FTX and the “Crypto Clawback”

Did you see this tweet?

While Balaji is correct about the importance of learning some of these terms in light of multiple failed centralized exchanges which are seeking protection in bankruptcy, he’s not quite correct about how the bankruptcy system operates, as noted by Van Brooks in a reply to Balaji’s tweet:

Customers who withdrew their crypto assets in the ninety days before FTX filed for bankruptcy could be sued by the company’s creditors to get the money back. This is called a ‘clawback’ under the bankruptcy code. A clawback is a broad term for the right of the bankruptcy trustee (also sometimes known as the Debtor in Possession or DIP) to seize funds transferred to creditors preferentially or through fraud. The goal of clawbacks, and ultimately of the Bankruptcy Code, is to ensure a fair outcome for creditors as a class. To accomplish this, the DIP may void deals retroactively and recoup debtor funds by recovering funds from transactions and transfers made within a certain period of time prior to the filing of the bankruptcy petition. Funds that are recovered are returned to the bankruptcy estate’s coffers with the goal of eventually giving creditors the largest possible recovery, distributed evenly among all creditors.

FTX’s Insolvency

On November 11, 2022, FTX Trading Ltd. announced it had filed a voluntary petition for bankruptcy under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware. The filing includes 134 “debtor entities,” functionally the full FTX corporate group (referred to as FTX throughout this article). This means that the bankruptcy court is now in charge of managing and reorganizing the FTX group. Over the next few months — or potentially years — all of the debtor group’s assets will be managed for the benefit of FTX’s creditors. It’s important to know that, unlike Chapter 7, Chapter 11 enables FTX to come out of bankruptcy and keep operating in some way in the future.

In the weeks preceding the filing of the bankruptcy petition there were — not unexpectedly — a significant number of crypto asset withdrawals from the exchange. A Twitter thread by the blockchain research group Arkham Intelligence lists the largest withdrawals from FTX in the days leading up to the bankruptcy. That report shows that trading firm Jane Street managed to withdraw $27 million worth of crypto assets from FTX on the eve of bankruptcy. While it might seem that Jane Street and other customers who were able to withdraw their assets from FTX have dodged a bullet, they are not necessarily in the clear.

Under the bankruptcy code, the date of insolvency is 90 days before the bankruptcy petition is filed. This means that customers who used and withdrew funds from entities in the FTX debtor group, organizations that received investments and political donations, and vendors receiving payments from approximately August 11, 2022 onward, may have any assets received clawed back into the bankruptcy estate. This timeframe extends to one year in the case of ‘insiders’ and in instances where there are allegations of fraud — including a determination of a Ponzi scheme — the period of time over which funds may be clawed back can extend beyond that. At this point, it is hard to say whether any funds will be clawed back. However, if a transaction occurred within the relevant time period, the recipient will eventually receive a notice from the bankruptcy court, and this is the starting point to mount a defense, negotiate a settlement, or engage in litigation.

Preference Claims

There are two main types of clawback processes: preference actions under Section 547 of the Bankruptcy Code and fraudulent conveyance actions under Section 548. Preference and fraudulent conveyance claims generally encompass larger transactions — as opposed to transactions by retail customers — that could appear irregular, even if the recipient did nothing wrong and had no knowledge of any potential impropriety.

A preference claim under Section 547(b) of the Bankruptcy Code permits the trustee to recover or avoid preferences. The law presumes that payments made in close proximity (generally ninety days) to the debtor’s insolvency gave the recipient preferential treatment over the debtor’s other creditors. A preference action attempts to undo the preferential payment and return funds back into the estate so they can be distributed equally to all creditors. As noted above, for the FTX debtor group this would include all transactions from approximately August 11, 2022, until the filing. However, if the debtor paid insiders or helped insiders remove assets from the estate, the trustee can claw back those assets within a year of the filing date. This means that preference actions in those specific instances could go as far back as November 2021. Additionally, the trustee has two years from the petition filing date, or until November 11, 2024, to commence any preference actions.

Generally, preference rules do not take the recipient’s intent or knowledge into account. This means that if a large FTX customer closed their account in the preference period, without knowledge of the upcoming bankruptcy, the money could still be clawed back. The purpose of a preference action and the bankruptcy code as a whole is not to punish those who received funds, but rather to promote fairness to all investors and creditors by making those that received money just before the collapse return the money and be treated like all other investors.

Some examples of preferential transfers include payments made within the 90-day period before the filing of a bankruptcy petition:

• on an invoice that is substantially overdue; the payment is considered preferential because it is made to ensure continued service or delivery of goods.
• of all outstanding invoices owed in a lump sum payment when the debtor generally pays each invoice separately on a monthly basis.
• of a debt immediately upon incurring the debt when the debtor generally pays the debt within a period of time after receipt of the invoice.

In each instance, the ‘preference’ to the creditor that received the funds is apparent because the payment allows one creditor to receive more than other similarly situated creditors. Alternatively, payments that appear outside of the ordinary course of business between the parties will trigger a preference assessment.

Fraudulent Conveyance and Ponzi Schemes

The second type of clawback is a “fraudulent conveyance claim” under Section 548. These clawbacks target transactions that occurred up to two years before the bankruptcy petition was filed. Fraudulent conveyance claims require an allegation that the debtor moved assets out of the estate for the purpose of frustrating future creditor claims. Fraudulent conveyance claims are more difficult to prove and more individualized to the specific transaction.

There are two types of fraudulent conveyance claims available to the trustee. The first — and more common claim — is constructive fraud based on the receipt of money or assets from the debtor without having provided anything of reasonably equivalent value in return. Fraudulent conveyance claims do not require intent to defraud by the recipient; they just require receipt of the debtor’s assets without having provided the debtor with anything of appropriate value in return.

The second type of fraudulent conveyance claim requires some proof of the recipient’s understanding that it was improper to receive the assets. In the context of a Ponzi scheme and its investors, the issue of reasonably equivalent value focuses on whether the investor is withdrawing more or less than originally invested. The original investment constitutes value given to the debtor, so withdrawals of the original investment are not subject to fraudulent conveyance claims — at least as long as the investor had no reason to know about the fraud. However, if more than the original investment is withdrawn, the investor’s withdrawal of the false profits generated by the Ponzi scheme is considered a withdrawal of another investor’s principal investment and is subject to clawback by the estate.

There have been some comparisons of FTX to the Madoff case; however, it is not yet clear whether FTX’s bankruptcy will be qualified as a Ponzi and subject to that form of clawback. Classification of the estate and conveyances as a Ponzi could significantly extend the life of bankruptcy proceedings. As of September 2022, the U.S. Department of Justice commenced its eighth distribution to Madoff victims since 2009, and efforts appear to be ongoing. Part of the theory behind a Ponzi determination is that the debtor never operated a legitimate business through the scheme, and accordingly, all of the payments that were made to investors were made with other investor funds that should be recovered for pro rata distribution to all the investors.

If FTX was started as a legitimate exchange and custodial trading platform and operated in that manner for an unspecified amount of time before allegedly misappropriating client funds, then it may ultimately be determined not to be a Ponzi. However, it is also notable that the CFTC and SEC have both seemed to allege that FTX was a “fraud from the start,” which seems to foreshadow the approach of their civil and criminal actions against FTX and may ultimately impact the way bankruptcy and civil forfeiture clawback efforts proceed.

Are Assets Property of the Customer?

The user agreements and other contracts between centralized exchanges like FTX and their users may determine what happens to customer funds in the event of bankruptcy. In a preference assessment, it is often important to know whether the customer or the exchange holds title to the assets that are held on the exchange. If assets that are withdrawn are not considered exchange property, then those assets cannot be clawed back from customers. The court may even direct the bankruptcy estate to transfer assets back to customers. Generally, whether crypto assets are property of a bankruptcy estate is a fact-specific determination and depends on several factors, including the terms of the customer agreement and how the crypto assets are held. As noted above, if title to the crypto is with the customer, the assets may be outside of the estate and remain the property of the customer.

Precedent From Celsius Bankruptcy Proceedings

Celsius is another large crypto exchange that filed for Chapter 11 bankruptcy protection in July 2022 in the Southern District of New York. According to a September 2022 filing, approximately 58,000 users held assets worth $210 million in Celsius’ “Custody” program. Of those customers, there were approximately 16,000 who held $44 million in what is known as “pure custody,” meaning those funds were never deposited in the yield-bearing “Earn” program. At the December 2022 hearing, U.S. Bankruptcy Judge Martin Glenn ruled that the “pure custody” group retained title to the assets and that those assets would be returned to the customers — and implicitly that those assets would not be subject to preference actions in the future.

Here, the ownership and title to the Custody Assets should be determined by the parties’ respective contractual rights, as articulated in the Latest Terms of Use, which are clear and provide ample evidence that the parties’ intent was that the title and ownership of Custody Assets remain with the customers, and that title and ownership of assets in the Earn Program and the Borrow Program are held by the Debtors.

In a January 2023 ruling, Judge Glenn confirmed that Earn and Borrow program assets were property of the estate. For those programs, the terms of service allowed for rehypothecation of the assets in exchange for yield and “unambiguously transferred all right and title of digital assets to Celsius.”

With respect to similarly situated FTX customers, according to FTX’s terms of service, title to customer crypto assets on the FTX platform remains with the customer and does not allow for rehypothecation. And, while Southern District of New York bankruptcy rulings are not binding precedent in Delaware District bankruptcy cases, Judge Glenn’s ruling can act as persuasive authority when this issue arises in the FTX case. However, one significant distinction between the Celisus and FTX cases is that FTX’s apparent misuse and co-mingling of custodied customer assets across the FTX debtor group may simply mean there are no readily identifiable customer assets to return.

Investments by FTX Ventures and Alameda

Notwithstanding issues relating to custody and trade of funds on the FTX platform, FTX pumped billions of dollars into startups and venture capital funds in the two years prior to its insolvency. This spreadsheet, first shared by the Financial Times, shows Alameda Research’s private equity portfolio, which includes nearly 500 investments amounting to $5.276 billion. This matters in the context of bankruptcy because the recipients of those investment funds are likely wondering what could happen next and if that money could be clawed back. The Financial Times spreadsheet does not indicate when investments were made, but for those made outside the 90-day insolvency window, the investments may not be preferential transfers because there is usually no debt attached to startup stock investments (in the form of SAFEs, SAFTs, etc.). For the investments to be clawed back as fraudulent conveyances, the trustee would need to demonstrate that the investments themselves were not made at fair market value (regardless of whether or not that value has since declined). It is also relevant that invested FTX funds or assets are likely no longer available but exist in the form of resultant assets, such as equity, digital tokens, or limited partnership positions.

FTX Political and Charitable Contributions

Notwithstanding all the partisan political posturing relating to FTX political contributions, at least some amounts of the contributions are subject to the clawback provisions discussed above. At least $73 million in political donations are tied to FTX. If it is determined that fraud is involved, then nearly all donations tied to FTX could be targeted for recovery. If there is no determination of fraud, there still appears to be at least $8.1 million subject to the 90-day insolvency period.

FTX also apparently made significant contributions to the Effective Altruism community over the past several years. In a post on the Effective Altruism Forum, the effects of FTX’s bankruptcy are discussed in depth. The poster appropriately points out that received funds should be segregated to the extent possible and remain so, not to be returned until some notice from the bankruptcy court is received.

Potential Defenses to Clawbacks

As discussed in the opening, individuals in receipt of any FTX funds determined to be preferential or subject to fraudulent conveyance will eventually receive a notice (and/or be served with a lawsuit) from the bankruptcy court. The crucial questions for most customers facing preference suits will be whether 1) the withdrawn crypto assets belong to the debtor or to the customer, 2) whether an affirmative defense applies, and 3) whether the safe harbor provisions for securities and commodities trading apply. Some examples of these defenses include:

• Section 548(c) of the Bankruptcy Code allows investors to assert a good faith defense should there be a determination that the debtor operated a Ponzi scheme. Good faith is generally measured under an objective prudent investor standard.
• Section 547(c) of the Bankruptcy Code sets forth nine separate affirmative defenses that a creditor can assert in response to a preference claim. The most common 547(c) defenses include: The subsequent new value defense, where new value is defined as “money or money’s worth in goods, services or new credit . . . .” Section 547(c)(4) allows a creditor to offset new value provided against a preferential transfer. The ordinary course of business defense under Section 547(c)(2) allows a creditor to assert payments it received from the debtor were made in the ordinary course of business. For example, payments made by invoices are generally not preferential unless the terms of the invoicing changed in response or close to insolvency. For crypto exchange customers, this is a fact-specific inquiry and considers the terms of the service agreement, time spent as a customer, and the size, timing, and circumstances surrounding the customer’s withdrawal. Situations where there appear to be “run on the bank” withdrawals in reaction to negative media are generally indicative that withdrawals were not made in the ordinary course. The contemporaneous exchange for new value defense under Section 547(c)(1) provides for a determination that the creditor extended new value to the debtor via contemporaneous exchange. As with a subsequent new value defense, the contemporaneous exchange defense provides an offset only to the extent of the new value given.
• The safe harbor defense under Section 546(e) exempts certain transactions involving securities and commodities contracts. This defense is subject to a determination regarding whether the asset in question is a security or a commodity, among other factors further discussed here.

Ultimately, given the complexity of the legal issues implicated as the bankruptcy process unfolds, it is most important to seek the advice of knowledgeable counsel. The docket contains further information regarding overall process and relevant deadlines and this author has also written a primer about the initial creditor claim process.

Nathan Postillion is a U.S. attorney with an active litigation and counseling practice assisting builders, developers, traditional companies, and decentralized communities. He is a member of the Blockchain Lawyers Group, BanklessDAO’s Legal Guild, LexDAO, LeXpunK, and member/consultant/contributor to a variety of DAOs and protocols. Read his scribblings on Mirror and connect on Twitter, LinkedIn, or at nathan@lexfg.com.

A version of this article was first published in BanklessDAO’s Decentralized Law newsletter on January 12, 2023.