The Questionable Virtues of Chapter 11 in the FTX Bankruptcy

On November 14, 2022, FTX, the third largest crypto exchange in the world, filed for bankruptcy. Since then, the company, its many affiliates, and its 30-year-old owner and founder, Sam Bankman-Fried, have been investigated by lawmakers and regulators across many jurisdictions, including the Commodity Futures Trading Commission, the Securities and Exchange Commission, and the U.S. Attorney for the Southern District of New York. Early reports indicate that the company faces aggregate claims from creditors in the billions of dollars and has traditional, liquid assets that fall far short of meeting these liabilities.

The bankruptcy declaration reveals the harrowing details leading-up to the filing. Facing an extreme liquidity crisis and the freezing of an affiliate company’s assets by securities regulators in the Bahamas, senior management at FTX discussed having Bankman-Fried resign as CEO. The result was the appointment of several independent directors and a new CEO, John J. Ray, III. Ray, an experienced restructuring executive, has been involved in managing a number of major corporate failures, including at Enron and Nortel. Once in control of the company and after reviewing the available financial records, Ray observed that never in his career had he seen “such a complete failure of corporate controls and such a complete absence of trustworthy financial information.” He noted that the individuals running the enterprise were “inexperienced, unsophisticated, and potentially compromised” – that the entire situation was “unprecedented.”

As of this writing, FTX is navigating the early stages of chapter 11 restructuring in the U.S. Bankruptcy Court for the District of Delaware, where it hopes to achieve five core objectives identified in the declaration. The first is the implementation of basic corporate infrastructure, including “accounting, audit, cash management, cybersecurity, human resources, risk management, data protection and other systems that did not exist, or did not exist to an appropriate degree.” The second and third objectives are asset protection and recovery (including attempting to track down assets that may be missing or stolen) and the investigation of any claims of the estate against the company’s co-founders and other parties. The fourth objective is to coordinate with any insolvency proceedings involving subsidiaries in other jurisdictions. The fifth and final objective is to maximize value for all stakeholders through potential sales or a reorganization.

Some of these objectives – such as maximizing the value of the estate – are common to all chapter 11 cases. But Ray seeks to do something more: to build. The focus on building – as opposed to refining — basic corporate systems and controls makes this case exceptional. For instance, Ray’s declaration and related first-day filings describe efforts to identify employees, reconstruct account ledgers, implement basic cash management systems, and establish corporate recordkeeping practices. And while most complex bankruptcy cases involve legal actions to recover money or property transferred by the debtor prior to the bankruptcy – as well as the prosecution of other claims of the estate – FTX’s activities, coupled with the complete lack of proper systems and documentation, will bring unprecedented challenges and important conversations.

One of those conversations, we believe, will address whether chapter 11 bankruptcy is the appropriate place to deal with crypto failures like those of FTX. More specifically, we should expect uncomfortable conversations about the costs and benefits of implementing proper systems and engaging forensics and asset-tracing experts and the administrative solvency of the estate.

Chapter 11 bankruptcy is a distributional and allocative process. And while there is still much we do not know about FTX, the profound scarcity of assets clouds the prospects of recovery. How much will stakeholders benefit from these chapter 11 proceedings and to what extent will they bear the burdens?

To be sure, chapter 11 bankruptcy is an incredibly flexible and adaptable process, overseen by an experienced bench and bar with considerable financial restructuring expertise. Broad standing rights and a focus on fairness and consensus-building provide opportunities for even the smallest stakeholders to participate in the proceedings. But these same features make chapter 11 expensive and time-consuming, with many decisions giving rise to intense conflict.

Meanwhile, like many financial institution failures, the collapse of FTX is about more than the company’s immediate stakeholders. It has sparked contagion fears across the crypto industry. FTX account holders stand to lose billions of dollars, leading many to question the wisdom of investing through crypto exchanges at all. At least one crypto lending firm, BlockFi, has recently filed for bankruptcy due to a liquidity crisis. Meanwhile, the ripple effects extend far beyond the crypto market. Institutional investors – including one of Canada’s largest pension funds – are poised to take massive write-offs of their investments in FTX. These and other concerns led a Bank of America senior analyst to reflect on the “diminished confidence in the crypto ecosystem” and the increasing “contagion risk” from FTX.

Because of these and other risks, lawmakers around the world have developed specialized regimes to handle the resolution of diverse types of financial institutions. For instance, when a U.S. securities brokerage firm fails, the Securities Investor Protection Corporation (SIPC) steps in to arrange the transfer of accounts to other brokerage firms or, if necessary, oversee the liquidation of the failed firm. Similarly, U.S. banks are subject to specialized insolvency regimes under state banking laws and via Federal Deposit Insurance Corporation (FDIC) receivership. Finally, under Title II of the Dodd-Frank Act, certain systemically important financial companies are subject to the Orderly Liquidation Authority, which creates a regulatory process for the FDIC to act as receiver and liquidate the failed firm.

But cryptocurrency exchanges are not covered by these specialized resolution schemes. Those seeking to restructure under U.S. laws have only one option: filing for bankruptcy protection.

As FTX proceeds through the bankruptcy process, we will eventually learn whether chapter 11 can address the massive failure of a multibillion-dollar crypto exchange. More broadly, the case will offer important insights into whether federal bankruptcy process can facilitate the orderly liquidation and reorganization of the opaque and intensely complicated companies that are crypto exchanges for the benefit of their stakeholders and the broader financial system.

This post comes to us from Professor Diane Lourdes Dick, and Professor and Michael & Brenda Sandler Fellow in Corporate Law Christopher K. Odinet, at the University of Iowa College of Law.

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