The crypto ecosystem is facing a full-blown financial crisis reminiscent of 2008. Numerous crypto companies have failed in the past few months, triggered in part by the collapse in cryptocurrency prices this year following their highs in 2021. These collapses have created a slow-moving contagion – again reminiscent of the 2008 financial crisis.

The collapse of the Terra/Luna “algorithmic stablecoin” ecosystem wiped out billions (if not tens of billions) of notional value – including the Terra “stablecoin” that was pitched as a non-volatile store of value. Several large crypto funds were reported to have sizable investments in that ecosystem, which destabilized their finances. However, because this was a purely crypto-based system and not a traditional company, its collapse was somewhat opaque: there were no insolvency proceedings, and numerous market players have denied exposure.

The next domino to fall was Celsius announcing on June 12, 2022, that it would freeze all customer accounts “[d]ue to extreme market conditions” – which, of course, was actually because it was insolvent. Others followed: crypto hedge fund 3 Arrows Capital (“3AC”) went radio silent and plunged into insolvency proceedings in the British Virgin Islands, leading to Voyager Digital (which had lent a vast amount of its assets to 3AC, filing for bankruptcy in the Southern District of New York on July 6, 2022.

Numerous other crypto companies have been bailed out – largely led by crypto exchange FTX. For example, FTX offered a liquidity facility to BlockFi of up to $400 million, with a purchase option to purchase all equity in BlockFi for a sliding scale price of up to $240 million.

However, in the past week, FTX itself has collapsed with a rumored massive hole in its customer accounts. FTX had one operating subsidiary placed into an involuntary liquidation in the Bahamas on Nov. 10, 2022, and FTX quickly (and without the usual preparation such a filing entails) placed the remainder of its entities into Chapter 11 in Delaware on Nov. 11, 2022 (along with certain other entitles associated with its CEO, including FTX US and Alameda Research). Hard data is scarce, but reports – sourced to presentations made by FTX’s CEO, Sam Bankman-Fried – indicate that FTX “loaned” $8 billion of FTX customer assets to his affiliated hedge fund, Alameda Research. More accurately, it appears the funds were simply stolen.

Brown Rudnick is closely following the FTX situation, and will put out separate updates on that situation as facts come in. That said, based on initial reports, we have several thoughts.

The bankruptcy of FTX (and affiliated entities FTX US, and Alameda Research) is going to be extraordinarily complex for several reasons. Among those are:

Assets: It is unclear what assets even remain to distribute to creditors, and where those assets are located. Leaked balance sheets suggest FTX Global has little, if any, “hard” crypto assets such as bitcoin or ether, and has a relatively small amount of assets that can be readily converted to dollars or other fiat currencies. Instead, FTX Global appears to hold largely illiquid tokens with values that may be illusory. Alameda – which reportedly received the funds stolen from FTX Global – may have lost those funds (either trading, or in turn stolen by its executives). Further, as FTX Global’s operating subsidiary in the Bahamas has been placed into a Bahamas liquidation, it is unclear which assets are under the control of the liquidators in the Bahamas, and which are under the control of the Chapter 11 debtors.

Subsequent Thefts: Less than a day after the FTX/Alameda/FTX US Chapter 11 petition was filed, it appears that hundreds of millions of crypto (estimates range from $477 million to $663 million) was transferred out of FTX US and FTX Global. It is unclear who was responsible, and suspicion has focused on both an “inside job” and an external hack. This action drained further funds from these already asset-poor entities, and while FTX US was previously (allegedly) solvent, it may no longer be as a result of the hack.

International Issues: Because FTX Global Markets (which appears to be the FTX Global main operating subsidiary) is in a Bahamas liquidation proceeding, and key FTX executives appear to be in the Bahamas, any bankruptcy process will require substantial international cooperation. First, the Chapter 11 estates and the Bahamas liquidation will need to reach agreement on claims between the entities and reach agreement on how to cooperate to maximize recoveries for all creditors. Failure to do so could be significantly damaging – in the Lehman Brothers liquidation, there were disputes between the Lehman Brothers U.S. entity and the Lehman Brothers U.K. entity for a decade, significantly slowing distributions and the resolution of those cases. In contrast, however, in the MF Global liquidation, there was significant international cooperation that hastened the return of funds to customers in that case. Further, assets may be secreted abroad in a number of different countries, and an international effort will need to be mounted to recover them.

The Role of Alameda: It seems inexplicable that FTX Global’s owner, Bankman-Fried, who was a multibillionaire on paper based on his FTX stake, would destroy FTX Global to bail out his crypto hedge fund – though based on public reports, it appears that is the case. If Alameda had lost significant sums of money and was insolvent, the logical answer would seem to be: simply let it collapse, let its creditors get stiffed because Alameda didn’t have enough money, and remain a multibillionaire with a thriving exchange. Further, Alameda and FTX were both understood to have made significant profits in the past – and those profits appear gone as well. Suspicions have been raised that Alameda may have been more entwined with FTX Global than previously understood, and that it may have been losing significant sums of money for some time. Whatever the answer is, the current situation does not make sense – and that means there may be further shoes to drop. If there are few remaining “hard” assets at Alameda as well, there may be a long road for customers to receive significant recoveries.

All of these issues create significant difficulties for the resolution of FTX/Alameda/FTX US’s bankruptcy cases. In particular, the following issues are likely to arise:

Claim Dollarization: In Voyager and Celsius, there has been an effort to pay claims “in kind” rather than converting the claims into dollars and paying in dollars. However, between the leaked balance sheets showing FTX Global has little (if any) “hard” crypto assets, and the subsequent theft of up to $663 million in crypto, there may be little or no “hard” crypto assets available to distribute.

FTX US: There is little useful public information on the status of this entity. While previously it was asserted to be entirely solvent, this assertion came from Bankman-Fried, who appears to have stolen all of the funds from FTX Global, making this statement not particularly reliable. While public statements by others have affirmed this, it’s hard to know if they are reliable either, given Bankman-Fried’s apparent control over all of these entities. In addition, even if it was solvent, post-bankruptcy thefts may have rendered it insolvent. If this exchange remains solvent – and if it has any “going-concern” value – is very unclear at this point, and as a result there is little certainty. Further, FTX US’s assets (including customer accounts) may not be available to other Bankman-Friedcontrolled entities – this is an issue that will likely be litigated.

Reorganizing: It seems unlikely that FTX Global can remain as a going concern. It appears to have perpetrated one of the largest frauds since Bernie Madoff. It has acquired a number of other companies, which may retain going concern value and may have assets that can be sold. But given that the best case for any particular member of FTX’s management is “not criminal, but just so incompetent they didn’t notice that $8 billion was missing” there appears to be no value whatsoever in maintaining those as FTX-run subsidiaries under control of (remaining) management rather than selling them to third parties.

Further, it may be difficult to sell customer accounts to a solvent exchange (or, if FTX US is relatively or completely solvent, to sell FTX US). Customers of Voyager nearly wound up going “from the frying pan into the fire” given Bankman-Fried’s attempts to purchase Voyager customer accounts out of Voyager and add them to FTX US. As a result, there will likely be extreme skepticism towards any potential transfer of customer accounts, unless strong steps are taken to ensure that no customers are exposed to companies they do not trust, and that any potential counterparties are fully vetted.

No Plan: It is clear that the Chapter 11 filings were made without the typical planning for bankruptcy that Voyager and Celsius conducted. The Chapter 11 filings were made without typical “first day” motions that obtain needed relief to continue operating the business. Instead, they appear to have been filed in extreme haste following the involuntary liquidation of FTX Global Markets by Bahamas regulators, to pre-empt any further involuntary bankruptcy filings. As a result, it is likely that the people currently in control of FTX do not know where all the assets are, do not have firm control over the business, and do not have a plan of what will happen next. This creates dramatic uncertainty and heightens the risk of further damage to the estates, like the post-petition theft of up to $663 million.

Litigation and Criminal Investigations: Because there appears to be such a vast hole in FTX Global’s customer accounts – and there are reasons to be skeptical that Alameda has enough assets to fill it in – recovery of assets will likely require litigation, which takes time and costs money. As a result, meaningful distributions to creditors may be significantly delayed, and creditors may have lower initial recoveries to fund such recovery efforts. Further, while governments will (appropriately) conduct criminal investigations of the individuals resolved, those investigations may take priority over bankruptcy efforts to recover funds, make it more difficult to obtain information, and may interfere with or delay efforts to recover funds.

The FTX collapse is certain to create additional contagion. It is widely expected that BlockFi – which has already halted withdrawals – will be forced to file for bankruptcy.1 Questions have been raised about other companies, including Numerous other crypto companies and projects are reported to have held their treasuries on FTX and face the prospect of being wiped out. It is unknown what parties may be significant creditors of Alameda (which has itself collapsed) and may have significant losses as a result. Further, the uncertainty will likely lead to credit drying up and parties seeking to pull funds back, as they fear their business partners or counterparties have been rendered insolvent by FTX’s collapse.

While crypto has a number of unique factors that differentiate itself from “traditional finance,” these financial issues also have significant similarities to past financial crises that offer key lessons for how this crisis may play out.

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