Expert Q&A on the FTX Bankruptcy: What Parties Can Expect | Practical Law

Expert Q&A on the FTX Bankruptcy: What Parties Can Expect | Practical Law

An expert Q&A with Dennis O'Donnell, Stuart Brown and Noah Schottenstein of DLA Piper on some of the implications of the FTX bankruptcy and the lessons we can learn from MF Global and similar cases.

Expert Q&A on the FTX Bankruptcy: What Parties Can Expect

Practical Law Article w-037-6659 (Approx. 11 pages)

Expert Q&A on the FTX Bankruptcy: What Parties Can Expect

by Practical Law Bankruptcy & Restructuring
Law stated as of 08 Dec 2022USA (National/Federal)
An expert Q&A with Dennis O'Donnell, Stuart Brown and Noah Schottenstein of DLA Piper on some of the implications of the FTX bankruptcy and the lessons we can learn from MF Global and similar cases.
On November 11, 2022, FTX and certain of its affiliates filed for bankruptcy in Delaware in one of the highest profile cryptocurrency bankruptcy cases ever, leaving an estimated 1 million customers and other investors facing total losses in the billions of dollars. The crypto exchange is said to owe its 50 largest creditors alone nearly $3.1 billion. Meanwhile, the Royal Bahamas Police Force in the Bahamas, where FTX is based, is investigating whether any criminal misconduct took place in relation to the company's implosion.
Practical Law asked Dennis O'Donnell, Stuart Brown, and Noah Schottenstein of DLA Piper to share their views on the implications of the FTX bankruptcy and how the FTX bankruptcy is unique from the other cryptocurrency bankruptcies that have filed in recent months. Dennis O'Donnell is part of DLA Piper's US Restructuring practice and a nationally recognized partner in their New York office. Stuart Brown is part of DLA Piper's US Restructuring practice and a nationally recognized partner in their Wilmington, DE office. Noah Schottenstein is a senior associate in DLA Piper's US Restructuring practice in the Dallas office. Combined, the DLA Piper restructuring team has more than 85 years of experience representing secured and unsecured creditors, debtors, equity holders, purchasers of distressed assets, and other parties in interest in a wide range of restructuring matters, including cases under Chapter 11, out-of-court workouts, and cross-border insolvency proceedings.
For more information on cryptocurrency Chapter 11 proceedings, see Practice Note, Crypto Chapter 11 Proceedings: Overview.

The FTX Bankruptcy: How Did We Get Here?

The crypto markets were rocked on November 11, 2022, by the collapse and bankruptcy of FTX and Alameda Research in the US and the institution of liquidation proceedings over FTX Digital Marketing in the Bahamas. Within a few short days, Sam Bankman-Fried (SBF) and his companies went from an industry leader and an apparently stabilizing force for the crypto markets, to being the cause one of the greatest disruptions in digital asset market history.
The destabilization of FTX began in October 2022 and stemmed from leaked FTX and Alameda Research financial data. On November 2, 2022, Coindesk published an article reporting that approximately $5.8 billion of Alameda Research's $14.6 billion balance sheet consisted of FTT Tokens (the native token issued by FTX). On November 8, 2022, FTX announced that it was suffering a liquidity crisis and was unable to meet withdrawal requests, something that should not have been the case as, according to FTX's terms of service, users retained title to and control over digital assets, including users' e-currency, on the FTX platform.
On November 10, 2022, the Wall Street Journal reported that FTX transferred approximately $10 billion to Alameda Research. At the same time, Binance, the world's largest cryptocurrency platform, was making public comments first about its intent to purchase FTX to save it, then its intent to liquidate its FTT holdings, then its conclusions that FTX had too many regulatory and financial problems for Binance to move forward with the purchase. Within 24 hours, regulators around the globe announced actions against the FTX operating entities within their jurisdictions. Finally, on November 11, 2022, FTX and Alameda Research, along with their affiliated companies (FTX Debtors), filed Chapter 11 bankruptcy cases in Delaware (Lead Case No. 22-11068), which have been assigned to US Bankruptcy Judge John T. Dorsey.
Also on November 11, an independent restructuring professional, John J. Ray III, who led the recovery efforts in many notable cases, including the Enron bankruptcy, was appointed as CEO and CRO for all FTX Debtors. Since his appointment, Mr. Ray has assembled an independent team of professionals, stabilized the FTX workforce, and has been working to secure FTX assets wherever they are located, identify or recreate reliable books and records, assemble the information necessary for the bankruptcy court, and respond to numerous inquiries from multiple regulators and government authorities. In his First Day Declaration that was filed in the bankruptcy case on November 17, 2022 (as supplemented by a Supplemental Declaration on November 21, 2022, and together, the First Day Declaration), Mr. Ray states that "never in [his] career ha[d] he seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information" as in this case.

What is Going on in the Bankruptcy Case?

When a debtor commences a Chapter 11 bankruptcy, the debtor typically files an array of pleadings which, among other things, explain why the debtor filed for bankruptcy and its goals for the case, seek authority for the company to finance and operate the debtor's business on an interim basis, and list the debtor's top 20 or 30 unsecured creditors. For more on first day pleadings, see Practice Note, First Day Motions: Overview.
Then, the US Trustee, an officer of the US Department of Justice responsible for overseeing the administration of the federal bankruptcy system, uses that information to form a creditors' committee. The creditors' committee serves as a fiduciary for all unsecured creditors in the case, including customers. The committee participates in the case and represents the interests of all unsecured creditors. The US Trustee is currently in the process of soliciting interest from creditors to serve on the creditors' committee. If formed in the FTX case, the creditors' committee is then likely to include, as it did in the Voyager and Celsius cases, several FTX customers, as well as be representative of the four Silos of the FTX businesses, discussed below. For more information on the role of Chapter 11 creditors' committees, see Practice Note, Chapter 11 Creditors' Committees.
As of the date of publication, the FTX Debtors have filed the First Day Declaration and have procedural motions to consolidate all FTX's 102 related cases, to modify filings requirements for creditor disclosures, and to allow service by email. The FTX Debtors have confirmed that unauthorized transactions from FTX occurred and that the remaining crypto assets were transferred into cold storage. They have additionally confirmed that representatives of the FTX Debtors have been in contact with the US Attorney's Office, the SEC, the CFTC and dozens of other federal, state and international regulatory agencies.
The First Day Declaration described the CEO's five core objectives for the future:
  • Implementing controls, including accounting, audit, and others.
  • Determining the location and securing the protection and recovery of estate assets.
  • Launching a comprehensive and transparent investigation into claims against SBF and others in coordination with regulatory stakeholders in the United States, and around the world.
  • Cooperating and coordinating with insolvency proceedings of subsidiary companies in other jurisdictions to promote efficiency.
  • Maximizing the value for all stakeholders from the eventual reorganization or sale of the debtors' complex array of businesses, investments, and digital and physical property.
The First Day Declaration also included a framework for the corporate organization of the FTX Debtors, and aggregated them into the following four silos:
  • A group comprised of Debtor West Realm Shires Inc. and its Debtor and non-Debtor subsidiaries which includes businesses known as FTX US, LedgerX, FTX US Derivatives, FTX US Capital Markets, and Embed Clearing, among others (the WRS Silo).
  • A group comprised of Debtor Alameda Research LLC and its Debtor subsidiaries (the Alameda Silo).
  • A group that includes Debtor Clifton Bay Investments LLC, Debtor Clifton Bay Investments Ltd., Debtor Island Bay Ventures Inc., and Debtor FTX Ventures Ltd. (the Ventures Silo).
  • A group comprised of Debtor FTX Trading Ltd. and its Debtor and non-Debtor subsidiaries, including the exchanges doing business as and similar exchanges outside of the US (the Dotcom Silo). The entity in liquidation in the Bahamas is within the Dotcom Silo.
Each of the Silos was controlled by SBF with minority interests held by SBF's co-founders. The WRS Silo and the Dotcom Silo also have third party equity investors, including investment funds, endowments, sovereign wealth funds, and families. In the First Day Declaration, the CEO states his belief that "no single investor other than the co-founders owns more than 2% of the equity of any Silo." The First Day Declaration also provides that the most recent unaudited balance sheets (that the CEO is not confident are correct because they were produced while the FTX Debtors were controlled by SBF) show for each of the Silos and related Debtor entities (some of which the CEO preliminarily estimates may be solvent):
  • The WRS Silo showing $1.36 billion in total assets.
  • The Alameda Silo showing $13.46 billion in total assets.
  • The Ventures Silo showing:
    • debtor Clifton Bay Investments LLC with $1.52 billion in assets; and
    • debtor FTX Ventures Ltd. with $493 million.
  • The Dotcom Silo showing $2.25 billion in total assets.
The following new independent directors have been appointed as directors of the primary companies in the FTX Group to provide corporate governance:
  • The Honorable Joseph J. Farnan, Jr. for the Dotcom Silo as Lead Independent Director.
  • Matthew A. Doheny for the Dotcom Silo.
  • Mitchell I. Sonkin for the WRS Silo.
  • Matthew R. Rosenberg for the Alameda Silo.
  • Rishi Jain for the Ventures Silo.
Other developments since the bankruptcy filing include:
  • Planning around the cash management framework in preparation for filing a cash management motion.
  • Notifying relevant banking institutions to freeze withdrawals.
  • Planning systems and processes necessary for Alvarez & Marsal, appointed as FTX's restructuring advisor, to produce reliable liquidity forecasting.
  • Repeated (unsuccessful) attempts to prepare a complete list of the parties previously working for the FTX Debtors.
  • Work on one or more motions to address issues relating to continuing employees and contractors, as approximately half of the employees remain working at the direction of the CEO.
  • Commencement of the implementation of a centralized disbursement approval process. Before their filing, employees of the FTX Group submitted payment requests using an on-line chat platform where a disparate group of supervisors approved disbursements by responding with personalized emojis. In the Bahamas, it is understood that corporate funds of the FTX Group were used to purchase homes and other personal items for employees and advisors.
  • Attempts to secure and recover digital assets and the recruitment of:
    • forensic analysts to identify potential FTX Debtors assets on the blockchain;
    • cybersecurity professionals to identify the parties responsible for unauthorized transactions on and after the bankruptcy filing; and
    • investigators to begin the process of identifying transfers of FTX Debtors property before the bankruptcy filing.
  • Statements by Bahamian officials claiming confiscation of customer assets to preserve and protect those assets for customers.
  • Attempts to recreate a record of business decision-making. This is made all the more difficult because SBF often communicated by using applications that were set to auto-delete after a short period of time and encouraged employees to do the same.
  • Implementing of defensive measures against unauthorized attempts to access cryptocurrency, digital assets, and other crucially sensitive data in repositories. The Debtors expect to seek special relief from the bankruptcy court to authorize measures to access this information as safely as possible. The Debtors cannot create a list of their top 50 creditors of each Silo without access to the data repositories.
  • Causing the Chapter 15 Petition for Recognition of a Foreign Proceeding to be transferred from the Southern District of New York to Delaware. The Joint Provisional Liquidators appointed by the Bahamas Court engaged new counsel and consented to the transfer of venue (see What is the impact of the appointment of liquidators in the Bahamas?).
On November 23, 2022, the Wall Street Journal reported that during a bankruptcy court hearing, the FTX Debtors' attorneys stated that a "substantial amount" of assets are either missing or stolen (see FTX Debtors' First Day Hearing Presentation, November 22, 2022). Also on November 23, 2022, the Delaware Bankruptcy Court entered several interim first day orders, including an interim order authorizing the FTX Debtors to pay prepetition and ongoing compensation and benefits, pay certain critical vendors, and operate a postpetition cash management system. The Bankruptcy Court is to receive additional pleadings on maintaining the list of creditors sealed and a hearing is to follow on December 17, 2022.

What Makes this a Complex Bankruptcy Case?

The more constituents involved in a bankruptcy case, generally the more complex it becomes to get all the constituents aligned and to make the best of the situation for all constituents. Some of the factors that add complexity to this case include:
  • The number of constituents that the case impacts:
    • more than 100 Debtors filed for bankruptcy protection each with their own customers and other creditors, balance sheets, and legal challenges to unravel. The locations of where the FTX Debtor entities are organized varies from debtor to debtor and span the globe, including the following jurisdictions: Delaware, South Dakota, Korea, Japan, the British Virgin Islands, Antigua, Hong Kong, Singapore, the Seychelles, the Cayman Islands, the Bahamas, Australia, Panama, Turkey, and Nigeria;
    • some of the debtor entities own equity interests in non-debtor companies;
    • numerous regulatory bodies across the globe are involved;
    • there are said to be more than a million creditors; and
    • over the past three years, the FTX Debtors secured at least $1.8 billion from venture capitalists across the globe.
  • The numerous complex legal issues involved in the case, including:
    • whether customers' money, coins or tokens stored in wallets on the exchange constitute property of the estate to be divided among all creditors of the estate;
    • questions around jurisdiction, venue and choice of law, especially as to potential clawback claims against customers that were able to withdraw some or all of their cryptocurrency assets from the FTX platform in the months and weeks leading up to the Chapter 11 filing;
    • Whether all of the Debtors and business lines are insolvent and the question of when each became insolvent;
    • whether equity holders have a viable path to recovery;
    • whether corporate separateness was maintained and whether customers of one entity may have claims against customers of another; and
    • whether a plan of reorganization intends to provide recoveries in kind in crypto currency or are claims to be converted to dollars;
  • The high probability of fraud. The FTX Debtors' attorneys have stated that a substantial amount of assets are either missing or stolen and some may be in the possession or control of government actors across the globe. This adds a layer of potential litigation and more resources for asset recovery. For more information on fraud issues in bankruptcy, see Fraud in Bankruptcy & Restructuring Toolkit.

What does the future look like for FTX customers?

Given the lack of transparency before the chapter 11 filing from the FTX Debtors, it is challenging to evaluate next steps for the FTX Debtors and the impact of the bankruptcy case on its customers and other unsecured creditors. A Chapter 11 debtor that has a viable plan of reorganization generally can build support from creditors and conclude the Chapter 11 process within 6 to 12 months or even more quickly, which preserves significant value for all stakeholders. For more information on the Chapter 11 plan process, see Practice Note, Chapter 11 Plan Process: Overview.
However, under the current circumstances, a sale of the FTX's remaining assets appears more likely and an expeditious and well-organized liquidation proceeding may also yield potential meaningful recoveries for customers and unsecured creditors (see Practice Note, Buying Assets Under a Chapter 11 Plan). It is said that the FTX platform was investor grade and may have intrinsic value to other parties in the market. This type of sale is likely to be followed by efforts to undo prior FTX transactions or otherwise claw back funds and assets for the benefit of customers and unsecured creditors (see Practice Notes, Fraudulent Conveyances in Bankruptcy: Overview and Preferential Transfers: Overview and Strategies for Lenders and Other Creditors).
Consider the example of MF Global, which entered bankruptcy in similar circumstances to the FTX Debtors. MF Global was a large, multinational commodities brokerage firm that was supposed to have held customer funds in custodial accounts in which customers retained title. MF Global was not allowed to use customer funds for proprietary purposes. In 2011, the company suffered unexpected losses at its proprietary trading desk, which gave rise to a cycle of customer withdrawals and margin calls that overwhelmed the company in a matter of days. On the way down, however, the company misappropriated customer funds to attempt to cover certain of the losses at its proprietary trading desk.
On October 31, 2011, MF Global filed for bankruptcy with a $6.7 billion shortfall. A trustee was quickly appointed to recover customer funds and liquidate assets. By April 2014, the trustee announced that customers were to be made 100% whole. Similar scenarios have played out in the Refco, Lehman, and Madoff bankruptcies, where long-term efforts to recover creditor value that appeared gone forever at the outset of bankruptcy have proven more successful than anticipated.
Although FTX and MF Global have similar stories, there are key differences that prevent a direct comparison at this stage of the FTX cases. Unlike MF Global and its more traditional commodities trading business, there are substantial legal uncertainties concerning decentralization and property rights in crypto holdings and the application of regulatory schemes to the FTX Debtors' businesses. Efforts are currently under way in the Celsius and Voyager Digital bankruptcy cases to address certain of these uncertainties, but certainty, both as a general matter and as specifically applicable to the facts of the FTX cases, is not likely to be achieved any time soon.
There are also many factual questions about how the FTX Debtors were run that are currently only the subject of speculation, especially concerning the apparent hacks on the eve of bankruptcy that resulted in an additional $300 million to $500 million in cryptocurrency being lost. Further factual investigation and legal developments are likely necessary. At this point, however, customers should not lose hope. Although much depends on how those legal and factual questions are resolved, the stories of MF Global, Refco, and other similar cases provide examples of creditors being made whole, even after suffering multibillion-dollar losses.

How may government regulatory actions impact creditors?

A vast array of US and international civil and criminal regulators have already begun investigating the FTX entities, including the US Commodity Futures Trading Commission, the US Attorneys' Office for the Southern District of New York, the US Securities and Exchange Commission, and Congress. Other regulators are likely to investigate as well. Significantly, these regulators are not bound by the automatic stay and have enormous power to search for, freeze, and seize assets. Several regulators have already acted to freeze FTX's operations in their respective countries. With a likely limited pool of assets, FTX customers should act quickly to evaluate how these regulators may impact customer recoveries and the potential outcomes for the FTX Debtors' bankruptcy proceedings.
For more information on the police and regulatory exception to the automatic stay, see Practice Note, Understanding the Police and Regulatory Exception to the Automatic Stay.

What is the impact of the appointment of liquidators in the Bahamas?

On November 10, 2022, the Securities Commission of the Bahamas obtained a court order placing FTX Digital Markets Ltd. into liquidation proceedings and appointed joint provisional liquidators to administer the assets of that company. FTX Digital Markets was not an entity that filed for bankruptcy in Delaware. On November 15, 2022, the provisional liquidators filed a petition in the US Bankruptcy Court for the Southern District of New York (Case No. 22-11516) for recognition of the Bahamas liquidation proceeding as the foreign main proceeding, which has been assigned to Judge Michael E. Wiles. On November 17, the FTX Debtors filed an emergency motion to transfer the Chapter 15 petition relating to FTX Digital Markets that was filed in the Southern District of New York to Delaware and for a stay of the Chapter 15 case until their emergency motion is heard. The pleadings filed by the provisional liquidators suggest a potentially adversarial relationship with the US FTX Debtors, but the provisional liquidators have announced to the Delaware Bankruptcy Court their intent to cooperate on the development of joint protocols so that the two proceedings can be coordinated to some extent. Customers should act quickly to assess how these developments may impact their claims and what strategies may be employed to safeguard their property and help maximize their recoveries.