Vulnerability of customer cryptography in the event of bankruptcy; Is help on the way? | Greenberg Glusker LLP
Major cryptocurrencies saw significant declines in 2022; with the crypto market losing $2 trillion of its peak market cap of $3 trillion in November 2021. In the midst of this “crypto winter,” Terra Luna and its algorithmic stablecoin crashed, triggering a domino effect of losses and illiquidity across the crypto industry. Hedge fund Three Arrows Capital was the first big domino to fall, defaulting on $1 billion in loans, including $650 million owed to Voyager Digital (“Voyager”). To avoid the proverbial “race to the bank,” many crypto exchanges halted transactions and froze client accounts, and some filed for Chapter 11 bankruptcy protection, such as Voyager and Celsius Network (“Celsius “).
Voyager and Celsius Chapter 11 filings allowed these crypto exchanges to use the breath of bankruptcy (e.g. automatic suspension)  to hopefully overcome the “crypto winter” and attempt to revamp or pursue another strategy to maximize recoveries for all stakeholders, perhaps at the expense of their customers.
The Voyager and Celsius bankruptcies raise a crucial question: are the crypto assets held by customers the property of the bankruptcy estate (which can be used to facilitate a reorganization and settle the debts of other creditors)?  If so, clients will be left with a general unsecured claim and risk losing most, if not all, of the value of their crypto assets. Otherwise, customers should be entitled to relief from automatic suspension and to recover their crypto assets. While the Voyager and Celsius bankruptcy courts have yet to weigh in on this issue; their decisions will likely depend on the following factors: (i) the intent of the parties, evidenced by the agreements between the crypto exchange and the client, (ii) whether a client’s crypto assets are mixed or can be easily traced, and ( iii) who controls the crypto assets.
Voyager customers are right to be concerned. of the Traveler customer agreement provides that Voyager does not hold crypto assets held in custody in separate accounts and may freely use such assets for its own account; only promising to make similar cryptos available to its custodian clients when they seek to trade or withdraw.
Celsius customers also have reason to worry, although their situation is not as bad. Under pressure from regulatory authorities, at the start of the year, Celsius changed its customer agreement provide that clients retain ownership of the assets held in custody; however, the agreement provides that crypto assets held in custody are commingled with the assets of other clients and the custody agreement may not be honored in the event of bankruptcy.  Why? It is virtually impossible to trace fungible crypto; thus, customers cannot claim their crypto. Will the bankruptcy court provide some type of equitable relief? find a basis to impose a constructive trust on the amalgamated account for the benefit of the custodial clients? In any case, pending a decision from the bankruptcy court, the crypto held in safekeeping remains on the exchange, inaccessible to customers and subject to the volatility of the crypto market.
Although it is too late to help Voyager and Celsius customers, efforts are underway, at the state and federal level, to address the uncertainty surrounding crypto custody agreements.
The Uniform Law Commission and the American Law Institute have recently approved and recommended for adoption in all states amendments to the Uniform Commercial Code (the “UCC”) to deal with emerging technologies. The proposed changes include changes to Article 8 which provide that, as with traditional securities, if a “securities intermediary” – which would include a crypto exchange – agrees with a client to deal in the client’s fungible crypto assets as “financial assets”, it holds those assets as a custodian, and the client retains its ownership interests even if the exchange holds the assets outside of an account for the benefit of the client and are commingled. If an intermediary mixes a customer’s crypto assets, the customer will have a pro rata ownership interest in the mixed crypto assets. It should be emphasized that the proposed amendments to Article 8, if adopted by states, will only be useful if exchanges adopt the protocols and agree with clients to treat crypto custodians as “financial assets”. Notably, in line with SEC guidelines for publicly traded crypto exchanges, Coinbase recently updated its OK for retail clients to state that they are a “securities intermediary” under the UCC and that they have agreed that clients’ cryptos are “financial assets”.
At the federal level, dozens of bills have been introduced in Congress to regulate the crypto industry that would attempt to rule like the cowboys of the crypto industry and protect customers. Two of the most important bills, the Responsible Financial Innovation Act (“RFIA”) and the Digital Commodities Consumer Protection Act (the “DCCPA”), provide that fungible crypto assets are to be treated as commodities and provide the Commodity Futures Trading Commission with the power to regulate the industry. They would require crypto exchanges to treat and treat all crypto assets of any customer as belonging to the customer and prohibit mixing (although a customer could opt out of mixing protections). The RFIA and DCCPA would also amend the definition of “commodity broker” in the Commodities Exchange Act and Bankruptcy Code to include crypto exchanges,  which would be subject to specialized liquidation provisions for commodity brokers in which client crypto assets would be effectively excluded from the bankruptcy estate.
It remains to be seen whether the RFIA or DCCPA (or similar legislation) will become law, but there is a growing consensus among lawmakers on the need for meaningful federal regulation of the crypto industry that includes the protection of custodial accounts. Stay tuned.
 Here, it is important to distinguish a custodial agreement from other agreements a client might have with an exchange, such as Voyager’s “Rewards” account or Celsius’ “Earn” account in which a client lends their crypto-assets to the exchange for a return (usually in the form of like-kind crypto) and transfers ownership to the exchange, which in turn lends the crypto assets to a third party.
 RFIA, section 4.07 and DCCPA, section 5(i).