What should customers expect from the FTX bankruptcy? Lessons learned from MF Global and similar cases

How did we get here?

The crypto markets were rocked again last week by the collapse and bankruptcy of FTX and Alameda Research. Within a few short days, Sam Bankman-Fried (SBF) and his companies went from a stabilizing force for markets and acting as an industry leader to causing one of the greatest disruptions in digital asset market history.

It began on November 2, 2022, when 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, FTX announced that it was suffering a liquidity crisis and could not meet withdrawal requests – something that should not have been the case as, according to FTX’s terms of service, users retained title to digital assets on the FTX platform.

On November 10, the Wall Street Journal reported that approximately $10 billion had been transferred from FTX to Alameda Research. Within 24 hours, regulators around the globe announced actions against the FTX operating entities within their jurisdictions. And, on November 11, FTX and Alameda Research, along with their affiliated companies (collectively, the 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.

To date, the FTX Debtors have disclosed that SBF has stepped down as CEO and an independent restructuring professional, John J. Ray III — who led recovery efforts in many notable cases, including the Enron bankruptcy — has been appointed as CEO for all entities. The FTX Debtors have also disclosed the appointment of five independent directors, one for each of the main parent companies within the FTX group:

• The Honorable Joseph J. Farnan, Jr., for FTX Trading Ltd., as Lead Independent Director
• Matthew A. Doheny, at FTX Trading Ltd.
• Mitchell I. Sonkin, at West Realm Shires Inc.
• Matthew R. Rosenberg at Alameda Research LLC
• Rishi Jain at Clifton Bay Investments LLC

What is going on in the bankruptcy cases?

Typically, when a chapter 11 bankruptcy case is commenced, the debtor will file 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.

Then, the US Trustee — an officer of the US Department of Justice responsible for overseeing the administration of the federal bankruptcy system — will use that information to form an official committee of unsecured creditors (the Committee). The Committee will serve as a fiduciary for all unsecured creditors, including customers, in the case and will be charged with participating in the case and representing the interests of all unsecured creditors, with the fees and expenses of its professional advisors being paid by the debtor’s bankruptcy estate. If formed in the FTX case, a creditors’ committee may include, as it did in the Voyager and Celsius cases, a number of FTX customers.

As of the date of publication, the FTX Debtors had made none of these filings, having filed only procedural motions to (i) consolidate all 134 FTX’s related cases and (ii) modify filings requirements for creditor disclosures and to allow service by email. These motions were accompanied by a statement that “[t]he Debtors anticipate seeking additional relief from the Court later this week [and] [i]n connection with those subsequent filings, the Debtors will provide additional information for the benefit of the Court and parties in interest.”

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 FTX Debtors have not revealed any further information about the status of the companies or any plans for the future. We expect more substantive filings to occur sometime later this week.

What does the future look like for FTX customers?

Given the lack of transparency 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. In general, a chapter 11 debtor that has a viable plan of reorganization can build support from creditors and conclude the chapter 11 process within 6-12 months (or even more quickly), thereby preserving significant value for all stakeholders.

Given the current circumstances, a sale of the FTX’s remaining assets appears more likely, and an expeditious and well-organized liquidation proceeding could also yield potential meaningful recoveries for customers and unsecured creditors. Such a sale is likely to be combined with efforts by a court-approved fiduciary to undo prior FTX transactions or otherwise claw back funds and assets for the benefit of customers and unsecured 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 would be made 100-percent whole. Similar scenarios have played out in the Refco, Lehman and Madoff cases, 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 cases to address 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 $300-500 million in cryptocurrency being lost. Further factual investigation and legal developments will be 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 will government regulatory actions impact creditors?

As noted above, a vast array of US and international civil and criminal regulators have already begun investigating the FTX entities. Other regulators are likely to investigate as well. Significantly, these regulators are not stayed by the automatic stay and have enormous power to search for, freeze and seize assets. A number of these 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.

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. The pleadings filed by the provisional liquidators suggest a potentially adversarial relationship with the US FTX Debtors. The provisional liquidators have requested emergency relief and a hearing at the earliest time the Court’s schedule will allow. Customers should act quickly to assess how this development may impact their claims and what strategies may be employed to safeguard their property and help maximize their recoveries.

If you have any questions regarding these developments, please contact any of the authors.