Silicon Valley braces for the legal fallout from FTX

November 14, 2022, 12:43 PM UTC
A white man with black curly hair and wearing a dark suit with a blue tie speaks into a microphone
Sam Bankman-Fried, founder and former chief executive officer of FTX, speaks during a Senate hearing.
Sarah Silbiger—Bloomberg/Getty Images

It has barely been a week since FTX blew up and already lawyers are circling. 

On Friday, FTX filed for bankruptcy as former CEO Sam Bankman-Fried resigned, replaced by John J. Ray III, the lawyer who oversaw the liquidation of Enron. The bankruptcy proceedings promise to be a convoluted affair, litigating how FTX spent customer funds and trying to untangle conflicts of interest among its 134 affiliated companies.

“It’s going to be complicated with so many affiliated companies, so many creditors, so many customers, and the jurisdictions in different countries,” explained Reena Aggarwal, director of the Georgetown University McDonough Psaros Center for Financial Markets and Policy. “This is a maze of issues.”  

There has already been plenty of finger-pointing at the VCs who raced to throw money at Sam Bankman-Fried, doing little or no due diligence along the way. “If you’re just making a minority investment, you might not do the level of due diligence that maybe you should if you believe in the founder and you think this is a hot industry. We’ve seen this in a number of contexts [in venture capital],” said Lee Reiner, a professor of FinTech Law and Policy at Duke School of Law.

And, to state the obvious, crypto has never exactly been known for intense scrutiny and a hardline focus on the fundamentals. Kevin March, founder of crypto prime brokerage platform Floating Point group, explained that VCs overestimated the credibility of FTX, but said playing it fast and loose is part of the nature of investing in digital assets, especially during the bull market in late 2021 and early 2022. “Everything in crypto moves so incredibly fast,” he said. “It’s hard to fault the VCs for playing the game that crypto has invented,” he explained, referring to how fast platforms like FTX raised cash last year when valuations were skyrocketing. If VCs didn’t jump into funding deals in a matter of days, they risked being left behind. Because crypto firms often have many bank accounts internationally, tracking down the flow of assets is not as easy compared to the due diligence process when examining the financial health of a standard tech firm, for example. 

So what will the legal fallout be?

Few think FTX’s VC backers are at risk of being sued by limited partners, which is uncommon in Silicon Valley. Agreements LPs sign often limit the liability of a VC partner in the case that an investment has disappointing returns. “For the Sequoias of the world, their LPs are not retail mom-and-pop investors, they’re large institutional investors that are accredited, high net-worth individuals,” Aggarwal explained. “In the bigger scheme of things for them, this was a small investment.” 

The legal experts I spoke to thought the pension plans that invested in FTX—such as the Ontario Teachers Pension Plan—may be in a trickier spot. “Certainly if you are a fiduciary, they have a legal obligation to manage plan assets in such a way that maximizes benefits for the beneficiaries,” explained Reiner. “Then they are facing potentially legal liability.” The Ontario Teachers Pension Plan invested through its venture wing, the Teacher’s Venture Fund. “While there is uncertainty about the future of FTX, any financial loss on this investment will have limited impact on the Plan, given this investment represents less than 0.05% of our total net assets,” OTPP said in a statement released Thursday. Aggarwal explained that since OTPP’s investment was relatively tiny, it’s unlikely to make a huge impact on an individual’s pension. 

One recent case study in post-blowup crypto case law is the bankruptcy proceedings for the defunct platform Celsius. One thing to watch for? The jockeying between depositors, creditors, and shareholders negotiating who is first in line to get paid during the bankruptcy proceeding. In the Celsius case, customers and shareholders are currently pitted against each other to see who comes first. March explained that with FTX there are likely to be a host of lawsuits as depositors, many of which are hedge funds and retail investors, strategize the best legal course of action to get something back. 

Aggarwal explained that there will not only be suits against FTX itself but likely suits against individuals as the extent of the culpability of Bankman-Fried and his inner circle is aired in court. “I’m sure there will be class action lawsuits here,” she said. However, even when customers have a case, it’s unclear what assets exist to pay litigants (Celsius is still in the midst of a slew of lawsuits that have yet to be resolved). 

As for SBF himself? It’s unclear right now whether his role in FTX’s implosion will send him to prison, as Fortune’s Jeff John Roberts reported. Complications such as FTX’s headquarters in the Bahamas and lack of clarity about SBF’s intent could present obstacles for prosecution. Yet Jeff reported, “A longtime crypto lawyer, however, told Fortune he has no doubt that SBF’s behavior and FTX’s business practices clearly demonstrated fraud. The lawyer, who spoke on condition of anonymity, pointed to evidence like FTX’s terms of service as well as the company’s investor presentations and public statements by SBF.”  If he is convicted of wire fraud, he could be sentenced to a maximum of 20 years in prison. 

Finally, my colleague Luisa Beltran published a closer look at SBF’s quant trading fund Alameda Research, including what we know about its 20-something CEO Caroline Ellison. You can read the full story here

Lucy Brewster
Twitter: @lucyrbrewster
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