The FTX fallout so far and what may come next

The collapse of FTX Trading Ltd. has been as dramatic as it has been fast. Until then, FTX had been the second-largest exchange in the world.

FTX's founder and CEO, Sam Bankman-Fried, was a rock star of the crypto industry who also held significant wider influence thanks to his financial clout, estimated to have peaked at $26 billion earlier this year, but now essentially zero.

Several weeks on from FTX's collapse, much uncertainty remains as to exactly what has happened. Various rumors immediately began circulating regarding missing customer funds, substantial loans to Bankman-Fried and other directors, unauthorized transfers to related businesses and a hack.

Court papers filed in the Chapter 11 proceedings initiated by over 130 FTX entities in the U.S. say that the "situation is unprecedented" and that there has been a "complete failure of corporate controls and […] a complete absence of trustworthy financial information."

Bankman-Fried was arrested in the Bahamas on Dec. 12 on various serious fraud charges and is expected to be extradited to the U.S. to face those charges.

On Dec. 13, a congressional hearing took place in the U.S. at which Bankman-Fried was due to testify, until his arrest the day before.

The testimony given by others at the hearing, including from John Jay Ray III, installed as CEO of FTX upon its collapse, makes for grim reading. All of this will be unpicked further over the coming months and years.

One certainty, though, is that a large number of customers and business partners look set to suffer significant losses. Reports suggest there are over 1 million creditors.

These victims of the FTX scandal are unlikely to receive much recompense via the Chapter 11 proceedings unless they have secured claims or had deposited assets without transferring title to FTX, and those assets remain in situ.

The latter point is where the problem often lies for customers of crypto exchanges: Many crypto exchanges hold some or all customer assets in a manner that transfers legal title to the exchange such that it is free to use the assets elsewhere to generate a yield.

The customer's "ownership" of the particular assets is recorded essentially by an entry on the exchange's internal ledger, together with a contractual agreement that the exchange will transfer assets of the same value back to the customer upon request.

This arrangement can present serious liquidity issues when large market movements occur and often linked to that, when a large number of customers wish to withdraw their assets at the same time, because the exchange may not be holding enough assets — or unencumbered assets — to meet those withdrawal requests.

This ought not to have been a problem for FTX customers. Its terms of service, or at least one version currently circulating online, expressly provide for English law to apply and state that title to digital assets held by it remained with the customer, and that none of those assets were "the property of, or shall or may be loaned to FTX."

As such, customers ought to have had greater protection in an insolvency scenario such as the one that has now arisen.

However, if the reports of FTX using customer assets for wider transactions are true — such as the approximately $10 billion reportedly transferred to Bankman-Fried's related trading company Alameda Research — then clearly something has gone badly awry. Any such transfers of customer assets would be a serious breach of FTX's terms of service and, at least under English law, a constructive trust is likely to have arisen over the misappropriated assets.

This would, in principle, give customers good grounds to pursue proprietary claims to recover their misappropriated assets. But the reality, given the apparent scale and complexity of the scandal, is that recovering all of a customer's assets in this way is still likely — at best — to prove extremely challenging. Customers are still, therefore, likely to suffer substantial losses.

Customers who do suffer such losses may therefore wish to consider how they may be able to make recoveries from other parties with deep pockets who have been involved in the events that brought down FTX, or perhaps who advised customers to invest in or via FTX in the first place.

There is, of course, nothing new in this approach. It is commonplace in all major financial scandals, from Enron Corp. to Madoff to Wirecard AG, where there is insufficient value in the failed business to meet all creditor claims.

Will banks be dragged into the mire? The biggest U.K. and international banks have shown caution in their dealings with crypto institutions and funds deriving from them, mainly out of concerns over money laundering but no doubt also with one eye on possible litigation arising from a situation like the one currently unfolding at FTX.

That said, if some of the allegations relating to FTX are true, it may well be that one or more banks become embroiled in litigation due to the part they played in any unauthorized movement of assets or their traceable proceeds.

Professional advisers and wealth managers will also, no doubt, face claims. For example, how did large, sophisticated investors such as Sequoia Capital, SoftBank Group Corp., Tiger Global LLC and Blackrock Inc., to name but a few of FTX's major investors, come to invest several hundred million dollars into a business that, it now seems, had no financial controls or trustworthy financial information?

Sequoia Capital alone is reported to have written down to zero its entire $210 million investment, with SoftBank reportedly set to lose $100 million. It is difficult to understand how large institutions such as these did not spot what now appear to be obvious red flags at FTX when making their investments.

These sorts of losses will not pass without serious scrutiny. It is likely that stakeholders in each of these investors will want answers from them and their professional advisers as to how this was able to happen. Inevitably, that will lead to litigation.

The jurisdiction for any FTX-related claims remains unclear. While FTX's terms of service stipulate English law, they also require arbitration in Singapore. But those terms will not apply to claims brought by creditors who were not customers of FTX, or any claims made against third parties.

One thing is clear, though: With a sprawling and global business such as FTX, it will not be easy to establish where any claims might best be brought. It will take time to unpick the complex circumstances leading to FTX's downfall, and indeed the personal circumstances of each customer or other creditor who has suffered loss.

As a result, we will see a raft of claims in multiple jurisdictions relating to the downfall of FTX for many years to come.

If there is one silver lining from the collapse of FTX, it is that it will hopefully precipitate a renewed focus on how best to regulate the crypto industry so as to preserve the ability to innovate and to continue to disrupt traditional finance, but in a way that is responsible and gives more protection to consumers.

2022 has clearly been a torrid year for crypto generally, and much work is needed to restore confidence in a sector that was thriving not long ago. Regulation is likely to play a key role in that.

This article was first published in Law360.