On November 11, 2022, FTX, the world’s third-largest cryptocurrency exchange, filed for Chapter 11 bankruptcy protection in the United States. Reports suggest that the exchange might have a shortfall of as much as US$8 billion. The collapse has sent shockwaves through the cryptocurrency market, undermined investor confidence and led to renewed calls for authorities to accelerate the implementation of fit-for-purpose regulations.

Chapter 11 Bankruptcy

Chapter 11 in the United States is a debtor-in-possession restructuring procedure that allows existing management, or in cases such as FTX where there are allegations of fraud, new management or a court-appointed trustee, to work with the stakeholders in the business (often represented by appropriate committees) to maximize stakeholder value. It involves a high level of court oversight to ensure stakeholders are not prejudiced and value is both maximized and distributed equitably among stakeholders with differing rights. Key issues that the court is expected to consider in FTX include whether any transactions executed ahead of FTX filing for Chapter 11 protection should be unwound and which assets held by FTX fall within the FTX Chapter 11 estate and which assets are held on behalf of customers and fall outside of the estate.

The Chapter 11 process typically results in a holistic restructuring plan being put before stakeholders for their approval or going concern sales of the business conducted under the auspices of the Chapter 11 court.

The FTX Chapter 11 cases were filed in the District of Delaware, where the US entities of FTX are incorporated. Most of FTX’s assets and creditors are outside of the United States, but as explained below, the US courts have extremely minimal jurisdictional requirements.

The Chapter 11 automatic stay applies worldwide, and local jurisdictions will generally be reluctant to take any action with respect to a Chapter 11 debtor unless authorized by the Chapter 11 court. However, there are several non-debtor FTX entities where creditors will likely assert local actions as these may be perceived to have a higher chance of recovering funds.

Questions of Jurisdiction

FTX headquarters is registered in the Bahamas, which was only recently removed from the EU’s AML blacklist. The Securities Commission of the Bahamas, the local regulator, has ordered that all FTX digital assets must be transferred to the Bahamas. They are making a case that any insolvency proceedings should submit to its jurisdiction. The US court is expected to reject these arguments. Under the US Bankruptcy Code, any entity with property in the US (even a bank account) is eligible for Chapter 11. US courts frequently exercise jurisdiction over foreign debtors with minimal US contacts so long as the filing is not seen to prejudice creditors or interests of the local jurisdiction.

The Bahamian liquidator has also sought recognition by the US bankruptcy court of the Bahamian liquidation in the US, meaning that the US bankruptcy court may enforce any orders entered into the Bahamian liquidation. Given the allegations of fraud by Bahamian authorities and FTX management in the Bahamas, the US bankruptcy court has postponed ruling on recognition without further evidence.

Fraud and Theft

There are reports of large FTX cryptocurrency transactions taking place on November 12 and 13. Officially, FTX accounts were frozen on November 10. Some investment firms have reported nine figures in assets that have vanished from their accounts. While further investigation will determine whether this is the result of fraud, it is undisputed that over US$1 billion in exchange customers’ assets were misappropriated to the other FTX business silos in contravention of the account terms.

Crypto Regulation

Global regulatory policy on crypto assets remains fractured. In the US, the Biden administration published a revised framework in a March 9 executive order. This set a number of objectives, including fostering financial inclusion and innovative technologies (and US leadership in the global financial system) while at the same time protecting consumers and investors, promoting financial stability, and countering illicit finance. However, the implementation timeline and respective roles of the SEC, CFTC and other state and federal authorities remain unclear.

In Europe, the EU’s Markets in Crypto-Assets Regulation (MiCA) was proposed in September 2020 and seeks to establish minimum capital requirements; organizational structures and internal control mechanisms (including standards of prudent management, oversight, governance, record-keeping and separation of duties); procedures to manage and avoid conflicts of interest, money laundering and terrorist financing; adequate risk management arrangements (including those applicable to group companies and third-party service providers); and, finally, processes and procedures to ensure the safekeeping, secure custody and segregation of client assets both during the normal operation of crypto-asset business and in the event of their failure.

However, MiCA has yet to be formally adopted by the European Commission, Parliament and Council, and it is likely to be early to mid-2024 before it comes into force.

The millions of dollars tied up in FTX (and in recent months, the collapse of Celsius and Terra/Luna) shows that markets in crypto assets can no longer sit outside the regulatory perimeter and underlines the need for a coordinated, robust, global approach by financial services authorities to ensure market integrity and customer protections.