Genesis Global’s Chapter 11 filing on January 20th was little surprise to those closely following the cryptocurrency markets and after its decision to “pause” withdrawals in mid-November. Digital Currency Group, Inc. (“DCG”), the parent of Genesis Global Holdco LLC (“Genesis”) and its largest borrower, is not part of the bankruptcy case and instead may find itself a defendant in an adversary proceeding. The company reported that it is conducting an investigation that will examine the circumstances surrounding approximately $850 million of unsecured loans advanced to DCG and certain of its affiliates, the DCG Note, including the purported setoff of approximately $52 million in November, and dividends paid to DCG, among other things. The outcome of the investigations will be of considerable interest to Genesis’ customers and creditors. The bankruptcy case also does not include Genesis’s OTC derivatives trading or custody businesses.

The company’s “first day” pleadings show a large institutional creditor base, many of which extended loans to Genesis pursuant to “master digital asset loan agreements.” Of nearly $2.6 billion in loans, only a small fraction of which were secured by Genesis’ collateral (approximately $350 million). It also had borrowed from customers of Gemini Trust Company (“Gemini”), with Gemini acting as agent on their behalf (the company states that it is not aware of the identities of the Gemini customers). Genesis had pledged certain interests in Grayscale Bitcoin Trust to secure its loans from Gemini customers. Another tranche of shares were intended to be pledged — originating from DCG — but that pledge was never consummated.  According the pleadings, Gemini foreclosed on the first tranche of pledged shares, an action that may be challenged by Genesis. According to Genesis’ schedules, the Gemini customers have an aggregate general unsecured claim of nearly $766 million.  

Following the playbook of Voyager, concurrently with their petitions, the company filed a proposed plan of reorganization which provides, very generally, (i) that holders of general unsecured claims will receive some combination of (a) cash and other assets, (b) equity interests in a reorganized entity and (c) interests in a trust to be established to pursue claims and causes of action that the company may have, including against DCG and Gemini. In order to maximize recoveries to creditors, Genesis Global says that will conduct a marketing process to sell the company or otherwise raise capital. The company suggests that it can complete a marketing process and confirm a plan of reorganization in four months. While complications are due to arise, recent rulings in Celsius’ bankruptcy case regarding the ownership of assets reflected in customers’ earn (or similar) accounts, may erase certain of the uncertainty and ease the path to confirmation.

Initially, given the large institutional credit base and nature of the lending based claims, the Genesis bankruptcy may have more straight-forward investment opportunities for distressed investors relative to FTX and other crypto-bankruptcies (which had a larger portion of retail investor claims and more uncertain claw-back risks). We will provide updates as circumstances warrant.

Earlier this month, the SDNY Bankruptcy Court answered one of the gating questions at the center of Celsius Network’s Chapter 11 bankruptcy regarding the ownership of the approximately $4.2 billion in crypto assets.  Celsius account holders had been demanding the return on their crypto deposits in interest-bearing accounts (“Earn Accounts”), while Celsius debtors asserted that these assets were, pursuant to Celsius’ Terms of Use, property of the Celsius bankruptcy estate. The court sided with the Celsius debtors and ruled that, according to Celsius’ unambiguous Terms of Use, these assets became the property of Celsius when they were deposited in the Earn Accounts on Celsius’ platform.

 In providing its rationale, the Court found that the Terms of Use, as amended, and accepted by 99.86% of Celsius account holders, gave Celsius “all right and title to such Eligible Digital Assets, including ownership rights”. Accordingly, any assets remaining in these accounts on the date of the bankruptcy petition became property of the bankruptcy estate and each such account holder became an unsecured creditor. The court viewed the ownership of these assets as a contract issue governed by New York law, and under New York law, when a contract’s terms are unambiguous, courts must apply them as written. This finding, while unsurprising, will have important consequences, not only in Celsius’ bankruptcy, but also for the billions of dollars in cryptocurrencies trapped on other insolvent platforms.

The simple but important takeaway is that contracts matter. Investors onboarding onto exchanges or trading platforms or entering into new trading relationships should closely review trading documentation to ensure their assets are treated as they expect. Are you lending the digital assets as a secured lender, or entering into a repurchase arrangements for digital assets where title is transferred? If and when is the exchange or counterparty permitted to rehypothecate digital assets? Are set-off rights mutual, or is only the exchange or counterparty permitted to exercise rights of set-off under the agreement? The answers to these questions may mean different treatment in a bankruptcy of the exchange or counterparty.  For distressed investors attempting to purchase claims, underwriting of the claim should include a deep dive into the trading agreements, terms of use or other documentation governing the applicable claims.

On January 3, 2023, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (the “Federal Banking Regulators” or “Agencies”) issued a Joint Statement (“Joint Statement”) highlighting key risks for banking organizations associated with crypto-assets and the crypto-asset sector. 

The Joint Statement notes the marked volatility of crypto-assets and crypto-related exposure in 2022, and highlights, among others, the following risks banking organizations should be aware of:

  • Risk of fraud and scams among crypto-asset sector participants;
  • Legal uncertainties related to custody practices, including ownership rights of crypto-assets, which the Federal Banking Regulators note is an issue currently subject to litigation;
  • Inaccurate or misleading representations, including about federal deposit insurance, and other unfair or deceptive practices that could substantially harm retail and institutional investors, customers, and counterparties;
  • Stablecoin run risk, which could create deposit outflows for financial institutions holding stablecoin reserves;
  • Contagion risk in the crypto-asset sector resulting from interconnectedness among various participants through “opaque lending, investing, funding, service, and operational agreements.”  Such risks may also present concentration risks for financial institutions with exposure to the crypto-asset sector; and
  • “Heightened risks associated with open, public, and/or decentralized networks,” including but not limited to, “lack of governance mechanisms establishing oversight of the system, the absence of contracts or standards to clearly establish roles, responsibilities, and liabilities,” cyber-risks, and illicit finance risks.

The Agencies stress the importance of ensuring that crypto-asset sector risks “that cannot be mitigated do not migrate to the banking system.”  The Agencies emphasize that they will continue to take a cautious approach to current and proposed crypto-asset related activities and exposures at banking organizations.  This includes assessments of financial institutions on how crypto-related activities may be conducted in ways that addresses safety and soundness, anti-money laundering and illicit finance statutes, consumer protection, and compliance with laws and regulations. 

While the Joint Statement notes that federally-regulated banking organizations, generally speaking, “are neither prohibited nor discouraged from banking” any specific type or class of customers, the Agencies express an ominous view of crypto-assets in the banking system.  Specifically, they note that based on their current understanding and experience, they believe that “issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices.”  The Federal Banking Regulators also highlight “significant” safety and soundness concerns associated with business practices that are concentrated in crypto-asset related activities, or have concentrated exposure to the crypto-asset sector.

Takeaways

Given the risks highlighted by the Agencies and their doubts as to safety and soundness of certain crypto-related activities, federally-regulated financial institutions may wish to review their crypto-asset exposure.  This could include a review of their own activities or customer base, and assess whether the Agencies’ highlighted risks are present, and how to manage such risks, including through board oversight, policies, procedures, and monitoring.  For example, recent events, including regulatory enforcement actions, have highlighted the importance of heightened due diligence on crypto-market participants, particularly around issues of custody, anti-money laundering (AML) and sanctions compliance, and cybersecurity. 

Conversely, crypto-market participants, particularly newer entrants, should assess their policies, procedures, and controls, as appropriate, around crypto custody, AML and sanctions compliance, and cybersecurity.  Such areas, including compliance with stated terms of service, may be subject to increased diligence by federally-regulated financial institutions as they consider onboarding such participants, maintaining existing relationships, or otherwise transacting with them, consistent with such institutions’ risk management practices and procedures, and potential regulatory notification obligations.

While legal, regulatory and tax uncertainty continues to affect financial transactions in digital assets, we are seeing incremental guidance developing on US federal taxation issues. The Infrastructure Investment and Jobs Act (Infrastructure Act), enacted in 2021, amended provisions in sections 6045 and 6045A to clarify and expand the rules regarding the reporting of information on digital assets by brokers.

On December 23, 2022, the United States Treasury Department and Internal Revenue Service (IRS) released Announcement 2033-2 (“Announcement”). Under the Announcement, brokers are not required to report additional information with respect to dispositions of digital assets which were not otherwise subject to reporting prior to the enactment of the Infrastructure Act until final regulations are issued under sections 6045 and 6045A.[1]

Section 6045(a) provides that every person doing business as a broker shall make a return showing the name and address of each customer, with such details regarding gross proceeds and such other information as may be required by IRS forms or Treasury regulations with respect to such business. The term “broker” includes a dealer, a barter exchange, any person who (for consideration) regularly acts as a middleman with respect to property or services, and any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.[2] Brokers must furnish payee statements to customers by February 15 of the year following the calendar year of the sale. Brokers must file information returns on Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, with the IRS by February 28 (or March 31 if filing electronically) of the year following the calendar year of the sale. The existing regulations under section 6045 do not specifically address the extent to which these requirements apply to sales or exchanges of digital assets and do not specifically include digital assets as a specified security subject to basis reporting.

Section 6045A(a) generally requires a broker who transfers to another broker securities that are covered securities in the hands of the transferring broker to furnish to the receiving broker a written statement setting forth information required by the regulations. The existing regulations under section 6045A require transfer statements to include specified information about the customer, the brokers involved, and the original acquisition information about the covered security. Brokers must furnish the transfer statements required under section 6045A(a) not later than 15 days after the date of the transfer. The existing treasury regulations under section 6045A do not specifically address the extent to which these requirements apply to transfers of digital assets which were not subject to reporting prior to the enactment of the Infrastructure Act.

This transitional guidance applies only to information returns filed or furnished by brokers. In contrast, taxpayers are still required to report any income they receive from transactions involving digital assets. They are also required to answer the digital asset question on page 1 of either Form 1040 or Form 1040-SR.

[1] All references to sections are references to sections of the Internal Revenue Code of 1986, as amended.

[2] Section 6045(c)(1)

John J. Ray, CEO of the FTX debtors will testify tomorrow before the U.S. House Committee on Financial Services at a hearing entitled “Investigating the Collapse of FTX, Part I.”  Sam Bankman-Fried, the former CEO of the FTX Group, is scheduled to appear as well, albeit remotely. 

Mr. Ray’s prepared remarks are available online and are a worthwhile read to learn more about the controls and governance failures at FTX, as well as Ray’s restructuring plan. 

Specific deficiencies at FTX Group identified by Ray, among others, include:

  1. Senior management access to systems that stored customer assets, without controls to prevent senior management from redirecting those assets;
  2. The ability of the Alameda hedge fund to borrow funds held at FTX.com for its own trading without effective trading limits;
  3. Commingling of assets;
  4. Lack of documentation for nearly 500 investments made by the FTX Group;
  5. Absence of audited or reliable financial statements; and
  6. Absent of independent governance of the FTX Group.

Mr. Ray described his restructuring plan as having five key objectives:

(1) implementation of controls, which is underway;

(2) asset protection and recovery, which has so far resulted in securing over $1 billion in digital assets to protect against the risk of unauthorized transfers;

(3) transparency and investigation, including working with U.S. and foreign regulatory and law enforcement authorities to gather evidence to help determine the events leading to the collapse of the FTX Group;

(4) efficiency and coordination among the various FTX insolvency proceedings occurring globally;

(5) maximization of value for all stakeholders through either a reorganization or sale of various assets of the FTX Group, including investments and digital assets.

Mr. Ray’s prepared remarks also shed light on the rationale for including FTX US in the US Chapter 11 petition.  Mr. Ray states “because FTX US was not operated independently of FTX.com. Chapter 11 protection was necessary both to avoid a ‘run on the bank’ at FTX US and to allow [my] team the time to identify and protect its assets.”  Mr. Ray also describes specific facts he and his team have been able to determine regarding commingling of assets, FTX Group expenditures, and loans and payments to FTX Group insiders, in excess of $1 billion.

The hearing begins at 10:00 AM ET on December 13, 2022, and can be viewed online here.

Chapter 15 of the Bankruptcy Code provides a mechanism for United States cooperation and coordination with insolvency proceedings abroad, often affording foreign debtors wide-ranging relief and expansive rights through the United States Bankruptcy Court system.  Not all proceedings in foreign jurisdictions are eligible — in order to be so, a proceeding must constitute a “foreign proceeding” under the Bankruptcy Code. The Bankruptcy Code defines a “foreign proceeding” as “a collective judicial or administrative proceeding in a foreign country…  under a law relating to insolvency or adjustment of debt in which proceeding the assets and affairs of the debtor are subject to control or supervision by a foreign court, for the purpose of reorganization or liquidation.”  It is generally understood that the definition should be interpreted liberally. Recently, the Bankruptcy Court for the Southern District of New York tested the limits of Chapter 15, providing important guidance regarding the eligibility of proceedings that do not involve “insolvency or the identification, classification, or satisfaction of debt.” See In re Global Cord Blood Corporation, Case No. 22-11347 (December 5, 2022).

Continue Reading A Line in the Sand: Caymans Proceeding Ineligible for Chapter 15

BlockFi Inc. and eight of its affiliates followed the paths of crypto platforms Voyager, Celsius and FTX by filing for bankruptcy protection.  The case, commenced in the District of New Jersey, on November 28, 2022, is off to a fast start. BlockFi filed a plan of reorganization on the first day of its case. The plan proposes a standalone restructuring but allows the company to toggle to a sale of all or substantially all of the company’s assets. The company had its first day hearing in New Jersey on November 29th and expressed an interest in exiting bankruptcy expeditiously.  

BlockFi’s financial advisor pointed out in a “first day” declaration that, while the company’s downfall came as a result of FTX contagion, it does “not face the myriad issues apparently facing FTX.”  The declaration highlights BlockFi’s efforts to lead the digital assets industry in compliance and transparency in an obvious attempt to distinguishing itself from FTX. BlockFi’s liquidity crisis was, at least in part, due to its exposure to FTX through financing provided by FTX US, loans the company advanced to Alameda, and cryptocurrency held on FTX’s platform.  BlockFi was also heavily exposed to Three Arrows Capital, the crypto hedge fund that collapsed earlier this year. Three Arrows was one of the company’s largest borrower clients and its failure led to the FTX rescue financing.  Based on testimony of the hearing, it seems that BlockFi had lent approximately $680 million to Alameda and has approximately $355 million frozen at FTX.

In its schedule of largest unsecured creditors, BlockFi listed a $729 million unsecured claim on account of an indenture (although does not mention any bonds in the declaration).  It also listed a $250 million unsecured loan from FTX US (which is purportedly subordinated to customer obligations) and an undersecured “institutional loan” in the amount of $21.67 million.  The remaining claims were identified as client claims and the customers were not identified.

In conjunction with the US cases, BlockFi International Ltd., a Bermuda company, filed a petition with the Supreme Court of Bermuda for the appointment of joint provisional liquidators.  It is fair to expect that a Chapter 15 proceeding will be commenced in New Jersey once the liquidators are appointed.

Shoba Pillay, the Examiner appointed in Celsius’ bankruptcy cases, filed her interim report on November 19, 2022.  The Celsius Examiner’s report provides some important insight into a crypto-exchange’s operational and risk management failures which may provide investors and creditors some insight into what to expect in FTX.

The initial report provides important insight on the financial management at Celsius and treatment of various types of customer accounts. Given Celsius’ management of the different accounts, and the commingling of assets between and among them, “customers now face uncertainty regarding which assets, if any, belonged to them as of the bankruptcy filing” as explained by the Examiner. Her report is extremely thorough and can be accessed here. We highlight a few high-level observations from the report below.

  • Earn Program. Pursuant to its “Earn” program, customers purported to lend cryptocurrency to Celsius in exchange for certain “rewards” plus the return of their principal. The terms of use, while changing over time, were largely consistent with respect to Celsius’ ownership of all cryptocurrency deposited. While each customer’s account reflected the amount of each digital asset deposited (plus rewards), Celsius did not have individual wallets holding those assets. Instead, when amounts were deposited by a customer they would be swept into one or more “Main” wallets that pooled many customers’ assets. Celsius accessed those accounts at its discretion for purposes of funding its many investments — needed to generate its customers’ expected returns. When needed, Celsius effectuated withdrawals related to the Earn program by transferring assets from any one or more of its many commingled Main wallets to its customers’ external wallets.
  • Custody Program.  This program was launched in April 2022 in response to investigations then underway by various state regulatory authorities. The program was designed to allow the company a mechanism to maintain relationships with unaccredited customers in the US, purportedly holding their assets in “custody” without the benefit of rewards. Generally, all deposits of US customers following April 15 would go to Custody accounts (and accredited customers could then move them to an Earn account). The terms of use with respect to Custody accounts were clear — title remained with the customer (although they also identified bankruptcy risks). Hastily developed however, the Custody program did not provide customers with individual wallets that segregated assets.  Instead, the company sought to maintain an aggregate level of deposits in commingled wallets (as expressly permitted by the terms of use) that roughly matched the assets held in such program. When first deposited by a customer, assets would be directed to the company’s Main wallets at which time it lost any ability to trace an assets to a customer. From Main wallets, assets were periodically, and manually, transferred to Custody wallets. The aggregate amount contained in these commingled Custody wallets did not necessarily correspond to the aggregate customer balances allocated to them. Reconciliations occurred from time to time. When a shortfall existed, Celsius would transfers coins from a number of sources into Custody wallets to regain balance. In the days leading up to the filing, the swings in liabilities to customers with Custody accounts and the amounts maintained in the Custody wallet swung by millions of dollars in value. The Examiner reports that the deficit reach $45 million by June 28th. When it came to withdrawals to Custody customers, Celsius effected transfers, not from Custody wallets, but instead from wallets located in a different workspace.
  • Withhold Accounts. Celsius was unable to offer Custody accounts to users in nine states due to regulatory issues. For customers in those states, the company purported to maintain Withhold accounts as a temporary substitute. These funds were unavailable for either Custody accounts or the Earn program, and customers were advised to withdraw them. Unfortunately, customers could not withdraw funds through the Celsius app but rather need to contact customer care. In the interim, rather than be treated similarly to Custodial accounts, assets supposedly held in Withhold accounts were held in the Main wallets and available for use by Celsius as those in the Earn program.

Based on the Examiner’s initial report, it appears that Celsius’ ability to match the cryptocurrency deposited by a customer, whether in an Earn account, Custody account or Withdrawal account, was non-existent shortly following deposit and that assets were commingled with other Debtor assets for a short period of time.  While certain customer accounts were being tracked by accounting ledgers, the facts revealed by the Examiner’s report will provide the Bankruptcy Court with additional factual guidance in determining whether account holders can claim that their assets were being held in trust or “constructive trust.”    In other non-crypto bankruptcy cases,  whether or not trust funds can be identified or traced after such funds have been commingled (sometimes using a technique called the “intermediate balance rule”) helps to determine how much a beneficiary can actually recover.   Under this standard, if the amount of the commingled deposit equals or exceeds the amount claim to be in trust, then a constructive trust may be imposed. The Examiner’s report provides important factual backdrop for that rapidly approaching litigation, the outcome of which will certainly have dramatic consequences of customers’ ultimate recoveries.

Relatedly, while an examiner has yet to be appointed in the FTX case, it will be important to monitor and understand the severity of record keeping and segregation failures by FTX and the impact it will have on their account holders and creditors.

FTX has warned its investors, customers and the crypto-world that they may have to file for bankruptcy protection without rescue financing to address its immediate liquidity crisis. Unlike the bankruptcy cases of Celsius and Voyager, FTX’s case, should it file, will likely involve many institutional investors with secured and unsecured claims. These institutional investors are now having to take steps to limit their exposure in the face of such uncertainty while considering the consequences of an FTX filing. While history rarely repeats itself, it does rhyme quite often, and lessons learned from Lehman’s epic bankruptcy in dealing with securities trades, loans, swaps, repos, customer property and dozens of other structured transactions may be useful guidance.  Of course, adding the novelty and complexity of digital assets and absence of regulatory clarity, an FTX case could be a tangle of confusion.

The legal questions that investors will face include:

  1. How will my digital assets or investments be classified in an insolvency proceeding?
  2. In a US Bankruptcy proceeding, do any traditional safe harbors apply which would allow termination, liquidation and set-off of claims?
  3. How will my claims or assets be valued?
  4. What should a counterparty do with any collateral they hold?
  5. What are the risks of withdrawing my digital assets today (assuming I still have access)?
  6. Do I have any legal recourse against management in connection with my potential losses?

This is a gut check moment for institutional investors in the cryptocurrency space and may be the first real test of how market, counterparty and legal risk management should respond to these types of events in digital asset investing and trading.

FTX’s insolvency will have repercussions on Voyager as well. As has been widely reported, Voyager’s exit from Chapter 11 is premised on the consummation of a sale of substantially all of its assets to FTX US (or West Realm Shires, Inc.).  Very generally, under the transaction FTX US would acquire the cryptocurrency on the Voyager’s platform and pay additional consideration which the company estimated to provide at least approximately $111 million of incremental value.  In its disclosure statement, the company reported that “the FTX US bid can be effectuated quickly, provides a meaningful recovery to creditors, and allows the Debtors to facilitate an efficient resolution of these chapter 11 cases, after which FTX US’s market-leading, secured trading platform will enable customers to trade and store cryptocurrency.” After this week’s news of FTX’s severe liquidity constraints and its own bankruptcy risk, Voyager’s prospects for a quick wind-down, and the associated recovery for customers and other creditors, have dimmed considerably.

It has been reported that Binance was a leading competitor of FTX US for Voyager’s assets. Binance has now backed out of any purported agreement to provide rescue financing to FTX, leaving FTX US’s ability to close on its acquisition in grave doubt. If unable to close, Voyager will surely look to Binance to revisit their interest in the  platform. While this will certainly cause a delay, the framework of Voyager’s plan to exit bankruptcy may hold.

The excitement in the distressed digital assets markets may only be in the early innings.

Over a decade after Lehman’s insolvency, the English High Court handed down a key judgement in Grant v FR Acquisitions Corporation (Europe) Ltd [1] on 11 October 2022. The judgement provides commentary on when certain Events of Default have occurred and are “continuing”.

Although the court addressed these issues in the context of interest rate swaps entered into pursuant to an ISDA Master Agreement (the “Transactions”) and the impact of Lehman’s UK entity, LBIE, coming out of administration, the judgement may have implications beyond the derivatives market, for example in the context of financing agreements, corporate documentation, and distressed debt trading, as well as cross-border restructuring or insolvency situations.

Continue Reading When Is an Event of Default “Continuing”?