Preparing for Doomsday: A Primer for Creditors to Protect their Rights Against the Demise of Cryptocurrency

FTX. Blockfi. Voyager. Celsius Network. Genesis. Silvergate Capital Corp. Whether due to alleged corporate fraud or the waterfall effect of a downward spiraling industry, as the past year has unfolded more and more cryptocurrency giants—previously touted by pundits and celebrities as sound new age investments—have filed for relief under the United States Bankruptcy Code. Now, as the bankruptcy court, trustees and other professionals attempt to discover what happened and how best these bankrupt crypto companies can move forward, creditors are left waiting months or years to find out what, if anything, they will receive on behalf of their claims against the respective debtors. While such creditors cannot control the innerworkings of crypto debtors or the bankruptcy court process, those creditors can and should take multiple steps to best understand their rights and ensure they are as protected as possible both before and after a bankruptcy case is filed.

Seek to Understand the Cryptocurrency Industry

First, crypto creditors should understand the cryptocurrency industry as a whole prior to joining to understand exactly what they face and when they should take action to protect their interests. Historically, the crypto industry has experienced boom and bust cycles roughly every 4 years since the inception of Bitcoin in January of 2009. Time will tell whether these cycles will continue, or whether the industry will mature and enter a period of reduced volatility or collapse into irrelevancy. Additionally, there are a myriad of legal and regulatory considerations to contend with during both good times and bad in connection with projects that survive the regular bear markets and avoid bankruptcy. There is arguably no coherent regulatory framework currently in place that clearly sets forth the “rules of the road,” and regulatory agencies compete for supremacy, including the Securities and Exchange Commission and the Commodity Futures Trading Commission. Participants are hopeful that Congress and/or regulatory agencies will adopt statutes and rules that clarify how to remain legally compliant in this nascent industry; however, in the meantime the lack of coherent and consistent policies does not mean that the industry is unregulated or that no rules apply. For example, even absent additional action by the SEC, the agency has the authority to designate any crypto asset as a “security,” and subject the issuance of the underlying token to the same rules that govern the issuance of equity in a corporation or other business entity. Absent corresponding federal and state exemptions, the default requirement is that all “securities” must be registered with the SEC, which is a cumbersome and expensive process that can be impractical at best and impossible at worst for many crypto projects. Understanding the cyclical nature of the industry and the pitfalls in its regulations can help creditors recognize when their investments may be at risk to trigger further action to protect their interests, including but not limited to withdrawing their investments.

Become Informed about Crypto Debtor Agreements

Second, crypto creditors should know what their documents and agreements with crypto debtors include. These agreements, whether lending agreements, deposit agreements or anything else, lay out the exact terms and obligations between the crypto creditor and debtor, thereby governing the parties’ relationship. For example, these agreements likely say what type of account the creditor’s funds will be held in or where the debtor may transfer the creditor’s cryptocurrency. These dense and innocuous terms become ever more important in the event of a bankruptcy filing. Depending on what type of account the creditor’s funds are held in or where their cryptocurrency has been transferred, under the letter of bankruptcy law those funds and assets could remain property of the creditor that should be returned or could qualify as property of the bankruptcy estate and thus no longer accessible by the debtor. Only by knowing what their relationship with the debtor is prior to a bankruptcy filing can the creditor know how exactly their money or assets are being treated and thus whether they should change that relationship at the first sign of financial trouble for the debtor. Otherwise, the creditor will be left at the whims of the proof of claim process, receiving—at best—pennies on the dollar for the full value of their lost money or cryptocurrency.

Consult a Bankruptcy Attorney

Third, if a crypto debtor does ultimately file for bankruptcy, a creditor should consult a bankruptcy attorney to better understand their rights under the Bankruptcy Code and for assistance in preparing and filing a proof of claim. As crypto bankruptcies are an entirely new trend with a limited but ever evolving realm of case law governing debtor and creditor rights related to the unique nature of cryptocurrency, it may be near impossible for a creditor inexperienced in bankruptcy court to protect its rights. Also, depending on the creditor’s agreement with the debtor and where their assets may now be held, they could be immediately owed the return of those assets. Without representation, however, the creditor may be subject to the accuracy of the debtor’s schedules for how their claim is listed to get an expeditious return. Finally, while the bankruptcy proof of claim form is a streamlined and straightforward document, the process itself can turn complex with potential objections and the uncertainty in how to treat creditor claims related to cryptocurrency. The assistance of counsel may therefore be vital to submitting an accurate and complete proof of claim form that will present the creditor with the best opportunity to get paid.

Just like the cryptocurrency industry itself, nothing is fool proof. No matter what, a bankruptcy filing of a cryptocurrency debtor will likely cause some form of disruption for creditors and their access to their money and assets. However, by taking the appropriate proactive and reactive steps, a creditor can limit exposure to the highs and extreme lows of a crypto debtor’s financials and thus keep their portfolio intact.

  • Dominick J. Grande

    Dominick’s practice focuses on combining an understanding of business and the law in order to help companies craft strategic solutions to their idiosyncratic needs.

    He represents clients of all sizes across a wide variety of ...

  • Samuel M. Andre
    Senior Associate

    Sam represents businesses, commercial lenders and individuals in the areas of debtor/creditor law, bankruptcy and complex commercial litigation. He works closely with clients to understand their specific financial and ...

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