A Crypto Bankruptcy Could Be an Investors’ Nightmare

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There are certain safeguards in place for individual investors when a digital asset platform files for Chapter 11 protection.

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In bankruptcy reorganization, crypto investors will navigate uncharted territory.

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“What can be safely predicted is that there will be litigation, and there will be delays,” said Adam Levitin, a Georgetown University law professor who studies bankruptcy.

Crypto exchanges and lending services provide individual investors with a ramp up in the markets, but according to regulators and legal experts, the cryptocurrency customers put on these platforms may not be theirs in the eyes of the bankruptcy court.

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If a cryptocurrency company goes bust, the digital assets of its users will go into bankruptcy assets, which are divided up by lawyers, financial advisors, lenders and other creditors. Customers’ assets can only be repaid on damages rather than returned to users. Even if clients of a troubled cryptocurrency firm eventually gain access to their tokens, they could still suffer major losses if the market turns against them during bankruptcy.

Many people were inspired to hold crypto assets in Celsius to earn interest rates up to 18%. Lenders take customers’ deposits and put them into decentralized finance investments so that they can get a refund or lend money to other users for a fee.

Celsius resembles a bank in many ways. But the company lacks the protections that banks have, such as federally backed deposit insurance. Celsius, and other cryptocurrency intermediaries, are not registered as broker-dealers, providing account holders with significant protection in the event of bankruptcy by keeping them separate from broker-dealers’ own funds. In the US, most crypto intermediaries have simple money-transmitter licenses issued by state governments, intended for companies such as Western Union.

In a recent paper, Mr. Levitin argued that the easiest way to protect investors would be for the Consumer Financial Protection Bureau, a federal regulator that requires cryptocurrency exchanges to segregate funds in bankruptcy-remote arrangements to hold customer funds. would be required. He said the CFPB has a clear mandate from Congress to take such steps, but the agency has not done so yet.

A CFPB spokeswoman declined to comment.

Crypto companies like trading platform Coinbase Global Inc.

In recent weeks it has tried to reassure investors that their crypto assets are safe.

“We have strong legal and operational safeguards to ensure that the assets of our clients are protected under any circumstances,” Paul Grewal, chief legal officer at Coinbase, said in an emailed statement on Thursday. “This involves completely separate accounting for these assets from any corporate fund.”

Shares of Coinbase fell in May following a disclosure by the company that customers could be treated as ordinary unsecured creditors in a fictitious bankruptcy.

Celsius also sought to reassure the customers some time before putting the withdrawal on hold. A spokesman for the firm told Businesshala in an email on Friday that it had no problem fulfilling withdrawal requests and that it has enough ether—a popular cryptocurrency—to meet its obligations.

Celsius CEO Alex Mashinsky took to Twitter to attack skeptics who suggested the company was on the ropes on Saturday, accusing them of spreading misinformation. On Sunday evening, the company froze the account. On Wednesday afternoon, the property was still frozen, and Mr Mashinsky tweeted that the firm was “working nonstop” on the issue.

In the event of bankruptcy, much will depend on the contract depositors agree to when placing their digital assets. The terms of use for Celsius specify that the legal status of users’ crypto holdings will not be clear if the firm goes bankrupt.

Some lawyers state that the type of contract between the investor and the firm may make a difference and may provide some protection of ownership rights in bankruptcy. The treatment of client assets may depend on whether the firm holds them in a way that is consistent with client ownership established under relevant commercial laws, said Jonathan Cho, bankruptcy and regulatory attorney for Allen & Overy.

For example, many firms have adopted the holding model available under most states’ commercial laws, which helps define what ownership rights should be, Mr. Cho said. Celsius also has a lending arm that offers cash loans with people’s crypto assets as collateral.

A bankruptcy judge may also have to decide whether Celsius depositors will be considered unsecured creditors or merely investors who rank even lower, said Jim Van Horn, bankruptcy attorney for Barnes & Thornburg LLP.

State laws on the ownership of assets in custodial accounts can be helpful to depositors. But they also may not land in bankruptcy if a judge determines that users are merely investors, Mr. Van Horn said.

Paul Kiernan at [email protected], Alexander Gladstone at [email protected] and Soma Biswas at [email protected]

Credit: www.Businesshala.com /

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