Vol. 96, No. 6

The Bankruptcy Court as Crypto Market Regulator

Yesha Yadav* & Robert J. Stark†
Bankruptcy Law, Financial Regulation, Technology
Articles

In the second half of 2022, several large and systemically important cryptocurrency firms, such as BlockFi, Celsius, FTX, and Voyager, collapsed into bankruptcy. Their sudden implosion can be attributed, at least in part, to a scant pre-existing framework for oversight, allowing firms to engage in runaway risk-taking, exuberant opportunism, and, in some cases, outright fraud. Bankruptcy courts adjudicating these cases found themselves in a strange role: serving as a sort of proxy overseer for a maturing cryptocurrency industry, and forced into doing some of the work historically entrusted to regulatory agencies like the SEC, CFTC, and Fed. This Article explores the implications of bankruptcy courts being drafted into this kind of quasi-regulatory service. We observe that bankruptcy’s intervention comes with numerous payoffs, given that Chapter 11’s end-goals often align with traditional regulatory objectives. Indeed, by case necessity, bankruptcy courts have overseen broad and detailed reporting from some of the industry’s darkest corners, rendered decisions that likely will have lasting impact on customer protection, directed regulatory attention to particular points of public vulnerability, and afforded opportunity for regulatory agencies to advance their policy initiatives. Nevertheless, we also observe that bankruptcy courts are inadequate proxies for administrative, technocratic oversight. Focused mainly on the debtor’s fate, the Bankruptcy Code is ill-equipped to address, in a prophylactic way, system-wide risks in crypto markets. Even disclosure––a foundational regulatory tool––works idiosyncratically when delivered in the bankruptcy context, intended to inform the debtor’s stakeholders in furtherance of bankruptcy-specific imperatives, rather than to facilitate knowledgeable investing by the general public. Bankruptcy courts are, moreover, statutorily constrained in ways that lack the mission, modalities, and mechanisms to protect an industry and its participants. As we show here, even as bankruptcy courts have stepped up to do their work, their role in overseeing crypto bankruptcies firmly establishes a paramount need for comprehensive regulation tailored for the digital asset space.

INTRODUCTION

The collapse of the FTX cryptocurrency exchange in November 2022 was a pivotal moment for the digital asset industry. The company’s sudden implosion triggered billions in economic damage across the sector, as well as immeasurable personal pain for millions of everyday customers.¹

Prior to its failure, FTX had been one of crypto’s brightest stars, serving as a leading trading hub for digital assets, offering a panoply of sophisticated financial products, and boasting a (supposedly) enviable balance sheet.² Just one year after its founding in 2019, the company was hosting $385 billion in annual trading volume.³ The following year, it reported five million customers worldwide, more than $1 billion in revenue, and almost $275 million in earnings.⁴ By January 2022, FTX was valued at $32 billion.⁵ The company had also been absorbed into popular culture, helping to demystify digital assets for everyday Americans: the FTX brand was emblazoned across the Miami Heat’s basketball stadium; it was endorsed by celebrities like Tom Brady and Larry David, including a memorable advertisement aired during the 2022 Superbowl; and, Sam Bankman-Fried, FTX’s once-wunderkind CEO, became known for contributing lavishly to political campaigns and marketing himself as the legitimizing, ethical face of crypto.⁶ In fewer than four years, FTX had become big, powerful, and ubiquitous––bridging Wall Street, Main Street, and the nation’s capital to a brand new crypto marketplace––which too had become far too big, powerful, and ubiquitous to ignore.⁷

But, in November 2022, FTX was outed as a possible fraud, suspected of grossly misrepresenting its enterprise value and misusing customer deposits.⁸ Within weeks, Bankman-Fried was in handcuffs,⁹ other FTX executives were cutting plea deals,¹⁰ and the company was in bankruptcy.¹¹ The resulting Chapter 11 case is sweeping, both in scale and complexity, spanning over 130 entities worldwide, with total value estimates ranging anywhere from $10 to $50 billion.¹² The administrative fee burn has been commensurately immense, with the debtor’s bankruptcy professionals seeking over $200 million in fees for the initial six months of work.¹³

Intriguingly, the FTX story is not unique.¹⁴ The company’s meteoric rise and sudden descent tracks that of other crypto behemoths. Firms like BlockFi, Celsius Network, Core Scientific, Genesis Global, Three Arrows Capital, and Voyager Digital each found themselves intermediating billions in crypto assets only a few years after launch and, like FTX, imploding in the wake of a sharp market downturn. Several major crypto bankruptcies have also generated substantial allegations of executive wrongdoing, and those allegations overlap, reflecting somewhat repeating patterns of alleged customer deception and sloppy safeguarding of customer assets.¹⁵

None of this should be terribly surprising. The crypto market has, through its evolution, lacked a systematic regulatory framework to constrain excessive risk-taking, interconnection, and propensities for predation against customers.¹⁶ This has meant, for example, a lack of vetted, mandatory public disclosure about the business dealings of some of its most significant enterprises, as well as their corporate governance and risk management practices.¹⁷ Nor has regulation imposed comprehensive standards for protecting customer assets.¹⁸ It has thus failed to speak on how the market should ensure the overall safety and soundness of crypto firms––and, importantly, what procedures crypto businesses need to follow in order to legally insulate the value of customer assets against instances of theft, hacks, and firm bankruptcy.¹⁹ This relatively threadbare regulatory environment has afforded considerable space for firms to take excessive financial risks or institutionalize problematic practices (e.g., opaque governance), with predictably costly consequences. This has left bankruptcy courts to become, oddly, the frontline responders–– tasked with cleaning up the fallout by imposing their jurisprudence onto an otherwise lightly governed crypto marketplace.

This Article shows that, by dint of historical happenstance, bankruptcy law has been required to partially fill an administrative void and to function in an almost quasi-regulatory capacity. Several bankruptcy courts in New York, Delaware, and New Jersey have come to simultaneously oversee what is, collectively, a sort of grand public inquest into crypto market infrastructure and operations, surveying a wide spectrum of industry-specific transactions, practices, and methods of corporate decision-making. These courts have also decided issues of first impression that will likely leave a lasting impact on the maturing crypto industry (e.g., modified terms of service).²⁰ The courts have been doing their work in advance of a mainstay framework for regulating cryptocurrency markets, driven by case imperatives to perform certain functions commonly entrusted to financial supervisors like the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Federal Reserve.²¹

In forwarding this argument, this Article moves to examine the implications of bankruptcy law and its courts being drafted into quasi-regulatory service. It makes three points. First, we observe that bankruptcy has stepped into an arena where financial regulators have struggled to craft a system of rules and standards, applying its own principles and processes to the messy task of preserving and allocating economic value. In many respects, crypto represents an inherently complicated challenge for U.S. financial regulation, given the industry’s extraterritorial nature, fast-moving technology, and originating anti-government spirit.²² But, even as the likes of FTX are far from the first crypto players to fail,²³ the scale of alleged wrongdoing and magnitude of damage caused by 2022’s “crypto winter”²⁴ have laid bare the significance of sparse regulation and deepened the strains experienced by the New Deal administrative apparatus in policing the digital asset space.²⁵ This has left the bankruptcy system charged with, among other things, calculating the economic costs of regulatory failure and, where possible, developing mechanisms to safeguard and redistribute enterprise value within otherwise under-protected crypto markets.

Second, we show that bankruptcy law offers a number of advantages when its courts are, by default, performing traditional regulatory functions. By its very design, bankruptcy involves a system of rules that advance certain core regulatory objectives. For example, Chapter 11 is demanding when it comes to disclosure, a phenomenon highlighted by the production of startling revelations across various crypto Chapter 11 proceedings (e.g., FTX, Celsius, Voyager, and BlockFi).²⁶ Chapter 11’s adversary process typically divulges more as the case unfolds. And, in bankruptcies involving particularly troubling facts, the court may compel the appointment of an examiner to deliver a “tell-all” report, as it did in two crypto cases (Cred and Celsius)²⁷ and is poised to do in FTX.²⁸ This emphasis on disclosure can meaningfully promote management accountability and, in turn, help ward away bad C-Suite behavior. In the Celsius case, for instance, the 689-page examiner’s report presented a damning account of the company’s historical business practices.²⁹ The report presaged, and likely contributed to, the Celsius CEO’s eventual indictment and arrest, which occurred only a few months after the report’s publication.³⁰

Bankruptcy disputes also deliver poignant teaching moments for government overseers and the wider public. For instance, a value allocation contest in the Celsius bankruptcy––pitting depositors in interest-bearing accounts against depositors in “wallet” accounts––revealed just how fragile customer ownership rights can be when deposited crypto-value exists in digital and legally ambiguous form.³¹ Customers came to learn that, contrary to marketing promises,³² the cryptocurrency ceased being legally “theirs” upon deposit in interest-bearing accounts. That is, customers were deemed to be merely unsecured creditors in the bankruptcy case, left to fight for scraps near the bottom of the priority ladder.³³ The bankruptcy court, in so ruling, not only resolved a critical case issue, it also delivered a hard truth to crypto customers: entrusting savings to an unregulated crypto exchange or “bank” comes with serious risks, given that these companies are not well policed for fraud and that customer savings lack conventional protective mechanisms, like federal deposit insurance.³⁴ Such lessons can be unsparing, yet also clarifying about the economic and legal vulnerabilities faced by crypto customers––who, en masse, were tempted by tantalizing marketing promises but ultimately found themselves exposed to inherently complex, opaque legal and economic risks.³⁵ By highlighting the traps, bankruptcy courts direct agency attention to acute public vulnerabilities, hopefully motivating regulators to develop the kind of customer protections that have long existed in more traditional marketplaces (e.g., securities or commodities markets).³⁶

As a concluding observation on this point, we show how bankruptcy represents a forum where regulatory agencies can press specific policy objectives in advance of a new statutory framework and without facing the usual set of political/rulemaking constraints and ramifications. Regulators have some leeway to inject themselves into bankruptcy proceedings, promoting an agency’s policy priorities.³⁷ The SEC and the federal government, for example, intervened in Voyager’s Chapter 11 case to object to its proposed sale to Binance.US, the American affiliate of Binance––the world’s largest crypto exchange, by volume.³⁸ The government contended that the proposed Chapter 11 sale came with serious regulatory problems, suggesting that Binance.US may not be a fully law abiding corporate citizen and that distributions to Voyager creditors (via Binance.US) might violate securities laws.³⁹ The government’s arguments floundered in court,⁴⁰ but its highly public attack effectively terminated the transaction.⁴¹ This case study illustrates how agencies can, with efficiency, produce regulatory impact when the target of their action falls under the bankruptcy court’s stewardship.

Nevertheless, in our third contribution, we observe that reliance on bankruptcy courts to perform regulatory functions comes with serious shortcomings. Bankruptcy courts are tribunals of limited jurisdiction, and their powers are localized to the specific debtor and its stakeholders, not the public welfare more generally.⁴² They are, in turn, intended to work in tandem with functioning regulatory arms of government; they are not supposed to assume their oversight responsibilities.⁴³ These courts are particularly ill-equipped to address risks arising from an interconnected and multifaceted financial market, especially in a prophylactic way.⁴⁴ Stated differently, corporate bankruptcy is not structured to expressly entertain regulatory imperatives, like stopping financial calamity before it happens or ensuring that a firm’s distress does not trigger systemic contagion within the wider market.⁴⁵

Further, Chapter 11’s legal and normative rules––focused on maximizing each debtor’s distributable value, allocating that value among stakeholders, and where possible rehabilitating the broken business––are not friendly to outsiders, even government outsiders seeking to advance public policy aims.⁴⁶ Competition between economic and regulatory agendas can, in fact, lead to value-deteriorating outcomes, such as dooming Voyager’s sale to Binance.US, contrary to bankruptcy’s primary mission. Even concerning matters of disclosure, the objective is case-specific (e.g., maximizing and allocating estate value) and often strategic in nature (e.g., the debtor’s desire to remain in possession of estate assets), not to obviate risk in the industry generally.⁴⁷ In some cases, the court may not favor augmented public disclosure if doing so may be prohibitively costly or where greater public disclosure threatens an orderly Chapter 11 process.⁴⁸ This may explain why examiner reports were commissioned in the Cred and Celsius cases, but not in the FTX case (that is, until compelled by the Third Circuit Court of Appeals).⁴⁹ Stated simply, even as bankruptcy is (by case necessity) doing important regulatory work, it is far from its natural functionality and is an inherently inadequate substitute for administrative agencies whose mandates include establishing a set of robust, lasting, and standardized rules that protect marketplaces both in peacetime and in crisis.

This Article proceeds as follows. Part I describes the cryptocurrency ecosystem and the challenges of establishing regulatory perimeters for this emerging asset class. Even though regulators have struggled to develop rules-of-the-road for the digital asset industry, this Part highlights some key risks (e.g., systemic risk, information deficits, and user vulnerability) that are commonly cited to justify the application of traditional financial regulation. Part II explains how Chapter 11 has been drafted into quasi-regulatory service to help clean up the mess enabled by crypto’s sparse regulatory environment. This Part illustrates how bankruptcy court oversight has generated a slew of benefits, with the potential to promote insight, expertise, clarity, and good governance. Part III explores the fuller implications of bankruptcy serving quasi-regulatory functions. It shows that, despite all their good and hard work, bankruptcy judges are imperfect overseers for the crypto marketplace. Not only do they lack the statutory directive and powers to address market risks, their decision-making is further limited by the estate-specific focus of bankruptcy’s adversary process, the case-specific nature of bankruptcy disclosures, as well as general inexperience in addressing complex, esoteric, and systemic financial risks––especially risks arising outside prevailing regulatory frameworks. Relying on bankruptcy courts for quasi-regulatory assistance, instead of technocratic rulemaking, is thus profoundly problematic, as Part IV concludes.

I. CRYPTO’S MISSING REGULATORS

Despite acquiring popular appeal and developing a sophisticated array of financial services and products, the market for cryptocurrencies has come of age largely outside of a comprehensive system of regulation.⁵⁰

papers.cfm?abstract_id=4405036 [https://perma.cc/S8C4-TN4B] (discussing the legality of “regulation by enforcement” and exploring why agencies rely on this approach, alongside the trade-offs of doing so, especially in the context of using litigation to test novel/ambitious applications of law to innovation). There are many reasons to explain this historical gap in oversight. For one, the asset class is legally complex, with agencies, most notably the SEC and CFTC, publicly at odds over which of them has authority.⁵¹ In other words, jurisdictional wrangling is underway over whether some or all crypto-assets ought to be legally defined as securities (the purview of the SEC) or commodities (the purview of the CFTC)––this determination being critical to situating crypto within existing bodies of securities and commodities regulation. Additionally, digital assets are far from monolithic in their design, with different types of tokens implicating different kinds of risks and entitlements: more decentralized and volatile cryptocurrencies like Bitcoin, for example, operate distinctively from so-called stablecoins, digital assets typically attached to an identifiable issuer and designed to maintain a steady one-token-to-one-dollar correspondence.⁵² Even while navigating such definitional challenges, digital assets raise intriguing considerations for policymakers looking to calibrate their supervisory toolkit, such as: how should domestic national authorities oversee risks arising across decentralized, globally dispersed blockchains; and, do existing administrative processes suffice, or might regulators benefit from crafting tailored solutions to match novel attributes of the asset class (e.g., decentralization)?⁵³

This Part has two objectives. First, it summarizes key features of crypto markets to highlight some of its distinguishing features and risks. Second, it describes fundamental theories of financial regulation that generally explain and justify its application (e.g., to protect financial stability and enhance consumer welfare). This Part shows that crypto markets exhibit the kinds of risks that fall under usual rationales justifying the application of financial regulation. We observe, however, that the crypto market has evolved largely outside of a dedicated system of financial regulation, leaving it intrinsically vulnerable to costly externalities and failure.

A. Some Key Features of Crypto Market Structure

Broadly, the cryptocurrency market is made up of three major parts: (1) at its most fundamental, it originates within globally dispersed computer networks that work to produce a “distributed ledger” (or blockchain) recording the transactions submitted to and verified by each network; these automated networks often mint digital tokens/coins as a means of rewarding users that work to maintain the system’s integrity;⁵⁴

click&module=RelatedLinks&pgtype=Article [https://perma.cc/P7DL-YD3C]; Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, Bitcoin.org 2–4, https://bitcoin.org/bitcoin.pdf [https://perma.cc/HFX5-DAWH]. (2) various types of more centralized firms like cryptocurrency exchanges and quasi-banks that intermediate access to cryptocurrency assets (e.g., coins) and offer related financial services and products;⁵⁵ and (3) a slate of digital applications aiming to offer financial products in a more decentralized manner, harnessing the verification capacity of blockchain networks. These applications derive their utility by running automated programs (colloquially, “smart” contracts), rather than relying on centralized firms like exchanges or banks to provide an intermediary service.⁵⁶ A detailed discussion of each of these component parts is outside the scope of this Article. However, the summary below outlines some of their defining characteristics (and risks).

1. The Building Blocks: Chains, Coins, and Ledgers

The origin story of modern-day cryptocurrencies emerges from the Bitcoin white paper, written by Satoshi Nakamoto, that sets out a vision for an entirely digital payments network capable of operating globally on a person-to-person basis.⁵⁷ Its radicalism lies in envisioning the creation of a payments system that does not look to centralized intermediaries like banks to validate flows of money, nor does it presuppose the power of the state to enforce bargains or maintain the integrity of the system. Instead, it conceptualizes an infrastructure for making payments that depends on a network of computers, running a common protocol, to verify and record transactions. In place of a bank checking key details (e.g., whether the sender has enough money in his account) or regulators monitoring transactions, these tasks are approximated by the application of computerized code. By running the Bitcoin protocol, participating networks of computers (“nodes”) apply verification rules that examine incoming transactions to check whether they conform to the protocol’s standards of accuracy and integrity. Once nodes agree, by consensus, that a transaction is valid, it can be accepted, processed, and written into the protocol’s “ledger.” Transactions are batched into blocks and presented for validation, a practice that has given rise to the nomenclature of the “blockchain.” Unlike a bank payment, which remains confidential between the parties and the bank, the ledger is public and verifiable. This transparency is supposed to provide a mechanism whereby external scrutiny constitutes a means of interrogating whether the system is running in a safe and trusted way (e.g., that the same coins are not being sent twice or double spent).⁵⁸ Once accepted and validated, transactions are generally irreversible. This aspiration for immutability provides a proxy for certainty and reliability within the system, where it is not subject to idiosyncratic changes by one or another player.⁵⁹

2021), https://medium.com/coinmonks/finality-in-bitcoin-f82890bf39b7 [https://perma.cc/ZHD7-NJLB] (noting that finality on the Bitcoin blockchain is probabilistic).

The “coins” underlying the Bitcoin blockchain speak to digital rewards given to those that work to safeguard the network. Within Bitcoin, the dispersed network of nodes is vulnerable to the risk that a node (or a group) turns malicious––seeking to disrupt its function or to use it for its own benefit (e.g., by only proposing transactions that are sent to accounts connected to operators of a malicious node).⁶⁰ To secure the network’s integrity, the blockchain looks to a system of “protectors” tasked with looking into the pool of transactions entering the system and picking those for approval that should meet the protocol’s standards.⁶¹

The network creates incentives for participants to become “protectors” by awarding “coins” to those that succeed.⁶² In the Bitcoin network, “protectors” can also collect any discretionary fees that users might attach to a transaction.⁶³ Bitcoin looks to a “proof of work” validation mechanism, where network protectors––or “miners”–– competitively deploy extensive computing power to solve a mathematical challenge. A winning miner then builds a block of transactions for the network to approve and receives new Bitcoin (and fees) for their effort.⁶⁴ The “proof of stake” validation mechanism is also common across major blockchains (e.g., Ethereum). Broadly, in a proof-of-stake blockchain, those that already have a number of coins in the system can win the chance to build the block and collect more coins (and fees) as rewards.⁶⁵

While this description is highly simplified, it serves to highlight some legal puzzles confronting regulators. Major blockchain networks, like Bitcoin or Ethereum, are global and open to anyone, anywhere, willing to download and run the relevant protocol on their computer.⁶⁶ Additionally, users do not give their real-world names in order to join, as they would when using a bank. Instead, users are known and accounted for on a blockchain by their “public keys,” a form of pseudonymous public handle, that links to a private password known to the user.⁶⁷ If a user loses her password, she cannot access her account or make and receive payments, meaning that value on the network is lost.

This globally distributed system, designed to operate outside of traditional private and public intermediation, presents unusual regulatory conundrums. How should U.S. regulators construct a system of rules capable of applying to an automated cross-border network that aims to avoid centralized governance and control altogether? What tools can regulation deploy to overcome information gaps, address potential misconduct, or costly fragilities existing within a blockchain’s operation?⁶⁸ And, what legal classification ought to apply to coins minted on blockchains: do they constitute securities or commodities under conventional stipulations of federal law, extending existing regimes to crypto assets; or, do they fall under an entirely different, more tailored legal category?

As such, while market regulation is usually equipped to accommodate innovation, crypto assets have come to pose a significant challenge.⁶⁹ For example, the definition of innovative kinds of security––as covered by the concept of an “investment contract” in the Securities Act of 1933––was elaborated by the 1946 case of SEC vs. Howey. Per Howey, a security is a claim that represents: (1) an investment of money; (2) in a common enterprise; (3) for profit; and (4) through the effort of others, where those that promote an investment exercise managerial control over any scheme.⁷⁰ A discussion of the jurisprudence born out of Howey is outside the scope of this Article. But concepts like “common enterprise” or “through the efforts of others” signal the difficulties confronting policymakers when seeking to apply conventional precepts to cryptocurrencies and their blockchains. Emphasis on miners/stakers extracting higher returns relative to other network participants, for example, sits uneasily with long-rooted notions of a horizontal common enterprise. The task of identifying promoters with managerial powers strains in the context of public blockchains that seek to structure themselves in ways that look to be deliberately diffuse from a governance standpoint and where self-help constitutes a basic rule-of-thumb.⁷¹ With these thorny definitional questions key to establishing how regulators legally assert authority in the first place, it is not surprising that debates on the issue have become contentious as between regulators themselves, each seeking to jostle for their agency to have primary jurisdiction.⁷² This administrative squabbling has arguably played an important part in delaying the production of a comprehensive system of rulemaking for digital asset markets, leaving them to evolve largely outside of everyday administrative oversight.

2. Centralized Finance in Crypto Markets

As much as decentralization is popularly perceived as the distinguishing feature of cryptocurrencies, the everyday experience of digital asset markets for many is often intermediated through “centralized finance.” Engaging with sophisticated blockchains, setting up public keys, protecting their private passwords, or learning technical specifics of the computing involved can act as a barrier to entry for the average person looking to enter the crypto market. Finding a party through which to buy and sell crypto on a blockchain might similarly be impractical for those unfamiliar or uncomfortable with searching online for brokers.

So-called “centralized finance” firms have emerged as essential conduits for mitigating these difficulties and increasing crypto’s appeal for the mainstream. Exchanges, in particular, have established themselves as organizing architecture for the crypto markets, bringing together volumes of institutional and retail users, developing a variety of financial products, and helping to popularize the asset class for everyday people.⁷³ By connecting to users through smartphone apps, advertising on prime time television slots (e.g., the Superbowl), and using top-flight celebrity endorsements, crypto exchanges like Coinbase, Binance, Kraken, and infamously, FTX have established a prominent position both within crypto as well as financial markets more broadly.⁷⁴

Exchanges deploy established market structure tools to connect cryptocurrency buyers and sellers. By creating an organized marketplace, users no longer have to worry about seeking out a counterparty privately within an ecosystem of pseudonymous users who could be located anywhere in the world. The need for self-help is also reduced. Centralized firms provide a known point of contact, capable of correcting problems (e.g., hacked accounts), as well as offering users compensation and recourse if they suffer damage.⁷⁵ Unlike public blockchains that demand that their users be capable of looking after their own interests or dealing with the consequences (e.g., irreversible transactions), exchanges offer services to facilitate uptake of cryptocurrency trading (e.g., by offering loans for trading, custody services, or educational resources). By reducing the transaction costs and building avenues for accessible participation, exchanges have introduced everyday users to cryptocurrency markets. Tellingly, leading exchanges were drawing in eye-catching trading volumes during most of 2021––the cryptocurrency market’s boom year. Binance, for example, intermediated around $7.7 trillion in trading over 2021, reportedly generating $20 billion in revenue.⁷⁶ FTX, founded in 2019, saw its valuation grow over 1000% in the course of 2021 to around $1.1 billion, soaring to $32 billion by 2022––before collapsing into insolvency in November 2022 and liqudidation in January 2024.⁷⁷ Even as trading volumes fell sharply with the onset of “crypto winter” and FTX’s failure, crypto exchanges remained financially significant for the digital asset ecosystem. In its first quarter earnings report for 2023, Coinbase reported revenues of $773 million, up 23% from the final quarter of the previous year.⁷⁸ In April 2023, Binance saw sharply reduced activity, losing almost 50% in trading volume, while still recording approximately $287 billion in trading activity for the month.⁷⁹

In addition to exchanges, centralized finance includes firms performing a variety of financial services (e.g., lenders, hedge funds, broker-dealers, and specialist traders). Cryptocurrency deposit/lending and investment firms, in particular, have assumed considerable importance. Crypto quasi-banks, for instance, took in vast sums of customer capital/crypto––offering lucrative interest rates on these deposits––and for a shot time profited handsomely by relending those deposits. Predictably, as the crypto markets suffered a sharp downturn in 2022, these entities were hit especially hard with loan defaults and collapsing collateral prices, pushing several of the more prominent quasi-banks into bankruptcy.⁸⁰

Take Celsius. Founded in 2017, Celsius billed itself as a way for everyday people to “unbank” themselves––meaning, exiting the traditional banking system and putting money into a vehicle that promised depositors tantalizing returns. At its height, Celsius marketed investments that would pay as much as 18% interest on customers’ crypto deposits. Given such dazzling promises, the firm ended up controlling assets of around $20 billion, reaching 1 million or so customers.⁸¹ Its business model relied on putting customer assets into high-yield, high-risk investments. The value of these investments eventually plummeted with the onset of “crypto winter” in May 2022. Owing approximately $4.7 billion to its customers and unable to make good, Celsius filed for Chapter 11 protection.⁸²

Genesis Global, alongside two of its lending subsidiaries, also found itself in Chapter 11 in January 2023. Genesis, too, functioned like a quasi-bank; it took in customer deposits, offering high interest rates, and redeployed those deposits as loans extended to other industry players, like hedge funds.⁸³ With a loan book totaling around $12 billion in 2021, Genesis found itself in a vulnerable position with the onset of “crypto winter”: first, it lent $2.4 billion (partially collateralized) to the defunct crypto hedge fund, Three Arrows Capital, that collapsed in Spring 2022; and, second, it lent hundreds of millions of dollars to FTX’s affiliated hedge fund, Alameda Research, which imploded a few months later.⁸⁴ The mounting losses, alongside larger struggles in the crypto market, contributed to Genesis entering into Chapter 11.⁸⁵

Centralized firms have come to exercise enormous economic influence within the cryptocurrency marketplace.⁸⁶ As exemplified by the likes of FTX, Celsius, and Genesis, centralized firms routinely hold deep pools of crypto capital and convene a crowded and diverse range of stakeholders within their institution.⁸⁷ This capacity to build scale and complexity within a purportedly decentralized marketplace is hardly accidental. As noted above, centralized firms often offer a range of services and conveniences that bypass many of the novel and technically quirky facets of crypto market structure.⁸⁸

The far-reaching pull of centralized platforms within crypto has given rise to sources of vulnerability, creating risk for everyday users and market integrity. For example, platforms routinely require customers to transmit the password to their crypto “wallets” to the venue.⁸⁹ Practically speaking, by taking custody of user passwords (or “keys”), the venue is able to move the user’s crypto into accounts (i.e., the “wallets”) that it (the platform) controls, meaning that assets can be pooled and placed by the venue into various onward investments. With the platform holding the customer’s passwords, users confront the risk that they lose control of––and, indeed, potentially even legal title to––their own assets.⁹⁰ Because crypto’s foundational design assumes that those that hold the password to an account constitute its owners, a platform’s custodianship can leave customers suddenly bereft should the platform fail or end up losing the passwords for whatever reason (e.g., a theft or fraud).⁹¹

From a broader structural standpoint, the ability of centralized firms to pool and deploy capital has resulted in the creation of fragile interconnections between various types of market participants. Described above, exchanges and firms like Celsius and Genesis have emerged as prolific investors, putting customer capital into various crypto ventures. Such investments have taken the form of loans––where funds have made their way into crypto-lending arrangements promising (sometimes) double-digit interest rates (e.g., Celsius). BlockFi, for example, found itself in Chapter 11 after making bad loans to failed hedge funds, Three Arrows and Alameda.⁹² But, they can also comprise equity investments. That is, platforms put capital into the riskiest slice of the corporate balance sheet in a bid to secure potentially unlimited upside should the venture succeed. Exchanges, for example, have emerged as active investors in start-ups. FTX, notably, collapsed holding an eclectic balance sheet comprising crypto as well as more mainstream equity investments, reportedly worth around five billion dollars at the time of its failure.⁹³ Seen as a whole, centralized finance firms have shown themselves to be economic lynchpins of the crypto ecosystem, creating close financial linkages between themselves, their customers, as well as any number of stakeholders through often opaque, complex investments. Such relationships have resulted in regulators confronting a broad tangle of interconnected exposures, where risks from one entity can be transmitted to other firms, and ultimately to everyday customers, resulting in potentially heavy economic fallout whose permutations are not understood ex ante and cannot be easily remedied ex post.

B. Rationales for Regulation in Crypto and Finance

Though crypto markets have evolved mostly outside of the regulatory perimeter, they showcase a number of features that have traditionally proven persuasive in anchoring oversight for financial markets: (1) vulnerability to systemic risks; (2) information asymmetries; and (3) customer and investor protection. While a full discussion examining theoretical grounds justifying financial regulation is outside the scope of this Article, the observations below demonstrate that the relative absence of oversight in crypto markets represents a costly gap out-of-step with established paradigms in financial market design.

1. Mitigating Systemic Risks

Traditional financial regulation is often justified by reference to the importance of reducing “systemic” risk.⁹⁴ The task of defining systemic risk, in practice, has proven to be notoriously slippery.⁹⁵

153927406281.pdf [https://perma.cc/MH65-GS8B] (noting the role of interconnectedness in the definition of systemic risks); Morgan Ricks, The Money Problem: Rethinking Financial Regulation, 52–77 (2016) (highlighting short-term run-risks within the unregulated money market sector as a key indicator of systemic risks, justifying financial regulation). Particularly in the shadow of the 2008 financial crisis, the capacious intervention of the federal government to backstop the safety of financial markets pointed to a concept whose parameters might only become clear ex post, when failure illuminates sources of previously unknown but intolerably high risks within the marketplace. Even as banking regulators invoked an emergency “systemic risk” exception to fully protect deposits at two fairly large but relatively niche banks in March 2023 (Silicon Valley Bank and Signature Bank), the ensuing debate surrounding the need and propriety of such interventions has only served to underscore the tricky boundaries of conceptualizing systemic risk and what regulators ought to do about controlling it.⁹⁶

Notwithstanding these definitional difficulties, containing systemic fallout has long been a critical objective of financial regulation. Broadly seen, it references two core scenarios. The first scenario is one in which a firm’s behavior leads it to take risks that result in it creating dangers that can spread far beyond its own four walls. In other words, a risky, failing firm lacks the resources to pay for its own behavior, forcing others to bear the losses, risking collapse themselves. The second scenario is where a shock to the market (e.g., a pandemic) causes similarly situated firms to face potential distress, resulting in crisis impacting multiple firms simultaneously.⁹⁷ Simplifying things, certain kinds of firms have traditionally been viewed as being especially susceptible to failure, with the potential to trigger a larger crisis. Specifically, firms vulnerable to sudden runs––for example, they owe money short-term and may have invested it in longer-term ventures––can face catastrophe if creditors seek to take out their money all at once. This can force a firm to sell its longer-term investments at distressed prices, plunging its balance sheet into the red, as assets end up fetching less than the money it owes. Conventionally, banks represent the quintessential purveyors of such run-risk. Their depositors constitute short-term (on-demand) creditors, while their assets typically take the form of longer-term loans. But, exemplified by the wide-ranging rescue of institutions like money market mutual funds in 2008, other types of firms and markets can become vulnerable to sudden crises, setting-off the possible specter of systemic collapse.⁹⁸

Regulation normally wields a range of tools to prevent such crises from occurring, as well as to respond to them when they do. Ex ante levers can include, for example, mandatory requirements on vulnerable firms to maintain buffers of high-quality assets that make a firm safer and less likely to end up without money.⁹⁹ Firms might be subject to regular “stress tests,” designed to interrogate how well they might withstand a sudden shock.¹⁰⁰ Federal insurance might prevent customers from panicking and rushing for the exits, where the state stands behind the promises made by a financial firm. U.S. bank accounts, notably, are protected by insurance that promises to cover up to $250,000 worth of deposits.¹⁰¹ Expert monitoring by regulators can help spot and punish the kinds of risky behaviors that might lead to a crisis and loss of customer confidence.¹⁰² In turn, ex post tools can also mitigate harm as and when they arise. Regulators might step in with emergency loans. The Federal Reserve, for instance, offers banks a “lender of last resort” facility, providing bridge lending during difficult times.¹⁰³ In extreme cases, liquidity support can take the form of federal facilities set up with the specific purpose of prioritizing systemic stability, even if such rescues protect firms that otherwise deserve to fail.¹⁰⁴ Or, if there is no prospect of a rescue, a specialist insolvency regime can step in to wind down a failing institution before its collapse can contaminate the rest of the market. In the context of banking, the Federal Deposit Insurance Corporation¹⁰⁵ operates a resolution regime for failed banks, designed to ensure that their loans and deposits can be transferred to viable firms without lengthy bankruptcy regimes that might leave depositors in limbo.¹⁰⁶

Crypto markets have shown themselves capable of inhabiting an ecosystem where systemic risks can manifest in a number of ways. First, as highlighted above, it is home to a number of centralized firms that constitute singularly important points of failure. Crucially, these firms have tended to become interconnected to a web of stakeholders, creating transmission pathways for losses to flow from one institution to another. FTX offers perhaps the most compelling example of such entanglement, where its sudden failure caused firms like BlockFi and Genesis also to seek bankruptcy protection.¹⁰⁷ Several traders failed too, as they were unable to retrieve their deposits from the FTX the platform.¹⁰⁸

Second, major centralized firms have shown themselves exposed to the costs of sudden runs, where customers seek to retrieve their funds en masse resulting in the platform suffering a cash crunch. FTX is again case in point, experiencing a wave of redemption requests from fleeing customers, eventually causing the firm to pause withdrawals.¹⁰⁹ Celsius, too, is instructive. According to a study by the Federal Reserve Bank of Chicago, 35% of all withdrawals in June 2022 (just before Celsius filed for bankruptcy protection) came from relatively wealthier depositors–– customers each with crypto worth more than $1 million in their accounts.¹¹⁰ Those holding $500,000 ended up being the fastest to retrieve their money. Put differently, larger institutional customers, likely possessing financial sophistication and reasonably roomy balance sheets, were among the most liable to trigger a panic. And, by dint of their size and resources, their private instincts to run resulted in a cost on those that could not adjust their behavior as quickly (i.e., less wealthy customers).¹¹¹

Unlike traditional markets, however, exposure to run-risk has come without the usual ex ante and ex post levers that might mitigate panic and control the costs of fallout. Even as a swath of crypto market participants––retail as well as institutional actors––faced the prospect of devastating losses, they lacked recourse to protections taken for granted in traditional financial markets (e.g., federal deposit insurance).

2. Addressing Information Gaps

A second key objective of financial regulation lies in addressing information gaps and the costs that they pose.¹¹² This involves ensuring that regulatory supervisors as well as market participants can acquire insight about the riskiness of claims and assets alongside an understanding of the institutions that operate within the perimeters of financial and capital markets. In seeking to intermediate the informational environment, policy can also seek to create ways in which thorough due diligence becomes less important, for example, where the claims being issued are presumed to be so safe that detailed investigation would be a waste of time and money.¹¹³ Broadly seen, regulation can work to provide tools and create incentives for reducing information costs, improving the accuracy by which risk is priced. It can help firms and investors protect themselves by equipping them with insight as well as offer spaces for creating informationally-insensitive claims, contracts that do not need a great deal of due diligence owing to their perceived safety, connecting parties in situations that might otherwise showcase complexity, and unknowable risks.¹¹⁴

perma.cc/2ZHA-GLDT] (highlighting varying interpretations of the notion of information insensitivity). A full discussion of this interplay between information deficits in markets and regulation is outside the scope of this Article. A few examples, however, serve to underscore how foundational this relationship is for shaping key aspects of market design.

First, regulation can help ensure that the marketplace enjoys a baseline level of insight about key claims and assets. When a company issues equity or debt in public markets, the worth of the promised cash flows emerges through an understanding of the capacity of the firm to deliver on its promises. At a very general level, whether and how it can do so constitutes a function of many aspects of its enterprise, such as its organization, governance, business model, and industry. This multiplicity of factors helps shape the kinds of results that a firm can achieve and, ultimately, what kinds of future cash flows investors and other stakeholders might expect to receive.¹¹⁵

Regulation has stepped in to overcome some of the frictions that might cause actors to withhold information about their firm. As modeled by Sanford Grossman and Oliver Hart, disclosure can be excessively costly for a firm, creating a disincentive for revelation. It also might expose a firm to outside scrutiny, give away competitive secrets, or highlight managerial failures.¹¹⁶ At the same time, where the firm constitutes the most knowledgeable repository of its own activities, the chances that single investors (or even regulators) might be able to obtain information efficiently about and from it are slim, if not outright impossible. Everyday investors will not be able to muster the resources, or obtain the access needed, to acquire key details of the risks governing their claim. Even deep-pocketed institutional investors may be loath to share the fruits of their labor, forcing others to replicate the same research and analysis that might still be incomplete.¹¹⁷

Where firms have few incentives to distribute information freely, regulation can mandate full and honest disclosure. In seeking to punish those that fail to disclose or lie, regulation modifies the incentives against putting information into the marketplace. Such broad and freely available distribution of prized information affords all investors access to this knowledge, reducing the pressure on their own pocketbooks and minimizing the risks of duplicative investigation. Rather, investors might focus on honing the quality of their analysis, making money, or deriving some other gain by bringing new interpretations of the disclosures to the fore.¹¹⁸ In this way, investors can learn about the kinds of risks that they are carrying in a relatively systematic and thorough manner. They can protect themselves by charging more for their capital, taking other precautions (e.g., putting only so much at risk as they are willing to lose), and ensuring that their prior biases and expectations are better kept in check.¹¹⁹

In addition to ensuring information about claims, regulation provides ways to increase understanding about entities within the marketplace. Regulators benefit from knowing whether entities that are active within financial markets can do so safely and have the resources to fulfill their obligations to stakeholders (including customers). This also entails supervisors knowing that firms can look after themselves, with sufficient and accessible resources to pay creditors and to reduce the systemic risks they create for others.¹²⁰ In place of enabling a free-for-all, allowing anyone to set-up shop, regulation imposes stipulations designed to procure detailed information from a firm. For example, eligibility criteria demand that those seeking to do business satisfy entry conditions concerning internal corporate governance, balance sheet capacity, and customer protection.¹²¹ Supervisors can conduct examinations on a regular basis to assure themselves that the firm conforms to expected rules and standards. Enforcement actions offer regulators and others a mechanism to learn more about an entity generating suspicion (e.g., via discovery).

Finally, regulation can control information gathering and dissemination to account for some of the costs and effects of disclosure. In particular, regulation can determine who gets data, how fully, at what speeds, and at what time intervals. Even where transparency constitutes a valuable policy goal, full openness to the inner workings of complex institutions can, in some situations, constitute a risk in itself. For example, regulators are typically careful about how much information is publicly disclosed about banks (e.g., through stress tests or supervisions).¹²² Revelations about a bank’s balance sheet might foster panic where information ends up interpreted by the public as presaging a collapse, triggering a needless run on the firm.¹²³ Relatedly, developing disclosure regimes can also look to policies in which the goal lies in ensuring that relationships do not have to require detailed disclosure between parties. For example, where money is lent on a very short-term basis and fully collateralized, lenders have less need to invest in uncovering information on a borrower. Instead, this debt becomes more informationally-insensitive, allowing for credit to flow more quickly, with fewer formalities, and still providing for risk mitigation by the terms of the debt agreement.¹²⁴

Limited comprehensive regulation for cryptocurrency markets has thus resulted in a relative paucity of tools for addressing the need to create information about the quality of claims being traded and market participants.¹²⁵ Interestingly, crypto represents a unique mix between the transparent and opaque. On the one hand, it is defined by its reliance on blockchains, which intend to provide the ultimate in transparency––by ensuring that each transaction is readily inspectable¹²⁶––as described above.

On the other hand, crypto’s larger ecosystem is opaque, with critical aspects of its workings taking place without adequate standardization and verifiability. For a start, digital assets themselves can exhibit unknown risks for which even the traditional regulatory system can be a poor match. Crypto inhabits an informationally complex environment from the point of view of its technology. As Chris Brummer, Trevor Kiviat, and Jai Massari observe, crypto combines legacy informational deficits (e.g., about a token issuer’s internal governance) with novel considerations about technological riskiness that conventional regulatory paradigms are ill-suited to match.¹²⁷ Without an applicable and properly tailored regulatory framework, token holders must take on the costs of diligence privately. Even where they can get some help (e.g., through “white papers” that typically launch new crypto ventures), a lack of regulatory vetting for these disclosures can result in limited accountability for those producing them.¹²⁸ Exchanges too might demand information from token issuers seeking to list the asset on their exchange. But, even here, the approach is ad hoc and varies by venue, creating a hodge-podge of regimes for customers to try to follow.¹²⁹

Crypto market regulation also lacks tools to acquire information about key market participants. As noted earlier, exchanges are key pillars within the crypto ecosystem. Notwithstanding this significance, considerable uncertainty exists about their inner governance, the quality of their balance sheets, or their readiness to respond in a crisis. According to a May 2023 Financial Times survey of 21 of the most prominent crypto firms, many refused to supply critical information about their governance, measures for customer protection, and balance sheets––underscoring concerns raised in the wake of “crypto winter” failures about opaque and complex governance structures that pose a risk for stakeholders.¹³⁰ In the absence of express disclosure regimes to stipulate eligibility criteria or supervisory regimes to ensure compliance, certain crypto firms appear to lean heavily on opacity as a part of their business model.¹³¹

3. Protecting Customers and Stakeholders

Perhaps the most straightforward rationale for financial regulation lies in protecting customers and stakeholders.¹³² Investors and financial consumers routinely fall prey to scams, display biases and impulsivity, and open themselves up to losses that can result in enormous personal suffering.¹³³

perma.cc/A9GZ-CNJV] (noting the especial prevalence of investment fraud); Sec. & Exch. Comm’n, Social Media and Investment Fraud––Investor Alert (Aug. 29, 2022), https://www.sec.gov/oiea/investor-alerts-and-bulletins/social-media-and-investment-fraud-investor-alert [https://perma.cc/PK5W-ZKDG] (noting the ways in which social media might lure investors in scams). Beyond safeguarding customers against predation, regulation can also step in to secure financial assets and their integrity. Predictably, where vast pools of customer money are entrusted to an agent (e.g., a fund or bank), there is the risk of misuse, misappropriation, and mismanagement. To counter such “agency costs,” regulation provides a slew of measures to safeguard customer interests and counter the negative incentives of those holding money for others.¹³⁴

Arguably the most consequential for a customer’s everyday peace-of-mind are rules designed to ensure that their assets are safely custodied and accounted for, and, where custody arrangements work, to prevent such assets from being mingled with those of the agent (e.g., a broker) in the event of an agent’s insolvency. Customer protection rules in securities and commodities regulation, for example, set out detailed procedures for ensuring that customer assets are diligently protected.¹³⁵ A variety of measures enable such assurance to be offered through regulation. For example, rules governing brokers of traditional securities and commodities provide that customer assets must be fully segregated, so that there can be no mixing between a broker’s funds and those of the customer.¹³⁶ Additionally, the broker must rigorously track how customer assets are being handled and can only entrust them to reputable custodians. To ensure compliance, firms face examination by regulators and must maintain an appropriate paper-trail.¹³⁷ Firms that fall short risk economic penalties and may suffer reputational damage.¹³⁸ Those risks can extend to supervisors, incentivizing more rigorous policing. When the failed brokerage firm, MF Global, was found to have breached applicable rules for protecting and safekeeping customer assets, its frontline regulator (the Chicago Mercantile Exchange) came under heavy scrutiny¹³⁹ and ultimately paid $130 million to the broker’s customers.¹⁴⁰

Crypto customers are subject to similar risks (e.g., being scammed and seeing their funds stolen or misappropriated) but they do not today enjoy specific protections as part of a regulatory scheme. This leaves crypto customers exposed to a slew of dangers that they have little power to mitigate, while being afforded few practical levers under law to safeguard their interests privately. The costs of this regulatory gap have come into sharp focus, as millions of everyday crypto customers fell victim to a series of high-profile firm failures during 2022’s “crypto winter,” leaving them caught in uncertain and costly bankruptcy proceedings, rather than protecting them from these processes in the first place.

II. BANKRUPTCY IN CRYPTO WINTER

Part I charted the limited federal regulatory landscape for the cryptocurrency industry. Post-pandemic, the crypto-market experienced sharp growth and, as a result, there was a period of time during which the digital asset marketplace was flush with customer money and able to operate freely in the relative shadows outside of a dedicated system of oversight. This created, predictably, room for mischievous C-Suite behavior, where billions in customer deposits could be lured with promises of outsized returns (typically adorned with marketing puffery about corporate integrity, transparency, and investment safety) but without providing customers any real capacity (e.g., through mandated disclosures) to know what was truly happening. A series of catalytic events would bring down large segments of the industry in mid-2022, starting the so-called “crypto winter.” Major Chapter 11 filings followed. But, while bankruptcy is used to cleaning up individual corporate messes, it is not the arm of government usually charged with taming unruly facets of a financial system. But, by necessity, that has become an inadvertent aspect of the work performed by bankruptcy courts in seminal crypto cases, as described in this Part below.

A. A Brief History of Crypto Winter

In May 2022, the Terra/Luna stablecoin ecosystem suffered a surprise crash, wiping out approximately $60 billion in value from digital asset markets.¹⁴¹ The hedge fund Three Arrows Capital held significant investments in Luna and, consequently, was immediately forced into liquidation in the British Virgin Islands.¹⁴² This resulted in the default of around $657 million in unsecured debt Three Arrows owed to Voyager, the crypto quasi-bank and brokerage firm.¹⁴³ As word spread, Voyager became inundated with customer withdrawal requests, prompting it to suspend trading and redemptions¹⁴⁴ A week later, Voyager filed for Chapter 11 protection.¹⁴⁵ Contagion also hit Celsius, another crypto quasi-bank. Celsius too was required to pause customer redemptions and withdrawals, ending up in bankruptcy come mid-July.¹⁴⁶ BlockFi, yet a third large quasi-bank, avoided bankruptcy by tethering itself to FTX, securing emergency financing from the then-powerful exchange.¹⁴⁷

On November 2, 2022, a leading news service dedicated to cryptocurrency, CoinDesk, reported (based on a leaked internal document) that the wealth of FTX’s hedge fund affiliate, Alameda Research, was largely comprised of FTX’s native token, called FTT.¹⁴⁸ This crypto asset was issued by the exchange itself and offered to customers, promising holders a variety of rewards like reduced trading fees, loyalty benefits, and miscellaneous customer services.¹⁴⁹ As the exchange’s popularity had grown, so too had the market value of FTT, even though the token’s intrinsic worth was controlled in key ways by FTX management (e.g., by calibrating the available float).¹⁵⁰ Thus, for purposes of determining FTX’s enterprise value, FTT may be better likened to FTX treasury stock than value independent of the corporate entity itself. ¹⁵¹

Prior to this publication, the public did not know the skewed composition of Alameda’s balance sheet. Once disclosed, the market reacted with fury. Binance, for example, promptly announced it would sell all of its FTT holdings.¹⁵² Watching its enterprise value plummet, FTX immediately offered to sell itself to Binance––which alone seemed financially positioned to catch the company in free-fall.¹⁵³ After some cursory due diligence, Binance passed on the offer,¹⁵⁴ thickening the cloud of suspicion hovering over FTX. Nine days after CoinDesk’s publication, FTX collapsed into bankruptcy.¹⁵⁵ Restructuring specialist John J. Ray III was appointed to succeed Bankman-Fried as CEO, and Ray promptly declared that, in his “40 years of legal and restructuring experience,” he had never seen “such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”¹⁵⁶ Bankman-Fried was soon arrested.¹⁵⁷

FTX’s sensational collapse deepened 2022’s “crypto winter.” The token native to Crypto.com, another large exchange, lost $1 billion in market value virtually overnight.¹⁵⁸ BlockFi, facing another round of withdrawal demands, liquidated all of its domestic crypto portfolio and filed for Chapter 11 protection.¹⁵⁹ Core Scientific, one the largest crypto mining firms, also filed for bankruptcy.¹⁶⁰ Genesis, the brokerage firm, lasted outside of bankruptcy only until mid-January 2023,¹⁶¹ as discussed above. Smaller and ancillary crypto companies succumbed as well.¹⁶²

On January 31, 2023, the court-appointed examiner in the Celsius Chapter 11 case filed her final report.¹⁶³ Purportedly, Celsius too operated in a deceitful manner: “In every key respect—from how Celsius described its contract with its customers to the risks it took with their crypto assets—how Celsius ran it [sic] business differed significantly from what Celsius told its customers.”¹⁶⁴ On July 13, 2023, the company’s founder and CEO, Alex Mashinsky, was arrested and charged with seven criminal counts, including securities and wire fraud.¹⁶⁵

The rash of bankruptcies and revelations of customer deception––following patterns that overlap across companies––began infusing popular culture. Late night television hosts turned crypto headlines into crypto punchlines.¹⁶⁶ The FTX logo was removed from the Miami Heat’s stadium.¹⁶⁷ Consumer fraud claims were filed against not only crypto executives but also celebrities that had provided paid endorsements.¹⁶⁸ Charlie Munger, Berkshire Hathaway’s venerable chairman, declared the cryptocurrency market to be “stupid and evil” and that digital assets are only useful to “kidnappers.”¹⁶⁹ Both chambers of Congress began a series of hearings focused on, among other things, what the government should do to rein in the perceived lawlessness.¹⁷⁰ But, neither Congress nor traditional regulatory arms of government (e.g., SEC and CFTC) seized the moment, essentially deferring to bankruptcy courts to assume immediate responsibility.

Chapter 11 thus became the default legal framework, overseeing not only the affairs of each individual debtor but also, seemingly, the trajectory of the industry more generally. Millions of individual customers had entrusted tens of billions to debtors that, collectively, controlled a substantial share of the ecosystem. How could all of this have happened? What kinds of value-maximizing strategies would be available to resolve these cases and deliver real value to customers as quickly and efficiently as possible? And how could bankruptcy’s recuperative powers help an industry in tumult, with government agencies still competing for jurisdiction, and a regulatory void still in existence? This simultaneously became the charge of several bankruptcy courts, primarily in New York, Delaware, and New Jersey. But, to better understand their particular case work, it first must be contextualized through the lens of Chapter 11’s general missions and mechanisms.

B. A Primer on Chapter 11’s Missions and Mechanisms

Chapter 11’s baseline theory is that business reorganization is preferable to liquidation.¹⁷¹ Rehabilitating productive, albeit insolvent, firms can generate more distributable value.¹⁷² It insulates contagion by preserving and continuing customer/vendor relations, jobs, retiree benefits, and future tax payments.¹⁷³ Reorganization also helps solve the so-called “common pool” problem––that is, the tendency of competing creditors to destroy value by racing to take before all others––by channeling stakeholders toward a durable system that prioritizes distributable value (e.g., equity in a reorganized entity) over distributable cash.¹⁷⁴ And, it provides legal rules that are not only flexible but also sophisticated about emerging economic and market theories,¹⁷⁵ as exemplified by developments in distressed debt financing and investment techniques.¹⁷⁶

The Bankruptcy Code, for all its size and complexity, boils down to five essentials: (1) the creation of the bankruptcy estate;¹⁷⁷ (2) the statutory pause and protective blanket of the automatic stay;¹⁷⁸ (3) interim steps a debtor may take to maintain and hopefully augment enterprise value, such as entering into a new financing arrangement (“debtor-in-possession” or “DIP” financing)¹⁷⁹ and the rejection of burdensome contracts and leases;¹⁸⁰ (4) rules governing value distribution to stakeholders, typically via a confirmed plan of reorganization;¹⁸¹ and (5) the debtor’s entitlement to lead the bankruptcy,¹⁸² subject to an effective adversary process.¹⁸³ The outcome is, in theory, supposed to distribute reorganization value largely consistent with stakeholder expectations established pre-petition under contract and other non-bankruptcy law.¹⁸⁴

The Bankruptcy Code does not look much further than the interests of the debtor and its stakeholders.¹⁸⁵ It provides a list of options available for the debtor to try to solve its financial woes; and, it offers rights and empowerments enabling stakeholders to counter or even undermine the debtor’s intended reorganization strategy.¹⁸⁶ The debtor is required to continue post-petition as a law-abiding corporate citizen¹⁸⁷ and the government’s police powers are excepted from the automatic stay.¹⁸⁸ But, the “general public interest” finds little quarter in the statutory regime.¹⁸⁹ The adversary process, rather, pits the debtor on one side of the bargaining table (and courtroom) against its stakeholders––typically, bank lenders and the official committee of unsecured creditors––on the other side.

Bankruptcy court jurisdiction hews close to this scheme. Bankruptcy courts are not Article III tribunals with full judicial power over life, liberty, and property; bankruptcy courts are, rather, Article I tribunals of limited authority.¹⁹⁰ Bankruptcy judges may only decide issues that are “core” to the bankruptcy, meaning those “arising in” or “arising under” the Bankruptcy Code.¹⁹¹ That includes matters such as DIP financing, asset sales, contract assumption or rejection, and plan confirmation¹⁹² Bankruptcy courts also may adjudicate matters “related to” the bankruptcy, but only if the litigants consent;¹⁹³ otherwise, the court may only issue proposed findings of fact and conclusions of law for the overseeing district court to consider.¹⁹⁴ Bankruptcy courts cannot conduct jury trials without litigant consent;¹⁹⁵ they cannot send anyone to prison for criminal contempt;¹⁹⁶ and, they cannot render judgments on personal injury claims.¹⁹⁷ Matters beyond what directly concerns the debtor and its stakeholders are for other courts to decide.¹⁹⁸

Separately, bankruptcy’s adjudicatory process is peculiar. In most commercial litigation, the plaintiff seeks redress for a past event. An alleged wrong happens, and the trial can be scheduled any time after the complaint is filed and pre-trial procedure has run its course. Chapter 11, by contrast, litigates to a future event, again most often confirmation of a plan of reorganization. The debtor’s business rehabilitation is, in other words, a sort of “becoming” in which much of the nucleus of operative fact develops post-petition, as the reorganization takes shape.¹⁹⁹ The process is, nevertheless, often pressured and time constrained. The debtor’s exclusivity periods to file and then solicit acceptances for a plan are not limitless.²⁰⁰ And, in cases where DIP financing is required (that is, most business cases), it is customary for such loans to include “milestone” covenants or a near-term maturity––essentially a ticking timebomb for the case.²⁰¹ The debtor must move the case along quickly, all the while meeting performance and other covenants, or the DIP lender may cut off liquidity.²⁰² The adjudicatory process thus invariably melds legal principle with pragmatism and business necessity.²⁰³ The Bankruptcy Code allows for this by establishing rules that, among other things, lean heavily on judicial discretion.²⁰⁴ But, in practice, that means bankruptcy courts are often required to make interim case decisions on relatively thin evidentiary records, always trying to preserve and advance the process to some form of successful outcome. ²⁰⁵

Further, getting to a confirmable plan can be brutal work.²⁰⁶ Section 1129 of the Bankruptcy Code imposes extensive structural, voting, and evidentiary requirements for plan confirmation, especially for so-called “cram down” on non-consenting classes.²⁰⁷ Stakeholders use those rules for their benefit, threatening and jockeying for larger helpings.²⁰⁸ They may accumulate “blocking” positions in critical debt classes.²⁰⁹ They may contest ambiguities and assumptions undergirding the debtor’s business plan and proposed reorganization value.²¹⁰ They may strategize to exclude others from plan treatments²¹¹ or exploit the debtor’s desperation for DIP or exit financing.²¹² Stakeholders exploit ingenious structures to fleece others in the capital structure, sometimes even above or within the same class.²¹³

These cases can, in sum, burn hot in their own self-contained crucible until extinguished by winnowing fuel or other paramount need for resolution. The announcement of a plan, any plan, can bring about hope and a sense of relief. The costs can be astounding, both in terms of administrative expense and consumption of judicial resources.²¹⁴ This is especially true in complex, multilayered cases.

To avoid this, bankruptcy tends to nudge stakeholders toward settlement. It does this in two primary ways. First, the Bankruptcy Code compels disclosure of substantial private information. Mandatory public disclosures include the debtor’s schedules of assets and liabilities,²¹⁵ statement of financial affairs,²¹⁶ monthly operating reports,²¹⁷ and a disclosure statement to inform voting on any plan of reorganization.²¹⁸ A debtor will invariably supplement the record with additional disclosures as it seeks interim relief from the bankruptcy court over the course of its Chapter 11 case.²¹⁹ Stakeholders may demand discovery in connection with any case dispute.²²⁰ They also may seek extraordinary discovery from the debtor and third-parties under Bankruptcy Rule 2004, so long as such discovery may serve a useful bankruptcy purpose.²²¹ In cases involving disconcerting facts, the bankruptcy court may order the appointment of an examiner to conduct an investigation and publish a “tell-all” report of their findings.²²² In these ways, bankruptcy embraces the unremarkable proposition that knowledgeable negotiations are ultimately more efficient and efficacious. Bankruptcy courts enforce this expectation.

Second, bankruptcy courts render decisions over the course of the Chapter 11 process that narrow points of disagreement. “Contested matters,” i.e., general bankruptcy motion practice, are resolved with procedural expediency;²²³ “adversary proceedings,” i.e., mini-lawsuits within the bankruptcy, follow more traditional federal civil procedure.²²⁴ But, either way, the bankruptcy court will often bring the matter to a quick evidentiary presentation, followed by a clear ruling that guides the case towards larger resolution. A bankruptcy court might, for example, determine, well in advance of a plan, whether a creditor does or does not have a perceived value entitlement; by resolving the dispute (one way or the other), the court clears a path to more effective plan negotiations.²²⁵ Same is true for corporate decision-making: if the case generates substantial allegations of corporate wrongdoing and such allegations start to inhibit negotiations, the court may prompt management changes.²²⁶

Respecting financial firms (e.g., a bank holding company or brokerage firm), bankruptcy relies on and works in tandem with regulatory authorities.²²⁷ By the time of filing, a financial debtor typically has been policed by government regulators (e.g., the SEC, CFTC, or the Fed) for quite some time. The company’s books, records, public disclosures, and manner of business have long been based on rules and expectations established by those administrative supervisors.²²⁸ The regulatory interplay is supposed to continue post-petition, with bankruptcy focusing primarily on a reworked balance sheet and regulatory authorities keeping an eye on operational developments.²²⁹ This affords regulatory agencies some leeway to intervene in the bankruptcy, asserting non-economic imperatives. As Jared Ellias, George Triantis, and Robert Rasmussen have observed, the interplay between bankruptcy and regulatory regimes can generate considerable case frictions.²³⁰ But, if all goes well, the company leaves bankruptcy in a stronger financial position, without objections voiced by regulatory supervisors.²³¹

This is the context in which bankruptcy courts have been engaged to oversee the factual development and consider the legal implications of 2022’s “crypto winter.” The crypto bankruptcies have, to date, shed disinfecting light on some of the industry’s darkest corners, revealing what may have occurred there and who may bear responsibility for the staggering losses. Bankruptcy courts have also rendered rulings that not only propel their cases forward, but also instruct the crypto community––and market regulators––more generally. Bankruptcy has, furthermore, provided a unique forum for regulatory involvement and, it seems, an occasional clash of economic and agency agendas. Below, we set out two case studies that exemplify the ways in which the bankruptcy court has emerged as a sort of default regulatory forum for crypto markets.

C. Crypto in Chapter 11: The Celsius and Voyager Cases

1. Celsius

Celsius, founded in 2017 and led by Alex Mashinsky, grew over a few years to be one the largest crypto finance platforms in the world. It presented itself as a sort of virtual bank. Individual customers could electronically, via computer or cellphone, deposit their crypto assets in a Celsius “Earn” account (akin to a traditional savings account) and accrue a relatively high rate of interest, payable in kind or in the Celsius native token, called the “CEL.”²³² Customers could borrow fiat money from Celsius (e.g., to pay household expenses with fewer tax consequences)²³³ collateralized by their deposited crypto in the Earn account.²³⁴ Celsius would, in turn, lend deposited crypto to third-parties, pocketing what it made in interest/fee income over what it owed to the account holders.²³⁵

Earn accounts, though functioning economically like general savings accounts, were not insured by the FDIC.²³⁶ Not to worry, said Celsius. The company’s management emphasized “safety,” touting that “our top priority is keeping your assets secure.”²³⁷ Celsius would not lend capital to third-parties without first conducting extensive diligence, and would use deposited capital only in “a very conservative” way, “such as only allowing very small or overcollateralized positions.”²³⁸ Even though Celsius was not a public reporting company, customers were promised even better disclosure: Celsius committed to “publish to a blockchain all our transactions which will provide users transparency as to how many coins we have and what they are used for.”²³⁹ Any Earn account holder that did not like how the business was operating had the ability to pull his money out at a moment’s notice.²⁴⁰

The company’s marketing strategy also sought to play into crypto’s anti-establishment ethos. As discussed above, Celsius was a home for those wanting to “unbank” themselves and thereby enjoy a newfound “financial freedom.”²⁴¹ Here, an everyday customer could “dream big” and help pursue “economic opportunity and income equality to everyone in the world,”²⁴² just as the people were freed from quarantine and the so-called “Great Resignation” became a mass phenomenon.²⁴³ Mashinsky presented himself as the leader of this “financial freedom” movement.²⁴⁴

The marketing strategy worked. By December 2020, Celsius had more than $3.3 billion under management²⁴⁵ and, by January 2021, that figure had grown to $4.5 billion.²⁴⁶ In October 2021, the business was valued at $3 billion.²⁴⁷ Management expedited plans to grow internationally, including the acquisition of an Israeli cybersecurity firm in October 2021.²⁴⁸ Come May 2022, Celsius had almost $12 billion under management and more than $8 billion in loans outstanding to third- parties.²⁴⁹ It boasted 1.7 million registered users by July 2022.²⁵⁰ Then it all came to an abrupt end: Luna’s collapse segued into a run-on-the-bank scenario for Celsius, leading to a brief suspension of withdrawals, and the company’s emergency Chapter 11 filing on July 13, 2022.²⁵¹

The bankruptcy was, from its inception, surrounded by controversy. In his “first day” declaration, Mashinsky asserted that Celsius was a sound, well-run company victimized by extraneous forces and rumor mongering.²⁵² He attributed the company’s financial troubles to the “macroeconomic” crypto environment and world economy, with only passing reference to certain “poor asset deployment decisions.”²⁵³ Purportedly, the bank-run was due to “unsupported and misleading” news reports.²⁵⁴

For many, the narrative did not add up. How could Celsius find itself in this position if it deployed capital in only “very conservative” ways? Indeed, Mashinsky’s own declaration admitted a “shortfall” in its balance sheet of at least $1.2 billion and about one-third of its loan book was comprised of “bad” debt.²⁵⁵ Moreover, news outlets started reporting that, while Celsius was touting CEL, Mashinsky was liquidating tens of millions of the native token from his personal account.²⁵⁶ Former employees began leaking stories of excessive risk-taking, disorganization, and perhaps even market manipulation.²⁵⁷

On September 14, 2022, the bankruptcy court entered an order directing the appointment of an examiner to conduct a broad-ranging investigation into the facts undergirding the case.²⁵⁸ Two weeks later, Mashinsky resigned as CEO.²⁵⁹ On September 29, 2022, the bankruptcy court approved the appointment of former federal prosecutor, Shoba Pillay, as examiner.²⁶⁰

On January 30, 2023, Pillay published her “tell-all” final report, a scathing 689-page description of the company and its historical practices. The report explained: (1) how the cryptocurrency ecosystem operates;²⁶¹ (2) Celsius’ important role in that ecosystem as a sort of virtual thrift bank for millions of individual customers;²⁶² (3) how the business operated day-to-day, including granular investment choices;²⁶³ and (4) how those operations and business decisions differed materially from what was represented to customers.²⁶⁴ Despite customer promises of disclosure and transparency, Celsius “frequently” made statements “that were inaccurate and misleading.”²⁶⁵ According to the report, Celsius ultimately could not generate earnings over what it owed customers, driving it into ever riskier investments that ultimately caused its undoing.²⁶⁶ The report includes an internal email describing certain corporate strategies as “very ponzi like.”²⁶⁷ It also revealed that, despite mounting corporate losses, Mashinsky pocketed nearly $70 million by selling his personal holdings in CEL, while the company was hawking CEL’s (supposed) intrinsic value to the market.²⁶⁸ The final report is a detailed account that, again, likely contributed to Mashinsky’s indictment and arrest seven months later.

Disclosure aside, Celsius came to bankruptcy with billions in assets, including fiat cash, crypto assets, a loan book, mining interests, and other hard and inchoate assets,²⁶⁹ which needed allocation among and distribution to the company’s creditors (predominantly customers). Prior to bankruptcy, management repeatedly communicated to the customer-base that crypto deposits remain “your” crypto,²⁷⁰ giving the customers the clear impression that Earn accounts liken better to safe deposit boxes than traditional savings accounts. With Celsius in bankruptcy, 600,000 Earn account holders, who had collectively deposited $4.2 billion, wanted “their” crypto traced, excepted from the automatic stay, and immediately released to their rightful owners.²⁷¹ This was, after all, what Mashinsky had promised all along.²⁷²

Celsius’ advertising puffery did not, however, match up with what was written in the customer agreements. Earn customers may not have realized, when they signed their Celsius contracts, that deep within the legalese was a transfer of ownership of all digital assets deposited into an Earn account.²⁷³ Earn depositors could redeem such assets at will, requiring Celsius to go into the market to cover any demanded crypto it did not then have in treasury. But, after deposit and prior to redemption, the crypto belonged to Celsius and could be exploited as management saw fit for the company’s own profit-making purposes.²⁷⁴ The contract relationship was, contrary to Mashinsky’s “unbank” representations, very much like that of traditional depository institutions.²⁷⁵

This entitlement issue was, as described by the bankruptcy court, “a gating issue at the center of many disputes in this case.”²⁷⁶ On January 4, 2023, following an evidentiary hearing, the bankruptcy court issued its opinion resolving the matter. The court concluded that, despite the marketing representations and client expectations, the language of the customer agreements control.²⁷⁷ Earn customers were merely unsecured creditors in the Celsius Chapter 11 cases, entitled to recover the remainderman’s interest after payment of ever-ballooning administrative expenses.²⁷⁸ Deposits were not, in sum, “your” crypto after all²⁷⁹ and, making matters worse, the deposits were not FDIC insured. The ruling delivered a painful lesson not only to the 600,000 Celsius Earn customers, but also hundreds of thousands of BlockFi customers who deposited their crypto in comparable accounts and came to learn that the Celsius ruling would be followed in BlockFi’s bankruptcy as well.²⁸⁰

2. Voyager

Voyager was founded a year after Celsius (in 2018) and, like Celsius, also focused its marketing strategy on individual crypto enthusiasts. But, Voyager was a hybrid brokerage and quasi-banking firm. Customers could trade, after depositing digital assets, using an interface accessible via the Voyager app.²⁸¹ They just needed to sign a customer agreement, download the app, and then select which of over one hundred asset types they wanted to buy or sell.²⁸² Voyager made money by pocketing the spread between the buy and sell prices of traded crypto assets and by relending customer deposits, akin to Celsius and BlockFi.²⁸³

Like Celsius, Voyager too experienced explosive growth.²⁸⁴ In 2020, Voyager counted only 120,000 users on its platform.²⁸⁵ A year later, Voyager’s app was among the top 10 in the world.²⁸⁶ At year-end 2021, Voyager had nearly $5.9 billion in assets under management.²⁸⁷ By springtime 2022, it counted over 3.5 million users.²⁸⁸ Then came the Luna collapse and Three Arrows defaulting on its $657 million Voyager loan. Mass customer redemptions followed.²⁸⁹ Voyager filed for bankruptcy protection on July 5, 2022.²⁹⁰

Given Voyager’s abrupt failure, the board of directors created a special committee to investigate underlying facts.²⁹¹ The special committee retained independent counsel to conduct this investigation.²⁹² The investigative report was made public (in redacted form) on February 14, 2023.²⁹³ The report focused on the decision-making process driving the Three Arrows loan, which was put in place only a few months before Luna’s collapse.²⁹⁴ As detailed, management conducted negligible diligence before agreeing to lend Three Arrows up to $1 billion. Prior to committing capital, Voyager: (i) received merely a single-line statement in lieu of detailed financials, to wit, “We confirm the following for Three Arrows Capital Ltd as at 1-January-2022 in millions of USD. NAV 3,729”;²⁹⁵ and (ii) conducted a single due diligence call with two executives from Three Arrows, where no mention was made of the fund’s Luna exposure.²⁹⁶ None of the loans were collateralized.²⁹⁷ At the time of Voyager’s bankruptcy filing, the Three Arrows debt represented nearly 58% of its loan book.²⁹⁸

Blame aside, Voyager’s bankruptcy––like all bankruptcies–– required an exit strategy. At case inception, Voyager proposed a plan of reorganization.²⁹⁹ This was, however, merely an aspirational statement, given the tumultuous state of the industry in July 2022.³⁰⁰ The plan, nevertheless, functioned as a kind of “stalking-horse” for alternative exit strategies, particularly a sale transaction.³⁰¹ On August 5, 2022, the bankruptcy court approved bid procedures, initiating an M&A process designed to find a buyer for Voyager.³⁰² That process concluded in September, with FTX advancing a $1.422 billion offer to buy the company.³⁰³ That transaction had not yet closed when, in November, CoinDesk published its article outing FTX as a possible fraud, and the company imploded.³⁰⁴

This was devastating news for Voyager and its stakeholders.³⁰⁵ By then, Voyager had incurred millions in professional fees chasing the FTX deal.³⁰⁶ Fortunately, Voyager found another potential suiter: Binance.US,³⁰⁷ the American affiliate of Binance, the behemoth cryptocurrency exchange.³⁰⁸ In December, Binance.US agreed to acquire Voyager for approximately $1.022 billion, and the transaction would be consummated as part of Voyager’s pre-existing plan of reorganization.³⁰⁹ Under the plan, Voyager customers would transition to the Binance.US platform, subject to various vetting procedures.³¹⁰ Ineligible customers would have their crypto liquidated and receive the cash proceeds.³¹¹ Same for customers located in jurisdictions where Binance.US was not licensed to provide digital currency services.³¹²

But, there was a problem. The federal government, as well as the SEC, United States Trustee, and several state regulatory agencies expressed concerns over Binance.US as purchaser.³¹³ Binance.US, it seems, was an entity of concern for federal and state regulators, evoking government suspicion that it was not a suitable buyer for Voyager’s expansive role in the U.S. market.³¹⁴ The SEC, in particular, contended that the Binance.US transaction and its distribution of digital assets to creditors might end up violating federal securities law,³¹⁵ with the federal government furthering that, as a matter of principle, the plan should not have any preclusive effect on regulatory authorities (federal or state) if the transaction or such distributions are subsequently found to be wrongful.³¹⁶ That meant, among other things, that Voyager and Binance.US executives, as well as bankruptcy professionals advising the debtors and the official committee of unsecured creditors, could face post-consummation regulatory scrutiny––perhaps even liability––for supporting and helping consummate the plan.³¹⁷

The bankruptcy court was unmoved by these arguments. The court accepted Voyager’s contention that the proposed transaction was the most value-maximizing path forward, with approximately $100 million in value over liquidation.³¹⁸ The court disagreed, as a matter of fundamental bankruptcy principle, that parties should remain liable under securities laws for helping the plan close and, in turn, fulfilling their statutory mandates under the Bankruptcy Code, especially as the government equivocated on whether the Binance.US transaction would or would not actually violate securities laws.³¹⁹ The court further chastised the government objectors for interposing objections rooted in speculation, not evidence.³²⁰ The court ultimately overruled the objections, and the plan was confirmed.³²¹ Voyager was thus authorized to move forward with the sale to Binance.US.³²²

The government appealed, focusing its argument on the plan’s exculpation provision, contending that it infringed on its regulatory authority to prosecute enforcement actions against, among others, those working to close the deal.³²³ A motion for stay pending appeal followed shortly thereafter.³²⁴ The appeal did not go far, however. In the face of these developments, Binance.US exercised its right to terminate the transaction, decrying the “hostile and uncertain regulatory climate in the United States.”³²⁵ On April 25, 2023, Voyager announced that it had pivoted to liquidation.³²⁶

The Voyager case story is, from the perspective of bankruptcy law, rather strange: the most value-accretive case solution was scuttled based on unproven contentions. But, considering the government’s larger regulatory ambitions, it is instructive. Management remained in possession throughout the case. The case background factswere not buried. The public ultimately received exacting, candid, and stark disclosures of how the C-Suite took excessive risks with customer deposits (i.e., the Three Arrows loan). These disclosures, when married with comparable revelations from the BlockFi, Celsius, Cred, and FTX cases, reflect patterns of governance failures that can be targeted by administrative agencies as well as the consuming public. Moreover, with respect to the failed Binance.US transaction, the case illustrates––in about as clear and impactful way as possible––how bankruptcy can provide an oddly effective forum for public regulators to advance their administrative agendas, prior to comprehensive regulatory reform, with relative ease and crisp effectiveness. That is so, even if the bankruptcy court is left almost entirely in the dark about what is motivating aggressive agency response.

These observations point to a number of gains for overseers arising out of the bankruptcy court’s role as accidental quasi-regulator. Just as traditional financial regulation seeks out ways to protect the marketplace, produce information on its risks, and safeguard user interests, the court’s unique legal toolkit can achieve outcomes aligned with these regulatory objectives. Indeed, there is an argument that the court’s intervention comes with specific advantages. The capacity of bankruptcy judges to exercise wide discretion in applying statutory measures, combined with powers to compel delivery of detailed disclosures, can allow for a flexible, solutions-orientated approach that may be especially well-suited to address the novel, evolving nature of the crypto industry. An objective examiner’s report (e.g., Cred and Celsius),³²⁷ for example, can reveal insights about a firm and its industry that may not be easily discernible through regular, standardized disclosures, where a company might present its affairs in an overly curated, sanitized light. Approaches to address thorny problems like valuation of crypto assets (e.g., Voyager) can reflect efforts on the part of any number of experts enlisted by the court, including regulatory agencies. This can better equip judges to develop resolution strategies that stand the best chance of success in addressing risks and distress within a novel, understudied asset class like crypto. Further, the public nature of the bankruptcy process means that the court’s efforts are afforded general scrutiny (including on social media). There is signaling of regulatory priorities (e.g., customer protection). And, the court’s judgments and analysis create opportunities for wider learning about the legal complexities (e.g., custody) and industry characteristics of crypto markets.

Yet, even as bankruptcy courts have risen to meet the legal and economic challenges posed by “crypto winter,” the consequences of their engagement reveal the high costs of relying on these courts to function as proxy financial regulators. As we discuss in Part III, bankruptcy courts are highly specialized actors that are poorly suited to act as general overseers and rule-makers for any financial industry.

III. THE BANKRUPTCY COURT AS (IMPERFECT) CRYPTO MARKET REGULATOR

Part II showed how bankruptcy is, functionally, administering the clean-up of large segments of the crypto ecosystem. It observes that some of bankruptcy’s work is serving non-bankruptcy regulatory objectives, including broad and exacting public disclosures, management accountability, loss allocation in ways that are instructive to regulators and crypto investors, even opportunity for traditional government supervisors to advance policy objectives before enactment of corrective regulation. This contention might, however, be troubling, perhaps even to the bankruptcy judges overseeing the crypto cases. As explained in Section II.B, bankruptcy’s purpose and intentions look no further than the estate and its stakeholders. Any larger-scale administrative objectives served by bankruptcy are, therefore, more or less incidental to––rather than and by virtue of––the Bankruptcy Code’s underlying design.

There lies the trouble with relying on bankruptcy courts to serve as default quasi-regulators. This Part surveys the implications. We observe that there are difficult tensions between core bankruptcy policies and those of more traditional financial regulation. Particularly on matters of systemic risk or customer protection, bankruptcy’s usual focus––looking to safeguard, augment, and ultimately distribute estate value––can result in destabilizing and costly externalities for actors like customers or creditors. Though knock-on hardships are commonplace and expected in insolvencies, bankruptcy courts cannot deploy the kind of tools available to financial regulators (e.g., to backstop customer money claims or provide emergency bridge financing for struggling counterparties) to shore up a hurting market or ensure its go-forward integrity.

Even disclosure, a foundational regulatory device, furthers a different imperative in bankruptcy. The timing, extent, and even reliability of bankruptcy disclosure encapsulates the point-counterpoint nature of bankruptcy’s adversary process. It is sharply focused on its intended audience––Chapter 11 stakeholders––not the markets more generally. Such disclosures can only instruct and, hopefully, positively affect crypto market development by presenting cautionary tales. Bankruptcy courts can do little more for the wider audience.

Finally, the frictions exemplified by BlockFi, Celsius, FTX, Genesis, Three Arrows, and Voyager illustrate the costs to financial market design where policy looks to the bankruptcy court as a frontline regulator––rather than as but one critical part of an otherwise larger, dedicated architecture for oversight and resolution. Requiring bankruptcy courts to step into a leadership role, rather than to adjudicate within an existing framework for oversight (where oversight is largely entrusted to other facets of government), imposes on these courts a responsibility far outside of their usual functions and capabilities, creating enormous inefficiency and, in the end, grave concerns over effectiveness.

A. Systemic Risk and The Bankruptcy Code

The interventions of bankruptcy courts in the context of crypto have exemplified the tensions between the Bankruptcy Code and financial regulatory approaches designed to address systemic risks. As noted in Part I, crypto markets showcase the potential for externalities––where institutions like exchanges (e.g., FTX, Genesis, and Voyager), quasi-banks (e.g., BlockFi and Celsius), and hedge funds (Alameda and Three Arrows) pose dangers to others, resulting in the creation of pathways for risk to move from one firm to others rapidly and unpredictably.

But, despite these risks, fundamental aspects of the Bankruptcy Code stand in tension with regulation’s emphasis on preserving market stability and assuring the safety and soundness of large, deeply networked financial firms. For one, the typical mission of bankruptcy courts looks to address the debtor’s insolvency, protecting and enhancing the value of the estate, and overseeing the development of a plan to distribute value to creditors. How bankruptcy courts achieve this has long elicited debate and prompted recourse to competing judicial philosophies to guide how the pie is best divided among stakeholders. Scholars have tussled, for example, over the workability of divergent economic approaches when deciding how much leeway to afford managers struggling to return a distressed business to profitability: whether only creditors’ rights ought to be recognized; or, if community interests should also be afforded some voice in a bankruptcy process; or even whether certain creditors (e.g., DIP lenders) ought to be permitted especially close control over the firm’s workings and managerial discretion.³²⁸ While not underplaying their importance, nor diminishing the attention bankruptcy courts often pay to non-economic stakeholders (like local communities and public policy imperatives), these variations generally operate with an overarching focus on the debtor and the financial distress that it is experiencing.³²⁹ Indeed, bankruptcy law expects third-parties to absorb loss, uncertainty, and distress of their own in order to afford the debtor an opportunity to reorganize.³³⁰ In other words, the focus of the Bankruptcy Code is almost exclusively on the debtor––rather than preventing the spread of distress to third-parties and the industry sector more generally.

Perhaps the most visible tension between the Bankruptcy Code and its effect on systemic risks can be seen in the broad application of the automatic stay. Designed to freeze attempts to collect debts against the debtor’s estate, it precludes any number of creditors from accessing and retrieving their funds.³³¹ In the context of crypto insolvencies, such as Celsius and BlockFi, this has meant precluding the firms’ customers from accessing assets and withdrawing them from the debtor platform, leaving billions of dollars trapped without clarity as to when they might be returned––if they might be returned at all.³³² Importantly, limited financial regulation has meant that the automatic stay is applied bluntly to crypto assets, without any calibration to reflect the common sense (but not, in the end, legal) notion that these assets constitute customer property.³³³ By contrast, in regulated securities and commodities markets, rulemaking mandates that assets be protected to clearly recognize investor ownership rights, with custody arrangements eliminating the risk of these assets becoming scooped up in a custodian’s bankruptcy.³³⁴

This tension has played out repeatedly across the major crypto insolvencies. Bankruptcy courts do not have discretion and must strictly enforce the automatic stay, without regard for potentially systemic consequences within the crypto-ecosystem and the economic damage inflicted on otherwise blameless retail creditors. For one, platform clients not been able to withdraw their assets, causing damaging knock-on effects, if they lack the cash to pay out on their own obligations.³³⁵ In the case of FTX, for instance, this included institutional creditors, such as BlockFi, that ended up pushed into their own insolvency.³³⁶ It also compromised millions of vulnerable retail interests, everyday savers with limited or negligible economic slack to absorb the shock.³³⁷ Indeed, in seeking to navigate the damage, retail creditors have been forced to reckon with sophisticated parties in crowded and confusing legal proceedings. This has required administrative investment in filing claims as well as in carefully following the trajectory of their legal entitlements.³³⁸ With these cases (and the automatic stay) stretching on for many months, the complex nature of crypto bankruptcies invariably threaten all customers, retail and institutional, with lengthy and legally burdensome separation from whatever value is ultimately left for them – no matter the resulting knock-on shocks.³³⁹

As an added source of risk, crypto holders confront reckoning with the shifting valuation of a highly volatile asset. As Anthony Casey, Brook Gotberg, and Joshua Macey write, the changing valuation of crypto assets can create incentives for a debtor to use these assets to fund itself at low cost.³⁴⁰ With crypto assets likely to have a depressed valuation on the filing date of a large bankruptcy, an exchange can gain by holding onto a base of assets with appreciating price, and to eventually reap winnings from the difference between a low-dollar customer claim and a higher valuation further into the insolvency process.³⁴¹

These risks are not new for insolvencies where the debtor’s failure might result in costly externalities for financial markets. Crucially, however, regulated markets have developed sophisticated conventions to recognize and privilege systemic risk considerations over the interests of the debtor. As noted above, custody arrangements in securities and commodities markets look to keep customer assets outside of the bankruptcy.³⁴² But, other provisions, too, are worth highlighting. For example, under the Bankruptcy Code, certain kinds of risky and short-term financial contracts are expressly exempted from the stay.³⁴³ For certain kinds of derivatives and short-term credit arrangements, a debtor’s counterparty is permitted to close-out the contract and set-off liabilities to secure what is owed to them.³⁴⁴ This process is designed to happen automatically, preventing these specific financial creditors from becoming locked in lengthy proceedings and facing the prospect of cash-shortages themselves.³⁴⁵ Of further note is the fact that certain kinds of financially systemic firms are saved from becoming subject to long and uncertain corporate bankruptcies. This is most clearly exemplified by the regime for addressing bank failures, where the process is managed by a particular government agency––the FDIC––rather than the courts. This design is supposed to offer a highly technocratic, fast, and minimally disruptive process, where customer deposits and outstanding bank loans are transferred (ideally) seamlessly to another bank, preventing worries about the larger solvency of the banking system and helping to prevent a run by frightened depositors.³⁴⁶

In other words, regulatory policy recognizes the tension between the Bankruptcy Code and the costs of system-wide fragility. Whereas rulemaking in securities markets, commodities, and banking regulation has looked to navigate this tension through well-established, Congressionally-approved, crafted tools, crypto markets have been left exposed to the vulnerability of systemic risks but with only the discretion and generalized case oversight of bankruptcy court for recourse. With courts equipped only with traditional tools (e.g., the automatic stay), bankruptcy law is ill-equipped to protect short-term creditors and vulnerable customers in crypto markets.

B. Bankruptcy Disclosure vs. Market Disclosure

The close nexus between financial regulation and disclosure finds its originating, and perhaps best, articulation in Justice Brandeis’ famous statement: “Sunshine is said to be the best of disinfectants; electric light the most efficient policeman.”³⁴⁷ And, so, while scholars have long debated the efficacy of disclosure as a regulatory tool, and contested even further how best it should be implemented to achieve its intended purpose, compelling businesses to periodically divulge core performance and governance data remains a vital component in the administration of financial systems.³⁴⁸ The general idea is that, if the law mandates regular and sufficient disclosure, the consuming public and markets more generally will do much of the policing on their own.³⁴⁹ The SEC and other regulatory agencies have, in turn, issued extensive guidelines and disclosure standards have evolved to aspire for clarity, consistency, and comparability in public communications.³⁵⁰

voxeu/columns/bank-transparency-regulation-and-stress-tests-what-works-and-what-does-not [https://
perma.cc/54KC-NXH8]. Broadly viewed, capital markets, as well as the general consuming public, have come to expect high-quality, reliable disclosures (as compelled by law and enforced by federal and state administrative agencies), assuring greater confidence in the efficient and safe workings of regulated markets.³⁵¹

That is not the nature of bankruptcy disclosure, however. Debtors do not have to broadly divulge information in their bankruptcy cases to accommodate a regulatory scheme intended to properly inform a market.³⁵² Come Chapter 11, the typical debtor’s securities are already delisted, ³⁵³ and disclosure imperatives arising under non-bankruptcy law shift to what is expected in bankruptcy. Thereafter, and as a normative attribute of Chapter 11, debtors tend to publicly disclose only what is necessary and only when they desire particular relief from the bankruptcy court.³⁵⁴ As explained in Section II.B, a debtor’s reorganization is a sort of “becoming” that often takes shape after the bankruptcy has started.³⁵⁵ Bankruptcy law does not compel the debtor to issue much in the nature of progress reports along the way. And, at least during the formative stages of the bankruptcy, a shroud of secrecy is generally acceptable, allowing key constituents, such as the official creditors committee, to do their work.³⁵⁶ Unlike the public more generally, key constituents receive sensitive information early on because they are the counter-balance in bankruptcy’s adversary process and they are the ones the debtor needs to eventually negotiate a plan.³⁵⁷ It is true, as mentioned above, that the Bankruptcy Code and Bankruptcy Rules compel granular public disclosures about the assets comprising and the debts burdening the estate, as well as public release of monthly operating reports.³⁵⁸ But, these disclosures are far from fulsome, they are not completely standardized, and they are neither designed nor intended to offer everyday market participants confidence, clarity, and comparability about firms and their workings.³⁵⁹ For example, monthly operating reports, untethered to a disclosed bankruptcy strategy or turnaround business plan, do little to elucidate where the case is going at any particular moment.³⁶⁰ It is not until the publication of a detailed disclosure statement that the “case story” comes together for the public more generally. But, by then, the story may be almost over.

Debtors do make interim disclosures in the bankruptcy––including, especially, the debtor’s so-called “first day” declaration (an explanatory, often lengthy, statement filed with the Chapter 11 petition)––and those disclosures often present a detailed case narrative: why and how the debtor finds itself in need in bankruptcy relief; what it hopes to achieve while in bankruptcy; how and when it expects to exit bankruptcy.³⁶¹ But, unlike disclosure requirements under non-bankruptcy law,³⁶² there are few repercussions for a debtor whose interim disclosures are ultimately found to be insufficient, incomplete, or even inaccurate.³⁶³ Bankruptcy anticipates that the debtor’s case narrative, including the “first day” declaration, may be inculcated with advocacy; it relies on the debtor’s case adversaries (e.g., the official creditors committee) to exploit discovery and other tools of bankruptcy to ferret out and eventually present the counter-narrative.³⁶⁴ Celsius, for example, initially presented its case narrative in the “first day” declaration of its CEO, Alex Mashinsky. This narrative was largely debunked in the examiner’s final report,³⁶⁵ and Mashinsky was arrested a short time later. But, tellingly, that did not lead to the appointment of a Chapter 11 trustee, conversion to a Chapter 7 liquidation, dismissal of the case, or even curtailment of the debtor’s exclusivity to file its own bankruptcy plan.³⁶⁶ Bankruptcy wants the parties to negotiate and, so, bankruptcy courts are loath to impose interim process changes over factual disputes, even where the debtor’s factual narrative is so blatantly wrong.³⁶⁷ Stated differently, bankruptcy rarely prioritizes factual accuracy in interim (prior to dissemination of a disclosure statement) public disclosure over an orderly Chapter 11 process.³⁶⁸

It is perhaps for this reason that examiner appointments have been rare occurrences in Chapter 11, historically reserved for only the most extreme cases.³⁶⁹ Examiners seize part of the adversary role occupied by creditor representatives, who are otherwise entrusted not only to learn the case facts but also to exploit them at bargaining table.³⁷⁰ Examiner appointments can, in other words, enervate the official creditors committee (among others) and that may not help the parties reach consensus on a plan.³⁷¹ Examiner reports also can be costly, eating into eventual recoveries, and they take time to prepare, resulting in case delay.³⁷² Moreover, examiners are required to make their investigative findings public––even the findings that may be best reserved for quiet negotiation––and this can further chill dealmaking.³⁷³ These dynamics may help explain why even in a case as extreme as FTX the bankruptcy the bankruptcy court was reluctant to order the appointment.³⁷⁴

Finally, and most specific to crypto, bankruptcy disclosure does not have permanence. Data delivered in cases such as BlockFi, FTX, and Voyager explain the root causes of failure, and thus can offer cautionary tales for regulatory authorities and the industry more generally to observe and consider.³⁷⁵ But, it can do little more. A “bad” Chapter 11 debtor will change its ways through the reorganization process; a liquidating debtor has no future; and, other industry participants have no obligation to study or heed any cautionary tale. Bankruptcy disclosure, therefore, offers little protection unless the lessons learned are formalized into some kind of mandatory rulemaking.³⁷⁶

C. An Imperfect Policymaker

Facing information deficits and without a mandate to address systemic risks and market stability, bankruptcy courts are a sort of “make-do” but ultimately highly imperfect proxy-regulator for the crypto-market. Yet, their decision-making is likely to have lasting effects that shape future rulemaking and constrain the room to maneuver available to policymakers looking to craft a framework for crypto oversight.

Perhaps the clearest illustration of the courts’ impact as imperfect policymaker is reflected in the ownership determinations respecting customer crypto assets deposited with bankrupt custodians. As detailed in Part I, cryptocurrencies reflect a relatively novel kind of asset class, where ownership rests with those holding the private keys (the passwords) to a crypto accounts. This design speaks to the fundamental self-help orientation of underlying blockchains that have emerged from a philosophical rejection of third parties like banks, brokers, or state regulators.³⁷⁷ However, as centralized actors have come to assume a critical role, attracting waves of customers, they have also become vast repositories of user assets, holding onto passwords and able to access accounts, the value of which they carry.³⁷⁸ As Adam Levitin notes, this leaves customer assets vulnerable, caught up in a legal gray zone where the fact of a custodian having de facto control and the capacity to access assets at will can leave customers holding a simple contractual––rather than a property-based––claim.³⁷⁹ It has also left the courts facing a complex policy conundrum, whether to (1) recognize customer property rights in crypto assets and, in turn, to permit those assets to remain outside of the custodian’s estate or (2) deem the assets property of the estate, repositioning customers as general unsecured creditors.³⁸⁰ Arguably, financial regulatory policy would favor recognizing and protecting customer’s property rights–and by extension their savings. As evidenced by the safeguards afforded to customer assets in securities and commodities markets, the emphasis placed by traditional financial regulation on investor protection is well-established and uncontroversial. Even where comingling of assets or failure to secure them has meant that customers have not been able to fully enforce their property rights, regulation has stepped in (e.g., MF Global) to ensure compensation and redress for those whose entitlements were abridged.³⁸¹

By contrast, the absence of a focused regulatory policy and a relative lack of prior rulemaking in crypto markets, has led the bankruptcy courts––the Celsius court in particular––to assert bankruptcy norms, thus reducing customer claims to a contractual (rather than proprietary) nature. As such, around $4.2 billion in customer assets deposited with Celsius were found to belong to the bankruptcy estate, and a broad swath of depositors entitled only to the remainderman’s interest after a long and torturous bankruptcy case.³⁸²

As detailed above, while this ruling might reflect bankruptcy’s interpretative norms, it nevertheless raises broader policy concerns surrounding fairness and market integrity. For one, the impact of this ruling can result in some customers faring better than others during a crisis. Specifically, the effect of the ruling means that those that leave assets with an intermediary face the risk that these assets can end up subsumed within a custodian’s estate. It follows that those able to hold their assets off-platform, hosted on their own private wallets face far better odds in maintaining their property rights. While straightforward, this scenario creates the risk of a two-tier market, where those possessing the technical savvy to protect themselves out-maneuver the risk, but those that are perhaps less knowledgeable or otherwise unable to take such steps lose their entitlements. Such a state of affairs appears especially problematic given that those most likely to see their assets tapped on a platform are likely to include the most vulnerable, with less knowledge and sophistication about using crypto technologies. In other words, rather than protect all customers equally, the decision leaves crypto investors to fend for themselves. Those that cannot––in other words, customers that are in the most precarious situation––end up unprotected and liable to be harmed.

The Celsius court’s ruling ended up being especially powerful in the absence of wider regulatory action to protect customers and support market integrity. This has meant that decisions of the bankruptcy court – formed within a particular system of constraints – have given rise to structural effects on the marketplace (e.g., interpretations of terms of service, review of custodianship norms). Unlike administrative rulemaking, however, this impact has taken effect without the benefit of precision market understanding, cost-benefit analysis, stakeholder consultation, or deliberation. While bankruptcy courts have done what they can within their mandate, bringing some order to the prevailing chaos, their intervention can hardly be considered as optimally engineered to provide a lasting and reliable set of guardrails for the crypto-marketplace, designed to operate both in peacetime and in crisis.

CONCLUSION

This Article has sought to offer a new account of cryptocurrency regulation to highlight bankruptcy’s role, by default, as a force in financial markets oversight. With the industry lacking a real framework to govern its integrity, customer protection, and relationship with regulators, bankruptcy courts have been required to step in, addressing gray areas and thorny problems surrounding cryptocurrency’s legal and economic underpinnings. In applying its expertise and authority, these courts have shown themselves to be deft and creative, bringing clarity to important questions impacting customer entitlements and the risk management practices adopted by crypto firms (e.g., in relation to crypto custody). But the courts’ role remains an imperfect and incomplete one. The focus of bankruptcy remains on the debtor. Bankruptcy courts cannot perform policy to address larger concerns––such as the immediate welfare of customers or the overall health of the market. Even as bankruptcy’s influence in this space has grown, its deficits have also become apparent, underscoring the larger costs of regulatory inertia and inaction for establishing standards of governance and safety within innovating industries. Ultimately, the bankruptcy court’s emergence as an accidental financial regulator raises deeper questions about how best to push administrative mobilization to rise to the challenge of complex innovation. As financial regulators endeavor to create new standards for crypto oversight, they face an even more complex task ahead, forced to maneuver in the shadow of the bankruptcy’s authority as a first mover in this arena.

96 S. Cal. L. Rev. 1479

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Yesha Yadav*

* Yesha Yadav is the Milton R. Underwood Chair, Associate Dean, and Professor of Law at Vanderbilt Law School.

Robert J. Stark†

† Robert J. Stark is Chair of the Bankruptcy and Restructuring Practice Group at Brown Rudnick LLP. We are deeply grateful to Kenneth Aulet, Jordan Barry, Preston Byrne, Cathrine Castaldi, Jill Fisch, Pamela Foohey, Andrew Hayashi, Elizabeth Pollman, Danny Sokol, Robert Rasmussen, Andrew Rizkalla, and Samuel Weinstein, as well as participants at the USC Digital Transformation in Business and Law Symposium, the Cardozo Law School Corporate Governance Symposium, and the BYU Winter Deals Conference for all of their valuable insights, comments, and perspectives. We also thank Matthew Fisher, Samuel Khan, and Roshni Parikh for excellent research assistance. In the interest of full disclosure, Robert J. Stark and/or his firm were involved in several of the cases discussed in this Article: he served as the examiner in the Cred Chapter 11 case; he represented the official creditors committees in the BlockFi and Prime Trust Chapter 11 cases, as well as the winning bidder (Fahrenheit LLC) in the Celsius Chapter 11 case; his firm represented an ad hoc claimants committee in the Genesis Global Chapter 11 case, the Bahamas Government in connection with the FTX collapse, and parties in other restructurings in the digital asset and mining spaces. This Article represents the views of the authors only. Errors are our own.