With Latest Probe, Vermont Is Playing an Outsize Role in Regulating Cryptocurrency | Business | Seven Days

Celsius Network, an online cryptocurrency lender, attracted more than a million users with promises of sky-high returns — until a market crash over the summer plunged the startup into bankruptcy and put members’ money at risk.

The company said it was the victim of extreme market conditions. But a bombshell court filing last week detailed evidence that Celsius had been misleading investors for years in a Ponzi-like scheme.

The source of those explosive allegations: the Vermont Department of Financial Regulation.

Vermont is by no means a crypto epicenter, but over the last few years, regulators in the obscure state agency have quietly been probing similar companies for securities compliance issues that federal regulators have been slow to take up. DFR’s first investigation led to a trailblazing $100 million national settlement earlier this year with a crypto lending company called BlockFi. Now, the agency is at the forefront of a multistate probe into Celsius, whose alleged mismanagement has ensnared the savings of more than 250 Vermonters.

With little federal regulation of cryptocurrency and its associated businesses, Vermont is seizing the moment to play an outsize role in trying to rein in this trendy, high-risk industry.

DFR officials declined an interview about Celsius, saying the department does not comment on ongoing investigations. But former DFR commissioner Mike Pieciak said the agency’s staff members have built up an expertise in the latest finance technology.

“They’re capable of leading on something like this,” said Pieciak, who stepped down in May to run for state treasurer.

In recent years, cryptocurrency has gained a foothold in the Green Mountain State. The number of transactions involving the virtual currency climbed from just 44,000 in 2019 to some 1.6 million last year. The dollar amounts tied to those transactions have also ballooned: $15 million in 2019 to $800 million last year.

Vermont regulators have homed in on cryptocurrency lenders, who have been pushing the envelope by acting as banks without being held to the same consumer protection regulations. These companies accept deposits of various cryptocurrencies and then lend or invest them, generating returns that get paid back to the depositors. Many promise yields far greater than what a typical bank might offer.

Perhaps surprisingly, Vermont’s small size has actually helped it regulate these complex companies, according to Pieciak. It’s among a minority of states to house banking and securities departments under a single regulatory body — in Vermont’s case, DFR — an arrangement that can be helpful when vetting new financial products that don’t fit neatly into any one bucket.

When cryptocurrency lender BlockFi came looking for a banking license in 2019, a DFR attorney reviewing the application realized the company appeared to be offering securities — tradable financial assets such as stocks — without registering to do so, in violation of Vermont law.

The DFR attorney kicked the application down the hall to the securities division, which then brought the matter to the attention of nearly three dozen other states and, eventually, the U.S. Securities and Exchange Commission. 

Cryptocurrency is built around the libertarian vision of a world in which commerce can exist outside the influence of government intervention; many who are attracted to it bristle at these bureaucratic hoops. But requiring crypto lenders to register is far more than a ministerial distinction. In Vermont, licensed securities brokers must disclose information about their financial health and show that they have adequate consumer protections for when “things go sideways,” Pieciak said.

“That was the thing that we were most concerned about BlockFi,” Pieciak said. “If the value of crypto did crash, it seemed like the business model was going to be in jeopardy — and they didn’t have the same kind of protections a bank would have,” such as federally backed deposits.

In February, BlockFi agreed to seek the proper registration and pay a $100 million national settlement. DFR said at the time that it was also looking into actions against other crypto banks. 

The New Jersey-based Celsius had emerged as one of the leading — and most controversial — lenders by then. Experts questioned how Celsius could possibly be meeting promised yields of up to 18 percent without making risky investments. Several states pursued cease-and-desist actions against Celsius, accusing the company of selling unregulated securities similar to BlockFi. 

The company’s founder and CEO, Alex Mashinsky, who lives in New York City, rejected the criticisms and continued to aggressively market Celsius as a safe and far more profitable alternative to traditional banks.

Yet Celsius was unprepared to weather a major crypto value fluctuation. When the currency crashed this summer, Celsius went down with it. 

On June 12, the company announced that it was freezing withdrawals “due to extreme market conditions.” That meant investors could not pull their money out, even as the price of Bitcoin and other cryptocurrencies continued to fall.

A month later, Vermont regulators issued a public warning cautioning people against investing in Celsius, asserting that the company was “deeply insolvent” and on the brink of collapse.

A day later, Celsius filed for bankruptcy.

A multistate investigative team is now looking into what went wrong with Celsius — and whether any laws were broken. Separately, the U.S. government has asked a federal judge to appoint an independent examiner who would have even broader powers than the states to investigate the company’s finances. Vermont’s recent court filing came in support of that request. 

At a minimum, the regulators wrote, Celsius violated laws by not registering to sell securities. But the company’s problems appear to have run much deeper. Mashinsky, the CEO, repeatedly made false and misleading statements about the company’s financial health and its compliance with securities laws, the filing says, when, in reality, his own CFO admitted to regulators that the company was underwater as early as 2020.

These false claims continued even as the cryptocurrency market began experiencing extreme volatility early this year, the regulators charged.

On May 11, for instance, Mashinsky tweeted that Celsius had not experienced any significant losses and “all funds are safe.” Internal company records, however, showed Celsius lost about $454 million over a 10-day period that month.

Notwithstanding the extreme market volatility, Celsius has not experienced any significant losses and all funds are safe.

— Alex Mashinsky (@Mashinsky) May 11, 2022

And on June 7, five days before Celsius froze its accounts, the company published a blog titled “Damn the Torpedoes, Full Speed Ahead,” in which it claimed that it had enough in reserves to meet its obligations. Records show the company actually had a “deeply negative net worth” by that point, according to the court filing. 

This willful deception, regulators wrote, likely led people to invest in Celsius or keep their money with it, despite obvious signs of market volatility.

Regulators floated two theories for how Celsius managed to stay in business for so long, despite hemorrhaging money. They cited “credible claims” that Celsius was improperly manipulating the price of its own crypto token, CEL, to artificially drive up the price so that it could use the proceeds to cover its debts. And they pointed to an admission from Celsius’ own CFO that the company never actually made enough money to cover the interest it advertised.

“This shows a high level of financial mismanagement and also suggests that, at least at some points in time, yields to existing investors were probably being paid with the assets of new investors,” the filing says.

That, according to Robert Fitzpatrick, an expert on financial fraud, is the definition of a Ponzi scheme.

“To take one investor’s money, give it to the other and call it a profit? That’s completely illegal,” said Fitzpatrick, who founded the North Carolina-based consumer protection organization Pyramid Scheme Alert.

The case comes amid a pitched battle over how the federal government should regulate crypto-related businesses. The industry has enlisted an army of lobbyists, while crypto billionaires are throwing money at political campaigns.

Sam Bankman-Fried, founder and CEO of the cryptocurrency exchange FTX, has single-handedly spent tens of millions in primary campaigns around the country, much of it through a super PAC dedicated to pandemic prevention and preparedness. He personally gave $2,900 in individual donations to the primary congressional campaigns of U.S. Rep. Peter Welch (D-Vt.), who is running for U.S. Senate, and state Sen. Becca Balint (D-Windham), who is running for U.S. House.

One of Bankman-Fried’s lieutenants, FTX head of engineering Nishad Singh, went even further. In July, he funneled $1.1 million to the LGBTQ Victory Fund Federal PAC, which then used nearly $1 million on so-called “independent expenditures” to buy ads in support of Balint’s campaign.

Balint, who went on to easily win the Democratic primary, has said she knows little about cryptocurrency and is not acquainted with Singh or Bankman-Fried.

Singh, though, knows her. He recently told Forbes that he was “really excited about Balint because she’s a strong proponent of pandemic prevention.” He did not respond to Seven Days‘ requests for comment.

“Victory PAC wanted to run an independent expenditure to support Balint,” he told the outlet. “I wanted to empower them to do that. My contribution here was personal and independent from my role at FTX.”

As states continue to probe Celsius, the fight over the company’s assets is playing out in federal bankruptcy court. 

Celsius lawyers have argued that most customers agreed to transfer ownership of their assets to the company when they signed up. If a judge buys that, then most depositors could be entitled to nothing. If a judge rejects the argument, then the company could immediately be forced to return what money remains.

Celsius, meanwhile, is looking for alternative ways to pay back customers who are collectively owed $4.7 billion. On Tuesday, the New York Times reported that Mashinsky recently pitched his staff on a plan to reopen the firm. He codenamed the project Kelvin, after the unit of temperature.

Court filings offer a window into what’s at stake. Hundreds of depositors have written letters to the judge describing their feelings of shame, anger and betrayal. One California man said the stress of potentially losing his family’s life savings drove him to excessive drinking, and his wife kicked him out of the house. 

“How do I begin the healing process with my wife and my daughters over this?” he wrote.