On June 12, 2022, one of the nation’s largest crypto lenders, New Jersey-based Celsius Networks, froze all withdrawals and transfers between its various client accounts, citing “extreme market conditions”, which, in crypto parlance, is usually a precursor. to insolvency. Shortly thereafter, on July 13, 2022, Celsius filed for Chapter 11 bankruptcy in the Southern District of New York – the case is titled Celsius Network LLC, et al., File Number: 22-10964 – seemingly marking the start of an era of bankruptcy among cryptocurrency exchanges.
Presiding U.S. Bankruptcy Judge Martin Glenn is tasked with resolving several first impression issues. One such question is whether the digital assets deposited on a centralized exchange are owned by the debtors or the depositors. A secondary issue related to the question of ownership is whether these deposits are subject to a preferred claim by the trustee or to compensation. His decision has the potential to reshape how deals between cryptocurrency exchanges and their clients are crafted in the future.
Context of Celsius programs
Before filing for bankruptcy, Celsius’ main product was called the Earn program. Accounts won under the Earn program paid interest to customers and allowed them to make loans, but regulatory investigations concluded that the accounts won constituted unregistered securities offerings. As a result of the investigation, Celsius replaced the Earn program with the Deposit Account program and the Hold Account program.
If a customer with an Earn account lived in a state where the deposit account was legal, the customer’s Earn account was transferred to a deposit account. Deposit accounts allowed users in the United States to store, access, borrow, spend, and develop crypto in Celsius products. If a customer with an Earn account lived in a state where the deposit account was not legal, the customer’s Earn account was transferred to a hold account. The hold accounts contained coins that did not earn interest and could not be used to repay loans, to deposit as collateral, or to buy or exchange for other coins. And especially for the issue of ownership in bankruptcy court, unlike other accounts at Celsius, Withhold Accounts had no contractual term of service. The third category of accounts, “pure” accounts, refers to accounts held by custodial or hold account customers who have never had an acquired account.
Estate ownership issues
The two issues before the bankruptcy court are (1) whether customer deposits in the Custody, Withhold and Pure accounts, which have been frozen since June 12, 2022, are owned by Celsius or the depositors; and (2) whether the deposits are the property of the customers, whether they are the subject of preferential action by the fiduciary or are offset against the loan obligations. Although Celsius acknowledged that at least some of the accounts are the property of customers, he argued that returning all customer deposits was not appropriate because the replacement of the Earn program occurred within 90 days. following the date of the petition, subjecting transfers of Earning Accounts to Custody and Retaining Accounts to claims of preference or set-off, two causes of action that are commonly used in bankruptcy to maximize the value of the estate of a debtor in order to repay creditors in an equitable manner. Preference shares allow a trustee or debtor in possession to collect payments received by a creditor within 90 days of filing for bankruptcy to the extent that such payments provided the creditor with an advantage in the bankruptcy event over others. creditors. Set-off is an equitable right of a creditor to set off a debt he owes the debtor from a claim he has against the debtor resulting from a separate transaction. Specifically, as of the filing date, at least $180 million in the deposit accounts and $15 million in the holdback accounts may be the subject of a preferred claim by the trustee. Additionally, approximately 58,300 users held assets worth $210 million in loan programs, which are eligible for compensation. Clients with Pure Accounts who have never used the Earned Accounts would not be subject to preferential action because no transfers between accounts were made within 90 days of the deposit date. Celsius, however, sought to hold all funds until the court determined which accounts would be given preference or set-off so that it did not have to pursue the recovery of funds after the have unlocked.
More than 50 objections have been filed to Celsius’s request to hold customer deposits until further court ruling. After several days of argument in early December, the Court ordered Celsius to release funds for clients holding less than $7,575 in assets, which is the legal cap for preferred stock under Section 547(c) (9) of the Bankruptcy Code. The Court also authorized the distribution to customers with Pure Custody accounts, which affected 15,680 customers holding approximately $44 million in Pure Custody accounts.
However, clients with Custodial Accounts, Hold Accounts, and Pure Hold Accounts over $7,575 in investments continue to have their funds frozen for further court ruling. The Court has not indicated when it intends to decide on the release of these funds.
Section 541 of the Bankruptcy Code provides that all property in which a debtor has a legal or equitable interest, including any interest in property that the debtor acquires after petition, becomes the property of the estate. To determine whether a debtor has a legal or equitable interest in the property or whether the property is ownership of the bankruptcy estate, courts must analyze state law and the debtor’s contractual rights. Cryptocurrency is an asset that has not been frequently litigated in bankruptcy courts or regularly valued under property or contract law. In the absence of a legal or regulatory framework, the parties rely on written agreements. Whether or not the crypto assets are owned by the estate will likely be determined by the language of the agreements between Celsius and its clients under applicable state law.
Title to any of your eligible digital assets in a custodial wallet will remain with you at all times and will not be transferred to Celsius. Celsius agrees not to transfer, sell, lend or otherwise remortgage Eligible Digital Assets held in a Depository Wallet, unless specifically instructed by you, unless required by a valid court order, competent regulatory body, body government or applicable law. As the legal owner of the assets, you bear all risk of loss.
When using the Guard [Program]you understand and agree that Celsius may act as custodian or that we may use a third party custodian to provide safekeeping [Program] . . . . Using the Guard [Program], you understand and agree to appoint Celsius or a third-party custodian selected by Celsius as your agent to store and secure eligible digital assets in a custodial wallet, and perform other tasks usually performed by a custodian. . . . Using the Guard [Program]you authorize Celsius to transfer your Eligible Digital Assets to one or more Third Party Custodians as Celsius may select, and to instruct such Third Party Custodian to transfer your Eligible Digital Assets to another Custodian or other Third Party Custodians, as applicable . selected by Celsius, or to Celsius, in each case without the need for further notice or consent by you, and in accordance with the provision of safekeeping [Programs] as shown here.
Reading the two provisions together suggests that Celsius did not intend to own the digital assets in custodial accounts, but rather to keep individual account holders as owners. Interestingly, hold accounts do not have terms of service governing the ownership of deposits in these accounts. This means that the Court would have to decide who owns the funds in the holdback accounts without having contractual terms, which could lead to an analysis under an implicit contractual theory.
On December 19, 2022, the Court issued an information program to determine Celsius’s liability to account holders under the Terms of Service. The final evidence hearing is scheduled for February 6, 2023.
What this means for you
Ultimately, Judge Martin Glenn will have to rule on the ownership status of all categories of accounts and whether the funds can continue to be held by Celsius while pursuing preference and compensation litigation. Its decision on the matter could have far-reaching implications for how crypto exchanges and their customers transact in the future.