The Legit Ledger Podcast Ep. 11
Understanding the Current Crypto Bankruptcies with Michael Driscoll
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In this episode of the Legit Ledger, Sheppard Mullin attorney Michael Driscoll joins host Afruz Sayah to discuss the current crypto bankruptcies involving Voyager and Celsius, including the circumstances that led to those bankruptcies, why the introduction of crypto complicates a Chapter 11 proceeding and how these latest bankruptcies will clarify legal issues around crypto insolvencies.
Guests:
About Michael Driscoll
Michael Driscoll is a partner in the Finance and Bankruptcy Practice Group in the Sheppard Mullin New York office, where his practice focuses on problem loan workouts, bankruptcy, judicial and non-judicial foreclosure and creditors’ rights and commercial law.
Prior to joining Sheppard Mullin, Michael served as a Trial Attorney in the United States Department of Justice’s Office of the United States Trustee for the Southern District of New York. During his tenure, he represented the United States Trustee’s office in over 150 Chapter 11 cases by ensuring compliance with applicable laws, rules, and regulations during all phases of bankruptcy cases.
About Afruz Sayah
Afruz Sayah is an associate in the Corporate and Blockchain Practice Group in Sheppard Mullin’s New York office, where her work focuses on capital markets matters with a main concentration in blockchain, cryptocurrency, NFT and other digital assets. Additionally, she advises clients on ongoing compliance and regulatory issues of various digital assets from the SEC and CFTC.
Transcript:
Afruz Sayah:
Welcome to The Legit Ledger. My name is Afruz Sayah. I am a member of the Blockchain Team here at Sheppard Mullin. Today, I have the privilege of interviewing Mike Driscoll. He is a partner in the Finance and Bankruptcy Practice Group in the firm's New York office. His practice often involves blockchain and crypto related matters, and he additionally takes an interest in the crypto space outside of work as well. Mike is here to help us try to understand what is going on with the current wave of crypto insolvencies, specifically the Celsius and Voyager bankruptcies, and what effect it may have on the future.
Hi, Mike. Thanks for making time for us today.
Mike Driscoll:
Pleasure to be here.
Afruz Sayah:
Thank you. I always find it interesting how one gets involved in this space. Can you tell us how you've entered into blockchain and crypto?
Mike Driscoll:
Yeah. Well, as you mentioned, I am personally an avid crypto enthusiast. I find it very interesting to see the rapid innovation that's happening in the crypto space, including in the DeFi world as well as in DeFi apps.
Afruz Sayah:
How has that evolved your work professionally?
Mike Driscoll:
Yeah. Absolutely. Because the crypto space is evolving so rapidly, I think it's a very interesting time to be a bankruptcy lawyer to the cases we're going to be discussing today are the Voyager and Celsius bankruptcies, and I think what we'll see in these cases that the type of asset that's being administered in these bankruptcies is so new that it is really requiring a lot of creativity by bankruptcy practitioners on how to approach these types of assets and how they'll be administered in the bankruptcies. So that is one aspect of why I'm professionally very interested in this because we are going to see more bankruptcies in the future involving crypto, and it will require a lot of different types of approaches because these assets are so new, and there have been really no case law yet on how they would be treated in bankruptcies.
Afruz Sayah:
Yeah. Why don't we take a step back? Can you tell us what led to the insolvencies? Was it just bad management? Did something happen? I know they're linked to Terra and what happened to Terra and LUNA. I know there's a vast history in what's going on, but for sake of this podcast, can you give us a quick summary of how we led up to these bankruptcies?
Mike Driscoll:
Yeah. Absolutely. Let's first start with Voyager. So Voyager was a crypto exchange that allowed customers to do a variety of actions on their platform, including buying, selling, loaning, trading, and storing crypto. Voyager blamed a few factors on its bankruptcy filing. First, one of Voyager's core businesses was to loan money and Bitcoin to certain borrowers in order to generate those high-interest yields that the customers were expecting to keep their coins and tokens on the platform. Voyager had loaned more than $600 million to a hedge fund named Three Arrows Capital. In turn, Three Arrows Capital was highly exposed to UST Stablecoin and Terra (LUNA) token, which caused Three Arrows Capital not to be able to service their loan to Voyager, and Voyager says that the fact that it was not able to collect on that loan was one of the factors that caused it to file bankruptcy.
The second factor is what you alluded to, which is we are seeing a lot of macro issues affecting crypto. Specifically, Voyager blamed the surge in inflation as well as the Ukraine war, creating volatility in the crypto markets that saw a surge in customer withdrawals from the platform. It initially tried to limit those withdrawals by setting certain dollar thresholds on withdrawals, but that did not work. In order to stop a further loss in value, it decided to use Chapter 11 of the Bankruptcy Code as the best way to maximize value for its creditors, and so it filed bankruptcy on July 5th.
On the other hand, we have Celsius, which was a crypto lender that permitted its users to earn rewards by depositing crypto on its platform. Like Voyager, Celsius says that it started to encounter problems due to negative macro-economic trends, including the Terra (LUNA) and UST Stablecoin collapse. This also, like Voyager, resulted in users withdrawing their crypto from the platform in large amounts and at a rapid pace. This caused Celsius to pause all of its withdrawals, and swaps, and transfers on its platform on June 12th as it evaluated alternatives, and then it filed for Chapter 11 bankruptcy on July 13th.
Afruz Sayah:
Okay. So this means that when people came in a great amount to take their assets off to withdraw, they didn't have enough liquidity. Usually, when that happens, why does that happen? Do you know? Why didn't they have enough liquidity?
Mike Driscoll:
Well, generally speaking, for both of these platforms, they were loaning their crypto out, and so they didn't have enough assets to honor, essentially, all the redemptions that were coming from the users. So when they saw that there was a large amount of requests coming in, they assessed that they would not have enough liquidity in the future to honor future withdrawals at that rate.
Afruz Sayah:
Okay, and so I read that they just froze all the accounts and froze people from withdrawing. Is that something they can legally do?
Mike Driscoll:
Yes. So I understood that they had the contractual right to freeze the accounts, but as a practical matter, when they filed for bankruptcy, they did have that power to marshal all of their assets and freeze them for the benefit of their creditors.
Afruz Sayah:
I want to narrow into talking about Celsius because to me, that seems like there's more of some fraudulent nature going on. Maybe "fraud" is the wrong word. That's just my opinion. So I want to hone in on Celsius because it's a little bit more complicated. I know Celsius has two products. They have Earn, a product called Earn, and a product called Custody. Can you discuss what the difference between those two are and how those two relate to this bankruptcy?
Mike Driscoll:
Absolutely. So let's first start with the Earn product. In that program, the users transfer their digital assets onto the Celsius platform. Celsius was then permitted to use those assets in its full discretion, including using those assets as collateral to take out additional loans to generate a yield. Celsius then paid rewards to users based on a set rate regardless of the yield generated by Celsius. Those rewards could be quite lucrative for the Earn user. For example, they were as high as 17%. However, on average, it said that users received rewards of about 4% to 5%. Let's discuss the Custody program. In that, users deposited their crypto, but they did not earn rewards. The assets were purportedly contractually owned by the user, but they were commingled with other users' crypto. The Custody users did not own their private keys under this program, and this will have implications on who actually owns the assets under bankruptcy law.
Afruz Sayah:
Okay. So the Custody users didn't own their private key, so they didn't really own their crypto. Who owned it? Who had the private key?
Mike Driscoll:
Well, we understand that the private keys were held by Celsius. The users deposited their crypto onto the Celsius platform. The implication of that is that by commingling their assets, there are some questions about whether they actually owned those assets when they were moved onto the Celsius platform.
Afruz Sayah:
Okay, and when it comes to the bankruptcy, is there a difference between the people who were doing the Earn and the people who were doing the Custody product? Are they both part of the bankruptcy, or is it just one?
Mike Driscoll:
The primary difference between them is the potential treatment of the Custody users and the Earn users in bankruptcy is that under the company's terms and conditions, users who participate in the Earn program transferred their digital assets, including all right and title, including ownership rights to such digital assets to Celsius. Whereas Custody users did not do that. The difference here is that those Custody users who did not, by the contractual terms, provide Celsius with their right and title, the active commingling assets with others has important implications in bankruptcy. There is case law in bankruptcy that commingled assets are the property right of the debtor's estate, and here, that would be Celsius. Whether that will play out as such in this bankruptcy is not yet determined because that will be determined through a plan of reorganization or liquidation that Celsius will execute later in the case.
Afruz Sayah:
Okay. Well, that leads into why Chapter 11. I'm not a bankruptcy expert. That's why we have you here. I know there's Chapter 11 and there's Chapter 7 bankruptcies. I don't know if there's anything else. Explain why they chose Chapter 11 and whether this was a good choice to go to, and what benefits, and what pros and cons there are to doing Chapter 11?
Mike Driscoll:
Let's first start with what is a Chapter 11 case. A Chapter 11 case is a court-supervised process whereby a company, here, Celsius and Voyager, can address its liabilities and reorganize as a healthy-going concern. The main benefit of Chapter 11 is that it provides the management of the debtor company with significant flexibility in outcomes, including executing a balance sheet, restructuring, achieving a final resolution of pre-petition litigation, and selling assets free and clear of liens, claims, and encumbrances.
One of the big benefits of Chapter 11 is that it allows the company to continue operating in its ordinary course of business under its existing management and board while it is executing these outcomes. It is different than a Chapter 7 case where the management no longer is in charge of the company. Rather, in a Chapter 7, a Chapter 7 trustee is appointed. That trustee is charged with liquidating all of the assets for the benefit of creditors. Essentially, a fire sale in a Chapter 7, whereas a Chapter 11 allows the management to execute this flexible process.
Afruz Sayah:
Deciding to file a Chapter 11 bankruptcy usually is done by somebody who wants to continue. Like after the reorganization is done, Celsius and Voyager want to continue doing what they're doing. Is that correct?
Mike Driscoll:
Well, yes, that's right. At the beginning stages of a bankruptcy, the management generally wants to continue to operate and execute a plan of reorganization that will let it exist in the future. In a Chapter 11 case, there are a lot of dynamics, and oftentimes, the debtor will run out of money or out of time, and so we'll have to execute what's called a 363 sale. That's the asset sales free and clear of all pre-petition leads. If that's the case, they will execute what's called a plan of liquidation, and they will try to achieve the best outcome for their creditors.
Afruz Sayah:
Okay. So, at the end of Chapter 11, some people do liquidate?
Mike Driscoll:
That's right. Yeah.
Afruz Sayah:
Okay.
Mike Driscoll:
You can liquidate or reorganize in Chapter 11.
Afruz Sayah:
Okay, because it was my thought process that they were doing Chapter 11 because after the bankruptcy was said and done, they're wanting to continue their ordinary course of business, and I was like, "Who's going to put their money or trust into these two entities now?" But that makes a lot more sense. During the whole Chapter 11 bankruptcy, what happens to the users' frozen crypto or their accounts? Do they stay frozen or?
Mike Driscoll:
Yes. For both of these platforms, as I mentioned, they froze the assets pre-petition, and they continue to be frozen at this point. What is not yet determined is what's going to happen to those assets. Let's talk about each one. So, right now, Voyager just executed what's called the 363 sale. I mentioned earlier they sold their assets for $1.4 billion to FTX US.
Afruz Sayah:
Mm-hmm.
Mike Driscoll:
So what's going to happen to those? Ultimately, the crypto that's held there is not known, but the assets will be moving over to FTX US. Now, with Celsius, that's very much in the air. There's a lot of balls in the air. There's a lot of outcomes that haven't been determined. However, it is in the middle of marketing its assets, and it will be having a 363 sale of its assets on October 17th.
Afruz Sayah:
Why does the introduction of crypto seem to make Chapter 11 bankruptcy cases more difficult than the average Chapter 11 bankruptcy?
Mike Driscoll:
Primary challenges associated with cryptocurrencies in the bankruptcy context is that these are types of products that are new, and they don't fall under the traditional characterization of assets compared to bankruptcies, for example, involving financial institutions. Currently, these crypto assets are not protected by any government programs. There are open questions on how bankruptcy courts will treat these assets. Are they like a currency, a commodity, security? Interestingly, some could argue that crypto has characteristics of none or all three. Ultimately, how these assets are characterized can have major implications on how a Chapter 11 plan is formed and how creditors will be treated in the future.
Afruz Sayah:
Do you think that these bankruptcies will help solve that issue, or do you think there's still a lot more that needs to be thought of before we come to figuring out how to do these crypto insolvencies or bankruptcies?
Mike Driscoll:
Yeah. Right now, we don't really know how the bankruptcy court is going to characterize these or if they will need to, but what I think is going to be the ultimate precedent here is that we have two Chapter 11 crypto cases going concurrently through basically 363 sales. That will probably be the precedent in the future. As you mentioned, there's probably not a lot of trust out there for a crypto platform that has went into bankruptcy for it in the future to truly reorganize and exist as a going concern. It will most likely follow the precedent of these two cases where those assets will be sold to likely a competitor who will take over the operations.
Afruz Sayah:
How do fraudulent actions play into bankruptcy proceedings? Does bankruptcy court take possible fraudulent actions into consideration? Because I know fraud right now in bankruptcy, fraud hasn't been determined, but there's a lot of talk in it, especially with Celsius. How does that come into play at all in the bankruptcy court, or how does that get involved with these cases?
Mike Driscoll:
Yeah. It's a great question, and you're right. There is a lot of talk out there among the Celsius account holders and users about what happened to their money and who possibly took it if anyone actually took it or it was just mismanaged. I would say that the bankruptcy system is well-versed in dealing with management that may have engaged in fraudulent conduct. For example, after a bankruptcy petition is filed, an unsecured creditors' committee will be appointed, and it is usually formed to conduct its own investigation into the debtor's affairs. If there is indeed allegations of bad faith conduct, the debtor's estate or this committee can ask the court to take protective actions or remove an officer or director.
Indeed, in Celsius' case, the creditors' committee recently asked Alex Mashinsky, the CEO of Celsius, to resign from his position. Although the committee there did not make specific allegations against him, it did indicate his presence was not in the best interest of creditors and that it was continuing to investigate claims against him and would pursue those in the future. In addition, the bankruptcy court in Celsius recently appointed an examiner to conduct an investigation into Celsius' pre-petition assets, its Earn and Custody services that we had talked about, and look into some tax issues. The examiner's report will be due in about 60 days. So, in sum, I would say that bankruptcy courts have a lot of tools to deal with fraudulent misconduct of any management.
Afruz Sayah:
Does going through a bankruptcy help protect some of these fraudulent actors? I know I was reading a little bit about third-party releases in bankruptcy. How likely is that in this case or after bankruptcy, said and done, can criminal actions be bought against certain players if there was fraudulent action, or are they protected?
Mike Driscoll:
Well, it's a very interesting question. So I would say at the beginning is that if there is indeed criminal conduct that has occurred, that will not be under the jurisdiction of the bankruptcy court. The bankruptcy court, if it learns of any actual criminal conduct, it would refer that to the US Attorney's Office for their investigation. Now, regarding civil liability for fraud, executives at bankrupt companies are oftentimes the subject of civil claims by a debtor's estate. In order to avoid that liability, the executives will negotiate some sort of compensation to the estate. This does leave the executive exposed to claims of third-parties such as individual creditors.
Therefore, as part of a Chapter 11 plan, creditors may be enjoined from pursuing these claims through a mechanism called a third-party release. Under current precedent in the Second Circuit Court of Appeals, non-consensual third-party releases are permissible in rare circumstances if a debtor meets certain requirements. However, the statutory basis for bankruptcy courts' power to grant these non-consensual third-party releases is currently under review by the Second Circuit in the Purdue Pharma bankruptcy case. We will see if the court there wants to change the terms in the manner in which it allows third-party releases to occur.
Afruz Sayah:
Okay, so a third-party release is basically the bankruptcy court saying that it's indemnifying the executives from further action. Is that correct, or do I have it backwards?
Mike Driscoll:
The way I would characterize a third-party release is that the individual creditors will not be able to pursue a claim or cause of action that they individually hold against that particular party that was released from liability. For example, and this is a totally hypothetical example because we don't know how this will play out in either of these two bankruptcies, but let's say an end-user who had deposited crypto on one of these platforms wanted to sue the CEO of the company.
Afruz Sayah:
Mm-hmm.
Mike Driscoll:
The company may want to enjoin that creditor from pursuing that type of litigation in their individual capacity, and they may be able to do this through what's called a third-party release. That's how it works.
Afruz Sayah:
Okay. That's interesting. So when it comes to getting their funds back, if they do, when they do, how will they get it back? So the people who have crypto, any type of crypto, whether it's Bitcoin, Ethereum, whichever they had on there, do they get USD back? Do they actually get their crypto back? Do the courts even know, or is that still up in the air?
Mike Driscoll:
It's very much unclear at this point when distributions will be made and the matter which they'll be made in both of these cases. Generally, distributions are made to creditors in cash after confirmation of a Chapter 11 plan.
Afruz Sayah:
But that's before crypto came into play, correct? This hasn't been...
Mike Driscoll:
That's right.
Afruz Sayah:
This is new for the court.
Mike Driscoll:
That's right. That's right. In these large and complex Chapter 11 cases like Celsius and Voyager, it's not unusual for distributions to take place more than a year after the bankruptcy case has concluded. To go back to your question, I think what's unique here is that both of these platforms are holding huge amounts of crypto, and whether the ultimate Chapter 11 plans will distribute those tokens or coins back to the creditors that had deposited there is just not yet determined.
Afruz Sayah:
Who chooses?
Mike Driscoll:
Well, ultimately, the creditors will be able to vote on it. The way this works is that a Chapter 11 plan is proposed by the debtors. So that would be by the management of Celsius and Voyager. They will solicit those creditors and tell them what they are likely to receive, possibly when they will receive it, and then those creditors will be able to vote on it. The Chapter 11 plan will have to be confirmed by the bankruptcy court.
Afruz Sayah:
So if the majority of the creditors decide that they want it back in fiat currency, do the minority of creditors who wanted their funds back in their crypto, do they have any recourse? Do they have any way to ask for it, or are they stuck with getting the fiat back because that was the majority rule?
Mike Driscoll:
Well, in the absence of some sort of special provision in a Chapter 11 plan that allows a creditor to elect whether they receive their distribution in fiat or in the crypto that they deposited, the minority creditors that you had referenced, the ones that didn't agree with that plan, they will be bound by the treatment of other similarly situated creditors.
Afruz Sayah:
So, I mean, there's potential for them to, if they get anything back, to lose a lot on the ones they get back, but I mean, I guess that's just what happens in these cases. One of the last things I wanted to ask you is I read something about... There was a leaked audio featuring Celsius' executives to uncover a plan to create an IOU cryptocurrency. Do you know anything about that, and do you have any opinions on that?
Mike Driscoll:
Yeah. What you're referring to was a leaked audio that may have occurred on September 8th by somebody attending an internal Celsius meeting. The leaked audio was released about two weeks ago. The audio was from somebody named Nuke Goldstein. He's the co-founder of Celsius, and he was briefly discussing a proposal to pay back Celsius creditors. Specifically, he was saying that Celsius may propose to issue a wrapped token that would consolidate all assets of Celsius. Rewards would be paid to creditors based on earnings that Celsius achieved from mining operations of Bitcoin or stake Ethereum. Creditors wanting liquidity could theoretically sell that token on a platform like Uniswap if it didn't want to wait for the rewards to be issued.
My take on this is that it's really too early to see how creditors will be paid back or whether Celsius will ultimately issue some sort of wrapped token. That will occur based on some very complex negotiations. That will occur between creditors' committee, Celsius, various other parties and interests in that Chapter 11 case. Bottom line is I wouldn't place too much authority on this leaked audio. I think there's just a lot of dynamics out there that still need to play out.
Afruz Sayah:
Is this something that the court would accept?
Mike Driscoll:
Well, the court may accept it because Chapter 11 is a very flexible process that allows a debtor to use many different types of corporate transactions to achieve the best result for creditors. So, here, if the debtor, and the creditors' committee, and ultimately, the creditors who vote believe that some sort of wrapped token is the best way to pay back creditors, the court could find an agreement with that because it's in the best interest of creditors.
Afruz Sayah:
Okay. That's interesting. We'll see if that actually happens, especially with all the execs stepping down. Okay. Thank you, Mike. I mean, I have a lot more questions because this is just super interesting for me at least, but I think we've already gone over our time. So I want to say thank you, and hopefully this clarified a lot of things for everybody, and I appreciate your time. Thanks.
Mike Driscoll:
Thank you so much for having me.
Resources:
Blockchain and Cryptocurrency: Law of the Ledger
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