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Non-Fungible Tokens (NFT) Newsroom

WHEN YOUR STABLECOINS ARE NOT YOUR STABLECOINS

WHEN YOUR STABLECOINS ARE NOT YOUR STABLECOINS

Shortly after the beginning of 2023, the U.S. Bankruptcy Court for the Southern District of New York hearing Celsius Network LLC’s (collectively with its affiliated debtors, “Celsius”) Chapter 11 case issued a key decision that conclusively held that the digital assets held under Celsius’ “Earn” program accounts (which we will explain in following paragraphs) are presumptively property of Celsius’ bankruptcy estate. While the court’s decision might not be a major blow to some of Celsius’ creditors, it certainly is a setback for many Celsius’ creditors who had sought to exclude the assets in those Earn program accounts from the scope of Celsius’ estate.

Background

Back at the time when Celsius was still standing, it had offered several products from which its customers could earn rewards or profits. The “Earn program” was the most popular product among Celsius customers as this program allowed the customers to deposit cryptocurrencies in Earn program accounts and receive “Rewards” in cryptocurrencies. (To put it simply, one would receive certain amount of BTC as rewards simply by depositing BTC in his/her Earn program account without having to engage in trades.) While the customers participating in the Earn program may choose what types of cryptocurrencies to deposit, many of them had gone with stablecoins (i.e., the type of digital asset having its value pegged to certain asset class, such as USD), and those stablecoins remained in the Earn program accounts following Celsius’ collapse and were valued at $23 million as of September 2022. Once cryptocurrencies were deposited into Earn program accounts, Celsius would rehypothecate, loan or use them as if they were Celsius’ own assets and would not segregate them from other assets. (This is contrary to the nature of Celsius’ “custody program”, under which the deposited cryptocurrencies would not yield returns and Celsius would not use them for any purposes other than custody.)

Following its collapse, Celsius petitioned to the court in September 2022 to sell certain stablecoins in its possession and use the proceeds from the sale to fund its operation and Chapter 11 proceeding. The proposed sale immediately drew objections from Celsius customers, the U.S. Trustee and various state government agencies on numerous grounds because, from the objecting parties’ perspective, the ownership of the stablecoins in the Earn program accounts should remain with the Earn program account holders and should thus be excluded from Celsius’ estate and future distributions to Celsius creditors. (The objecting state agencies had different reasons to oppose to such sale. For instance, the State of New Jersey submitted to the court that the determination on the ownership of those stablecoins is premature as the examiner is completing the investigation.) Accordingly, the very question that the Celsius court had to address is whether the ownership of the stablecoins deposited in the Earn program accounts has been transferred from the account holders to Celsius at the time the account holders accessed and participated in the Earn program.

Why the Court Determined that the Ownership of the Stablecoins under the Earn Program has been Transferred to Celsius

The fundamental ground underlying the court’s decision is the formation of a valid, enforceable contract between Celsius and its Earn program customers. The court first observed that Celsius’ user agreement (the “Terms of Use”) governing the Earn program was governed by New York law, pursuant to which courts have upheld the validity and enforceability of a clickwrap agreement from time to time so long as necessary conditions are met and the concerned agreement does not present bad faith of an involved party. The Celsius court then concluded that the Term of Use had formed a binding clickwrap agreement because (i) the Earn program customers were required to consent to the Term of Use by clicking relevant “I agree” button (or any button to that effect) before participating in the Earn program, (ii) the Earn program customers had received considerations (i.e., rewards generating from the deposited cryptocurrencies) in connection with their consent to the Terms of Use, and (iii) evidence shows that 99.86% of Earn program customers accepted version 6 or a later version of the Terms of Use, which included a “transfer of title clause” that effects the transfer of ownership of deposited cryptocurrencies from the Earn program customers to Celsius.

Following the finding of the binding and enforceable contract between Celsius and the Earn program customers, the court went on to determine whether the Terms of Use were unambiguous with respect to whether [Earn program customers] retained ownership or transferred ownership of cryptocurrency assets by depositing the assets into Earn Accounts.” The court expressly indicated that under New York law, “contracts are interpreted and enforced in accordance with their plain meaning and their clear and unambiguous terms.” Referring to the actual language in the Terms of Use, the court found that even though versions 1 to 4 of the Terms of Use did not contain any language concerning the transfer of title and ownership of deposited cryptocurrencies, version 5 (and all versions thereafter) did contain a clause specifying that the Earn program customers grant Celsius . . . all right and title to such Digital Assets, including ownership rights.” The court accordingly concluded that such language constituted unambiguous and clear language regarding transfer of title and ownership of assets in Earn Accounts” and is applicable to almost all of the Earn program customers given that 99.86% of Earn program customers had agreed to be bound by version 5 (or later versions) of the Terms of Use.

Additionally, while the objecting parties argued that the use of words like “lending” or “loan” in the Terms of Use would make Earn program customers believe that they were “lending” deposited cryptocurrencies to Celsius rather than giving up their ownership, the court nevertheless rejected such argument on the grounds that (i) such words would not create ambiguity when read in connection with the transfer of title clause, and (ii) relevant language expressly provided that no ownership interests or lien in favor of Earn program customers was intended. The court also noted that even if such deposition under the Earn program is categorized as a loan, Earn program customers would still be unsecured creditors in this proceeding.

Takeaways

The Celsius court’s decision has once again evidenced that the contractual language (along with relevant factual circumstances) would determine the relationship among the parties regardless of whether novel asset class or service model is involved in the dispute. The immediate impact of this decision is that Earn program customers’ deposited assets are subject to Celsius estate and thus any withdrawal by such customer from the Earn program within the 90-day period preceding the commencement of Celsius’ Chapter 11 case could be deemed as avoidable withdrawals. That being said, the court also made it clear that Celsius creditors’ rights with respect to certain claims are reserved given the potential violation of applicable state and federal laws as well as allegations against Celsius and/or its CEO. Accordingly, Earn program customers could still raise claims with respect to the cryptocurrencies transferred to Celsius, including fraudulent inducement into the contract, fraudulent conveyance, breach of contract, and the unconscionability of the contract, on individual basis.

Also, going forward, users seeking services from crypto asset platforms may find it ideal (or even necessary) to at least skim through applicable terms of use and relevant governing documents so as to ascertain the fundamental rights and obligations governing the assets stored or otherwise used on that certain platform. Although the determination on the implicated rights and obligations is fact-specific, the contractual language may sometimes be dispositive, and it thus become important to have a good grasp of what is provided in the agreement and what other factual circumstances (e.g., statements made by relevant platform executives or marketing materials circulated with general public) are involved and are contradictory with the actual contractual language.

Relevant Developments in State Regulations

In addition to Celsius court’s ruling, one noteworthy development in relevant state regulations is the guidance published by New York State Department of Financial Services on January 23, 2023, the regulator who oversees and administrates BitLicense (which mandates all virtual currency entities doing business in New York to be licensed thereunder). In the Guidance on Custodial Structures for Customer Protection in the Event of Insolvency, the regulator emphasizes the following points by which the BitLicensees must abide with respect to the custody services offered to their customers.

  1. Segregation and separate accounting

    While 23.NYCRR.200.9 and 200.12 have generally set forth custody and book and records requirements for a BitLicensee, the regulator further stresses that (i) customers’ digital assets must be segregated from the BitLicensee’s own assets (both on-chain and on the licensee’s internal ledger account), and (ii) appropriate policies and procedures should be in place for such segregation.

  2. Licensee’s limited interest in and use of customers’ assets

    The regulator makes it clear that so long as a customer engages a BitLicensee for custody services, the licensee should take possession “only for the limited purpose of carrying out custody and safekeeping services” and should not establish a “debtor-creditor relationship” with the customer on the basis of the said services. The regulator also specifies that no other use of customers’ digital assets is permitted under the regulation and gives out some concrete examples, including (i) the prohibition of using digital assets under the licensee’s custody as collateral for an obligation and (ii) no extension of credit based on the said digital assets.

  3. Permitted sub-custody arrangements

    The regulator generally permits a sub-custody arrangements (e.g., retaining a professional wallet service provider) so long as the BitLicensee seeking such arrangement has obtained the regulator’s prior approval. The regulator indicates that given the nature of a sub-custody arrangement, such arrangement will be deemed as a material change to the licensee’s business, and the licensee must submit the following items (along with other applicable materials) for the regulator to review: (i) Risk assessment conducted for the contemplated sub-custody arrangement; (ii) Service agreement evidencing the arrangement; and (iii) Policies and procedures revised for the arrangement.

  4. Customer disclosure

    Finally, the regulator mandates that BitLicensees must:

    (i) clearly disclose to each customer in writing the general terms and conditions associated with its products, services and activities; (ii) obtain acknowledgment of receipt of such disclosure prior to entering into an initial transaction; (iii) specify in relevant agreement that it is the parties intent to form a custodial relationship but not debtor-creditor relationship; and (iv) make the standard disclosure and relevant agreements readily accessible on website.

In short, the guidance issued by the New York regulator primarily focuses on the “custodial service” for digital assets and its substance does not materially alter or deviate from the BitLicense requirements or relevant state or federal court rulings (like Celsius court’s decision on assets subject to the Earn program). That being said, the requirements under the guidance on segregation, separate accounts and restrictions would further straighten the legal and contractual relationship between licensed cryptocurrency platforms and their customers as all such platforms are required to store assets in separate wallets and ensure that no customers’ assets will not be commingled with platforms’ assets (e.g., through dubious transfer or appropriation of assets). Having such requirements reduced to legal/regulatory standards, customers now could at least expect more transparency and clarity when it comes to their cryptocurrencies or other digital assets entrusted with a NY-licensed custodian.

Stay tuned to Ingram’s NFT Newsroom to learn more about the latest developments and announcements, and connect with us on LinkedIn and Twitter.


By: Chih-Hsun (Tim) Lin


TimLin