As with any downturn, a number of crypto companies will likely not survive the current “crypto winter.” In the last cycle, many projects simply ran out of cash, lacking the assets to reorganize around or sell.
This time things are different because projects now have real assets, real businesses and real creditors.
Whether we’re dealing with a CeFi protocol with a significant number of depositors (read: unsecured creditors) or a decentralized blockchain with tokens but no cash, bankruptcy looms. We’ve already seen a few filings. There will be more.
As chapter 11 of the U.S. Bankruptcy Code has become a new buzzword for many crypto enthusiasts, let’s take a deep dive at some of the key issues in crypto restructurings.
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The crypto sector has seen hundreds of projects fail before. What is different this time around? Answer: The existence of creditors.
When a start-up fails, shareholders lose money. When a CeFi protocol with $2.0 billion in deposits fails, it can’t pay that money back. Its depositors are now its creditors.
Countries have bankruptcy laws that govern situations where an enterprise cannot pay its creditors. Among other principles, these laws are premised on the notion that, for example, if the company has only $1.0 billion in assets, there should be an orderly process to ensure depositor-creditors each get 50 cents on the dollar (after payment of lawyers and other administrative costs). Faced with insolvency, a board of directors may determine they have no choice but to put the company into bankruptcy.
Chapter 11 and the U.S. Bankruptcy Code have an important role globally for a number of reasons, including jurisdictional rules that make it easy to access the courts and the control chapter 11 affords management under the concept of debtor-in-possession. Plus, crypto is truly international and chapter 15 of the U.S. Bankruptcy Code enables foreign debtors in foreign courts to obtain assistance from a U.S. Bankruptcy Court.
Recently, Singapore-based Three Arrows Capital (3AC) filed a chapter 15 case in New York to assist its main liquidation proceeding in the British Virgin Islands.
TL;DR! What’s the Single Biggest Issue?
The biggest issue in these insolvency cases will revolve around the characterization of crypto depositors at CeFi protocols and potentially crypto exchanges, like Voyager Digital. When token holders entrusted their tokens in exchange for 15+% interest, they thought they were making a deposit. Protocols, however, are not depository institutions like banks, whose custody of consumer deposits is strictly regulated and protected. Token holders, unfortunately, may find themselves deemed unsecured creditors, with no particular rights to the tokens deposited.
What About Crypto Exchanges?
In theory, crypto exchanges can do more to protect their clients’ deposits. Oftentimes, however, inadequate protections are employed, including commingling of assets, limited or no restrictions on the use of funds deposited, and ill-conceived legal structures.
Recently, apparently under pressure from the SEC, one large crypto exchange platform disclosed that the custodial fiat and cryptocurrencies that it holds on behalf of its customers could potentially be included in a bankruptcy estate, and its customers could be treated as general unsecured creditors. While this crypto exchange strongly refuted the characterization, it then promptly revised its account agreement to ensure deposits are better protected.
While customers in this instance may never have been at risk, the cat is out of the bag. One can easily conceive of a chapter 11 case where the protections are inadequate. Perhaps more worrisome, one can also foresee a case where non-depositor creditors are highly motivated to re-characterize deposits as general assets of the estate available to all creditors.
What about the crypto enthusiasts who are working to control the contagion?
Ah yes, those noble crypto billionaires!
Folks, we have a word for investors who buy up troubled assets that are running out of cash and/or facing bankruptcy: vultures.
Of course, there’s nothing wrong with being a vulture investor. It’s a good business model.
People like to view themselves as saviors of projects, rather than vultures buying on the cheap. But that’s just a narrative, nothing more.
If there’s a CeFi or crypto exchange bankruptcy, will I get the full value of my tokens back?
There’s a lot to unpack in that question – and every case will be different.
In a case like Voyager with a hole in its balance sheet thanks to 3AC, it’s conceivable the debtor may try to make its depositors-creditors whole to the fullest extent possible. Other situations will be uglier.
Another issue will be the amount of the claim. In bankruptcy, a creditor’s claim is fixed at the start of the case. Here, the claim is to tokens. Why not simply give the tokens back, regardless of value at the outset or later in a case (even if subject to a haircut). It’s going to be a big issue.
It is also certainly conceivable that the value of the tokens could increase during the case, like Bitcoin holders in Mt. Gox, who ended up net-positive . . . after a 7+ year bankruptcy legal battle.
Can I access my tokens when a bankruptcy starts?
No, the filing of a chapter 11 case will trigger an automatic stay.
Creditors (including depositors) will be precluded from enforcing their claims. Plus, the debtor may benefit from the freezing of accounts upon filing so as to avoid the exodus of assets.
This all lines up nicely with a potential sale of the company’s business. The debtor may kick and scream that these are non-creditor depositors, but secretly not mind an account freeze pending sale.
Can Crypto Projects Be Reorganized?
We don’t have a definitive answer on this. Surely, some can be.
There is reason to suspect, however, that a number of crypto companies will lose consumer confidence, which will be the death knell. Others will be liquidations plain and simple.
It seems somewhat likely a number of projects will reorganize, while others will sell their assets of value to bidders who will rebrand.
What if I borrowed from a DeFi / CeFi platform?
If you borrowed from a DeFi or CeFi platform, they could demand repayment of your loan in full — as that loan is the protocol’s asset.
Where collateral has been posted, you may be able to setoff your claim to reduce the amount owed to the debtor.
What about a troubled project that has not filed for bankruptcy?
Troubled companies usually need cash or a buyer. If they can get either, they may be OK. Keep in mind that a sale may need to be effectuated through the bankruptcy court. This applies to crypto in the same way that it would apply to businesses in any sector.
Role of Token Holders and DAOs
If we ignore the whole “is a token a security?” debate, token holders are neither creditors nor equity holders. Our main concern is that token holders will be a new type of chapter 11 party in interest without adequate representation in a case.
As for DAOS, not all DAOs are created equal. Some are not quite decentralized. Some are not quite autonomous. And other organizations may have their existence questioned where no legal entity exists.
Of course, any project which files for bankruptcy is likely going to witness a massive decline in the value of its token, so the damage will be done to token holders and DAOs, whose treasuries are built around the native token.
What does this mean for Crypto Law Insiders?
As Insiders know, we try not to play the guessing game on legislation, regulation or the way the courts will rule.
Even the most experienced restructuring professionals acknowledge the answers to the questions posed herein (and a host of others) are uncertain.
As one crypto enthusiast said to me when we were discussing the crypto downcycle: “buckle up, it’s going to be a bumpy ride.”