly 100 related companies – all used the Chapter 11 provision of the US bankruptcy code in 2022 to reorganize their ailing business lines. Meanwhile, Three Arrows Capital filed for Chapter 15 bankruptcy in order to deal with insolvency and creditors on a global scale.

According to Joe Acosta, a partner at the law firm Dorsey & Whitney, while courts continue to identify the most efficient and cost-effective way to restructure — and, hopefully, make creditors whole — regulators will be watching the eventual outcomes attentively.

“The recent bankruptcy filings of five big cryptocurrency organizations, including Celsius, a lender, and FTX, an exchange, may expose the true nature of cryptocurrencies: whether it's an investment, a currency, a digital asset, or something else,” Acosta said.

Not only is the outcome of the individual cases important, but so is the possibility of precedent-setting judgments that might create a legal and regulatory framework for the sector as a whole. There have already been prominent examples, according to Acosta.

Celsius, previously one of crypto's most renowned lenders, declared bankruptcy in July 2022 after suspending withdrawals the previous month due to “extreme market conditions.” The presiding judge determined earlier this month that tokens put in interest-bearing accounts belong to Celsius, not the clients. According to Acosta, it might pave the way for future token classification and ownership regulations.

“[Celsius' bankruptcy] Judge [Martin] Glenn found that crypto is not a currency — by the standard definition — because it is not a medium of exchange created, authorized, or adopted by a domestic or foreign government, an intergovernmental organization, or an agreement between two or more countries,” Acosta explained.

Customers who deposited cryptocurrency with the company prior to its bankruptcy were handing over something resembling a “digital asset,” according to the judge, which the lender might subsequently invest or transfer.

The criminal actions against FTX's former CEO, Sam Bankman-Fried, add a another element of complication, according to Acosta. According to Acosta, the allegations that client funds were transferred to other investment vehicles, individuals, and even politicians should put beneficiaries of FTX monies on notice.

“Everyone is basically waiting for the FTX bankruptcy estate to claw back a lot of these transfers,” said Acosta. “Claw backs are generally permitted under state and federal law when an insolvent corporation makes transfers without obtaining equivalent value. Many of the transfers made by FTX appear to be returning to FTX.”

The clawback approach would not be the first time it was employed to make creditors whole. Marc Powers, a former Baker & Hostetler securities law practice head, stated his company was able to help recover $14.5 billion of the overall damages resulting from Bernie Madoff's Ponzi scam, which totaled somewhere between $18 and $20 billion.

“I do believe [the Madoff case] is analogous to here,” Powers said last month. “And I believe they will follow the same plan, utilizing US Bankruptcy Code clawbacks.”

In any case, the industry's collapse has just added gasoline to the fire for regulators who had previously been pressing for stricter control, according to Acosta.

“Everyone knows that the crypto business is not severely regulated by the SEC, because crypto purists have convinced the SEC that cryptocurrency is not an investment or security,” he explained. “However, without regulation, it's easy for clients to be deceived.”

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