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A $4 Billion Reason to Consult Your Lawyer – A Cautionary Tale of How Celsius’s Legal Counsel “Saved the Day”

22/02/2023

People often resort to simpler and cheaper methods for creating standard contracts and terms of business, believing that things will go “as they should”.

However, it also often happens that one clause in a contract dramatically changes the future course of events. Moreover, when it comes to cloud contracts (most commonly referred to as Terms of Use or Terms of Service), the “fine print” can impact thousands of people who have agreed to such terms just by clicking on “agree” when registering a user account.

A great example of how legal assistance can make an incredible difference (in this case, a difference of 4 billion dollars) is demonstrated by the recent developments in the crypto world with the so-called Celsius crisis, which is often referred to as the “Lehman Brothers experience”. This blog delves into the interesting lessons from the bankruptcy proceedings held against the crypto and DeFi company Celsius in the United States.

For people trading digital assets, this story is already well-known, but now we finally have an example of how one (seemingly not so important) piece of advice or sentence can impact more than 100,000 individuals (creditors of this crypto giant).

What Business Did Celsius Network Run?

At its core, Celsius Network was a crypto and DeFi company that primarily focused on collecting crypto deposits from its clients (mostly smaller investors) and then investing those funds in the digital asset market. In addition to other services and programs, it offered its users, Celsius attracted clients by offering high-interest rates in crypto through its “Earn” program for depositing crypto, with the promise of little risk involved in such transactions. Celsius used the funds it collected in this manner for its own further (often highly risky) investments.

Celsius based its Earn program and platform on the following functionalities:

  • No deposit and withdrawal fees for the deposited crypto assets,
  • No obligation for the depositors to conclude fixed-term deposit agreements.

So, Celsius offered interest on deposited crypto funds and provided its clients with the right to withdraw their funds at any time. In his social media appearances, one of the co-founders, Alex Mashinsky, promised an annual return of 17% on invested funds through the Celsius Earn program!

However, the rising interest rates in 2022 and other economic and geopolitical events led to a mass sell-off of tokens, causing a new drama in the crypto world. The problems for the outside world became evident in mid-June 2022, when Celsius, facing increasing withdrawal demands, froze its clients’ funds, making it impossible for anyone to “withdraw” their investment.

At one point, the platform had a value of around $4.3 billion in assets and $5.5 billion in debt. After negotiations to secure funding from other crypto companies failed, it was clear that bankruptcy was inevitable.

Then, the situation became even more turbulent. During the bankruptcy proceedings, the question of property rights arose, that is, the question of who owned the digital assets on the Celsius platform became one of the key issues.

The answer seems simple at first. The users, or clients, had the right to use these funds as they pleased – so the crypto they deposited was theirs, wasn’t it? However, in January 2023, a competent bankruptcy court in New York ruled that the deposited digital assets represent Celsius’ ownership[1].

This decision is not a product of mere coincidence, and it determined the fate of more than 4.2 billion US dollars worth of deposited digital assets[2]. How and why this happened, we analyze below.

Who Owns the Deposited Digital Assets?

To answer this question, it is first necessary to understand the positions of the users – depositors and Celsius as a service provider.

Celsius is a company that has gone bankrupt due to its own insolvency, which means that all of Celsius’ assets are subject to settlement of creditors’ claims. In other words, all creditors’ claims must be discharged from the remaining assets of Celsius, according to the order and rules established by law. However, this does not mean that every creditor will get their fair share. It often happens that such satisfaction of claims is negligible or remains completely unfulfilled, which creates reasonable concern for creditors in any bankruptcy proceeding.

However, one of the exceptions that allow some creditors to sleep soundly in such cases is the status of a privileged creditor. A privileged creditor is a person who, based on their personal or property right, has the right to demand that a specific item be separated (extracted) from the bankruptcy estate, i.e., the property of the bankrupt company (the bankruptcy debtor). The consequence of such extraction is that the item is separated and directly returned to its rightful owner because the bankruptcy debtor is not actually its owner.

The extremely privileged position of the privileged creditor, therefore, consists in the fact that such a person will get their item or property back, and will not have to be part of a complex and uncertain bankruptcy process in which other creditors will try to settle their claims from the remaining bankruptcy estate. The main condition for extracting a specific item from the bankruptcy estate is that a particular person has ownership of the specific item that is currently in possession of the bankrupt company. This was precisely the point of contention between Celsius and the individuals who deposited their cryptocurrency. Basically, depositors claimed that the cryptocurrency was their property, while Celsius claimed otherwise.

Why Did the Court Rule That the Deposited Digital Assets Belong to Celsius and Not to the Users-Depositors?

The reason for this decision lies in the wording of one of Celsius’ general terms and conditions, which all depositors accepted simply by clicking, when using Celsius’ Earn program on the platform’s website. By accepting these general terms and conditions, depositors agreed to transfer their ownership rights on the deposited cryptocurrency to Celsius.

This contractual mechanism is not unfamiliar in traditional banking agreements. It is lesser known to the public that even with banking services, users are also obliged to transfer a certain amount of money to the bank through a deposit agreement together with their money ownership rights to the bank, while the bank has obligation to return the money to its client upon request, as well as to provide certain payment services or pay interest in return.

Celsius applied a similar contractual mechanism in its general terms and conditions. As a result, Celsius clients, while entitled to interest and the return of deposited digital assets, cease to be the owners of the transferred crypto assets until they are essentially returned to their crypto wallets.

The legal background for such contracting lies in the fact that without this transfer of ownership, a bank or DeFi company would not have the legal basis to reinvest such funds in their own name and for their own account as part of their own property, for the purpose of making a profit. Therefore, the mechanism is such that users of these services exchange their ownership rights for interest, while the bank or DeFi institution acquires ownership of money or crypto for the purpose of its use for further investing and profit-making.

Could the Takeaway Be: It Is Essential to Include Numerous Comparable Contractual Clauses in the Standard Terms and Conditions of a Business, at All Costs?

The answer to this question is both yes and no. The example of Celsius highlights the importance of incorporating well-crafted protective clauses into the general terms and conditions of business. In this case, these contractual provisions protect the service provider, not its users.

General terms and conditions of business, as well as contracts in general, are of invaluable importance for digital services, primarily since these activities are characterized by innovation and constant change, which often develop faster than the legislator can keep up. As a result, these industries often rely on well-formulated contractual provisions as the only protection against uncertain and unforeseeable consequences. Therefore, in addition to the significant business logic that demands maximum profit with minimal costs, we should also keep in mind the other one, which states that prevention is better than cure, as it is often much more expensive to cure the consequences than to prevent them from happening.

However, the mere incorporation of contractual provisions that would maximally aim to protect one of the contracting parties can often be contrary to the law and legal principles that regulate the relevant matters. Therefore, such an approach is in many cases not advisable.

Finally, the $4 Billion Question Is: How Do I Know Which Provisions and in What Manner to Incorporate in Order to Be Maximally Protected in the Future?

The answer to this question depends on the client’s specific needs and the business model’s circumstances, but what makes a fundamental difference is knowledge of the crypto industry and its legal regulation. Namely, the legal system of each country should involve a multi-step observation aimed at producing well-formulated provisions of general terms and conditions and contracts in general.

Simply put, it is necessary to go through the following thought phases:

What Will Now Happen With Celsius?

There are two possible scenarios ahead for Celsius. The first scenario is a standard bankruptcy process in which fair and equitable settlement of creditors’ claims would be attempted by selling Celsius’s assets, including user-deposited crypto. The second scenario basically comes to the Restructuring of the company. Recently, Celsius’s lawyers announced that the bankrupt crypto giant aims to transform into a new “Company for recovery” which could happen in the coming months. The proposal, which is still awaiting approval from the creditors’ committee and other relevant state bodies of the US, involves a mechanism that could be set down to the following. One part of the creditors, who fulfill the certain threshold criteria, would receive a new digital token (called Asset Share Token or AST) that would represent a proportional part of the remaining Celsius assets’ value. Thus, each creditor would receive the new AST digital token instead of their deposited digital assets, which would correspond to the value of the digital assets they previously deposited.

The owners of the new AST token would then either have the option to hold onto their tokens and gain the right to future dividend payouts or sell them on the open market. The remaining users, estimated to make up between 60% and 70% of the platform’s user base, who would fall below the prescribed threshold, would receive a one-time payment in a liquid cryptocurrency such as Bitcoin, Ethereum, or one of the stablecoins. This approach aims to avoid total bankruptcy while partially satisfying a certain number of creditors.

It remains to be seen how things will develop in the coming months and whether this crypto giant will be able to overcome the problems it faces through digital assets once again.

What Lessons Can We Draw From All of This?

Many people were not surprised by the Court’s decision, given that the Terms of Use are legally binding, even if users do not fully understand or read them at all. In this particular case, it can even be stated that Celsius’s Terms of Use were extremely explicit regarding the ownership of the property that users deposited within the Earn program. Once deposited, the crypto became Celsius’ property in every sense.

Therefore, the most important lesson is that cloud contracts have extreme significance in industries such as IT. The reason often lies in the nature of the IT industry itself, namely its highly innovative nature making it hard for the regulative to keep up with. As a result, contracts or general terms and conditions of business are often decisive in regulating the mutual rights and obligations of users and service providers. The second lesson is the one for users of online platforms, which is that the key to avoiding unfavorable scenarios such as this one is to be well-informed and to read the terms they agree to.

This court decision will be the subject of many analyses and comments within the legal profession, as well as in the crypto community. However, this decision will not set a precedent, that is, it will not be sufficient to draw a definite conclusion in each similar dispute that might arise. In fact, determining ownership of crypto assets on platforms is a complex issue whose answer will vary depending on the specific circumstances of each case, as well as the specific terms and conditions offered by the online platforms.

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