Crypto Trading Platforms and Bankruptcy Law: Are Clients Protected? | Tonkon Torp LLP

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Cryptocurrency investors, who were already in the icy clutches of the so-called “crypto winter,” now have another reason to shiver.

Insolvency issues crop up with some frequency among crypto companies, highlighting the lack of legal clarity surrounding aspects of this unregulated industry. For example: Who owns the crypto assets held in a custodian-controlled account in the event of a bankruptcy filing?

Two recent bankruptcy filings and a filing with the Securities & Exchange Commission have added urgency to this issue; and while the answer is slowly being sorted, some investors will find themselves caught in the crossfire. Voyager Digital, a public company, and Celsius, a private company, recently filed for bankruptcy and both crypto custody platforms could try to treat client assets as their own.

In its May 2022 filing with the Securities Exchange Commission, crypto giant Coinbase Global, Inc. indicated that in the event of insolvency, it may treat customer assets as company assets. To ease investor concerns, Brian Armstrong, CEO of Coinbase, quickly “clarified” in a Tweeter that Coinbase was far from filing for bankruptcy and investors’ funds are safe. However, his tweet did not explain the company’s SEC claims regarding investor status in the event of a bankruptcy filing, however remote that may be.

The SEC bankruptcy filings and disclosure highlight something that SEC Chairman Gary Gensler has frequently warned investors about; crypto exchanges lack federal regulation and oversight compared to traditional financial services organizations

What does this mean for investors whose funds are under the control of a custodian? This means they could be treated as unsecured creditors and would likely receive, at best, pennies on the dollar in the event of bankruptcy.

An unprecedented situation

In the bankruptcy filings of brokerage institutions or more traditional banks, this situation cannot occur; regulations require traditional brokerages to keep client assets segregated and segregated from company assets and bank deposits are insured up to $250,000 by the FDIC. Not only does this help ensure clients’ money is returned, but it keeps them out if bankruptcy negotiations become protracted or contentious.

For customers of unregulated cryptocurrency platforms, however, bankruptcy puts them directly in the middle of the dispute for several reasons. Most significant is the lack of clarity surrounding crypto company bankruptcies and customer status, which has yet to be resolved by any bankruptcy court. The other stumbling block for clients is the long way to go for bankruptcy negotiations due to the highly complex nature of restructuring crypto platforms. As a result, major litigation is likely and the process could take years.

To complicate matters, determining who owns the crypto assets will likely depend on interpretations of applicable laws of non-bankrupt states and/or interpretation of past bankruptcy cases in different industries which may or may not be good analogs. For example, some states have done more to address crypto issues and have more clarity, and some states may have money transmitter laws, or other laws, that could play a role. This means that bankruptcy courts could come to different conclusions based on different state laws, not to mention potential differences in the bankruptcy case law of their particular region.

What should investors do now?

The SEC has warned of the unregulated nature of cryptocurrency trading platforms, but the bankruptcy filings of Voyager Digital and Celsius, and others to come, will likely give investors more time and reason to brace themselves. protect.

For crypto investors currently participating in the market, the relatively simple answer is to own your crypto assets yourself. Crypto assets held by a custodian are generally controlled by that custodian, which exposes them to the bankruptcy issues that Voyager Digital and Celsius customers face.

You can, however, store your own crypto assets in a wallet rather than on a trading platform. Depending on the business model, not all crypto platforms allow you to store your own assets, so you will first need a platform that allows self-storage. Then you can choose between a “cold” or “hot” wallet.

A cold wallet is offline. The most common type is on a hardware wallet that connects to the internet only when you transact. A paper wallet is also a form of cold storage involving printing of relevant information needed to complete a crypto transaction. A hot wallet is an application that allows online storage, which carries a risk of hacking, however minimal.

If you have a lot of crypto assets, you can use a combination of storage options. It is clear that leaving assets on a trading platform is risky and should be avoided if possible until the question of how they will be treated in the event of a company’s bankruptcy is settled – and that may take years. . In the meantime, if you have assets stored on trading platforms that have filed or are filing for bankruptcy in the coming months, contact an attorney and do not assume that you can successfully withdraw the assets at your convenience.

This update is prepared for the general information of our customers and friends. It should not be considered legal advice.

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