The global market in crypto assets is currently experiencing a “crypto winter”, losing approximately US$2 trillion in value since the peak rally in 2021. The price of Bitcoin has retreated approximately 70% from its November 2021 high of nearly US$69,000. In this stormy environment crypto insolvencies are on the rise.
However the rapidly evolving nature of the crypto industry and the complex nature of crypto assets and transactions present unique challenges for insolvency practitioners (IPs) seeking to resolve or restructure crypto firms.
In this note we explore the current crypto winter, and some of the specific issues that arise in respect of insolvencies of crypto firms. In particular, we address:
- what is causing financial distress to crypto firms, and why we can expect more insolvencies in this space;
- why crypto assets are relevant in insolvency processes;
- the challenges in securing and recovering crypto assets; and
- issues with realising crypto assets.
A bitter crypto winter
While the crypto market has seen previous winters, the current cycle has produced more widespread financial distress than its predecessors. This seems likely due to a combination of increased institutional and retail participation in crypto markets, a broader range of yield and leverage opportunities available through decentralised finance (DeFi) markets, contagion effects between crypto firms, failures by those firms to manage risk, and a macro-economic environment of political turmoil, increasing inflation and tightening monetary policy.
The contagion between crypto firms was exposed recently by the domino effect triggered by the collapse of cryptocurrency “Luna” (and related stablecoin “TerraUSD”), which contributed to the demise of Three Arrows Capital (3AC) and flow-on distress for other crypto firms including Voyager Digital, BlockFi and Celsius.
We anticipate this contagion is likely to affect crypto firms in Australia and the APAC region, although the extent is presently unclear.
What businesses are particularly vulnerable?
This crypto winter has impacted a range of participants in the crypto economy, including:
- exchanges, brokerage and dealing services (digital platforms enabling users to buy and sell crypto assets, or exchange fiat currency for crypto assets, in return for fees), which have experienced liquidity pressure, declining fee revenue and workforce downsizing (e.g. Coinbase, Gemini);
- lending and borrowing platforms (e.g. BlockFi, Voyager and Celsius) and ‘shadow banks’, which have found themselves with insufficient funds to honour customer withdrawals;
- crypto-based startups, projects or decentralised autonomous organisations (DAOs) that run on ‘tokens’ with utility in a particular product/platform or used for fundraising, which have been impacted by the rapid decline in crypto asset prices;
- retail and institutional investors and venture capital (e.g. 3AC), which have been affected by declining investments, loan defaults and exposure to contagion effects;
- miners and node operators that facilitate blockchain transactions and maintain distributed ledgers in return for ‘mining’ and other rewards or incentives, which have seen those incentives decline along with crypto asset prices; and
- traditional corporations and financial institutions (‘TradFi’) running pilot or commercial projects using crypto assets, or otherwise with exposure to crypto markets.
The particular vulnerability of crypto firms in this winter is attributable (at least in part) to the rise of DeFi and lending platforms since 2018, which has resulted in increased debt and leverage (and financial interdependency/contagion between firms) throughout the global crypto market.
In around 2018, leverage was mainly confined to derivatives available to (mostly) retail investors on some centralised crypto exchanges. However, the rise of DeFi and lending platforms since that time has enabled crypto funds and lenders to take on high levels of debt from retail customers, particularly through “earn” or staking products into which retail customers deposit crypto assets in return for high yield returns. For example, in early 2022, the lending platform Celsius (now in US bankruptcy proceedings) was offering yields up to 18% on deposited crypto assets. In some cases, funds and lenders appear to have invested retail deposits elsewhere in the crypto ecosystem, increasing contagion risk.
Are crypto assets relevant in insolvency?
Whilst the value of many crypto assets has significantly declined since late 2021, many still continue to hold significant value (with the global market cap of crypto assets hovering around US$1 trillion) and are held by many players in large quantities. For many crypto firms and projects reliant on crypto assets for funding, their crypto asset holdings remain a very substantial part of their value.
While there is still some uncertainty about the legal character of crypto assets, it seems likely crypto will be treated as property in Australia, Singapore, New Zealand, the UK and other jurisdictions.
Regardless of their precise legal treatment, given the potential value of these assets, it is important that IPs immediately investigate upon appointment whether a distressed company may hold any crypto assets, and if so take rapid steps to secure those assets. By their nature, crypto assets can be very easily transferred by anyone with access to a private key or custodial account holding the assets (discussed below), and there is significant risk that individuals associated with a distressed company may abscond with assets. In the case of 3AC, liquidators were concerned that the founders, whose whereabouts were “unknown” at the time of filing for bankruptcy, would attempt to transfer away 3AC’s substantial crypto asset holdings to new accounts or wallets in their control.
Furthermore, since ownership of crypto assets is recorded publicly on the blockchain, IPs should bear in mind that evidence of any failure to secure these assets for the benefit of the estate and deal with them appropriately will be available indefinitely to anyone who wishes to bring a potential claim against the IP in future.
Securing crypto assets
There is a broad range of crypto assets and different methods by which they can be held.
Crypto assets can be defined in various ways, but typically include any digital representation of value or rights recorded on a distributed ledger whose authenticity is secured using blockchain and cryptography. They include digital currencies and stores of value (such as Bitcoin), tokens with utilities in specific digital platforms and ecosystems (often issued by private operators or organisations), and non-fungible tokens (NFTs). The variety of crypto assets is continually expanding.
In practical terms, the steps required to secure control of the crypto assets upon appointment depend on how the crypto assets are held, and by whom. In most cases, crypto assets will typically be held by a third party custodian or held directly by the distressed company.
Crypto assets may be held by a third-party custodian, such as an exchange or institutional custody service. In this situation, the “owner” does not directly control the assets, and (depending on the circumstances and relevant contractual terms) may have no more than a contractual right against the custodian for delivery of crypto assets on demand (effectively, an “IOU”).
For an IP, securing these crypto assets will require contacting the custodian directly and obtaining control of the account with the custodian. The custodian will hold the alphanumeric private keys to blockchain account(s) holding those assets, and therefore have practical control of the assets themselves, such that the depositor has only a right against the custodian in respect of the asset. Exchanges and custodians differ in how they hold crypto assets internally – in some cases, they may hold customers’ assets together in a common wallet with those of other customers.
A key question is whether the depositor has proprietary rights in the asset held by the custodian, or merely has a contractual entitlement. In relation to the collapse of New Zealand’s Cryptopia exchange in 2019, the High Court of New Zealand concluded that Cryptopia essentially fulfilled the role of a bare trustee in relation to the account holders and the digital assets were held in trusts.
In the US, calls for clarity were recently prompted by statements by Coinbase in quarterly disclosure to the effect that, in the event of bankruptcy, crypto assets could be considered property of the bankruptcy proceedings and customers could be treated as unsecured creditors.
Crypto assets may also be held by non-custodial means, such as by the “owner” possessing the alphanumeric private key required to make transactions using the account recorded on the blockchain as holder of the crypto assets. This might take the form of a software wallet (phone or computer app) or hardware “wallet” (similar to a USB drive) which contains a copy of the private key. In practice, this is equivalent to possession and control of the crypto assets, although the concept of legal ownership is not as straightforward.
For an IP, transferring crypto held in this way to an account controlled by the IP is essential. Until this occurs, there is a risk that a director, employee or other individual associated with a distressed company may have knowledge of the private key and effect a transaction in the business’s assets. For example, in the case of the Cryptopia exchange, it emerged that a former employee had made unauthorised copies of Cryptopia’s private keys which he uploaded to his home computer to extract Bitcoin worth around $250k.
Conversely, IPs should also consider the risk that a distressed company’s private keys might be stored insecurely or lost, resulting in permanent loss of the associated crypto assets. This occurred in the case of Quadriga (formerly one of Canada’s largest crypto exchanges) following the death of its founder, who had sole possession of the exchange’s keys.
Staking and liquidity pools
To add further complexity, it is also possible that crypto assets of a distressed company may be “locked” by a smart contract into a liquidity pool, DeFi protocol or other staking arrangement rendering it impossible for an IP to access them in practical terms for the duration of the lock up period (which may range from a few hours/days up to several years).
In these cases, the depositor will typically have the practical ability to require the smart contract to repay the assets deposited after the lock-up period ends. However, the legal status of this interest is unclear.
Securing crypto assets is potentially a complex exercise and, depending on the circumstances of the relevant firm, may involve dealing with counterparties in multiple jurisdictions and enforcement difficulties similar to traditional asset tracing and recovery. Courts in Australia (and other jurisdictions) have been willing to make freezing orders over crypto assets and in relation to blockchain accounts. Courts in other jurisdictions have permitted service of Court documents directly to blockchain accounts where the persons controlling those accounts are unknown.
IPs may need to seek assistance from foreign courts to locate and secure crypto assets (or to protect the position of the crypto firm more generally) through applications under the UNICTRAL Model Law on Cross-Border Insolvency (as enacted in various countries around the world). A recent example of this is the US and Singapore recognition applications in respect of the British Virgin Islands (BVI) liquidation of 3AC.
Accordingly, it is important that IPs understand the nature of crypto assets and the unique challenges and risks they present, and how to use the range of potential local and cross-border legal tools available to best protect the estate upon appointment.
If an IP’s investigations reveal a “voidable” transaction in crypto assets, it may be necessary to seek a return of those assets. Some companies (such as Chainalysis) provide advanced crypto tracking and transaction analysis services which may assist in identifying relevant transactions.
In the case of assets transferred to an institutional custodian or exchange, it may be efficient for the IP to deal directly with the custodian/exchange. The custodian/exchange may be cooperative, but if not, it may be necessary to seek Court orders compelling the custodian to return the assets.
In the case of assets transferred to a (non-custodial) blockchain account of a third party, the ability to recover assets will be determined by control of the private keys of the account. If the person holding the keys cannot be identified or located, or is unwilling to make a reversing transaction (and unable to be compelled to do so), it may be practically impossible to recover the assets even if a Court has ordered them to be returned.
Realising crypto assets
Once assets are identified and recovered, an IP may face the challenge of realising those assets in a volatile or illiquid market. Timing may have a significant impact on sale price. For certain crypto assets, such as NFTs or crypto assets which are not traded on larger exchanges, it may be difficult to find potential buyers or adequate liquidity.
Because of the volatility of crypto markets, IPs will also need to consider the question of whether to hold or sell crypto assets. This remains an open question, although the prospect of crypto prices recovering from the crypto winter – or even potentially rising to new highs before creditors are paid – has been raised in the context of the Celsius bankruptcy.
IPs may also need to consider using crypto brokerage and over-the-counter services to realise crypto assets of significant value.
Further guidance for IPs
Globally, there is limited regulatory guidance on the treatment of crypto assets in insolvency.
In the US, where several bankruptcy proceedings from crypto firms such as Celsius and Voyager are on foot, there have been calls for clearer guidelines. In Singapore, the Monetary Authority of Singapore is considering additional consumer safeguards on crypto (including rules on the use of leverage) in light of recent bankruptcies (including 3AC) and has foreshadowed strengthened regulation.
While guidance on appropriate steps for IPs is limited in Australia, the Australian Financial Security Authority (AFSA) has provided views on dealing with cryptocurrency in the context of a personal bankrupt estate.
How can we help?
Unlike traditional financial markets, crypto markets are still relatively unregulated. Further, crypto assets involve a range of considerations beyond other asset classes. As the crypto winter continues, the practical realities of dealing with crypto assets are likely to create more challenges for IPs and companies in distress.
Herbert Smith Freehills is well placed to assist IPs, creditors and crypto firms navigate the complexities of crypto insolvencies. Our global team combines market leading expertise in restructuring, turnaround and insolvency with cutting edge knowledge of crypto assets, blockchain and digital law.
 CNBC, ‘This ‘crypto winter’ is unlike any downturn in the history of digital currencies. Here’s why’ available at: https://www.cnbc.com/2022/07/14/why-the-2022-crypto-winter-is-unlike-previous-bear-markets.html.
 CLM v CLN and others  SGHC 46 (Singapore); AA v Persons Unknown  EWHC 3556 (Comm) (UK); Ruscoe v Cryptopia Ltd (In Liquidation)  NZHC 728 (NZ). Note that the UK Law Commission has published a paper considering a distinct category of personal property for crypto provisionally called “data objects”: https://www.lawcom.gov.uk/law-commission-proposes-reforms-for-digital-assets-including-crypto-tokens-and-nfts/
 Ruscoe v Cryptopia Ltd (in Liquidation)  NZHC 728
 Chen v Blockchain; Abel & Ors v Blockchain  VSC 93..
 Fabrizio D’Aloia v Binance Holdings Limited  EWHC 1723 (Ch); LCX AG v John Doe No. 1-25 (Dkt.No.,154644/2022) (N.Y. Supreme, Ct., NY County).
 In re Three Arrows Capital, Ltd (28 July 2022, Case.No.,22-10920) (United States Bankruptcy Court, SDNY).
 Australian Financial Security Authority, ‘Dealing with cryptocurrency in a bankrupt estate’ available at: https://www.afsa.gov.au/insolvency/i-am-practitioner/dealing-cryptocurrency-bankrupt-estate.