Shoba Pillay, the Examiner appointed in Celsius’ bankruptcy cases, filed her interim report on November 19, 2022. The Celsius Examiner’s report provides some important insight into a crypto-exchange’s operational and risk management failures which may provide investors and creditors some insight into what to expect in FTX.

The initial report provides important insight on the financial management at Celsius and treatment of various types of customer accounts. Given Celsius’ management of the different accounts, and the commingling of assets between and among them, “customers now face uncertainty regarding which assets, if any, belonged to them as of the bankruptcy filing” as explained by the Examiner. Her report is extremely thorough and can be accessed here. We highlight a few high-level observations from the report below.

  • Earn Program. Pursuant to its “Earn” program, customers purported to lend cryptocurrency to Celsius in exchange for certain “rewards” plus the return of their principal. The terms of use, while changing over time, were largely consistent with respect to Celsius’ ownership of all cryptocurrency deposited. While each customer’s account reflected the amount of each digital asset deposited (plus rewards), Celsius did not have individual wallets holding those assets. Instead, when amounts were deposited by a customer they would be swept into one or more “Main” wallets that pooled many customers’ assets. Celsius accessed those accounts at its discretion for purposes of funding its many investments — needed to generate its customers’ expected returns. When needed, Celsius effectuated withdrawals related to the Earn program by transferring assets from any one or more of its many commingled Main wallets to its customers’ external wallets.
  • Custody Program. This program was launched in April 2022 in response to investigations then underway by various state regulatory authorities. The program was designed to allow the company a mechanism to maintain relationships with unaccredited customers in the US, purportedly holding their assets in “custody” without the benefit of rewards. Generally, all deposits of US customers following April 15 would go to Custody accounts (and accredited customers could then move them to an Earn account). The terms of use with respect to Custody accounts were clear — title remained with the customer (although they also identified bankruptcy risks). Hastily developed however, the Custody program did not provide customers with individual wallets that segregated assets. Instead, the company sought to maintain an aggregate level of deposits in commingled wallets (as expressly permitted by the terms of use) that roughly matched the assets held in such program. When first deposited by a customer, assets would be directed to the company’s Main wallets at which time it lost any ability to trace an assets to a customer. From Main wallets, assets were periodically, and manually, transferred to Custody wallets. The aggregate amount contained in these commingled Custody wallets did not necessarily correspond to the aggregate customer balances allocated to them. Reconciliations occurred from time to time. When a shortfall existed, Celsius would transfers coins from a number of sources into Custody wallets to regain balance. In the days leading up to the filing, the swings in liabilities to customers with Custody accounts and the amounts maintained in the Custody wallet swung by millions of dollars in value. The Examiner reports that the deficit reach $45 million by June 28th. When it came to withdrawals to Custody customers, Celsius effected transfers, not from Custody wallets, but instead from wallets located in a different workspace.
  • Withhold Accounts. Celsius was unable to offer Custody accounts to users in nine states due to regulatory issues. For customers in those states, the company purported to maintain Withhold accounts as a temporary substitute. These funds were unavailable for either Custody accounts or the Earn program, and customers were advised to withdraw them. Unfortunately, customers could not withdraw funds through the Celsius app but rather need to contact customer care. In the interim, rather than be treated similarly to Custodial accounts, assets supposedly held in Withhold accounts were held in the Main wallets and available for use by Celsius as those in the Earn program.

Based on the Examiner’s initial report, it appears that Celsius’ ability to match the cryptocurrency deposited by a customer, whether in an Earn account, Custody account or Withdrawal account, was non-existent shortly following deposit and that assets were commingled with other Debtor assets for a short period of time. While certain customer accounts were being tracked by accounting ledgers, the facts revealed by the Examiner’s report will provide the Bankruptcy Court with additional factual guidance in determining whether account holders can claim that their assets were being held in trust or “constructive trust.” In other non-crypto bankruptcy cases, whether or not trust funds can be identified or traced after such funds have been commingled (sometimes using a technique called the “intermediate balance rule”) helps to determine how much a beneficiary can actually recover. Under this standard, if the amount of the commingled deposit equals or exceeds the amount claim to be in trust, then a constructive trust may be imposed. The Examiner’s report provides important factual backdrop for that rapidly approaching litigation, the outcome of which will certainly have dramatic consequences of customers’ ultimate recoveries.

Relatedly, while an examiner has yet to be appointed in the FTX case, it will be important to monitor and understand the severity of record keeping and segregation failures by FTX and the impact it will have on their account holders and creditors.