Bankruptcy law professors highlight controversy over management of FTX estate in 2nd Circuit appeal
On Friday, a group of bankruptcy law professors submitted an amicus brief as part of SBF’s appeal. They argue that the extent of the FTX debtors’ “cooperation” with prosecutors was unprecedented compared to similar cases like Enron and WorldCom, blurring the healthy boundary between the bankruptcy and criminal justice systems. The authors warn that this precedent threatens to undermine the efficiency and fairness of these systems by encouraging the use of bankruptcy “to exaggerate victims’ losses in a parallel criminal proceeding while enjoying tens of millions of dollars in creditor-subsidized, back-office support.”
“Congress did not enact chapter 11 of the Bankruptcy Code to make life easier for prosecutors,” the professors assert. “Yet, that is how Mr. Ray and S&C appear to have viewed their role at the Debtors.”
Key points of the brief
The scale, scope and immediacy of the debtors’ support for SBF’s prosecution was extraordinary.
Turnaround CEO John Ray and bankruptcy counsel Sullivan & Cromwell (S&C) report responding to a “phenomenal number” of requests from criminal authorities “on an expedited basis”. They say they provided “full access to the information on a real time basis” and generally “whatever the Government request[ed] relative to cooperation” from day one. In fact, S&C’s criminal investigation into SBF arguably commenced even earlier than prosecutors’, which appears to have been triggered by a message they received from S&C reporting unspecified “concerns”.
Ray and S&C publicly characterised SBF as a criminal long before his trial. “[I]t is hard to think of a CEO in recent memory who has been more focused on trashing the previous management,” wrote one commentator in April 2023.
When claiming credit for the direction and speed of criminal proceedings, S&C and Ray put themselves on a level with prosecutors, proposing that “if it were not for [our] prompt and immediate response, we would not have seen the indictments and the plea agreements that we have seen to date” and “[t]he Debtors, through the declarations in this case, [Ray’s] congressional testimony and, most importantly, the tireless work of Federal prosecutors and the admissions of those who have plead guilty, have made it quite clear exactly what transpired, how it occurred, who was principally involved and the results of their actions.”
S&C say they effectively billed creditors “tens of millions of dollars” for their prosecutorial work.
The goals of bankruptcy law are to reorganise viable businesses and maximise creditor recovery. However, the authors of the brief observe that in this case, “It is...hard to see how Mr. Ray could know in ‘real time’ that ‘full access’ was consistent with the interests of the Debtors’ estate unless he was so fully aligned with the government that the difference did not matter to him.”
Moreover, the Bankruptcy Code generally subordinates claims for fines, penalties and forfeitures. Yet the debtors “coordinated” the government’s seizure of assets, billing for nearly 200 hours of asset-forfeiture related work by June 2023. If they enabled the government to seize assets, they were preferring the government over FTX’s customers and other stakeholders.
The speed of SBF’s prosecution compared to creditor recovery enabled the debtors’ premature claim that FTX was insolvent to reach the jury.
One expert described the speed of SBF’s prosecution as “the prosecutorial equivalent of breaking the sound barrier.” This led to an unusual situation at trial in which the economic impact of the purported crimes had not yet been confirmed. Prosecutors were thus free to argue that customers would recover nothing, apparently expecting jurors to take this as evidence of fraudulent intent.
This may have misled the jury, especially since customers are now poised to receive almost 150% of their claims and SBF was barred from presenting evidence of FTX’s solvency at trial. Insolvent debtors almost never pay interest on unsecured claims, as FTX plans to do. In fact, if one puts aside suspect government fines of around $8.9bn, the debtors’ own Disclosure Statement supports SBF’s contention that FTX has always been solvent—and undermines the debtors’ assertion that they are insolvent even now—with a current surplus of $2.8-$4.6bn.
Conflicts of interest abound.
Anyone employed by a failed company is potentially liable for the problems that developed. S&C had represented FTX in 20 pre-bankruptcy matters, including work in which the firm may have learned of practices that formed the basis for the prosecution. They were therefore heavily incentivised to direct as much blame as possible towards another party, whether through public statements or facilitating convictions.
S&C were also heavily incentivised to have FTX placed into bankruptcy, so long as they could ensure their appointment as counsel to the estate (a far more lucrative opportunity than their prior work for FTX had been). S&C appear to have misled and pressured SBF into authorising the commencement of bankruptcy proceedings, bypassing the various company boards. And they handpicked the successor CEO who in turn appointed S&C as counsel to the debtors. S&C have since charged the estate hundreds of millions of dollars for its services.
With Enron and WorldCom, bankruptcy counsel had no prior connection to the debtors and independent examiners were appointed from the outset to investigate the causes of the businesses’ failures. With FTX, the debtors successfully resisted independent examination until after SBF’s trial had concluded. As a result, the authors of the brief conclude, “the investigation—and the use of the information uncovered—was generated and controlled by Mr. Ray and S&C”.
Zooming in: Was FTX ever insolvent? Does it even matter?
As mentioned, the estate plans to pay customers almost 150% of their claims. This is a phenomenal outcome. Everyone from prosecutors to the CFTC insisted that the money was irrecoverable. According to Ray, the claim that FTX had more assets than liabilities when it filed for bankruptcy is “categorically, callously, and demonstrably false”. Claims were initially trading at 3 cents on the dollar. No one expected such a fortuitous turn of events.
Well, almost no one. SBF has always maintained that the reason he paused withdrawals during the run on FTX was not because customers’ funds had vanished, but because he couldn’t sell assets fast enough—and even raising emergency cash via loans or equity would take a few weeks. A leaked balance sheet revealed more assets than liabilities in the hours before the bankruptcy filing. Admittedly, given the sudden emergency, this balance sheet was very hastily put together. But it was still sufficient reassurance to attract liquidity offers of $6bn+, backed by funds not included on the balance sheet, namely SBF’s personal equity. (SBF’s subsequent description of FTX as “insolvent” used the technical definition of “unable to immediately meet withdrawals” rather than the more typical “liabilities exceed assets”.)
Some customers object that they are not being fully repaid because of the dollarised nature of their claims and the rise in value of bitcoin since the petition date. But it must be remembered that it was Ray who commenced bankruptcy proceedings for FTX and over 100 affiliates just three hours after taking control in November 2022. He even admitted the following week that “many regulated or licensed subsidiaries of FTX, within and outside of the US, have solvent balance sheets, responsible management and valuable franchises” and that the solvent entities included FTX EU and the legal entity that operated FTX.US. If Ray had instead chosen to continue SBF’s promising efforts to raise the cash needed to meet withdrawals, perhaps customers would have been repaid in full before the month was out, rather than having their funds frozen in bankruptcy for two years. Moreover, Michael Lewis contends that the debtors can still afford to fully repay customers in-kind—they’ve just chosen not to.
When attempting to reconcile the astounding success of the bankruptcy proceedings with the assumption that FTX was “really bankrupt” in November 2022, commentators almost always credit the rise in the price of bitcoin. I can only recall one reporter ever acknowledging that “FTX had not benefited from the phenomenal growth in the market” since “FTX...held only 0.1% of the bitcoin and 1.2% of ethereum” that customers had deposited. And even this reporter failed to draw out the implication that, in the absence of the “bitcoin went up” explanation, the most natural conclusion is that FTX was in fact always solvent—and the burden of proof is on anyone who claims otherwise.
Does any of this matter for SBF’s culpability? Judge Kaplan apparently thinks not. Using an analogy that has proved popular in more recent discussions of the case, he argued that “[a] thief who takes his loot to Las Vegas and successfully bets the stolen money isn’t entitled to a reduction of his sentence.”
But even if there were a legal sense in which the question of solvency is irrelevant, it would still strain credibility to maintain that it had no impact on jurors’ assessment of intent. Otherwise, why would prosecutors go to the trouble of telling the jury 97 times that customers had lost $8 billion? “Billions of dollars from thousands of people gone,” they summarised. “[T]he defendant schemed and lied to get money, which he spent, and now it's gone.” And if the level of risk the “loot” was exposed to is immaterial, why spend an hour explaining how SBF wanted Alameda to make investments that would raise the risk of loan repayment delays—and thereby potentially delays with FTX customer withdrawals in the event of a bank run—from 0.45% to 2.5%? (“That means if we made this $3 billion of investments and there was bad market news leading to a significant market downturn [10% likelihood] and our loans got called [25% likelihood], that there was no way we would be able to make the payments [immediately].” The prosecutor then rewords this as “When you concluded that there was a hundred percent chance of not being able to repay your loans…. MR. COHEN: Same objection. THE COURT: Overruled.”) Clearly, as the bankruptcy law professors propose in their brief, the prosecution hoped jurors would interpret the apparent disappearance of funds after a seemingly risky gamble as a demonstration of criminal intent.
Zooming out: How does this relate to SBF’s appeal?
The professors take no position on the guilt or innocence of SBF; their focus is on the troubling precedent his case may set for future bankruptcies if the problems are not addressed soon. But there are two main areas where the professors’ concerns overlap with core threads of the appeal.
Firstly, both the amicus brief and the appellate brief take issue with the asymmetric rulings on evidence of loss, which the professors refer to as a “one-way ratchet”. Essentially, the judge precluded the defence from giving evidence of solvency, while allowing the prosecution to give evidence of loss. Both briefs highlight prosecutors’ statements that Alameda was “deeply in the red”, “$10 billion plus in the hole” and “totally under water”—and that SBF “knew” this.
Secondly, both SBF and the professors argue that the debtors have exerted an undue influence over criminal proceedings through their extraordinary and, again, asymmetric “cooperation” with the government. One particularly revealing declaration that did not appear in either brief is from Ray in January 2023:
The advisors working at my direction have worked tirelessly and nonstop for the last seventy days to take control over what can only be described as a ‘dumpster fire’.... The villains are being pursued by the appropriate criminal authorities largely as a result of the information and support they are receiving at my direction from the Debtors’ advisors. Through the efforts and cooperation supplied to Federal prosecutors which is ongoing, two individuals have plead guilty and another has been charged. This is not a ‘whodunit’ puzzle in which the parties in interest lack knowledge about what transpired.