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Given the recent media coverage and growing concerns among investors over the risks associated with a bankruptcy filing of a cryptocurrency exchange, it feels timely to highlight some issues that arose in the Chapter 11 cases of Cred Inc. and certain of its affiliates (collectively, “Cred”).

The story of Cred provides valuable reminders and lessons for investors in the unregulated frontier of cryptocurrency.  Cred was founded in 2018 by Lu Hua and Dan Schatt and operated what they described as “a global financial services platform serving retail and institutional clients in 183 countries.” Cred’s customers would transfer digital cryptocurrency to the company, often pursuant to a loan or financing agreement, and Cred would then invest that cryptocurrency with third-party asset managers (the “CreditEarn” program”). This allowed customers to achieve a current yield on their cryptocurrencies. Cred also allowed customers to deposit their cryptocurrencies with Cred and borrow against them and pay a fixed rate of interest (the “CreditBorrow” program”).  Cred encountered a number of pitfalls during its short life and filed for bankruptcy protection on November 7, 2020.  At the time of its filing, Cred had liabilities to customers in excess of $160 million.  Shortly thereafter, the Bankruptcy Court ordered the appointment of an examiner to review allegations of fraud and mismanagement (the “Examiner”).  After a fulsome investigation, the Examiner issued a report on March 8, 2021 (the “Examiner’s Report”).  Ultimately, Cred confirmed a liquidating plan of reorganization which treated Cred’s customers as general unsecured creditors of Cred, entitled to share in recovery only after secured claims, administrative claims and priority claims were paid in full.

Cred provides a cautionary tale for investors in cryptocurrencies that are seeking yield on their cryptocurrencies.  The Examiner’s report revealed issues that should concern investors, as highlighted below.   

  • Ownership of Cryptocurrency.  Cred’s customers did not retain ownership of their cryptocurrency following transfer to Cred.  Instead, CreditEarn transactions were treated much like any other loan in a fiat currency.  At the expiration of a loan or finance agreement, a customer would receive their principal and interest in the form of cryptocurrency that they originally delivered, but not the same cryptocurrency.  Protections typically found in loan agreements for fiat currencies were absent.  For example, according to the Examiner’s Report, there were no restrictions on, or parameters governing, the use of proceeds (i.e., investments) and, despite contrary implications elsewhere, Cred’s repayments obligations were not collateralized.  Collateral for CreditBorrow transactions (i.e., a customer’s digital currencies) were not segregated and were not returned upon repayment of a loan. When Cred filed bankruptcy, its then-current holdings, whether traceable or not, became property of Cred’s estate and available to satisfy the obligations of all creditors.

Transaction documentation needs to be reviewed closely and Investor should carefully consider what protections should be included in transaction documents such as limitations on investments and use of proceeds.

  • Governance and Internal Controls.  Messrs. Hua and Schatt were the only two members of Cred’s board – there were no outside, independent directors to provide guidance and oversight. Despite investments exceeding $150 million, according to the Examiner’s Report, there was no investment committee or other mechanism ensuring proper diligence regarding lending decisions or the selections of investment managers. Internal controls regarding asset transfers were absent, and funds received in connection with the CreditEarn and CreditBorrow programs were commingled. There was a general lack of formality to its reporting, accounting and finance functions.  Instead, considerable authority was bestowed upon the Chief Capital Officer of whom little, if any, diligence was performed when hiring. The COO was allegedly responsible for a number of purported investments that lead to considerable, if not total, loss.

This is a reminder that Investors should be comfortable with their due diligence of governance and management issues and consider requiring regular and transparent financial and operational reporting.

  • Understanding the Counterparty’s Business. Cred’s business model was unreasonably exposed to fluctuations in price of cryptocurrencies. Cred’s obligations to its customers took the form of cryptocurrency yet many of Cred’s investments were made in fiat currency or stablecoin. While Cred attempted to hedge its exposure generally, the hedges were primarily intended to protect Cred in the event that cryptocurrency prices spiked up, but not if they plummeted. The hedges proved inadequate during the “flash crash” of March 2020.  As a result, Cred faced a number of margin calls that it was unable to satisfy.  Further, due to liquidity constraints, Cred failed to reinstitute hedges to account for an upswing in the prices of cryptocurrency.  When that upswing occurred, Cred found its obligations to its customers increasing while its investments remained static.

In addition, Cred provided a substantial amount of loans to moKredit Technology (Hong Kong) Company Limited, a Hong Kong company, and moKredit, Inc., a Cayman Islands company (collectively, “moKredit”).  moKredit’s business appears to have primarily taken the form of extending unsecured micro-loans (in Yuan) in China. Cred converted cryptocurrency from its customers into fiat currency which were then lent to moKredit, again, exposing Cred to severe fluctuations in the prices of cryptocurrency. As a result, Cred’s customers were, unbeknownst to them, ultimately taking the credit risk of the hundreds or thousands of moKredit’s micro-borrowers in China, rather than Cred.  As of the petition date, moKredit was approximately $39 million in debt to Cred and had renegotiated its interest payment schedule.  

While often a difficult task, Cred illustrates the importance of understanding a company’s business model and how it matches its assets and liabilities.

Although different from a cryptocurrency exchange, the losses suffered by Cred’s customers provide an important reminder to cryptocurrency investors that proper due diligence regarding the activities and operations of their counterparties should be a critical element of their investment decision.