OpEd: Crypto Winter Arrives
The following article is the first in a two-part series written by Adam Levitin, a Georgetown University Law Center professor and a member of Gordian Crypto Advisors LLC.
The Crypto Winter has descended: The prices of cryptocurrencies are falling, and the crypto industry is facing distressed situations on a previously unparalleled scale. Crypto businesses of all sorts have many of the same concerns of traditional businesses — they need to be able to make payroll, pay vendors and meet their financial obligations — but they also face certain unique issues when facing financial distress.
Many cryptocurrency businesses use traditional legal structures, such as corporations or limited liability companies. Some, however, have more decentralized governance structures, and even the more traditional businesses often operate in an ecosystem that involves some decentralized actors. Decentralization complicates attempts to address financial distress because there is no counterparty with whom to negotiate. Likewise, many relationships in the cryptocurrency world operate through smart contracts, which are not designed to have the flexibility necessary to effectuate a restructuring of the contract.
Cryptocurrency companies’ capital structures also often vary from those of more traditional firms. They are unlikely to have much funded debt, and what debt they have is likely to be secured by their main assets — cryptocurrency holdings and, in the case of mining companies, their mining rigs. Additionally, for many crypto businesses, customer funds and redemption rights are among their major obligations. These are not merely financial obligations, but the centerpiece of these companies’ business. Thus, the stakeholders for these businesses include both traditional parties, such as employees and vendors, but also customers who are effectively investors in the crypto product itself.
Distressed crypto businesses raise many of the same issues as with failed traditional financial, or Tradfi, institutions. Tradfi institutions are subject to special resolution regimes with substantial government involvement that are designed to ensure an orderly liquidation of the institution with minimal disruption to customers. No such regimes exist for crypto businesses, however, which have a choice of either attempting to find voluntary, out-of-court restructuring and liquidation solutions or filing for bankruptcy.
Cryptocurrency Out-of-Court and Bankruptcy Options
Distressed cryptocurrency companies may be able to address their problems out of court. If the problem is only one of liquidity, new financing or a white knight acquisition may be sufficient to address the problem. It is imperative, however, that cryptocurrency companies facing liquidity problems address them promptly with minimal disruption to customer access to funds. Cryptocurrency businesses are financial institutions that require customer trust to be viable. Restricting withdrawals erodes customer trust. Customers are unlikely to be forgiving of any business that causes them disruptions in access to their funds. “Crypto bank holidays” are likely to be more harmful than helpful to the distressed company.
If the terms of a crypto business’s obligations need to be restructured, an out-of-court workout will be challenging because of the difficulty coordinating among multiple creditors, particularly for retail-facing cryptocurrency businesses such as exchanges, brokers and lenders. Moreover, attempts to restructure can undermine customer confidence and trigger a run on the company.
In many cases, by the time a crypto business seeks to bolster its capital or find a buyer, it may be too late, and the company may be in a death spiral, with bankruptcy as the only option. Bankruptcy fixes leverage problems, not business models. Thus, if a company is merely overleveraged but has a fundamentally sound business model, bankruptcy provides the possibility of a forced debt-to-equity conversion, accompanied by the wipeout of old equity; some or all of the pre-bankruptcy creditors end up owning the deleveraged, reorganized company.
Many crypto companies, however, are unlikely to be able to successfully reorganize in bankruptcy because they lack going-concern value absent customer trust. No customer will trust a financial services business that has lost his or her money. When financial services businesses file for bankruptcy, they generally end up liquidating. The same is likely to be true for cryptocurrency companies.
Even in a liquidation, however, bankruptcy provides useful tools for the preservation and even creation of value. Bankruptcy law gives debtors supercharged sale power that lets them sell assets under conditions that they cannot outside of bankruptcy, thereby unlocking potential value. For example, assets can be sold even if subject to liens without the lienholders’ consent.
Likewise, even in a liquidation, bankruptcy can be extremely useful in dealing with litigation. A bankruptcy filing triggers the “automatic stay,” which freezes all attempts to collect from the debtor outside of the bankruptcy process. This means that all pending lawsuits are stopped and must be moved over into the bankruptcy process. It is also possible to get a stay of litigation against nondebtor related parties, such as directors and officers.
Once the litigation is moved to the bankruptcy court, the cases will be determined by the bankruptcy judge without a jury, and possibly using summary estimation (particularly useful when dealing with large numbers of claims). Bankruptcy also provides a method for paying litigation claimants out of assets of uncertain value — those assets can be placed in a trust, and the claimants can be given interests in the trust, which may pay out over time as the assets’ value becomes certain.
Distressed cryptocurrency companies are likely to end up liquidating in bankruptcy, which provides a unique set of value-maximizing legal tools for the benefit of creditors. To the extent that firms are able to proactively engage with distressed situations, however, they are more likely to have more restructuring options and to be able to save value for all stakeholders.