Crypto Chapter 11 Bankruptcies in 2022: What You Need to Know

What is a Chapter 11 bankruptcy, and how does it differ from others? Chapter 11 bankruptcy can protect a company, while leaving investors without repayment of debt owed. A crypto bankruptcy repayment plan can vary from other types, especially when debt is considered unsecured. In this article, we’ll define Chapter 11 bankruptcy and examine its effects on the average crypto investor.

What Is Chapter 11 Bankruptcy?

Chapter 11 bankruptcy is commonly referred to as “reorganization” bankruptcy. Crypto investors need to know what a Chapter 11 bankruptcy is, and how it can affect them.

Chapter 11 vs. Chapter 7 Bankruptcy

Chapter 11 and Chapter 7 bankruptcies might seem similar, but they’re very different. One bankruptcy involves liquidating assets, while the other one reorganizes debts. When a company is in dire financial straits, they can choose between several types of bankruptcies. Chapter 11 and Chapter 7 are the most common types. 

Chapter 7 is often referred to as a "liquidation" bankruptcy, as businesses move past the initial stage of reorganization and focus on selling off their assets. Usually, the bankruptcy court appoints a trustee to ensure all creditors receive payment in the correct order, which follows the rules of absolute property. For example, secured debt takes precedence over any unsecured debt. As a result, secured debts are the first to be paid. Once they’re paid off, the remaining cash and assets are pooled and distributed to creditors with unsecured debt.

On the other hand, Chapter 11 bankruptcy is intended to reorganize a business. It’s a complex form of bankruptcy. Not only are the filing fees expensive for Chapter 11, but the business must head to court several times during the reorganization process. Unlike Chapter 7, Chapter 11 bankruptcy allows the company to reorganize debts, emerging as a healthier business.

Bankruptcy Debt and Filing

Companies that want to file for Chapter 11 bankruptcy must request a bankruptcy court hearing. During this process, the debtor remains in business while trying to stabilize their company. These stabilization efforts may include selling off assets, cutting expenses and attempting to negotiate with debtors. All of these actions remain under the supervision of the court.

Debt is not absolved in a Chapter 11 bankruptcy, meaning the restructuring only changes the debt terms. The debtor must pay back the creditors with future earnings. When a company successfully emerges from Chapter 11, it operates with a newly structured debt. Unfortunately, if Chapter 11 is unsuccessful, the business will file for a Chapter 7 bankruptcy, and the company may then liquidate its assets to pay off debts.

Let’s look at the differences between a Chapter 11 and Chapter 13 bankruptcy filing.

Chapter 11 vs. Chapter 13 Bankruptcy

There are fundamental differences between Chapter 11 and Chapter 13 bankruptcies. Filing for Chapter 13 must implement a plan to repay the debts within three to five years. In most cases, the debtor may keep some assets. Chapter 13 bankruptcy filers often pay a monthly amount to a trustee, who then pays the creditors.

Chapter 13 bankruptcies require a trustee. However, Chapter 11 bankruptcies make this optional, and the trustee isn’t needed in most cases. The trustee reviews the bankruptcy proposal, makes recommendations to the court and distributes creditor payments. The Chapter 11 process can often be drawn out, taking several years to complete. Chapter 13 bankruptcy has a shorter approval process than Chapter 11. However, all disposable income must be made available to the trustee for distribution to the creditors during the repayment process.

What Happens During a Chapter 11 Bankruptcy Filing?

All Chapter 11 bankruptcies start with a petition filed in court. To qualify for Chapter 11, the debtor must not have any past bankruptcies deemed "non-compliant" by the courts. With the filing, the debtor must submit an income and expenditure schedule. The business must also list assets, liabilities, unexpired leases and executory (still to be fulfilled) contracts. Once the debtor files the petition, the company assumes the role of "debtor in possession," meaning that it retains control of operations and assets during the reorganization process.

The petition includes the debtor’s following information:

• Tax identification number
• Location of residence
• Location of principal assets
• An intended reorganized plan

When the court receives the petition, it charges a $1,167 filing fee and an administrative fee of $500. The fee must be paid in whole or as installments to the court.

The company must also file a plan of reorganization and disclosure statement with the court. The reorganization plan will contain the classification of debt claims and the treatment of each one. If the creditor has an impaired claim, the creditors can vote to accept or reject the plan of reorganization through balloting. A creditor's claim is considered impaired when the original terms of the debt change in a negative way, such as lengthening the payout period or reducing the interest rate.

Disclosures and Stays

A disclosure statement contains details about the debtor's liabilities, assets and business affairs. This information often allows the court to make informed decisions about the plan of reorganization. After the court has reviewed the disclosure statement and tallied the creditors' votes, it conducts a hearing on confirming or denying the plan of reorganization.

Since the Chapter 11 bankruptcy puts the debtor "in possession," the debtor is responsible for handling several functions, such as accounting for assets, filing reports with the court and examining any objections to claims. With the court's approval, the debtor in possession may employ professionals to help with these duties. These can include auctioneers, accountants, attorneys and appraisers.

Sometimes, a trustee may be required to monitor the debtor's progress in these reporting requirements. If the debtor in possession fails to comply with specific reporting requirements, the trustee may file a motion to dismiss Chapter 11, or have the case assigned to another bankruptcy chapter.

Some businesses may ask, "What is Chapter 11 bankruptcy, and how can it help with current judgments?" During this time, an automatic stay order goes into effect, suspending all foreclosures, collection activities, judgments and repossessions that occurred before the petition. Once the petition is filed, the stay against the creditor(s) immediately goes into effect. As a result, the debtor will have a chance to hold negotiations to resolve any financial distress. In some cases, secured creditors may apply for relief from the automatic stay to foreclose on assets and receive sale proceeds to satisfy their debts.

Once the Chapter 11 bankruptcy is filed, the debtor must have a plan within 120 days. Occasionally, the court can grant another 180 days to receive a confirmation for the plan. The plan's creditor claims are designated into classes for treatment in the reorganization plan. Additionally, the plan lists creditors in order of priority for repayment, with secured debts at the top of the list.

Planning and Rebuilding

In a Chapter 11 bankruptcy, an entire class of creditors must approve the reorganization plan. At least two-thirds of creditors, or one-half of the allowed claimants, must accept the reorganization plan. Also, it needs to be approved by one class of creditors who have impaired claims. After that, the reorganization plan is considered accepted by the majority of creditors.

Even if a class of creditors objects, the plan may move on, as long as specific requirements are met. The reorganization plan must be equitable and must not discriminate against a particular class of creditors. If there are no objections, the court will confirm the plan, which must comply with the rules outlined for Chapter 11 bankruptcy. After a ruling in court, the plan becomes binding and defines how the debts will be treated.

However, the court may decide not to accept the Chapter 11 bankruptcy reorganization plan. In this situation, the court can either convert the case to a Chapter 7 bankruptcy filing or dismiss it. A rejection of the plan will return the business to the same status as before the filing. With that, creditors may opt for a non-bankruptcy filing to protect their interests.

We’ve described what a Chapter 11 bankruptcy is — but what does it mean for crypto firms? Let’s find out, as some companies have filed for Bitcoin or crypto-related Chapter 11 bankruptcies to protect their assets.

What Happens to Existing Investors If a Crypto Firm Files for Bankruptcy?

When a crypto firm files for a crypto-related or Bitcoin Chapter 11 bankruptcy, their stocks and bonds continue to trade on the exchange, allowing them to proceed with normal business operations. Any firm facing a crypto bankruptcy must report its changes to the SEC. With the announcement of a Chapter 11 bankruptcy protection, there’s a risk that shares could lose their value. The announcement of a Chapter 11 bankruptcy may cause a company’s stocks and bonds to plummet, despite the reorganization plan put in place to satisfy creditors. 

Unfortunately, investors are the least protected entity in a crypto bankruptcy. Custodially held crypto assets are considered the property of the bankrupted firm. In a crypto bankruptcy, the asset may be subject to bankruptcy proceedings. In other words, customers could be treated as unsecured creditors. As such, these investors have little or no resources to recover their cryptocurrency or the equivalent cash balance in the event the firm goes bankrupt.

Chain of Events That Led to the Recent Crypto Implosion

News of any crypto bankruptcy often shakes investors. While cryptocurrencies have hit all-time highs over the past couple of years, there’s been a downturn of approximately 75% over the last few months. Crypto Chapter 11 filings have created fear in the market.

Terra Ecosystem Experiences Unparalleled Growth

At one time, Terra (LUNA) was the most successful blockchain platform. Its native token, LUNA, benefited from the growth of the stablecoin known as TerraUSD (UST), and the DeFi ecosystem started to gain mainstream popularity with many investors. In 2021, LUNA traded at an all-time high of $199. Additionally, the entire Terra DeFi ecosystem was valued at $45 billion.

With Terra’s unprecedented gains, a crypto bankruptcy wasn’t even on the radar for most investors. Many believed Terra would never head toward a crypto bankruptcy with its unprecedented gains. However, there were other indicators that the crypto market was headed for turbulence.

Do Kwon Dissolves Terraform Labs Korea

While Terra experienced unparalleled growth, there were signs of cracks in the company. Few people knew that these signs would cause a shift in the entire crypto market.

Terraform Labs founder Do Kwon closed down the company on May 4, 2022. This action took place days before the collapse of UST and LUNA. After a general shareholder meeting on April 30, 2022, Terraform Labs Korea dissolved its branches in Seoul and Busan. Do Kwon was listed as the liquidator in the crypto bankruptcy filings. After that, the platform began to face more challenges in the market.

Algorithmic Stablecoin UST Loses Its Peg

The TerraUSD stablecoin, UST, briefly lost its peg to the U.S. dollar, falling to $0.987 on May 8, 2022. UST was once known as the largest algorithmic stablecoin, and some investors considered it the backbone of the crypto economy. Unfortunately, UST lost its peg after the team embarked on a bid to build its Avalanche and Bitcoin reserves. Depegging often occurred when investors made significant withdrawals from Anchor Protocol, a lending market that offers high yields to users who deposit UST. Large quantities of UST were also withdrawn from liquidity pools, including withdrawals made by Terraform Lab’s creators.

Panic Withdrawals Cause LUNA and UST to Plummet in Value

After these events, LUNA and UST prices rapidly lost between 70% to 99% of their value. Terra had focused on building its reputation and fame in the stablecoin space, but its price plummeted after the depegging. Unlike most other stablecoins, which are backed by fiat money, UST was backed by an algorithm that maintained its price. To support UST, LUNA had to be minted. As panic set in, investors and traders quickly sold their UST for other currencies, creating a stunning price fall for both UST and LUNA.

Crypto Entities State ‘Extreme Market Conditions’ as Main Reason to Halt Withdrawals

The debacle with LUNA and UST caused panic in the market. In some cases, these extreme market conditions put a halt to withdrawals. When news of the LUNA and UST fiasco hit, the company paused all withdrawals to avoid causing more pain to the fragile market. Celsius has been one of the most prominent players in the crypto lending space, with over $12 billion in assets and $8 billion in assets lent to clients. However, the move raised concerns about its solvency as the value of its assets fell by half in less than six months. Celsius is the biggest holder of CEL, which has seen 97% of its value erased. Many wondered if Celsius was going to be the next firm to file a crypto bankruptcy, which they eventually did on July 13, 2022.

Major Firms Are Caught Off Guard With News Leaks of Exposure to Terra Ecosystem 

The implosion of the Terra ecosystem caught many of the major crypto platforms off guard, leaving them to wonder about the possibility of more Chapter 11 bankruptcy filings for crypto firms. Only months earlier, UST had been the leading stablecoin in the market. The situation with LUNA and UST sent the crypto market into a tailspin. Like Celsius, many significant firms sought ways to reduce the pain in the crypto market. While these stops may have helped stabilize the market in the short term, they’ve also led to uncertainty and the fear of another crypto bankruptcy announcement.

Hedge Funds, Brokerages and Lending Platforms Face Insolvency Risks

The Terra ecosystem’s weaknesses have highlighted other problems in the crypto marketplace, leading to fear of more Chapter 11 filings. While many crypto lending platforms, hedge funds and brokerages had looked like can't-miss investment opportunities, the past two months have shown that some of them are at risk of insolvency. When these entities file for crypto bankruptcy, there’s hardly any protection for investors, further compounding investors’ fears.

Major Crypto Firms That Have Filed for Chapter 11 Bankruptcy Protection

Along with the woes of the Terra ecosystem, other major firms have filed for their own crypto bankruptcies. Some of these firms include:

Three Arrows Capital

Three Arrows Capital (3AC) has backed many projects, including holding approximately $200 million in LUNA coins. With the broad decline in the market, LUNA's prices fell. As a result, 3AC failed to meet its margin call and was unable to make payment on a loan from Voyager Digital. While Three Arrows Capital didn’t officially file for a crypto bankruptcy, its liquidation was ordered by the court in the British Virgin Islands on June 27, 2022. 

Voyager Digital

The actions of Three Arrows Capital may have been the cause of Voyager Digital Assets Inc.'s own crypto bankruptcy. Voyager Digital needed to protect its assets after Three Arrows Capital defaulted on a $666 million loan. The service suspended all withdrawals and trades on the platform days before the crypto bankruptcy filing. At the time of its Chapter 11 bankruptcy filing on July 6, 2022, the company held between $1 billion and $10 billion in assets and liabilities.

Celsius Network

On July 13, 2022, the Celsius network filed for Chapter 11 bankruptcy. Problems for the company have resulted from the crypto bankruptcy concerns of Three Arrows Capital. The value of CEL, the currency issued by Celsius Network, has significantly plummeted, leading to more problems for Celsius. The fintech platform had claimed it held $167 million in cash, but Chapter 11 bankruptcy court documents indicate a $1.2 billion shortfall.

FTX and Alameda Research

On November 6, 2022, FTX, one of the largest crypto exchanges, was rumored to have artificially inflated its balance sheet due to overleveraging on its token, FTT. This created fear that FTX was facing liquidity issues, causing a bank run by its users. This eventually led to the exchange’s pausing of withdrawals on November 8, 2022. On November 11, FTX — together with its trading company, Alameda Research — filed for Chapter 11 bankruptcy, immediately facing almost $8.8 billion in total liabilities. The new FTX CEO, John J. Ray III, has taken command and will be overseeing the bankruptcy process. Ray previously oversaw the bankruptcy of Enron, another prominent company that was fraudulent in its corporate control.

Who Else Is at Risk?

Some other firms had exposure to Three Arrows Capital, while one firm had exposure to FTX and Alameda Research. This means they may face a crypto Chapter 11 filing and are at risk of insolvency. A few examples of these firms on the edge of crypto bankruptcy include the following.

Babel Finance

Babel Finance, a crypto financial service provider, has temporarily suspended the redemption and withdrawals of crypto assets after the lender failed to pay its clients. Many investors wonder if the company can remain solvent, or must face a crypto bankruptcy.

BitMEX

BitMEX, a crypto trading platform, was on the verge of releasing its token, the BMEX. However, with unfavorable market conditions, the company has decided to postpone the release.

CoinFLEX

After a counterparty failed to meet a $47 million margin call, CoinFLEX, a crypto platform for earning and trading crypto, halted all withdrawals on June 23, 2022. The company has reopened, but is only allowing investors to withdraw 10% of funds; the remaining funds are listed as locked. Some experts in the crypto industry have wondered whether CoinFLEX is keeping these funds for a potential Chapter 11 bankruptcy filing.

Finblox

With its exposure to Three Arrows Capital, Finblox, a crypto digital asset platform, imposed a $1,500 withdrawal limit on customers. However, the company plans to raise the limit to $50,000 in the coming weeks for verified users.

Genesis Global Trading

According to reports, Genesis Global Trading, a noncustodial crypto OTC market-maker, experienced hundreds of millions of dollars in losses due to its exposure to Three Arrows Capital. Fortunately, Digital Currency Group, its parent company, has helped shield Genesis from some of these losses, preventing a crypto bankruptcy.

BlockFi

BlockFi, one of the most popular crypto lending platforms for earning yields on idle crypto assets, was exposed to counterparty risks and is potentially facing insolvency. It supposedly received financial assistance from FTX and has also paused customer withdrawals. BlockFi is currently exploring a Chapter 11 bankruptcy filing. It’s also in the process of seeking financial help from other organizations, such as Binance.

The Bottom Line

Crypto bankruptcy is not uncommon in these uncertain times. Platforms, hedge funds and firms teetering on the brink of insolvency can make any investor nervous. While most investors know what a Chapter 11 bankruptcy is, they may not understand what a crypto bankruptcy can do to their assets. Sometimes, investors may be deemed unsecured debtors, with no means to reclaim any of their digital assets. While understanding what a Chapter 11 bankruptcy is may not lead to recovery of everyone’s funds, it’s important for any investor seeking knowledge and empowerment to become better informed in the days ahead.