BlockFi embroiled in bankruptcy drama over customer wallets 

Quick Take

  • Failed crypto lender BlockFi is in a legal dispute over hundreds of millions of dollars in customer wallets. 
  • The complicated custody issue has come up in several crypto bankruptcies and even caught the attention of the Securities and Exchange Commission.

While its customers have been locked out of their accounts since November, failed crypto lender BlockFi is locked in a bankruptcy court battle.

The war of words is playing out on a court docket in New Jersey, with the fight over customer wallets becoming so tense that BlockFi debtors have suggested the creditors in the case are “divorced from reality.” Those creditors in turn accused BlockFi of having a “temper tantrum.”

The case could provide cues for custody issues in other crypto cases, legal experts say, and the court battle also underscores how tricky it can be for customers of defunct crypto firms to get their money back. 

“It'll set a very important precedent for future crypto bankruptcies,” said Alex More, a partner at the law firm Carrington, Coleman, Sloman & Blumenthal.

A bankruptcy court is considering whether BlockFi customers can touch the digital assets in their wallet accounts. Lawyers for the BlockFi debtors argued in a December motion that clients should be given access, citing the company’s terms of service.

“The debtors have always prioritized doing right by their clients,” BlockFi’s lawyers wrote in a court filing. “The debtors seek to do just that, by permitting clients to access digital assets that are owned by them and were held in their wallet accounts on BlockFi’s platform as of the platform pause.”

The motion was met with objections from the Official Committee of Unsecured Creditors in the bankruptcy, along with another ad hoc committee of creditors. Several others, including individual creditors, also filed objections with the court. 

“No good deed goes unpunished,” BlockFi’s lawyers wrote in another filing. 

Lawyers have agreed to hash out their disagreements outside of the courtroom and update the judge on their progress at a hearing next month.

“This is not the first time a motion in front of me morphed into more than what was anticipated at the outset,” Judge Michael Kaplan said during a recent court proceeding. BlockFi did not respond to a request for comment. 

'Not enough money to go around'

The Official Committee of Unsecured Creditors in the BlockFi case agrees with allowing clients to access their wallets, but lawyers dispute BlockFi’s timeline for addressing the withdrawals.

The BlockFi debtors say withdrawals were paused on Nov. 10, when the firm announced it would halt withdrawals on Twitter. BlockFi filed for bankruptcy protection the following day. Some customers were able to move their money in the platform after the pause was announced, and BlockFi has asked for permission to update the user interface to adjust transactions to address the pause.

“There’s all kinds of issues as to when the withdrawals were paused. There’s all kinds of issues because some people still got transfers even though paused, and they didn't true it up on their internal ledgers as was the habit and custom when they were transferring money out of the interest accounts to the wallets,” said Joanne Gelfand, of counsel at the Akerman law firm. “That’s what we're interested in here, because the interest account holders, they're the ones that are going to really be holding the bag. There's just not enough money to go around.”

The objectors take issue with the Nov. 10 date, and instead are asking BlockFi to honor withdrawals through Nov. 23. For its part, the Official Committee of Unsecured Creditors has requested more legal analysis before wallets are reopened. The committee did not respond to a request for comment. 

'Good idea'

“Releasing wallet funds to account holders is a good idea, and one that the committee supports; but, there are certain legal issues that need to be worked through,” lawyers for the unsecured creditors committee wrote. “The factual record is incomplete and convoluted and demands substantial legal analysis before any conclusion can be made as to which transfers should be honored and to whom the money should be distributed.”

An individual creditor was more direct in his assessment. Andre Paim Carollo dos Santos said in a court filing that BlockFi was trying to “rely on their own public misstatements and misrepresentations to deprive BlockFi users of the funds which are fully and rightfully owned by them.”

Lawyers on either side of the dispute have not minced words. The BlockFi debtors say the analysis that the creditors committee has requested will be very expensive for the bankrupt crypto firm. 

“The committee’s proposals for the return of funds are divorced from reality,” the lawyers wrote, saying that the objectors have “initiated needless, burdensome and wasteful discovery and litigation” over the wallet issue.

The Official Committee of Unsecured Creditors, however, argued that BlockFi was the one filing unnecessary court documents. 

“The statement reads more like a temper tantrum than a thoughtful exposition of legal analysis, and the committee remains puzzled by this unnecessary pleading,” the committee wrote. 

Custody issues are widespread

BlockFi is hardly the first crypto bankruptcy to spark a fight over customer wallets. A judge in New York settled a similar issue in the bankruptcy case for failed crypto lender Celsius last month. 

“The issues are very similar in nature,” said Ido Alexander, the founder of AlignX Law. 

In that case, Judge Martin Glenn ruled that assets in Celsius Earn accounts belong to the company, not customers. The majority of Celsius users are part of the Earn program, which allowed users to deposit assets into an account that Celsius used to generate yields. Lawyers have cited the Celsius decision in BlockFi court filings, and crypto custody issues in bankruptcies like those two companies have drawn scrutiny from the SEC in recent weeks.

SEC Chair Gary Gensler said this month that digital asset firms are in broad violation of custodial rules meant to safeguard customers, and the commission voted to tighten existing custodial rules.

The outcome of the BlockFi case could also have an impact on crypto behemoth FTX, which filed for bankruptcy protection in November, although it won’t set a binding precedent. The exchange was once valued at $32 billion and had 9 million customers.

“Both the BlockFi terms of service and the FTX terms of service make it clear that that the title to the digital assets remain with the customer and do not transfer to the exchange,” More said. “Whatever the BlockFi court rules may very well set an important precedent for the FTX bankruptcy.”

FTX fight

The fight over customer assets is only beginning to emerge in the FTX case. The judge has not yet taken up a request filed by FTX customers who are seeking a declaration that assets they deposited on the platform belong to them and not the bankruptcy estate. Making matters more complicated, the former executives of FTX and its related trading firm, Alameda Research, are facing criminal charges for allegedly mishandling and commingling customer funds. 

In the meantime, BlockFi customers are left to wait while the bankruptcy lawyers hash out the fate of the digital assets in their wallets. 

The sums left in limbo are staggering. The BlockFi debtors estimate there are approximately $291.7 million of pending client withdrawals from wallet accounts, $375 million of digital assets that were requested to be transferred from clients’ Blockfi Interest Accounts to their wallet accounts and $7.4 million of digital assets that were requested to be transferred from client wallet accounts to BlockFi Interest Accounts. Additionally, there are $3 million of pending trades that were initiated but never effectuated during the platform pause period. 

“I don't think the single customer is really going to have much of an option here other than just sit and wait and see what the decision here is,” said Ido Alexander.

The many crypto bankruptcy cases playing out in courthouses across several states will hardly inspire more confidence in the industry, said Oliver Linch, the CEO of Bittrex Global. 

“The point of regulations is to protect people. And if you're sitting there googling U.S. bankruptcy laws at three o'clock in the morning desperately hoping to get your cash back, yeah, that's not going to inspire confidence in crypto long term or even in short term,” Linch said.

Disclaimer: The former CEO and majority shareholder of The Block has disclosed a series of loans from former FTX and Alameda founder Sam Bankman-Fried.

© 2023 The Block. All Rights Reserved. This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.