In January, a US bankruptcy judge issued a decision in the ongoing Celsius Network Chapter 11 bankruptcy case, ruling that Celsius was the legal owner of a majority of the cryptocurrency held by customers on its online platform. Specifically, approximately $4.2 billion of assets (a majority of customers' assets) placed with Celsius under its Earn program were ruled to be property of the estate due to the terms of service that users signed. This decision has the potential to have a number of downstream impacts on how crypto-assets are managed during the bankruptcy process.
How did we get here?
2022 has been a turbulent year in the crypto-asset world. There have been a number of high-profile collapses beyond Celsius, such as the collapse of the TerraUSD and Luna cryptocurrencies in May 2022, Voyager in July, and the more recent events surrounding FTX. With this, there has been an increased focus on how the world of crypto-assets interacts with the rules and processes surrounding corporate bankruptcy. Although how one values a crypto-asset in these circumstances is a clear topic for debate, of even more fundamental importance - and the subject of the court decision - was the question of who actually owns these things in the first place?
Digital assets – Ownership vs Control, technology vs legal
Before we discuss the ruling, and its implications, it’s worth recapping a few principles of what “ownership” can mean in the world of digital assets.
We often refer to crypto-assets being held in “wallets”, though it’s more accurate to say that the “wallet” is more of a keyring, holding the cryptographic “keys” which allow the users to access and “spend” the crypto-assets. This is why an oft-used idiom in the world of crypto-assets is “not your key, not your coin”. If you don’t have access to the private key (such as if you lose it), you can’t control the asset. Regardless of whether you think you own it, if you can’t use the key to spend the coin, and particularly if someone else does (e.g. if it was hacked or stolen), then to all intents and purposes you do not “own” the asset. According to the blockchain, whoever has the key does.
This hard-and-fast rule for ownership gets a little murkier when other aspects of the crypto-asset environment start to get involved. A custodial exchange, for example, will typically hold crypto-assets on their customers’ behalf, removing the need to have your own “wallet”. The exchange, in this case, holds the keys that can be used to control the asset, but they are doing so on behalf of their customers. In this case, the legal framework surrounding the relationship between the exchange and their customers is what defines the ownership. Although the exchange might control the asset via having access to the keys (and, from a pure “not your key, not your coin” perspective, would “own” it), the legal relationship means that their customer is the owner.
It’s also possible that crypto-assets might be locked up in a smart contract, where the question of control can be defined by the code of the contract itself. For example, crypto-assets may be held in the contract until a particular date has passed, without any possibility of removing them beforehand. Ownership is again somewhat moot while the assets are locked away, and it’s entirely possible that the value of those assets could have changed entirely by the time they can be accessed. Things get even murkier when considering other vehicles such as staked crypto-assets (for example, staked Ethereum), where the ability to withdraw funds is subject to a software upgrade. When depositing in a smart contract, the contract then effectively controls the funds; it is up to the code at that point to determine how and when the user can “withdraw” the funds.
Description of the ruling
On 4 January 2023, Judge Martin Glenn in New York issued his findings. In the ruling, the court found that crypto-assets placed under the company’s Earn program were the property of the estate. This was not derived from any of the technological underpinnings of the crypto-assets, but was far more focused on the legal relationship that was put in place and the “clickwrap” terms of service agreements signed by users of such accounts.
Notably, customers with certain other account types that were not subject to the same terms of service as Earn accounts are able to withdraw their assets, highlighting how critical the underlying agreements are. However, even in these situations, customers are only able to access their assets if, among other restrictions, they do not have any outstanding borrowings from Celsius (which would be subject to set-off) and those assets were not transferred from Earn accounts in the 90 days prior to filing (which would be subject to preference actions).
What this could mean in practice is that, in situations where the legal relationship between a company and its customers was worded in such a way that the depositing of crypto-assets represents a transfer of ownership, those assets may just belong to the company - regardless of what the practicalities of any of the technologies in place might dictate. In the event of insolvency, this could mean that they form part of the company’s estate, rather than belonging to the customers.
It might take some time for the full impact of this ruling to be felt, but there are some fairly likely consequences of this change.
At the cutting edge of fintech, quite a lot of focus can be taken by the underlying technology that is in use (and this is still important, as we’ve previously discussed). However, this ruling shows that, regardless of how a financial product might be implemented, the terms and conditions that wrap around this can be equally important. Critically, in this case, the terms and conditions included a transfer of title over the assets from the depositor to the company.
Depositors have to take their place in line
An immediate implication of this for bankruptcies of this type is that depositors would become just another creditor of the company, and their eventual payment will be subject to distributions available to such creditors, rather than the value of assets they placed. Consequently, they may only receive a fraction of their deposits, if anything at all, once other preferential creditors have received their distributions.
Turning back the clock
Furthermore, U.S. bankruptcy rules provide for a clawback of any assets transferred from the estate in the 90 days leading up to a filing. This potentially exposes users who had previously transferred title to the company to the same creditor treatment, even if they extracted their assets prior to the filing.
There are doubtless some practical challenges in implementing this in practice, as ultimately the ability for the assets to be clawed back will depend on how and where they were transferred, and whether the depositor is susceptible to legal action. Whilst it might be fairly straightforward to reclaim the assets if they’re held at a U.S.-based custodial exchange, this is a world apart from a depositor based overseas with the funds stored in an offline cold wallet, where the feasibility of recovering any funds will depend on jurisdictional issues that are far too complex to cover in this article.
For crypto-asset companies, this demonstrates that, although the excitement of being on the cutting edge of technology might make this your main focus, it’s still important to get the Ts and Cs right, as how they’re written can have consequences that are as significant as a bug in your code.
It also poses some interesting upcoming challenges for bankruptcy professionals, as they need to be aware of both the technical and legal aspects that can come with identifying which crypto-assets actually belong to the company, and how they can be secured, particularly where they may have already been transferred from the company into a broader crypto-asset ecosystem. The often-public and immutable record of transfers made “on-chain” can be tracked and quantified, which can provide additional firepower for the estate and its advisors to identify assets and the ultimate recipients.
Regardless, if there’s one lesson that any of us can learn from this, it is that, whenever making use of these types of services, be sure to read the fine print before you click “accept”.