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Jan. 26, 2024

Emerging Issues in Crypto Bankruptcies

By Ryann Connell

The new frontier of crypto bankruptcies brings with it unique challenges. As more crypto platforms face financial distress and insolvency, investors find themselves navigating the intricacies of the Bankruptcy Code in a never-before-seen context. 
When a debtor files for bankruptcy, the Bankruptcy Code aims to ensure fair and equitable treatment for creditors by establishing an organized and transparent process for the distribution of the debtor's assets. To ensure this fair treatment, there are a number of mechanisms utilized by the courts. This article explores new issues related to withdrawal clawbacks and valuations in crypto bankruptcies.

Withdrawal Clawbacks:

Withdrawal clawbacks refer to the recovery of funds or a percentage of funds transferred from a distressed entity to another within a specified timeframe leading up to the bankruptcy filing. The purpose of these clawbacks is to prevent certain creditors from receiving preferential treatment at the expense of others during the period leading up to a bankruptcy filing – 90 days for non-insiders and one year for insiders.

However, in crypto bankruptcies, withdrawal clawbacks can significantly affect unknowing investors. It is common for investors to move money in and out of crypto platforms. Many investors do so without considering their potential exposure and risks associated with such actions. This is precisely why withdrawal clawbacks present a unique challenge. If a platform is steering a path toward bankruptcy, then uninformed investors withdrawing funds may be subject to future withdrawal clawbacks.

That is not to say every crypto investor is at risk. Typically, withdrawal clawbacks will have specifications outlined in the bankruptcy plan. For example, in the FTX bankruptcy, the plan only looked at withdrawals that exceeded $250,000 and occurred within ten days of the petition date. FTX Trading Ltd., Case No. 22-11068 (Bankr. D. Del.). On the other hand, the plan in the Celsius bankruptcy cast a broader net, using the entire 90-day window and reviewing transactions over $100,000. Celsius Network LLC, et al., 22-10964 (Bankr. S.D.N.Y.).

If creditors do not cooperate with a clawback action in bankruptcy, the bankruptcy trustee or the debtor entity initiating the clawback may take legal action to enforce the recovery. It's important to note that the legal consequences for non-cooperation with a clawback action will depend on the specific circumstances of the case, applicable bankruptcy laws, and the bankruptcy court's decisions. Creditors are generally expected to comply with court orders and participate in the bankruptcy process in good faith.

Crypto investors should stay informed about the financial health of their investment platforms and the implications of withdrawal clawbacks on their digital asset transactions, as they may be subject to recovery by the bankruptcy estate if they were of a certain amount and made during the specified preference period. Understanding the legal framework surrounding clawbacks is crucial for intelligent investors who want to safeguard their assets in the event of a crypto platform's insolvency. Creditors subject to a clawback action should seek legal advice to understand their rights, defenses, and the consequences of non-cooperation.

Valuations:

When a debtor files for bankruptcy, creditors are encouraged to file any proof of claim they may have against the bankruptcy estate. In a Chapter 11 bankruptcy, a plan of reorganization is then created that places creditors into classes and states what each class will receive upon the company’s emergence from bankruptcy. For that reason, valuation of collateral and creditor’s claims is an important and contentious part of the plan confirmation process. Once a plan is confirmed, the valuation is set as of a specific date - usually the petition date.

However, with the crypto market’s significant volatility, digital assets are often subject to extreme decreases and increases in value. Because of these significant swings in valuation, it’s difficult to predict the value of digital assets from one date to another.

Where a plan has been confirmed and digital assets have increased in value since a petition date, many creditors have expressed dissatisfaction with the amount they are set to receive pursuant the bankruptcy plan. For example, in the FTX bankruptcy, the plan set the valuation date for digital assets as the date FTX filed for bankruptcy — Nov. 11, 2022. FTX Trading Ltd., Case No. 22-11068 (Bankr. D. Del.). Given a recent surge in crypto values, many FTX creditors are claiming that they stand to lose a substantial amount of their investments and are arguing for what they believe is a more equitable valuation of their claims.

While creditors have demanded reconsideration of the valuation process for crypto bankruptcies, nothing has yet to be decided. Regardless of future decisions, crypto investors should be prepared to navigate the long-standing intricacies of bankruptcy proceedings, including the existing methods of valuation in the plan confirmation process.

Conclusion:

As the bankruptcy courts continue to explore the new frontier of crypto bankruptcies, more unique challenges are sure to unfold. In determining how the Bankruptcy Code will apply in this new context, creditors concerned about their rights and defenses should seek legal advice from bankruptcy professionals.

Nelson Mullins attorneys are experienced in handling bankruptcy matters of all sizes and are well equipped to advise debtors, trustees, purchasers, professionals, and other stakeholders on both the legal and practical aspects of any number of issues that arise in a bankruptcy case, including issues arising in crypto bankruptcies.