Author:
Global | Publication | February 2023
Hot off the press in the last week or so is the proposal by lawyers for Celsius Network, a crypto lender currently subject to Ch 11 proceedings in the United States, that the company would seek to ‘reinvent itself’ as a new publicly traded corporation. The proposed restructuring plan would also see creditors, who have assets held on the Celsius Network platform, receive a token which reflects the face value of those assets. The details of when and how those assets are to be valued has not to date been revealed.
The object of the plan is to retain the current crypto assets on the platform, rather than sell them at fire sale prices in the current market. Creditors allocated tokens could either hold those tokens, which would entitle them to dividends over time, or the tokens can be sold in any market where there are buyers.
The type of plan proposed is arguably best considered when crypto businesses, such as cryptocurrency exchanges or lenders, are facing financial distress. Such businesses often have no traditional secured debt, with the predominant creditors being customers who have deposited cryptocurrency with the platform. These businesses also rarely have significant tangible assets with the assets being both liquid and illiquid digital assets that may or may not have a market value on any particular day.
So the obvious question for anyone managing an appointment over such a business is ‘could a Celsius type proposal work with my appointment?’ In Australia, at least, we think that it is feasible to use a token to either restructure a crypto company’s debt or vary creditors’ rights under the Corporations Act. However, there are complexities about whether such a token would be caught by the Corporations Act as a ‘financial product’ or be subject to any other regulation around promoting such assets in the Australian market. There are also difficult issues to face when seeking to value the tokens and advise creditors about their options.
The concept of tokenising debt or an IOU to creditors, is not new in the crypto industry. It was successfully employed in 2016 when the Hong Kong registered cryptocurrency exchange Bitfinex was hacked and the exchange was robbed of 120,000 Bitcoin (valued at $72M at the time). Rather than file for bankruptcy Bitfinex created BFX tokens with each representing one dollar of the amount that had been lost in the hack.
The object of the plan involving tokens was to allocate them to customers of the exchange in consideration for agreement that those customers would not immediately seek the return of the hacked cryptocurrency. Commercially the purpose of the tokens was to incentivise creditors to agree to a voluntary moratorium on enforcing their claims to avoid a ‘run’ on the exchange.
Notwithstanding that not all customers had actually suffered loss from the hack, the allocation of the losses was calculated on a pro rata basis across the total holdings of all accounts (which has been the process used in a number of insolvencies with claims on a fungible asset base). Accordingly, each customer bore the company’s loss from the hack on a pari passu basis in a similar way that would have occurred had the company formally entered bankruptcy. Practically this saw each customer account credited with the new BFX token at the rate of 1 BFX to 1 dollar lost.
Ultimately the BFX tokens were required to be redeemed by Bitfinex (or a related entity), at par, and prior to that redemption the customers could trade BFX in any available market. Within 8 months of the hack Bitfinex had used profits from its ongoing trading activities to redeem all BFX at par or had exchanged their tokens for shares in the Bitfinex holding company.
Bitfinex repeated the tokenisation of debts owing to customers in 2019 when a significant portion of its assets were frozen during a regulatory inquiry and it was again required to halt withdrawals to stop a run on the exchange. This time Bitfinex created the LEO coin as compensation for its customers who could not immediately withdraw their cryptocurrency. The token contained both a trading and redemption right at par. The LEO tokens are being redeemed on a rolling monthly basis, based on the company’s monthly revenue (or the receipt of additional funds), with the majority of the LEO redeemed during 2022 with the proceeds of Bitcoin recovered by US authorities relating to the 2016 Bitfinex hack.
Many pundits have criticised tokenising debt as ‘outrageous,’ ‘feeding into the cryptocurrency Ponzi scheme’ or ‘a clear breach of all regulatory controls.’ Those opinions are valid and the basis for the financial distress of the business should be taken into account together with the relevant legislation and regulations in each jurisdiction. However, what also needs to be considered is the object of placing a company’s affairs under some form of administration when it experiences financial distress. In Australia that is to either maximise the chances of the company continuing in existence or if that is not possible, to provide a better return to creditors (and members) than would result from an immediate winding up of the company.
With that in mind what are the obvious risks and rewards for creditors consenting to some or all of their claims being tokenised?
In the best case scenario the company would trade on or be sold, the tokens would be redeemed or exchanged for shares and the creditors would get all of their money back in dollar terms. It may take time but it would avoid a once off payment at a significantly discounted rate. However, it may only work in situations where there is a real possibility of the company trading out of its difficulties and returning to profitability.
As a worst case scenario customers will be left with useless tokens and will have given up the opportunity to recover the previously proposed once off payment. However, if there is a market for the tokens there is nothing stopping creditors from assigning or transferring their debt tokens and cutting their losses immediately, leaving the prospect of a company turnaround to others with a greater appetite for risk.
The 2016 Bitfinex experience indicates how a market may react to trading such tokens. Initially the price of each token plunged to approximately 15 cents (from the $1 par value). A surge of large purchases brought the price up to approximately 50 cents with the token trading at approximately 90 cents at the point at which all tokens were redeemed. So in insolvency terms, a creditor, at worst, would have received 15 cents in the dollar if they had sold their BFX tokens at the point of receipt. At best the recovery was 100 cents at the point of redemption. So a true loss from the tokenisation would only have occurred if the company had not turned around and the creditors would have received more than the 15 cents upon the company’s liquidation.
Reorganisation or restructuring a company or corporate group in financial distress often sees unsecured creditors taking a haircut on their claims in favour of salvaging something. A liquidation of corporate assets regularly has creditors faring even worse.
But what if it was possible for creditors of crypto businesses to actually get themselves a better overall deal if viable businesses were permitted to trade on and restructure their debt with tokens that permitted customers to be repaid over time? Or better still provided for a repayment with other entitlements attached that could yield value over and above compensation?
There are several different ways that such a proposal could be approached in Australia.
This is the most effective way to structure a tokenisation if the company is not in fact insolvent. The effectiveness of this was seen in Bitfinex and has the advantage that the company that is attempting to trade on is not stigmatised by the legislative requirements in Australia to note on all public documents that a company is subject to some form of insolvency process.
Such a workout will be most effective if there is a relatively concrete prospect of a turnaround of the business or the reason for an inability to meet immediate obligations is readily explainable with the restructuring only necessary for a short to medium term fix. In the context of crypto businesses this could be when there is a temporary halt on withdrawals or there has been a hack of some but not all cryptocurrency assets. Theoretically a company could trade through such an event if it did not face a ‘run’ on withdrawals.
In traditional insolvency scenarios this course has limited success unless creditors have an incentive to agree to a restructuring plan or are a small and compliant group. However, an informal work out may have some merit where tokens can be programmed to provide creditors with benefits for some patience and a realistic plan. It is also important to note that many investors in the crypto space are believers in the product. Many are motivated to remove themselves from the infrastructure of traditional finance so a tokenised debt offering may have some appeal to the types of creditors to which it is aimed. As an example, many Twitter threads indicated that leading up to the Ch 11 filings of FTX there was a preference amongst customers of the exchange to allow the directors to adopt non-traditional methods to make customers whole rather than to commence a formal bankruptcy process.
If directors suspect that a company may become insolvent (for example,if there is suspicion that there may be a run on a digital currency exchange because of certain activity in the market) then they may avail themselves of the safe harbour regime to attempt to restructure the business.
In such a scenario the usual course is for the business to halt withdrawals. Such a strategy could be supported by the safe harbour provisions if the director(s) is in fact taking this course with further action in mind. Such action could include tokenising some or all of the debt owed to customers in consideration for a moratorium on withdrawals with a view to trading the business out of its immediate difficulties. It is beyond the scope of this paper to consider the intricacies of the safe harbour regime save to say that in the context of tokenising debt the outcome of such a course would need to likely lead to a better outcome for creditors than the immediate appointment of an administrator or liquidator to the company.
A scheme of arrangement may be the preferred course where the objective is to have creditors give up their rights against third parties or related entities. However, schemes are cumbersome, expensive and time consuming requiring two court approvals and detailed material to be provided to creditors pursuant to legislative requirements. It is likely that a scheme would only be recommended when the company(s) is significant, the benefit to creditors is clear and there is an issue present which cannot be solved by a deed of company arrangement.
A deed of company arrangement may provide the best formal tool to utilise when tokenisation is contemplated. Of particular importance is the continued trading of the business during the period of the deed (albeit the company is required to advertise its status as a company subject to a deed of company arrangement). The tokenisation could simply form part of the resolution for creditors to approve the deed. The terms of the tokens and the redemption rights and obligations would also comprise the arrangements with creditors in a similar way that capital injections are recorded. Of course, a deed should only be recommended if that course of action is in the best interests of creditors. The administrator must disclose the terms of the deed to creditors and the report to creditors must also contain sufficient detail to enable creditors to make an informed decision about their interests including whether the return on a proposed deed of company arrangement is more favourable than that likely to be received upon winding up the company. Accordingly, significant detail in relation to any proposed tokenisation, and the likely outcome of that for creditors, would need to be included.
If it is envisioned that a crypto business would be stigmatised by trading under the deed of company arrangement, or if selling the company will accelerate payments to token holders, then there may also be merit in utilising a creditors’ trust where the trust could be used as the vehicle for depositing the funds necessary to redeem the tokens.
Although not common, options for agreements with creditors of a crypto business already in liquidation are also available. However, these options will rely more on an external market for the tokenised debt rather than the prospects of trading the fallen business out of its current difficulties.
Section 477(1)(c) of the Corporations Act allows a court appointed liquidator to make any ‘compromise or arrangement’ with creditors with an actual or alleged claim against the company. This particular right may be of use to enable a liquidator to compromise claims with willing creditors but will only have utility against creditors who actively assent to the arrangement. Accordingly, there may be merit in utilising the provision if large creditors can be convinced to tokenise debts, and vary their statutory rights, while smaller creditors are repaid in accordance with the ordinary statutory regime.
Alternatively, a liquidator can look to section 510 of the Corporations Act to enter into an arrangement to bind the body of creditors and adjust their rights. The phrase ‘arrangement’ is to be construed broadly. However, an arrangement that renders a company solvent so that a winding up resolution is not passed is not covered and in such circumstances the scheme provisions must be used. That is, after the arrangement is entered into there is still a requirement that a resolution be passed for the winding up of the company if that has not already occurred.
The procedure is relatively quick and unlike a scheme of arrangement does not require court approval (although court directions could, and have, been sought). Case law indicates that the procedure can be used to bind dissenting creditors when they are paid pari passu with voting creditors (otherwise the dissenters need to consent to the arrangement). However, it is unclear whether that proposition requires all creditors to be paid pari passu or whether it is flexible enough to only apply to creditors of the same class. On the latter interpretation it would be possible to repay the debts of priority creditors and then tokenise the claims of some or all of the customer creditors that intend to continue trading in cryptocurrency. If the former interpretation was employed it is feasible to think that the arrangement could fail if a priority creditor dissented on the creditor vote and then appealed to the Court to have the arrangement set aside or modified (section 510(4) Corporations Act). The latter interpretation of pari passu lends itself to separating creditors into classes and paying those classes at the same rate of return, as occurs in schemes, which may support the idea that such a proposal is in fact an attempt to bypass utilising a scheme of arrangement.
Of course, once it is established that tokenising debt can be done legally the ancillary questions include whether it should be done, if it would be successful and whether there are any additional limitations in Australia or another jurisdiction that could impede a successful outcome.
It is beyond the scope of this paper to consider all of the additional requirements and obligations in relation to offering crypto assets to the public in Australia save to say that consideration must be given to the structure and programming of any token and whether that proposed is a ‘financial product’ for the purpose of the Corporations Act. Further, where an insolvency professional has an ongoing role in dealing with those tokens, whether there is any requirement to hold an AFS licence (for example, if the tokens were a liability of a creditor’s trust).
Finally, a practical limitation to the concept of tokenisation appears to be the lack of a market for trading the tokens in Australia. This is particularly important when a benefit to incentivise creditors to agree to tokenisation is the ability to trade or realise the tokens depending on a creditor’s preference. Until such a market exists, and is viable, it is difficult to see how tokenisation could successfully operate unless a financially distressed business was able to utilise its own platform (or that of a related entity) to trade the issued tokens.
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