Crypto Exchange Bankruptcies: Are Prepetition Crypto Withdrawals And DeFi Loan Repayments Avoidable Preferences?

• Published date: 22 November 2022
• Subject Matter: Insolvency/Bankruptcy/Re-structuring, Technology, Insolvency/Bankruptcy, Fin Tech
• Law Firm: Morrison & Foerster LLP
• Author: Ms Theresa A. Foudy, Andrew Kissner and Miranda K. Russell

Over the span of two weeks in July 2022, two of the largest retail-facing cryptocurrency platforms, Celsius and Voyager, filed for chapter 11 bankruptcy protection. Both cases were precipitated, at least in part, by a "run on the bank" in which retail customers withdrew substantial amounts of cryptocurrency from each platform.¹ Recent reports suggest that, in the weeks and months leading up to the bankruptcy, Celsius insiders also pulled tens of millions of dollars' worth of their own crypto assets that had been deposited on the platform.²

In addition to providing retail trading and lending services, Celsius, like many other cryptocurrency platforms, also had significant borrowings under "decentralized finance" (or "DeFi") loans-that is, dollar-denominated loans collateralized by pledged cryptocurrency assets that are often governed by self-executing smart contracts and recorded on the blockchain. In the month prior to its bankruptcy filing date, nearly $650 million of Celsius' DeFi loans were repaid, freeing up excess cryptocurrency that had previously served as collateral for such loans.

In light of these events, the Celsius and Voyager debtors (or their respective statutory committees, seeking to act as fiduciaries on behalf of the estates) will likely explore all avenues for maximizing value, including by considering whether customer withdrawals and repayments or liquidations of DeFi loans in the lead-up to the bankruptcy filings might be deemed as "preferential" and avoided for the benefit of the estate.³ Indeed, the Celsius debtors identified the potential avoidance of customer withdrawals and loan liquidations as preferences as a "key" legal issue that would be "critical to the outcome of the case."⁴

Although there is a dearth of authority relating to these exact issues, it seems that those seeking to augment creditor recoveries through avoidance of cryptocurrency withdrawals and DeFi loan repayments will face several obstacles in doing so, including: challenges to establishing each necessary element of a preference under the Bankruptcy Code; affirmative defenses that may be raised by defendants; and the potential applicability of one or more "safe harbors" to shield transfers from avoidance. This article considers each of these issues in turn.

The Elements of a Preference

Bankruptcy Code section 547 allows a trustee or debtor-in-possession to avoid as preferential any "transfer" of a debtor's "interest . . . in property" to a creditor "on account of an antecedent debt," if such transfer was "made while the debtor was insolvent . . . on or within 90 days" prior to the petition date, and such transfer enables that creditor to receive more than they would receive in a case under chapter 7 of the Bankruptcy Code.⁵

In other words, if a creditor receives payment on a pre-existing debt within 90 days of the bankruptcy at a time when the debtor was insolvent, that payment potentially can be clawed back to the extent it allowed such creditor to receive more than his or her pro rata share of the bankruptcy estate. This is generally understood to serve two purposes: preventing a "race to the courthouse" by creditors upon learning of a debtor's distress and furthering the general bankruptcy policy of ensuring equality of distribution among similarly situated creditors.⁶

Some elements are easier to prove than others

As they relate to the potential avoidance of a crypto withdrawal or DeFi loan repayment, certain of the seven preference elements-that is, a (1) transfer, (2) of an interest in property, (3) to a creditor, (4) on account of a preexisting debt, (5) made while the debtor is insolvent, (6) within 90 days of the petition date,⁷ (7) allowing the creditor to receive more than it would in a liquidation-are more easily satisfied than others.

For example, the Bankruptcy Code defines "transfer" extremely broadly to include "every conceivable mode of alienating property, whether directly or indirectly, voluntarily or involuntarily."⁸ This definition certainly encompasses either the voluntary repayment (or involuntary liquidation) of a DeFi loan by the debtor or a withdrawal by a customer from a debtor's rewards program (such as Celsius' "Earn" or Voyager's PIK-bearing deposit accounts).

The Code's definition of "creditor" is similarly broad, and includes any entity that holds a "claim" (virtually any right to payment, whether fixed, contingent, disputed, or otherwise), while an antecedent debt is merely "liability on a claim" that arose prior to the date of the challenged transfer.⁹ Both DeFi lenders and customers clearly hold a right to payment from a debtor, and that right to payment generally will have arisen prior to the time of the relevant repayment or withdrawal (i.e., any payment or withdrawal would be on account of an antecedent debt). That said, as discussed below, there may be creative arguments raised as to when a transfer was actually made, particularly where a given loan is governed by a smart contract.

In addition, although a transfer can be preferential only if made while the debtor is "insolvent," there is a rebuttable presumption under the Bankruptcy Code that the debtor is insolvent in the 90 days leading up to the petition date.¹⁰ If the preference defendant can introduce even "some evidence that the debtor was not in fact insolvent at the time of the transfer," then the burden shifts back to the debtor to prove by a preponderance of the evidence that it was in fact insolvent at the time of the challenged transfer.¹¹ This leaves the door open for individual defendants to raise solvency as a defense, particularly if a crypto exchange's downfall was due to a sudden and precipitous drop in crypto prices that occurred immediately prior to the petition date (and after the transfer at issue).

Are the crypto assets property of the estate?

Assuming that the debtor could show that there had been a transfer to a creditor on account of an existing debt within the preference period, the determination as to whether that transfer was of an "interest of the debtor in property"¹² is more complicated. Generally speaking, a debtor only has an interest in property if that property "would have been part of the estate had it not been transferred" prior to the bankruptcy filing.¹³ For these purposes, property held in trust for the benefit of another is not considered the debtor's property (and a transfer of that property thus cannot be avoided as a preference). On the other hand, property to which the debtor has legal and equitable title, and which it is free to use or spend in its own discretion, generally will constitute estate property.

Thus, in the context of crypto debtors, a key question is, who has title to the cryptocurrency held on the platform? The answer will be highly fact specific.

For example, Celsius' "Earn" program-far and away Celsius' most popular product, representing approximately 77%¹⁴ of the crypto deposited on the Celsius platform as of its bankruptcy filing-allowed customers to enter into "open-ended loans" to Celsius of certain eligible crypto assets and earn "Rewards" in the form of yield paid either "in-kind" (i.e., Bitcoin would earn yield denominated in Bitcoin) or in Celsius' proprietary token.¹⁵ The terms of use for the Earn program clearly and explicitly state that, in exchange for earning yield, customers "grant Celsius all rights and title" to the underlying crypto, which will become "Celsius' property, in every sense and for all purposes." Thereafter, Celsius "may lend, sell, pledge, hypothecate, assign, invest, use, commingle or otherwise dispose of" such assets in its sole discretion.¹⁶ Based on the foregoing, it would appear that there is a strong argument that any crypto enrolled in the Celsius Earn program would constitute estate property, and therefore that the withdrawal of such crypto by customers is potentially susceptible to avoidance.¹⁷

By contrast, under Celsius' Custody Service-which is described as being more akin to a traditional deposit or custodial account, and on which users cannot earn yield-title to any deposited crypto "shall at all times remain with the customer and not transfer to Celsius," who may "not transfer, sell, loan or otherwise rehypothecate" such crypto without the customer's consent.¹⁸ Voyager maintained a similar custodial program, but also allowed customers to earn yield on deposited assets.¹⁹ At first glance, then, Crypto deposited in such programs would seem to fall outside of the ambit of the estate, given that title purportedly remains with the customer and may not be used freely by the debtor.

However, neither Celsius nor Voyager establish individualized wallets or accounts for each customer; rather, customers transfer crypto from an external wallet to the exchange's wallet. Thereafter, that crypto is reflected on the blockchain as belonging to the exchange, and the customer's rights with respect thereto are reflected solely in the exchange's own internal database.²⁰ In light of crypto's essential nature as a digital bearer instrument-reflected in the popular saying, "not your keys, not your coins"-such an arrangement may give rise to an argument by debtors (or their trustees) that, notwithstanding the terms of any custody agreement, title to deposited crypto does not remain with the customer, and that such crypto instead constitutes property of the estate.²¹

Further, both Voyager and Celsius commingle crypto assets deposited in their custody programs with those of other customers.²² This would complicate efforts to establish any sort of trust relationship and could require a tracing exercise to establish the extent to which a given customer's crypto assets were separate from the debtor's estate. Both platforms also disclaim the existence of any fiduciary relationship with their customers and go to great lengths to disclose that the custodial accounts are not true deposit accounts, as such term is used in the context of banking and...