Crypto investors get a crash course in bankruptcy law—and how they sit at the bottom of the pile

July 18, 2022, 1:47 PM UTC
Photo illustration by Fortune; original photos by Getty Images

The sudden bankruptcies of Celsius and Voyager—two crypto platforms that lured thousands of small investors with promises of risk-free returns of 9% or more—are now offering those investors a hard lesson in the adage of “not your keys, not your crypto.” The saying sums up a suspicion of centralized platforms on the part of crypto purists, who argue that it’s never a good idea to allow third parties to take control (or hold the “keys”) of their digital assets. In the case of Celsius and Voyager, the suspicion proved all too justified, not only by the companies’ bankruptcies but by their subsequent behavior—they claimed the crypto deposits they held didn’t belong to their customers, but rather that the deposits are corporate assets that the firms can use to pay off larger creditors and claw themselves back to solvency.

Worse for the small investors, this is likely permissible under U.S. bankruptcy law. At the same time, consumer protection laws and the country’s deposit insurance regime can do little to help them recover the crypto they entrusted to companies like Celsius. No matter the promises the crypto companies might have made when times were good, the ugly reality is that retail users are at the very back of the line when things go wrong. Is it time to change this? 

How crypto bankruptcies fall short

When an American company goes bust, it can file for bankruptcy under Chapter 11, where a court helps the company restructure its debts. Or, having lost all hope, it can file for a Chapter 7 bankruptcy, where the court sells off what assets remain to pay off its debts.

In the event of, say, a U.S. bank collapse, customer deposits up to $250,000 are protected by the Federal Deposit Insurance Corporation (FDIC). Those customers are first to recover while everyone else seeking funds from the bankrupt company is placed in a long line of creditors.

At the front of that line are secured and priority creditors, like banks and other lenders. At the back are “general unsecured creditors,” who receive a cut of whatever’s left after everyone else has had their share. 

Customers of bankrupt crypto companies, like Celsius, should expect to fall to the bottom of the pile. The FDIC doesn’t cover crypto holdings and bankruptcy lawyers say a customer’s claim to the crypto stored in the bankrupt exchange—the property rights that would prevent them from becoming the unenviable “general unsecured creditor”—is weak and difficult to enforce.

“They’re going to have to wait in the back of the line with all the other unsecured creditors for a pro rata share of whatever happens,” says Adam Levitin, a Georgetown Law professor who specializes in bankruptcy.

Some exchanges have already made this explicit. In a May 10 SEC filing, Coinbase said there’s a risk that a court could treat customers as “general unsecured creditors” in the event of a bankruptcy. Voyager’s bankruptcy proceedings classify consumers as distinct from “general unsecured creditors,” but they’re still “impaired” claimants who are not entitled to get all their money (in the form of crypto) back. 

What law for lost crypto funds?

When a bank goes under, the law makes clear that its depositors are ranked first when it comes to claiming whatever cash is left—a far cry from the situation facing customers at Celsius and Voyager, which have acted much like banks but are now claiming their customers’ deposits as their own. Is that legal?

“The law is, frankly, unclear,” says Levitin, noting that a court may refuse to view crypto funds as customer property in the first place.

This is, in part, because crypto companies typically pool customer funds into a common digital wallet, meaning “it’s going to be difficult for the customer to establish they have a property right,” according to Daniel Saval, a bankruptcy lawyer at Kobre & Kim.

And if the company mixes customer funds with its own pools of crypto, “then you’ve got a total mess,” said Levitin. “It makes it much more likely to all be treated as the property of the owner rather than the property of the customers.”

Unfortunately for customers, this practice of mixing funds together is commonplace at crypto service providers, since doing so allows companies to carry out transactions internally rather than paying fees to record each of them on the blockchain. 

What’s more, crypto companies like Celsius use customer funds to carry out transactions of their own, such as pledging deposits as collateral for loans. This practice, known as rehypothecation, further weakens the customer’s claim of ownership over their deposits, says Levitin—particularly when, as happened when Celsius lent crypto to the now-bankrupt Three Arrows Capital, those loans go wrong.

The upshot is that Celsius and Voyager customers appear to be unsecured creditors who likely face a long and hard row in bankruptcy proceedings. Levitin predicts that, if customers receive any crypto payouts at all, they will amount to pennies on the dollar—and could take “anywhere from months to years”. (Indeed, customers of Japanese crypto exchange Mt. Gox still haven’t received a payout—and that exchange crashed back in 2014).

If crypto is to flourish again, it may need to better protect consumer funds to win back trust.

Can crypto provide better consumer protection?

In May, SEC Chair Gary Gensler offered what turned out to be a prescient warning, telling customers to pay attention to the fine print when dealing with crypto firms: “If the platform goes down, guess what? You just have a counterparty relationship with the platform. Get in line in bankruptcy court.”

It’s possible, however, that this stern regime may change. A bipartisan bill in Congress calls for crypto companies to be more transparent with customers about what would happen to their funds in the event of bankruptcy, and to obtain their consent before using those funds for rehypothecation.

Perianne Boring, the president of the Chamber of Digital Commerce, a crypto trade organization that supported the bill (and counts Celsius among members of its executive board), says it’s “pretty much the only thing that’s out there today.” Realistically, there’s little chance of the bill becoming law anytime soon, though it may pick up momentum after the November midterm elections.

Boring adds that the industry has been slow on developing policies to coordinate on issues like using customer funds. Meanwhile, another trade organization, the Blockchain Association, declined to comment while the crypto think tank Coin Center says it focuses on policy issues for protocols, not business practices.

As for pulling crypto platforms under the FDIC umbrella, banks would likely oppose such a move—while the crypto community, which has long viewed the traditional financial industry with hostility, would also likely balk. “I don’t think you’re going to get much support [for making] the government their lender of last resort or an insurance provider.”

If there is hope of improving protections for crypto customers, it may come in the form of individual companies acting on their own. New York–based Gemini, for instance, holds its customers’ funds in trusts, and says in bankruptcy it “would distribute the assets we custody back to our customers or transfer them to another custodian.”

And Coinbase’s chief legal officer, Paul Grewal, said in a recent blog post that “customer funds could [never] be confused with corporate assets” since the company tracks funds for each customer’s trading accounts. Coinbase also states it will never use customer funds for activities like lending. The company also updated its user agreement to conform with Article 8 of the Uniform Commercial Code, which makes clear users are the ultimate owner of funds in their accounts.

Despite these added protections, Coinbase CFO Alesia Haas told CNBC in May there is “zero case law” for a crypto exchange bankruptcy, meaning the company can’t rule out a “very small tail risk” that a bankruptcy court could treat customer funds as company property.

Thus, if it is case law that crypto companies are waiting on to gain clarity, they may not have long to wait—rulings in both the Voyager and Celsius debacles could come by the end of this year.

Sign up for the Fortune Features email list so you don’t miss our biggest features, exclusive interviews, and investigations.