Celsius’ Reorganization & Smart Contract Super Priority
This article discusses the super priority of smart contracts in the context of crypto-related bankruptcies using Celsius’ proposed reorganization as a lens.
Part I provides some general background information on Chapter 11 bankruptcies for those not familiar with the process. Skip ahead to Part II if you already understand why and how bankruptcy works. Part II explains the business model of Celsius and the events leading to its bankruptcy. Part III explores Celsius’ controversial reorganization plan. Part IV concludes with thoughts on how smart contracts are enjoying super priority over other creditors, including customers who are being treated as unsecured creditors.
I. Ch. 11 Bankruptcy aka Reorganization
A. Why do we need bankruptcy?
The bankruptcy process is a pillar of America’s economy.
America’s economy is a debt-based monetary system.
For example, when you deposit money into a savings account with a bank, you are really lending the bank the money with an expectation that it’ll earn interest. The bank then lends your deposited money to a debtor or invests the money with the expectation to earn a positive return. A percentage of the return the bank receives from loaning/investing your money is then given to you in the form of interest. This example demonstrates how all of the transactions underlying our economy are debt-based.
Proponents of debt-based monetary systems argue that they’re more competitive and have a greater flow of capital resulting in heightened innovation and economic growth.
But without bankruptcy, there’d be no relief for debtors who default and it’d be difficult for creditors to settle conflicting claims against mutual debtors. Consequently, borrowing money would become prohibitively costly because debtors wouldn’t want to borrow without recourse and creditors wouldn’t want to make loans without protection. When the cost of capital becomes prohibitively costly in a debt-based monetary system, innovation is hindered and economic decline results. The bankruptcy process helps to avoid that outcome.
Art. I, § 8, Cl. 4 of the U.S. Constitution authorizes Congress to make “uniform laws on the subject of Bankruptcy” and there has been some form of legislative bankruptcy process in place since the original Bankruptcy Act of 1800. According to the Supreme Court, the purpose of the bankruptcy process is to “relieve the honest debtor from the weight of oppressive indebtedness and permit him to start afresh free from the obligations and responsibilities consequent upon business misfortunes.” Currently, the U.S. Bankruptcy Code provides for six different types of bankruptcies, including Chapter 11 Bankruptcy, also referred to as reorganization.
B. Some Basic Facets of Reorganization
Reorganization is the bankruptcy process reserved for corporate entities, such as corporations or partnerships. The purpose is to allow insolvent businesses to reorganize their capital structures to maximize the returns to creditors and investors.
Generally, reorganization gives an insolvent debtor the opportunity to keep operating their business (even if it requires borrowing more money) as “debtor in possession” (DIP) until the plan of reorganization is submitted to the court for approval. The plan of reorganization lays out how the debtor will continue to operate its business or liquidate its assets to pay off its debts over a fixed time period.
As DIP, existing management or ownership acts as a trustee over the company assets and continues to pay important expenses, like payroll and trade/supply debts. DIP financing is the form of financing given to distressed companies who file under Chapter 11. Under § 364(c), creditors who provide DIP financing enjoy many special privileges including a security interest on the debtor’s assets with priority over all other claims (i.e. super priority). This is intended to compensate the DIP creditors for loaning money to the already struggling company.
Another important aspect of reorganization is the automatic stay under § 362, which freezes prepetition debt and prohibits existing creditors from contacting an insolvent debtor about the money they’re owed while the reorganization is underway. The automatic stay is essential to the reorganization process because it allows debtors to take a deep breath and focus on the task at hand.
One way creditor interests are protected is by the ban on preferential treatment. Under § 547, the trustee or DIP is allowed to claw back certain transfers, known as “preferential transfers,” that occurred within the 90 days preceding the bankruptcy petition. The purpose of this statute is two-fold: 1) to ensure the prepetition bankruptcy estate isn’t depleted, and 2) to ensure that creditors receive fair and equal treatment.
Priority among creditors is one last essential facet of reorganization that is worth noting for purposes of this article. It’s easiest to think of priority in terms of a single-file line with one rule–NO SKIPPING! (…unless you’re a DIP creditor.) This NO SKIPPING rule, also known as the “Absolute Priority Rule,”is found in § 1129(b)(2).
At a high level, there are two types of creditors: secured and unsecured. A secured creditor is one whose loan is collateralized, or backed up by specific assets that belong to the debtor. So if the debtor fails to repay the loan, the creditor has authority to seize the assets covered by its security interest. By contrast, an unsecured creditor is a party who’s loaned money to the debtor with nothing to back the loan other than the debtor’s contractual repayment obligation. If a debtor fails to repay an unsecured loan, then the creditor has a legal claim against the debtor.
In the single-file line, secured creditors always come before unsecured creditors. Between secured creditors, whomever was first to file or perfect is in front. Unsecured creditors are grouped together, classified according to the nature of their claims, and represented by an Unsecured Creditor Committee under § 1102. When classifying claims, the goal is to ensure that similarly situated claims are treated equally. Although lesser in priority than all secured creditors, the Unsecured Creditor Committee typically consists of the seven largest unsecured creditors and has great influence over the direction of the reorganization plan.
DIP creditors enjoy super priority over all other claims against the debtor’s assets meaning the NO SKIPPING RULE doesn’t apply to them. Whenever the debtor gets its shit together or liquidates its assets, the DIP creditors get paid first from whatever is left to be divvied up. In other words, they’re allowed to jump to the front of the line ahead of all secured and unsecured creditors. Remember, the rationale is that it’s fair since they are the ones taking the largest risk by continuing to provide capital to an already struggling company.
With that general background information about the Chapter 11 Bankruptcy process out of the way, the article will now turn to Celsius.
II. The Fall of Celsius
A. Overview of Celsius Network
Founded in 2018, Celsius Network Inc. is a crypto lending platform. Its key business segments are 1) retail interest deposit accounts, lending services, and custodial services, 2) institutional lending and borrowing services, 3) Bitcoin mining, and 4) deployment.
The retail interest deposit accounts, referred to as the Earn Program, mimic traditional banks by enabling users to deposit cryptocurrency which is then loaned out by Celsius to retail and institutional borrowers generating a return for the users. As of April, this service is only offered to accredited investors after U.S. regulators forced Celsius to ban non-accredited investors from using the feature.
The retail lending service, dubbed the Borrow Program, allows users to deposit cryptocurrency as collateral and receive USD or cryptocurrency in return. Like other DeFi applications, users must be overcollateralized, meaning they must back a loan with collateral that’s more valuable than the loan. This protects Celsius from the risk of volatile asset prices. The interest rate on a loan is based on the value of the collateral that’s backing it.
When users post their crypto as collateral in the Earn or Borrow program, custody of that crypto transfers to Celsius and they’re able to do with it as they please. Users can choose to accept rewards or earn interest in the form of the platform’s own token, CEL, which results in higher returns and interest discounts. At its peak, Celsius was offering interest returns as high as 18% for depositors.
The retail custodial service segment is essentially a wallet service that lets users store their cryptocurrency in a secure location while retaining custody to it and without the intention to earn yield.
Celsius’ institutional lending and borrowing segment permits institutional clients (e.g., hedge funds and market makers) to borrow funds at rates set according to the clients’ creditworthiness.
The Bitcoin mining segment is Celsius’ cash cow and operates through its subsidiary Celsius Mining LLC. Celsius boasts that it’s one of the largest Bitcoin mining operations in the country with over 43,000 rigs currently active. Impressively, this accounts for only about half of the 80,500 rigs that it currently owns. Earlier this year, Celsius had plans to take the mining subsidiary public but quickly abandoned the plans due to its recent financial woes. Still, the company reports that it plans to expand to 112,000 rigs by Q2 of 2023.
The deployment segment deploys and stakes assets into various DeFi protocols (e.g., AAVE, Compound, MakerDAO) with the purpose of generating yield. It also participates in market-neutral trading on CeFi platforms.
As of May, it had more than $8 billion lent out to clients and $12 billion assets under management.
B. How Shit Hit the Fan
It all started with the crash of Terra Luna, which caused a domino effect in the crypto market beginning in April. Since a major tenet of Celsius’ strategy is to deploy and stake its assets in other platforms to generate yield, the sudden collapse of other crypto platforms correspondingly caused the total value of its assets to collapse. Between March and July, Celsius’ digital assets holdings fell from $14.6 billion to only $1.7 billion. The steep decline in asset value coupled with widespread panic by users trying to withdraw their assets forced Celsius to freeze user rewards, withdrawals, and transfers on June 12 because of liquidity concerns. Just over a month later, Celsius filed for Ch. 11 protection from its creditors.
According to Alex Mashinsky, CEO of Celsius, the issue is that the company grew too big, too quickly. As users flocked to the platform, the need to generate higher yields arose, resulting in the company making increasingly risky investments. In addition to its failed investment in Terra Luna, Celsius’ investment in staked Eth, stETH, busted. A large amount of Celsius’ assets was also deployed in various DeFi applications as collateral for loans. Another major nail in the coffin was when Tether, issuer of USDT, liquidated a $1 billion loan to Celsius. In a court filing, the company admitted to having a $1.2 billion hole in its balance sheet, owing $5.5 billion with only $4.3 billion worth of assets.
III. Celsius’ Controversial Reorganization Plan
Up to this point, Celsius’ approach to reorganization has been met with calls for blood.
Many customers whose accounts are locked up are upset that Celsius has yet to release their assets. But, according to Celsius’ legal counsel, those complaints are falling on deaf ears since the terms of service for the Earn and Borrow programs specifically state that title of the assets transferred to Celsius. Another relevant concern regarding the locked up funds is whether Celsius will choose to clawback certain transactions made during the 90 days leading up to its bankruptcy petition under the § 547 prohibition against preferential treatment.
Moreover, Celsius is claiming that customers prefer to wait out the crypto winter rather than having their funds immediately returned since the crypto market is currently in a downturn. Assumedly, the company plans to continue deploying those locked up assets to generate yields to pay off debts as part of its reorganization. The alternative would be customers receiving their assets back at an extreme discount. Currently, even those holding wallets with Celsius’ retail custodial service are unable to withdraw or transfer their assets, despite the fact that the terms of service for that product never transferred title to Celsius.
Coinbase made a similar claim in a recent Form 10Q, stating,
“Because custodially [sic] held crypto assets may be considered to be the property of a bankruptcy estate, in the event of a bankruptcy, the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors.”
In other words, if Coinbase was to file for bankruptcy, customers whose assets are in the custody of Coinbase would be last in line when it comes to receiving their assets back.
Likewise, Celsius’ legal counsel is questioning whether users of the custodial services should receive differential treatment from users of the Earn and Borrow programs. Retail customers are unhappy with Celsius about this since the custodial service and Earn and Borrow programs were all advertised as separate products. At the beginning of this month, custody claimants, representing approximately $180 million in claims, hired legal counsel and sued Celsius to get their money back.
Though widely regarded as a crypto lending platform, Celsius is now doubling down on its status as a dominant Bitcoin miner. Most of its reorganization plan centers on increasing revenue from its Bitcoin mining segment by expanding the number of rigs under operation. Since its mining subsidiary is also listed as a debtor in its Chapter 11 petition, Celsius must receive court approval for the related expenses.
At its first bankruptcy hearing, Celsius asked the court to approve $5 million to be spent on finishing the construction of its mining facility and to pay duties on mining rigs held up by customs authorities. According to Celsius’ legal counsel, the mining segment mines 14.2 BTC per day and expects to mine 10,100 BTC by the end of 2022.
On Tuesday, the court gave Celsius approval to sell newly minted BTC over the objection of creditors and the Department of Justice stating that it was a business decision within the discretion of the company. Importantly, the proceeds will be kept separate from the company’s cash management system.
Even though the court has been supportive of Celsius’ plan thus far, there are doubts about the plan’s efficacy. Celsius’ mining projections are ambitious, with hopes of mining 15,000 BTC through 2023. Last year, Celsius mined a mere 3,114 BTC.
At this week’s hearing, the judge in charge of the case emphasized the need to settle the dispute with custodial claimants as quickly as possible.
IV. Smart Contract Super Priority
Celsius’ bankruptcy has raised many novel questions, including how to treat debt owed to DeFi applications and governed by smart contracts with respect to other creditors.
Smart contracts are self-executing contracts written in computer code and performed on a blockchain.
There are many benefits to smart contracts, such as there being no need for an intermediary or trust between transacting parties. Since they’re autonomous, once the stated condition is met, the contract is enforced.
On the other hand, a disadvantage of smart contracts is smart contract risk; meaning, a smart contract is only as secure as the underlying computer code. If there’s a faulty condition, the code isn’t secure, or there’s any other need to change the contract in some way, it can be very difficult and expensive to do.
Sounds a lot like hiring lawyers haha
Within DeFi applications, smart contracts allow transactions to be executed without any oversight. But, in the bankruptcy context, this is problematic since it leads to preferential treatment of DeFi creditors.
Distressed crypto companies have to pay off their debts to DeFi creditors before anyone else because failure to do so will result in the loans defaulting and them losing their assets. Put differently, debt governed by smart contracts enjoys super priority over other creditors since the autonomous nature of the smart contract makes the debt unavoidable. This characteristic of smart contracts makes traditional bankruptcy protections such as the automatic stay and ban of preferential treatment ineffective.
Many critics assert that it was unfair preferential treatment. Others opine that it was necessary to preserve the value of the company’s assets postpetition, especially considering that the value of the collateral backing the loans is more valuable than the corresponding debt.
In my opinion, one problem with smart contracts enjoying this super priority is that they’re an integral part of crypto companies’ debt structures but go largely unreported.
Crypto companies hunting for high yields may be colluding by making risky under-the-table deals with one another at the expense of customers and they unfortunately won’t be exposed until the risky endeavors backfire, as they did for Celsius. And even once exposed, these smart contracts will still be able to enjoy super priority over other claims, including the claims of customers as unsecured creditors.
In other words, they’ll skip the line.
DIP creditors get to skip the line because they provide financing to an already struggling company. No equal justification can be made for debt contracts governed by smart contracts that were entered into prior to going bankrupt.
All in all, the need for meaningful crypto regulation is more crucial than ever.
Perhaps the entire time all the grandiose crypto personalities were chanting “WAGMI”(“We’re All Gonna Make It”), it was really an inside joke at the retail investor’s expense.
It’s unfortunate that some of crypto’s biggest giants have opted to abandon the WAGMI narrative but perhaps this should’ve been foreseeable. When shit hits the fan, the ultimate goal is survival. You must live to fight another day.
The beauty of reorganization is that it gives companies who reach for the stars a cloud to fall back on.
But, if we’re not careful, failing crypto giants may really be falling back on the graves of the customers who built them up.
The current and looming wave of crypto bankruptcies will continue to raise a lot of novel questions and set some groundbreaking precedent for governing digital assets.
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