Two crypto lawyers discuss Three Arrows Capital’s bankruptcy and liquidation: How investors can learn from it and reduce losses

The recent order by the British Virgin Islands court to liquidate 3AC and 3AC's application for Chapter 15 bankruptcy protection in the United States seem to mean that the 3AC incident itself is coming to an end. Crypto industry lawyer @wassielawyer explained and discussed the relevant extension of bankruptcy liquidation on Twitter, and @gonbegood also provided a way to help relevant whale investors to better reduce liquidation losses. Wu said that the compilation is as follows:

It is understood that there appear to be two liquidation applications filed by 3AC in the British Virgin Islands. One application is a liquidation application filed by 3AC itself, while the other is a provisional liquidation application filed by 3AC's creditors.

What is the difference between the two?

Liquidation means that a liquidator is appointed to liquidate all the company's assets and distribute them to creditors. This is the end of the company.

Provisional liquidation is an interim procedure whereby creditors appoint a professional to take over the company before a winding-up petition is heard - a petition to the court to wind up the company.

Provisional liquidation is usually done to preserve a company’s assets. Creditors will seek this if it is clear that the company is insolvent and there is a real risk of losing its assets, making it necessary to change the company’s management in the interim.

It was quite surprising that the winding-up order came so quickly because there is usually a delay between the winding-up petition and the winding-up, and it now appears that the reason the winding-up order happened so quickly was that 3AC filed the winding-up petition themselves.

The only controversy here is the choice of liquidator.

Why is choosing a liquidator so important? A liquidator should be impartial and act in the best interests of the stakeholders when liquidating a company, but obviously having a relationship with the appointed liquidator helps.

For example, if a 3AC liquidator is appointed, the 3AC may find it easier to talk to the liquidator and the liquidator may be more sympathetic to them when it comes to claims against directors etc than a liquidator nominated by the creditors.

Interestingly, Su Zhu is trying to claim compensation from 3AC as a creditor. I almost respect the shamelessness of it all, which is why the creditors are happy because the liquidator is chosen by the creditors.

So who is the liquidator?

@Teneo, they are a very well known consultancy that recently acquired KPMG's British Virgin Islands restructuring business and Deloitte's UK restructuring business. The two liquidators are from the former KPMG firm.

Their next step will be to assess 3AC's existing assets and the total amount of claims against them. They will also assess claims against other parties, including the directors, namely Su Zhu and Kyle Davies. A creditors' meeting should also be held soon.

In addition, how do you understand Chapter 15 of the U.S. Bankruptcy Code?

Chapter 15 is a recognition proceeding whereby a foreign representative (in this case, the liquidator) may seek to have a BVI reorganization proceeding recognized in the United States.

This is very important in cross-border bankruptcies.

Because 3AC’s assets are not in the BVI. They may be in bank accounts in other jurisdictions such as the US or Singapore (their operations are not in Singapore). If the US does not recognize the BVI court order, it is worthless because the liquidator needs to be able to control the US bank account that holds 3AC’s assets.

I hope that the liquidators will apply for recognition of the BVI liquidation in Singapore and other jurisdictions in due course.

Next, the liquidators will audit all of 3AC's books to clarify the details of the funds. Then, they will negotiate with creditors to seek compensation and fairly distribute 3AC's remaining assets to creditors.

Separately, the BVI court also gave the liquidator explicit authority to sell the crypto for USD, USDC or USDT, so there could be another sell-off? Assuming there’s any 3AC left.

As mentioned above, after negotiating claims, the remaining assets will be fairly distributed to creditors. Attorney @gonbegood also provided a way of thinking, teaching whales with escrow funds in insolvent escrow institutions to save millions of dollars using this trick.

Typically, if insolvency occurs and the custodian enters bankruptcy proceedings, the allocation of losses will depend on the legal nature of the custodian. If it is a pure contract, users will have no property rights to their cryptocurrencies and will be listed as unsecured creditors... (e.g. SU ZHU itself is also an unsecured creditor of 3AC)

But they may have a chance to get something back. If they can establish that their custodian is based on a trust, then they will have property rights in the cryptocurrency held in custody by the exchange.

This situation does not help if the cryptocurrency is held in trust by a custodian and allocated individually to each user, each user would directly bear the shortfall loss for the specific affected holdings.

However, if cryptocurrencies or related interests are subject to a trust but held by multiple stakeholders on an unallocated commingled basis, there are no established rules in law as to how shortfalls should be allocated between the parties.

A practical, default approach might be to allocate shortfall losses pro rata, so that the risk of loss from the pool is shared among everyone.

After the collapse of Lehman Brothers, the UK introduced a special administration regime (SAR) for investment banks, which required that any asset shortfalls in multi-client omnibus accounts be distributed pro rata.

They did this because many of their clients were involved in big lawsuits against Lehman Brothers, which were time-consuming and cost a lot of money in legal fees.

But there is no similar default rule for cryptocurrency custodians to pro-rate shortfall losses.

So if you are a whale holding assets in a trust and facing a shortfall, you might want to have another big debate on this issue (and discuss the best options for you).

Roughly speaking, the options are:

1. First in, first out. Withdrawals that would cause a shortage of funds in the asset pool are considered to be the removal of assets in the order in which they were deposited. Therefore, the shortfall losses will be disproportionately distributed to and borne by the earliest depositors.

2. Global amortization. Each withdrawal from the pool is considered individually. Each withdrawal from the pool will be considered a proportional reduction of the overall pool unless it can be attributed solely to a specific depositor or source.

Therefore, creditors may be able to propose corresponding shortage loss distribution plans based on their actual circumstances.

Related Links:

https://twitter.com/wassielawyer/status/1543238225338454016

https://twitter.com/gonbegood/status/1542891312013316102

Compiled by GaryMa Wu Talks about Blockchain