Depositors’ Troubles in Nonbank Cases

By Jonathan Batiste

Bankruptcy professionals traditionally consider the employees, executives, creditors and owners of debtors in corporate insolvency cases.1 However, the Synapse Financial Technologies Inc.2 bankruptcy highlights the vulnerability of consumer depositors in cases of nonbank corporate insolvencies. While the Federal Deposit Insurance Corp. (FDIC) protects depositors in the event of the failure of an FDIC-insured depository institution (IDI), the FDIC does not insure depositors against the insolvency or bankruptcy of any non-IDI third party, even if the non-IDI party does business with an IDI.3

The inability to access deposited funds may cause depositors to become insolvent by being unable to pay debts as they become due, while not technically being insolvent from a “balance sheet” standpoint.4 When an IDI freezes deposited funds, which can be considered cash equivalents, it converts those funds into nonliquid assets as depositors become unable to liquidate their claims. In such situations, despite a depositor not necessarily becoming insolvent in the balance-sheet sense as is used by the Bankruptcy Code,5 a depositor’s temporary inability to pay debt obligations can serve as grounds for creditors to commence an involuntary bankruptcy case against the depositor.6

This article discusses some of the pertinent facts of Synapse, the dangers that similar cases of insolvency pose to society, and how bankruptcy professionals can use their expertise to help prevent future harm to society. It further discusses the political and regulatory reactions to Synapse and other similar cases.

Regulatory Agencies Closely Scrutinize Depository Institutions

Regulators pay keen attention to the banking and financial service industry in their mission to preserve the integrity of the nation’s financial system.7 The Office of the Comptroller of the Currency stated that institutions participating in the nation’s financial system are among the most highly regulated businesses in the country.8 However, the protections in place are not all-encompassing, and depositors may unintentionally take on unexpected risks when they participate in unregulated segments of the financial system. Using contractual relationships and a tri-party business model, the parties in Synapse effectively circumvented regulations protecting depositors.9

BaaS Has Allowed Businesses to Circumvent Banking Regulations

Banking as a Service (BaaS) utilizes custodial deposit accounts (CDAs), where a party with custody of another party’s funds is responsible for opening a deposit account at an IDI on behalf of the funds’ owner, who does not have a direct relationship with the bank.10 Recent innovations in the financial services industry has included the popularization of nonbank “fintech” businesses offering consumers banking-related products and services.11 The services offered include the management of depository accounts.12 However, without adequate recordkeeping, these developments impede the FDIC’s ability to make insurance determinations in situations where depositors lose access to their funds.13 The new models have increased the risks that consumers take on by causing confusion regarding insurance coverage of deposited funds.14

In Synapse, the debtor was a “middleware provider” for fintech businesses, enabling Synapse to offer financial services by utilizing its relationships with several IDIs that “enabled fintech companies to quickly develop products and services that used deposit accounts at IDIs to hold customers’ funds.”15 The debtor provided the technological infrastructure required to integrate banking services into third-party applications.16 After the debtor filed for bankruptcy, an associated IDI froze customer deposits when the debtor denied the IDI access to relevant CDA records.17 On June 20, 2024, the appointed chapter 11 trustee of the Synapse estate contacted regulators regarding the devastation that the Synapse bankruptcy caused depositors.18

Depositors in Synapse suffered similar harm to depositors in the Voyager Digital bankruptcy.19 In the Voyager Digital case, the debtor falsely represented that the depositor funds that it held were insured against its failure by the FDIC.20 Similar to Synapse, when the debtor failed, numerous depositors were unable to access their funds.21 Leading up to Synapse’s failure, depositors likely believed that their funds would remain accessible because Synapse’s partner companies made representations to customers that the FDIC insured the deposited funds.22 In response to cases of prohibited conduct, the FDIC issued advisory letters requesting corrective action to prevent the misleading of consumers regarding deposit insurance.23

However, the FDIC has stated that many consumers impacted by the Synapse bankruptcy did not understand the nature of FDIC insurance and the relationships they entered into by doing business with nonbank fintechs providing financial services.24 Understandably, depositors attempted to recover their funds and looked to FDIC insurance as a route to recovery. However, FDIC insurance does not protect against events where a third-party recordkeeper fails to keep sufficient records, as occurred in Synapse.

How Administrative Laws Impact Interested Parties

Customers incorrectly believed that FDIC deposit insurance covered them. This demonstrates the importance of familiarity with administrative law when representing consumers, corporate clients and bankruptcy estates.25 Administrative laws can complicate the resolution of bankruptcy cases, such as instances where the FDIC must make insurance determinations.

In cases of insolvency, deposit account records are crucial for insurance determinations following the failure of an IDI in possession of relevant deposit account records.26 Current regulation allows for consideration of records held by non-IDI parties if the records are maintained in good faith and in the regular course of business.27 However, inadequate or unreliable third-party recordkeeping impedes the FDIC’s ability to make deposit insurance determinations for funds in the custody of an IDI.28 In Synapse, the parties could not access and interpret relevant CDA records the debtor held, diminishing the FDIC’s ability to promptly make deposit insurance determinations.

Protect Stakeholders in Future Transactions with Education

Historically, debtors have not participated in the legislative process of bankruptcy reform to the same extent as other interest groups:

The obvious explanation for debtors’ silence is a problem of timing. Future debtors often do not think of themselves as debtors.... For the same reasons, debtors and soon-to-be debtors cannot easily coordinate in order to act collectively. Most existing debtors do not expect to file additional bankruptcy petitions in the future, so they are not likely to show much interest in contributing to a lobbying organization for debtors.29

In their stead, other interest groups such as the consumer bankruptcy organizations, bankruptcy academics and consumer interest lawyers have advocated on consumers’ behalf.30 The failures in Synapse demonstrate the benefits of professionals’ participation in consumer advocacy and education. Without an understanding of bankruptcy, administrative law and the regulation of financial services, consumers are often unequipped with the knowledge to understand the risks inherent to different banking and financial services. Thus, consumers are often dependent on professional expertise. Professionals can therefore serve the common good by maintaining knowledge in these areas of the law.

An organization setting an example of what professionals can do is Credit Abuse Resistance Education (CARE), a national nonprofit organization to which many bankruptcy and financial services professionals lend their time and expertise. Hon. Martin R. Barash of the U.S. Bankruptcy Court for the Central District of California (who presided over Synapse) gave an interview after CARE named him its 2022 Volunteer of the Year. While he became a judge to help people, Judge Barash found that his role as a judge does not offer him opportunities to help people avoid the problems that lead to bankruptcy.31 Judge Barash said that he has felt “immense satisfaction” from being able to share his knowledge and experience with the public.32 By contributing to organizations that help consumers and other potential debtors by arming them with needed knowledge to navigate the financial world, bankruptcy professionals can help limit the damage caused by such bankruptcies as Synapse and reduce the likelihood of similar cases occurring in the future.

Conclusion

The banking and financial services market is a delicate space that essentially every member of society participates in, and a staggering number of bankruptcy filings affect consumer participation in that market.33 The problems caused by the Synapse case show how bankruptcy professionals can contribute to the reduction of harm that society suffers, as is the premise of much of the Bankruptcy Code. Bankruptcy professionals can serve the public good by advising regulators who want to maintain the stability of the financial system. Further, they can educate potential debtors about the risks inherent to different financial agreements.

Jonathan Batiste is a student interested in chapter 11 and insolvency accounting who is based in Los Angeles. He has worked as a judicial extern for Hon. Martin R. Barash in the U.S. Bankruptcy Court for the Central District of California, and for Hon. Andre Gammage in the St. Joseph County Circuit Court.