Who Owns Custodied Crypto Assets? New Bankruptcy Ruling Amplifies Concerns for Account Owners

January 9, 2023

Danny Newman - Tonkon Torp LLP

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As we first warned last summer, crypto property held in a custodian-controlled account could become the property of that custodian in the case of a bankruptcy filing. At the time, we recommended that crypto investors avoid this possibility by self-storing their assets in either a “cold” or “hot” wallet. We urgently reiterate that suggestion now.

On January 4, 2023, our concerns were confirmed. A U.S. Bankruptcy judge in New York ruled that, under the plain terms of the Terms of Service, Celsius Network owns the assets in approximately 600,000 interest-bearing customer accounts and can use those funds as the bankrupt company sees fit in its bankruptcy process. For account owners, the judge’s ruling means that rather than immediate repayment in full, they are unsecured creditors, which moves down the repayment line and very likely means they will not ever receive all their funds back.

While the ownership question is far from settled—the ruling will most certainly be appealed—it does further muddy the waters for cryptocurrency investors with custodian relationships. Celsius is not the only company to claim ownership of customer funds. In May, crypto giant Coinbase Global caused waves when the company’s SEC Form 10-Q indicated that, in an insolvency event, it could treat customers’ assets as corporate assets. At the time, Brian Armstrong, Coinbase’s Chief Executive, tried to clarify in a tweet. However, he did not retract the statement, he simply said investor funds were safe because Coinbase was nowhere near filing bankruptcy.  And it does not appear Coinbase has changed their Terms of Service to ensure account holders truly own the assets in their accounts in the event of a Coinbase bankruptcy petition.

Bankruptcy filings are, however, increasing among crypto custodians. For example, Voyager Digital’s July bankruptcy filing essentially paralleled the Celsius filing. Then things got interesting—FTX imploded and Sam Bankman-Fried became a household name. The fallout had a ripple effect, and one casualty was BlockFi. In late November, BlockFi filed for Chapter 11 bankruptcy, after the collapse of crypto hedge fund Three Arrows Capital created a liquidity crisis and an attempted bailout by FTX failed to materialize. Given the upheaval within the cryptocurrency industry, other bankruptcy filings may follow.

What should crypto investors do now?

The recent Celsius asset-ownership ruling by U.S. Bankruptcy Judge Martin Glenn certainly brings the issue to the forefront once again. Crypto-property custodians are not traditional brokerage institutions or banks. Regulations require that traditional brokerages keep client assets separate and apart from company assets and bank deposits are insured for up to $250,000 by the FDIC.

Crypto investors who held assets in Celsius interest-bearing accounts have no such protections, according to the Court.

Just as we recommended several months ago, we again encourage crypto investors to hold your crypto assets yourself. Choose either a “cold” or “hot” wallet—or both.

A cold wallet is offline. The most common type is on a hardware wallet that connects to the internet only when you are transacting. A paper wallet is also a form of cold storage involving a printout of the relevant information needed to perform a crypto transaction. A hot wallet is an app that allows for storage online, which carries a small hacking risk. Just remember you will be responsible for safeguarding access to your wallet. If you lose access to your crypto assets, they are most likely gone, just as if you lost a physical asset.

It is unclear how the cryptocurrency ownership debate will ultimately be settled, and the result may be different depending on the court that hears the argument. Each Terms of Service in question could be different as well, potentially leading to different results. But it is abundantly clear that the road to legal clarity will be a long one. Assets caught up in the process will, at the very least, remain in limbo and may never be returned except for as reduced payments to unsecured creditors.  By far the safest course of action is for investors to remove their funds from interest-bearing accounts at crypto custodians unless the Terms of Service are clear that they are not property of the custodian but instead held in trust for the benefit of the account holder.

This update is prepared for the general information of our clients and friends. It should not be regarded as legal advice. If you have questions about the issues raised here, please contact Danny Newman or the attorney with whom you normally consult.

About Tonkon Torp

Tonkon Torp LLP is a leading business and litigation law firm serving public companies, substantial private enterprises, entrepreneurial businesses, and individuals throughout the Northwest. For more information, visit tonkon.com.