FTX Afermath and Bankruptcy Law

FTX Aftermath and Bankruptcy Law

Justice Jaynee Lavecchia (ret.)

David J. Adler

April 20, 2022

Major Types of Cryptocurrencies

First half of 2022 - “Crypto Winter”

▪ May 7, 2022 – Terra/Luna Collapses Overnight. In one week, Luna’s price fell from $82.55 to $0.000001 per token, eliminating $18 billion of value in the cryptocurrency sector. The collapse of Luna’s stable coin, Terra, creates even greater problems.

▪ May 2022 – The Terra/Luna collapse results in a “run of the bank” for certain exchanges (especially those which were thought to have exposure to Terra/Luna) and the liquidity of these exchanges rapidly deteriorates.

▪ June 15, 2022 - Three Arrows Capital, reportedly due in part to the collapse of Terra/ Luna, ordered by court in British Virgin Islands to commence liquidation proceedings.

▪ July 2022 -- As a result of the “run on the bank”, two large exchanges, Celsius and Voyager, each file for chapter 11 within 10 days of one another.

2022 (cont.) - The FTX Saga–9 Days In November

▪ November 2, 2022 -- CoinDesk released a report revealing that on Alameda’s balance sheet, $5.8 billion of its $14.6 billion in assets was $FTT, FTX’s self-minted utility token. Coindesk Article 11/2/2022

▪ November 6, 2022 -- Binance CEO tweets that “Due to recent revelations that have come to light, we have decided to liquidate any remaining FTT on our books.”

▪ November 7, 2022 -- SBF tweets “A competitor is trying to go after us with false rumors. FTX is fine. Assets are fine.” A second tweet states “FTX has enough to cover all client holdings. We don’t invest client assets (even in treasuries) . . .” SBF Deleted Tweets

▪ November 8, 2022 -- FTX pauses all customer withdrawals.

▪ November 8, 2022 -- Binance announces the signing of a non-binding LOI for acquisition of FTX.com.

▪ November 9, 2022 -- Binance announces that it will pursue the acquisition of FTX.com.

▪ November 10, 2022 -- FTX assets are frozen in the Bahamas.

▪ November 11, 2022 -- FTX files for bankruptcy.

▪ November –January 2023 – FTX Fallout – Crypto exchanges Blockfi, Genesis have significant exposure to FTX and ultimately file for bankruptcy.

Common Issues in Crypto Exchange Bankruptcy Cases

▪ No funded or secured debt. Retail Customers account for nearly all the liabilities of the Exchanges.

▪ Types of Crypto Creditors. –

A. Earn/Yield/Rewards – Customers who deposited their crypto in exchange for interest

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B. Borrow/Lend – Customers who deposited their crypto in exchange for a fiat loan.

C. Custody/Wallet. Customers who deposited their crypto which was not deployed.

▪ Privacy/Confidentiality of Customers – In Celsius, the Court directed that the Debtors disclose the name of the retail customer and the type and amount of crypto held on the exchange. In other crypto cases, bankruptcy courts have preserved the anonymity of the retail customers.

▪ Ownership of Crypto. Terms of Use between Exchange and Retail Customer will, in the first instance, determine the property rights of the Retail Customer. In Celsius, the Bankruptcy Court determined that with respect to the crypto that was placed into the “earn” program, the terms of use clearly indicated that the customer transferred title to Celsius. See Celsius January 4, 2023 Earn Decision

▪ Dollarization of Claims. Nearly every Retail Customer wants their crypto back “in kind”. The concern is that the Debtor will seek to dollarize their claim (as of the filing date) and distribute fiat pursuant to a plan, rather than crypto.

Retail Customer Frustration

▪ Retail Customers are often unsophisticated investors and, depending on the exchange, dispersed all over the world. Many Retail Customers viewed the crypto exchange as a bank or a brokerage. However, unlike a bank/brokerage, there is NO insurance fund (e.g. FDIC/SIPC) available to quickly satisfy customers’ claims in the event of insolvency. As a result, Retail Customers have been forced to “wait in line” for their distribution (pending the resolution of the Chapter 11 process) and are extremely frustrated. As reflected in the image below, in the first month of the Celsius bankruptcy, over 250 letters were filed by pro se customers with the Court.

Novel Legal Questions predominate the proceedings

The rulings on these legal issues may have far reaching implications in the crypto world

▪ Property Issues. Is cryptocurrency a general intangible, currency, a security, a commodity (or both), or something else? Does the determination change if the crypto is based on proof of work or proof of stake?

▪ Securities Laws. Are the bankrupt exchanges that seek to distribute crypto pursuant to a plan of reorganization violating federal and state securities laws with respect to the purchase and sale of “unregistered securities”? Can federal and state regulators prevent the confirmation of these plans if they argue that these plans may violate federal or state securities law (e.g., Voyager)?

▪ Tax Issues – What actions trigger a disposition of crypto (i.e. a taxable event)? If a BTC holder receives property other than BTC pursuant to a plan, is there a taxable disposition?

▪ Commercial Law Issues. How does one create and perfect a security interest in cryptocurrency? Does the manner of perfection depend on the type of crypto (e.g., BTC v. ETH)?

▪ Consumer Lending Laws. Are borrowers who posted their crypto as collateral in exchange for a loan entitled to the return of their collateral under consumer lending protection statutes? Are the loans issued by the crypto exchanges enforceable if the exchange did not have the necessary licenses (e.g. money transmitter licenses/lending licenses) from federal and state agencies or did not follow the provide the appropriate lending disclosures (e.g., Truth in Lending Act disclosures)?

The voyage of Voyager

▪ July 6, 2022 - Voyager files for chapter 11.

▪ September 27, 2022 -Voyager selects FTX as the highest bidder in the auction of its assets.

▪ November 11, 2022 - After FTX files for bankruptcy, Voyager reopens bidding process.

▪ December 19, 2022 – Voyager announces that it has reached an agreement to sell is assets to Binance.US.

▪ February 2, 2023 – SEC objects to Plan to sell assets to Binance noting that “[h]ere, the transactions in crypto assets necessary to effectuate the rebalancing, the re-distribution of such assets to Account Holders, may violate the prohibition in Section 5 of the SecuritiesAct of 1933 against the unregistered offer, sale, or delivery after sale of securities.” Feb 22nd SEC objection (emphasis supplied).

▪ March 8, 2023 – Bankruptcy Court enters Order confirming Plan and overruling SEC objection. Confirmation Order

▪ March 9, 2023 – SEC appeals Confirmation Order.

▪ March 27, 2023 – SEC obtains stay pending appeal from District Court. March 27th Article

▪ April 1, 2023 – Debtors appeal Stay Order to Second Circuit Court of Appeals.

▪ April 11, 2023 – Second Circuit dismisses appeal for lack of appellate jurisdiction. As a result, the parties will brief the issues before the District Court which will ultimately determine whether to affirm or reverse the March 9th Order.

▪ April 18, 2023 – Drop dead date for Voyager/Binance to close transaction.

cases given the current environment

▪ March 9, 2022 -- Executive Order 14067 - “Ensuring Responsible Development of Digital Assets”. Executive Order 14067

▪ September 15, 2022 – Following ETH “merge”, SEC Chair indicates that proof-of-stake cryptos could be investment contracts that subject them to securities regulations. Sept 15th Article

▪ December 7, 2022 – SEC Chair urges that crypto companies come into compliance with existing securities laws:

“The basic message that I have had is the same public message as private message . . .Come into compliance. Your field will not last long outside of public policy norms.” (emphasis supplied).

▪ February 10, 2023 – Kraken fined $30 million and directed to halt its staking service. SEC Chair states that labels – whether a program is called "lend," "yield" or "earn" – didn't matter as much as the underlying economics. "There's a saying in crypto that 'says not your keys, not your coins.' So those other platforms should take note of this and seek to come into compliance, do the proper disclosures and registration and the like.“ (emphasis supplied).

▪ March 9, 2023 – NY State Attorney General files complaint against Kucoin

“The Tokens KuCoin sold and purchased to and from New York are securities under New York law. In In re Waldstein, 160 Misc. 763 (Sup. Ct, Albany Cnty. 1936). . . . ETH, LUNA, UST, and KuCoin Earn are each securities under Waldstein.” Kucoin Complaint (emphasis supplied).

▪ March 15, 2023 – SEC Chair states: "Whatever they're promoting and putting into a protocol, and locking up their tokens in a protocol … I would just suggest that each of these token operators ... seek to come into compliance, and the same with the intermediaries…” March 15th Article

▪ March 22, 2023 - SEC issues “Wells Notice” to Coinbase. Coinbase Press Release

▪ April 6, 2023 -- Treasury Department issues “Illicit Finance Risk Assessment of Decentralized Finance” - Treasury Department Press Release

▪ April 18, 2023 – In Congressional testimony, SEC Chair avoids answering the direct question of whether ETH is a security.

Regulators are likely to be active participants in these bankruptcy