Cryptocurrency company FTX and its young founder, Samuel Bankman-Fried (“Sam”), once were valued at nearly $30 billion. The company was a hub for all things crypto, performing several key roles in the sector. Investors used FTX as a trading platform to make crypto bets. FTX supported its own crypto token, FTT, and speculatively traded in various cryptocurrencies for its own benefit. FTX also was a financier in numerous other crypto-related ventures.
FTX and SBF ultimately did none of these things well, landing in competing bankruptcy proceedings in the Bahamas, as well as ancillary proceedings known as Chapter 15 in Delaware. Customers, investors and others now are wondering: What’s the future? How will SBF’s structures, transactions, investments, and other machinations be unwound? How will FTX’s assets be liquidated?
To fully understand FTX and the challenges for its many creditors, one must first realize the full extent of this scandal and that FTX was not the only player involved. FTX was simply one cog in the machine of a much bigger and overarching scandal ― if not conspiracy ― that involved other major crypto players such as Three Arrows Capital and Celsius
Many of the crypto firms were effectively investing in each other, either through equity purchases, or more often buying each other’s propriety cryptos, such that they were all interconnected. For instance, Company A would invest in the shares of Company B, and then Company A would then also start buying Company B’s crypto tokens. This raised the theoretical value of Company B, and thus Company A could show on its own books an increase in its own value by way of its investment in Company B ― even though Company A actually spent assets to achieve that increase in Company B’s book value. Of course, Company B would be doing the same think back to Company A, and to other crypto companies as well, and thus a very circular and quite incestuous financial circle developed.
The advantage to this scheme was its interconnectedness, and the ability of all the involved companies to show massive increases in their respective book values and also to pay returns ― at least on paper ― to investors and depositors.
A common financial expression is that “a rising tide lifts all boats.” When some companies in a sector do well, usually the equity values of all the companies will also increase. With the crypto companies, the interconnectedness meant that as the tide rose, each company was able to book not only its own gains, but the gains of other companies in which they had invested either in equity or in their proprietary tokens. Thus, the increases in these companies’ values was not a straight line based upon ordinary equity investments or profitability, but rather there were exponential increases in value as each company booked not only their own gains but a portion of many of the other companies’ gains as well.
It was at this point that the circular investing which had caused all the exponential growth, now began to cause an exponential collapse. Crypto companies had to book not only their own direct losses, but also the losses of the companies in which they were investing. Since the companies in which they were investing were also investing in them, those companies had to book additional losses. The sector-wide death spiral thus began.
To make matters worse, some crypto companies began to make increasingly high-risk bets on various cryptocurrencies in an attempt to staunch their own bleeding. These desperation bets of course were largely bad. Although the final chapters in what is now being referred to as the “Crypto Crash” are yet to be written, many of the major players in crypto ended up in bankruptcy, including the aforementioned FTX, BlockFi, Three Arrows Capital, Voyager Digital, Celsius Network and also FTX’s sister company, Alameda Research.
It is significant that the crypto companies have filed for reorganization and not liquidation. Eventually, however, an independent bankruptcy trustee will be appointed for the debtor company. Subject to the bankruptcy judge’s oversight, the bankruptcy trustee may use all the powers of the court to take legal possession of all the debtor’s assets and to set aside transfers made immediately prior to the filing of the bankruptcy, known as preferential transfers. The bankruptcy trustee may challenge other transfers, typically going back as far as four years, under both federal and state fraudulent transfer laws. Additionally, the trustee may take various steps to unwind transactions and deals involving the debtor.
The marshaling and liquidation of the debtor’s assets is ordinarily a relatively straightforward process in most bankruptcies. With these crypto companies, however, the bankruptcy process will be a mess because of interconnectedness of the crypto companies, and the fact that they have so many circular deals between them. What will happen is that the trustees of the various crypto companies will be making claims against each other. Very likely, however, there will be little or no recovery by any of the trustees on the circular trades between the crypto companies, for the simple reason that there were no real assets involved in the first place ― only illiquid assets with grossly-inflated book values such as stock in companies which are themselves bankruptcy and the now-worthless proprietary tokens of these companies.
The thing about bankruptcy is that investors of a bankruptcy company are effectively wiped out. That still leaves depositors, being folks who placed their own cash and crypto with these firms for their own trading purposes, and creditors. How will they recover, if at all? This is where we start to look at the assets which went out the back doors of these companies shortly before their bankruptcy filings, and sometimes not so shortly.
The numbers are not small. For instance, there were $6 billion in withdrawals from FTX in the three days preceding its bankruptcy filing, including $204 million by Alameda Research, which was Sam’s original company and also FTX’s sister company. There have also been reports that Sam and his parents, along with other FTX insiders, purchased at least 19 properties in the Bahamas worth $121 million. The story that Sam in now spinning is that he doesn’t know how the properties ended up titled in his parents’ name, and at any rate was meant to house FTX staffers who had relocated to the Bahamas. And, of course, assets in the 10-figures seem to have gone just completely missing, thanks to record-keeping that would make an Enron executive blanch.
There also appears to be ample evidence of investor fraud. Sam told Forbes in 2020 that Alameda Research had made $1 billion in profits, and FTX leaked financials which stated that FTX had $388 million in net income in 2021. The truth was vastly different: The two companies had instead posted a net loss in the neighborhood of $3.7 billion. This is important because it may unlock one very powerful remedy to claw back funds that might not otherwise be available in the average case.
That remedy is known as a constructive trust. This is not a trust in the traditional estate planning sense, but rather is an artificial device that basically follows fraudulently-obtained funds so that ownership is deemed to remain in the original legitimate owner.
Clawing back money from insiders will be a function of the preferential and voidable transactions laws. As to the latter, these laws can operate to unwind transactions made by a debtor within four years and sometimes longer. In these situations, bankruptcy trustees and creditors need only prove two things, being that the debtor was insolvent at the time the transfer was made and that the transfer lacked “reasonably equivalent value” ― or, in other words, that the debtor didn’t get anything back in exchange which was of roughly equal value to creditors. Both preferential transfer and voidable transaction law can also reach so-called “insiders of insiders”, such as family and friends of insiders who received money from the debtor companies without providing reasonably equivalent value.
Finally, it may be important to creditors to obtain a finding with regard to some of these crypto companies that they operated as Ponzi schemes, meaning that the companies used the crypto of new depositors to meet the redemptions of old depositors. The reason that this finding would be important is that it would then cause the so-called “Ponzi scheme presumption” to kick in. In that event, the bankruptcy trustees could force persons who received profits over their deposits, which persons are known as net winners, to disgorge their profits for the benefit of all creditors. This sort of disgorgement litigation against net winners has been common with many of the recent high-profile investment frauds such as Bernie Madoff and Alan Stanford.
Will creditors and depositors get much back? Even with most Ponzi schemes, bankruptcy trustees and receivers are usually able to generate recoveries greater than 50% for the individual investors, usually by going after net winners. Such recovery is probably not possible here for the reason that most of these crypto companies’ moneys were simply gambled away, and there may not be any great number of net winners to go after. There will likely be some recovery against insiders and others, but perhaps not a substantial amount compared to the gigantic losses that were involved. Thus, creditors and depositors may have to be content watching criminal penalties, if any, against these firms and their insiders, which may be satisfying to the soul but not so much to the wallet. But that is for the future as well as we watch how all of this plays out.