Tag: sec

What Happened

Earlier this month, crypto lender Celsius Network filed for Chapter 11 bankruptcy protection in federal court the Southern District of New York. The filing was not a surprise to many familiar with the company’s recent news, as it had been more than a month since Celsius halted customer withdrawals due to self-reported and self-described “extreme market conditions.” What alarmed many in the industry, especially Celsius users, is the way the company will likely treat the frozen funds.

In the court filing, Celsius’ Chief Executive Officer Alex Mashinsky disclosed a roughly $1.2 billion hole in the company’s balance sheet. As of July 13, 2022, the company had $5.5 billion in total liabilities and $4.3 billion in assets. Celsius said it owes consumer users (as opposed to institutional partners) more than $4.7 billion.

A financially distressed company can choose between a few different types of bankruptcy proceedings. Celsius chose Chapter 11, which generally prioritizes repayments to secured creditors first, then unsecured creditors, and finally equity holders. Unsecured creditors are most likely to be individuals or institutions that lent money without obtaining specified assets as collateral, or “security”, to protect their loan.

While it is unclear how Celsius and the bankruptcy court will classify Celsius users that have been prevented from accessing their funds, Celsius’ terms of service and court papers seem to indicate users will be treated as unsecured creditors. This begs the question of when and if Celsius’ customers will be able to recoup some or any of their losses. This may well be the subject of heated litigation in the bankruptcy court.

Key Actors

● Celsius Network

● CEO Alex Mashinsky

Context

Celsius Claimed To Be As Safe As A Bank

Celsius held itself out as a safe alternative to traditional banks and promised users high interest rates. Customers could use their credit cards or bank accounts to buy crypto assets. To entice customers to stake their cryptocurrency with Celsius, the company promised returns of up to 20% on deposits, including 8.8% on stablecoins like Tether’s USDT.

Mr. Mashinsky consistently downplayed risks entailed by these strategies and called initial allegations that the company was having issues as “Fud” (“fear, uncertainty and doubt”).

Many Celsius customers have written to the Bankruptcy Court, arguing to get access to their funds and saying they felt lied to by the company and Alex Mashinsky.

“I watched every single AMA (Ask me Anything) each Friday since sign-up, and week in and week out Alex would talk about how Celsius is safer than banks because they supposedly don’t rehypothecate and use fractional reserve lending like the banks do,” says Stephen Richardson.

Another Celsius user, Brian Kasper, said “Celsius continued to tell people they were better than a bank. Safer, with better returns. As well as tell us they had billions in liquid cash.”

Despite Celsius only recently filing for bankruptcy, questions about its risk management procedures had been circulating for years. For instance, in June 2021, Crypto Custodian Prime Trust cut ties with Celsius after its risk team expressed concern about Celsius’ strategy of “endlessly re-hypothecating assets.” Since March 2020, Celsius had been using Prime Trust to store assets for some of its customers.

As Scott Purcell, founder of Prime Trust and Fortress.xyz, told me, “In 2020 I took a long look at Celsius and other lending/staking platforms out of professional curiosity. The more I learned about their business models, the more concerned I became. I researched how they were paying such high interest rates. I can certainly understand getting a premium for doing something that banks were shying away from. I also understand lending (hypothecating) assets to enable people to borrow (margin). That’s a terrific business. But that didn’t explain the huge range of interest rates Celsius (and others like them) were paying people for lending BTC, ETH and other crypto assets. I read that they weren’t just lending once (hypothecating) but that their model was one of rehypothecation; lending the same assets over and over and over again to juice yields. If true, that was stunning, it might or might not be legal (I’m not an attorney, so not my call) but, without question, this would be destined for failure as any sharp market movement in either direction would be catastrophic to such a ridiculously leveraged business model. And yet people were lining up to send cash or crypto to them on this model…insane.”

Celsius initially claimed it could generate such large yields by simply lending customer funds to institutions but Celsius shifted strategy and began using more decentralized finance (DeFi) platforms. This ultimately led to the recently disclosed $1.2 billion shortfall in Celsius’ balance sheet.

Not All Bankruptcies Are Created Equal

Because Celsius was not a registered broker dealer, it was able to file for Chapter 11 bankruptcy protection, rather than under Chapter 7.

Chapter 11 bankruptcy allows businesses to operate while they restructure their finances to pay creditors. Had Celsius been regulated as a securities or commodities brokers or filed for Chapter 7 bankruptcy, its only option would be to liquidate, allowing the court to sell off what assets remain to pay off debts.

Celsius has been making efforts to free up as much operational capital as possible. Recently Celsius freed up more than a billion dollars in crypto assets, mostly in wBTC and a type of ether (ETH) derivative token called stETH by paying off its remaining debt to a variety of decentralized finance (DeFi) protocols such as AAVE and Compound.

In its bankruptcy filings, Celsius requested permission to pay up to $3.76 million in liens and vendor claims, and said it has $167 million in cash to support business operations.

Celsius Slipped Through Crypto’s Regulatory Cracks

Celsius’s terms of service – if enforceable – may present problems for customers seeking full recovery of their deposits. The terms states that users transfer “all right and title” of their crypto assets to Celsius including “ownership rights” and the right to “pledge, re-pledge, hypothecate, rehypothecate, sell, lend, or otherwise transfer or use” any amount of such crypto, whether “separately or together with other property”, “for any period of time,” and “without retaining in Celsius’ possession and/or control a like amount of [crypto] or any other monies or assets, and to use or invest such [crypto] in Celsius’ full discretion.” Celsius has written in court filings that customers transferred ownership of crypto assets to the company, making those customers unsecured creditors.

Had Celsius been a bank, deposits of up to $250,000 would be insured by a federal body. Users of a broker-dealer would be insured for up to $500,000 in securities and cash by a separate body, the SPIC.

In September 2021, regulators in Kentucky, New Jersey and Texas hit Celsius with a cease and desist order, arguing its interest-bearing products should be registered as securities. State securities boards in Alabama, Kentucky, New Jersey, Texas and Washington have also launched probes into Celsius, Reuters reports. The SEC is also reportedly looking into Celsius.

This May Not Just Be a Celsius Problem

Other pseudo-banks like Voyager (also bankrupt) and BlockFi (fortified by FTX) have similar language in their terms of service.

Blockfi’s terms states that “BlockFi has the right, without further notice to you, to pledge, repledge, hypothecate, rehypothecate, sell, lend, or otherwise transfer, invest or use any amount of such cryptocurrency provided by you under a Loan, separately or together with other property, with all attendant rights of ownership.” BlockFi warns, “[a]ny bond or trust account maintained by BlockFi for the benefit of its clients may not be sufficient to cover all losses incurred by clients. In light of these risks, you should carefully consider whether holding cryptocurrency in a BlockFi account is suitable.”

Voyager’s terms point out that it is unclear how customer’s cryptocurrency would be treated in case of an insolvency proceeding and explicitly warns that customers could be “treated as an unsecured creditor” and experience “the total loss of all Customer Cryptocurrency.”

Voyager filed for bankruptcy protection earlier this month. Then last week, the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) ordered Voyager to cease any representations that its customers’ funds would be protected in case of the company’s failure. The statement said, “Voyager has made various representations online, including its website, mobile app, and social media accounts, stating or suggesting that: (1) Voyager itself is FDIC-insured; (2) customers who invested with the Voyager cryptocurrency platform would receive FDIC insurance coverage for all funds provided to, held by, on, or with Voyager; and (3) the FDIC would insure customers against the failure of Voyager itself. These representations are false and misleading and, based on the information we have to date, it appears that the representations likely misled and were relied upon by customers who placed their funds with Voyager and do not have immediate access to their funds.”

Key Numbers

Celsius has said it owes users more than $4.7 billion.

Celsius was valued at about $3 billion after raising $690 million in a Series B financing round in May 2022, according to the bankruptcy filing.

Celsius said in court that the value of its assets have fallen by about $17.8 billion since March 30, 2022, to $4.3 billion from roughly $22.1 billion.

Key Quote

“We’ve seen again that lending platforms are operating a little like banks. They’re saying to investors ‘Give us your crypto. We’ll give you a big return 7% or 4.5% return.’ How does somebody offer (such large percentage of returns) in the market today and not give a lot of disclosure? . . . If it seems too good to be true, it just may well be too good to be true.” – Gary Gensler

Outlook

In general, Chapter 11 bankruptcies prioritize repayments to secured creditors, then unsecured creditors, and finally equity holders. Celsius listed over 100,000 creditors around the world in its filing, including Pharos USD Fund ($81 million owed) and Alameda Research (owed almost $13 million).

Celsius noted in its bankruptcy filing that its customers transferred ownership of their crypto to the company, which likely indicates Celsius’ intention of treating users as unsecured creditors. While users may litigate their status as secured or unsecured creditors, this will take years and could still result in users never seeing their assets again.

Adding further complications, in traditional bankruptcy proceedings, creditors have claims denominated in dollars and those claims are measured as of the date of the bankruptcy filing. Many wonder how the price volatility of bitcoin will play out in this instance.

Celsius is scheduled to appear in bankruptcy court again later this month.

Decision Points

These recent bankruptcy proceedings in the cryptocurrency space serve as a reminder that the lack of regulatory clarity often results in a lack of clear consumer protections and rights.

Terms of Service often indicate how customers will be treated when things go wrong. Investors should carefully review terms of service and reach out to the company or their own legal representation before trusting funds with platforms. Users should also understand that if something sounds too good to be true, it likely is and usually big rewards (like high interest offerings) also pose big risk to users.

The premise of bitcoin was always self-custody, which means users don’t earn returns but also means they act as their own bank.