Expert Views: Celsius Court Rules Customers Relinquished Ownership of Crypto in Earn Accounts
Fri Jan 20, 2023 3:24 pm

Editor’s Note: Below is the latest in Reorg’s Expert Views series: an article written by Timothy Karcher, Vincent Indelicato and Daniel Desatnik of Proskauer Rose LLP. Request trial access of Reorg’s coverage of Celsius’ bankruptcy.

In resolving a “gating issue” in Celsius’ chapter 11 cases, the United States Bankruptcy Court for the Southern District of New York determined that Celsius, and not the customers/account holders, owns the cryptocurrency assets deposited in Earn accounts.

Rather than owning their deposited crypto, Earn account customers are left with an unsecured claim in Celsius’ chapter 11 cases, fixed as of the petition date.

The impact of the Celsius decision on other crypto-related bankruptcies may be limited, as it was driven by the unambiguous language in the Celsius terms of use, which provided for a transfer of title.

When customers flocked to Celsius to deposit their cryptocurrencies in “Earn accounts” in exchange for attractive interest rates, many of them believed they would continue to own their crypto and be able to withdraw it at any time. After Celsius filed for chapter 11 bankruptcy and revealed a $1.2 billion hole in its balance sheet, these customers braced themselves for the possibility that some of the crypto in these Earn accounts, estimated at approximately $4.2 billion, might not be recoverable.

Celsius, however, took the position that all of the deposited crypto in the Earn accounts was property of the bankruptcy estate and not property of these customers. As such, Celsius could seek authority to sell a portion of the crypto deposited in the Earn accounts to fund its bankruptcy cases and its operations. The bankruptcy court agreed. In a decision that could have reverberations across the crypto industry, the U.S. Bankruptcy Court for the Southern District of New York ruled that under the unambiguous terms of Celsius’ terms of use, Earn account customers agreed to transfer all title and ownership rights to the crypto upon deposit. To paraphrase one Celsius creditor’s reaction, “I thought I was getting a haircut, and they chopped off my head.”

Contract Law Issue

While crypto is a novel asset class, the bankruptcy court’s opinion largely rested on a straightforward application of contract interpretation principles. The bankruptcy court’s analysis proceeded in two steps. First, it examined whether the terms of use formed a valid, enforceable contract between the debtors and each Earn account holder. Second, if a valid contract existed, the court would determine whether the terms of use unambiguously transferred title and ownership of the deposited crypto from the customers to Celsius.

Celsius obtained a valid and enforceable contract with its customers through a “clickwrap agreement” whereby each customer had to click a button accepting the terms and conditions in order to keep using Celsius. Under New York law, such contracts are enforceable even where they do not require the customer to actually read the terms of use. Celsius presented evidence that at least 99% of the Earn account customers had assented to the terms of use in this manner.

After determining that customers had agreed to the terms of use, the bankruptcy court next examined whether the customer unambiguously transferred title and ownership to Celsius. In particular, the court was persuaded that language in the terms of use stating “you grant Celsius … all right and title to such Eligible Digital Assets, including ownership rights” effectuated a transfer of ownership to Celsius. While multiple creditors argued that this arrangement was referred to elsewhere in the terms of use as a “loan,” and thus implied that customers continued to own the crypto, the court found no such conflict. Instead, it found that creation of a loan and transfer of title are not mutually exclusive concepts, and noted that it is common for a loan of securities to a broker to also constitute a transfer of the title thereto, with the broker having a contractual obligation to return equivalent securities (but not the same exact securities) to the initial transferor.

The bankruptcy court’s ruling dealt a major blow to the 600,000 Earn account customers who had hoped for the swift return of at least a portion of their cryptocurrency from Celsius’ bankrupt estate. In light of the decision, the distribution of cryptocurrency to these Earn account customers does not seem likely anytime soon. Having learned that the cryptocurrency is property of the debtors’ estates, the 600,000 Earn account customers must now wait for distributions under a chapter 11 plan before they see any recovery on account of their claims.

Profound Impact on Celsius Customers

The Bankruptcy Court’s decision is likely to have a profound impact on many aspects of Celsius’ chapter 11 cases, and, while not binding precedent for other cryptocurrency exchange bankruptcies, the holding might influence the outcome of other cryptocurrency cases, or at least the strategy.

While the full measure of the fallout has yet to be determined, here are just a few initial observations. First, the size of each Earn account holders’ unsecured claim has ballooned exponentially from what they likely believed their exposure to be. Many of these customers believed they would get much of their crypto back and then have a small unsecured claim for what was unrecoverable. However, in light of the court’s decision, they now have an unsecured claim for their entire deposit.

Second, the path to recovery for Earn account holders has seemingly become much longer and uncertain. Rather than getting some portion of their deposit back and waiting for a return on the deficiency, the Earn account holders will have to wait for distributions under a confirmed chapter 11 plan, and that could take a long time.

Third, the ruling may have complex tax implications for the Earn account holders if, as stated in the court’s decision, account holders transferred ownership of their crypto to Celsius on each of the dates the crypto was deposited in an Earn account. One area of focus might be the value of Celsius’ promise to the customer, especially when it turned out that that Celsius ultimately was not in a position to fulfill its obligation. Further, customers who lost their crypto will likely have to wait until the end of the case to know the magnitude of their loss.

Perhaps most crushing to the Earn account hopefuls is that they now must face the reality that, for them, these cases are a liquidation, where the seller – Celsius – will play the dual role of villain and auctioneer of the assets the customers thought they owned.

Impact on the Crypto Industry and Crypto-Related Bankruptcy Cases

The impact of the Celsius decision on the question of whether crypto is property of the bankruptcy estate in other crypto bankruptcy cases may be limited. Ownership of deposited crypto will likely be governed by the specific language of the applicable terms of service and the circumstances under which customers may or may not have become bound to the terms, rather than any unique feature of crypto assets.

Where the decision may have a greater impact is on how crypto exchanges communicate their terms of service to customers going forward, and what customers might demand to see from these crypto exchanges before depositing their digital assets with them.

While the issue of crypto ownership was treated as a “gating issue” in the eyes of the court, Earn account customers are likely left to wonder whether this all-or-nothing dispute, impacting more than $4.2 billion in claims, needed to be resolved at this point in the proceedings or whether it could have been resolved at a later date. However, both the debtors and the unsecured creditors committee supported the application at this time because the debtors wanted authority to sell $18 million of stablecoins to fund administration of the chapter 11 cases. As the amount realized through the sale is only sufficient to provide one additional month of liquidity, Earn account holders will likely wonder whether the debtors, working with the UCC, could have found another way to address the debtors’ liquidity needs while allowing the ownership to be resolved through a global compromise in furtherance of a chapter 11 plan. In any event, once the ownership issue was put squarely before the court, it is hard to see how the outcome of the decision could have been any different.

Moreover, because both the debtors and the UCC argued that the crypto in the Earn accounts was property of the estate, individual Earn account customers who opposed the application were left in the difficult position of having to litigate against the debtors and the UCC on their own. Many creditors had argued that statements of Celsius’ then-CEO, Alex Mashinksy, modified the terms of use or fraudulently induced customers to open accounts, but none of the objecting parties entered this evidence into the record despite the court holding an evidentiary hearing. While the bankruptcy court left open the possibility for individuals to argue that, under their unique facts, the contract is unenforceable or not binding, the default position now is that there was a binding, enforceable contract transferring ownership of the cryptocurrency to the debtors.

The Celsius decision highlights the tension between creditors seeking to increase the size of the bankruptcy estate to fund distributions and customers seeking the return of crypto they believe is their property. It remains to be seen whether a critical mass of the Earn account holders can find an organized way to successfully counter the negative effects of this decision, either in the claims resolution process or otherwise. Moreover, the decision may also affect how other crypto cases proceed. In the future, debtors and committees may consider whether there is sufficient ambiguity about the ownership to form the basis of a global settlement incorporated into a chapter 11 plan.

Reorg is covering crypto bankruptcies including Voyager, Celsius, FTX and BlockFi. Read a summary here.

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