As we learn more about FTX’s operations, speculation is slowly giving way to certainty. It’s clear FTX’s collapse will have a deep impact on the future of regulations, its bankruptcy will help create the blueprint for clawbacks in the crypto space, and potential tensions between the trustee and foreign liquidators could forge new jurisdictional law.
Scrutinizing the Regulators
As discussed in our summary of current and proposed U.S. and E.U. crypto regulations, prior to FTX’s collapse, the momentum had been with the Commodity Futures Trading Commission (CFTC) to become the lead regulator of digital assets, but FTX and frauds uncovered in the industry may push the pendulum toward the SEC, a much larger agency with a more robust enforcement division (SEC has more than 4,000 employees; the CFTC only has a few hundred). Earlier this month, the CFTC filed suit against FTX and Sam Bankman-Fried to recover ill-gotten gains. Given calls for greater scrutiny and clearer regulations regarding digital assets, all eyes will be on the CFTC to see how efficient and effective it is at recovery and how its efforts benefit customers.
Claw-Back to the Future
Six billion dollars of reported withdrawals by customers on the eve of the FTX bankruptcy filing indicates a serious risk of preferential and fraudulent transfer actions against customers.
The market is watching the interplay of the CFTC’s efforts to recover ill-gotten gains and the trustee’s potential recovery of preferential and fraudulent transfers from customers and political organizations. Events in the liquidation of Bernie Madoff’s firm will be instructive, but not entirely predictive, given the novel legal issues presented by crypto (and the uncharted nature of crypto exchange bankruptcy proceedings).
Importantly, per FTX’s terms of service, FTX expressly agreed that none of the digital assets in customer accounts were the property of FTX and that it wouldn’t treat customers’ property as its own. That agreement wouldn’t necessarily be binding on the trustee in bankruptcy. Commingled assets under FTX’s control can become property of the estate. The implication for customers is that the trustee could argue – based on what actually happened versus what was agreed – that customers are left with unsecured claims and subject to a clawback of estate property under preferential and fraudulent transfer laws. Customers would likely have defenses based on their expectations and also lack of knowledge of FTX’s scheme.
Separately, as I discussed with Bloomberg Law, in Madoff, property that was subject to forfeiture to the federal government was used to establish a victims’ fund by the DOJ, which had its own claims process and separate distributions concurrently but apart from the Madoff liquidation and distributions to customers. Here, a similar forfeiture fund may be set up to distribute any funds recovered from Sam Bankman-Fried and FTX.
Will Bahamas Play Nice in The Sandbox
The liquidation of Madoff’s firm shows there is precedent for cooperation between foreign liquidators and a U.S. trustee to be productive. There, the Madoff trustee and the liquidators of the largest offshore so-called feeder fund, Fairfield Sentry, worked a deal to focus their clawback efforts on separate targets and share the proceeds. In FTX, there is already evidence of some cooperation in the agreement to transfer venue.
Unlike the Madoff case, the foreign liquidators for FTX Digital have gotten off on the wrong foot, with allegations of a money grab by Bahamian customers getting public attention with the support of Congressional leaders.
Based on what occurred in past situations with U.S. debtors and offshore liquidators with competing interests, the offshore liquidators could seek to pursue claims under state law theories to bring money back to their proceedings. In connection with the Madoff liquidation, Fairfield Sentry attempted this by bringing hundreds of actions against investors based on state law theories such as unjust enrichment and clawback claims under British Virgin Island law. These types of claims can generate complex jurisdictional disputes. To date, the Fairfield Sentry liquidators have been largely unsuccessful.
In the weeks since the FTX bankruptcy filing, there’s been a flood of speculation over what happened, and a slow trickle of facts. But speculation isn’t necessary to see that the legal disputes will be framed in terms of expectations versus reality, and legality versus illegality. The crypto space may be fairly new, but the legal principles to be applied are not.