March 5, 2024
“Shall” means “shall.”
The Third Circuit issued this obvious, but necessary, reminder in its decision January 19, 2024 in the much-watched FTX bankruptcy, ordering that an independent examiner should be appointed to investigate and report on certain issues at the former crypto giant, notably potential conflicts of interest of the company’s main bankruptcy counsel, BigLaw firm Sullivan & Cromwell (S&C).
As anyone with an internet connection knows, FTX was among the largest and perhaps most trusted digital asset exchanges in the world. At its peak, it was said to be worth more than $32 billion. Its “math nerd” owner, Sam Bankman-Fried, was a disheveled charmer, showing up on stage and at major media events with large hair and signature cargo shorts. He and his company were the subject of a major Michael Lewis treatment, released last fall as Going Infinite.
And then everything became very finite. In June 2022, the market for crypto currency began to collapse. Bankman-Fried assured investors, regulators and the public that FTX assets were fine because no one could borrow against or otherwise touch your account at FTX.
This turned out to be false. A hedge fund known as Alameda, also owned by Bankman-Fried, and run by his on-and-off girl-friend Caroline Ellison, had “secret borrowing privileges”, and had run up a big tab with FTX. In the fall of 2022, while crypto values were plummeting, reports began to emerge that Alameda in fact owed FTX billions of dollars and a good portion of its assets were a “token” known as FTT (essentially convertible into FTX equity). Panicked depositors began to make withdrawals and Bankman-Fried and the other insiders (including Ellison) were charged with various forms of fraud. The others pled; only Bankman-Fried stood trial. It took a jury four hours of deliberation to convict him. He now faces decades in prison (sentencing is scheduled for March 28, 2024).
Less is known about the parallel bankruptcy of FTX, itself. In the early-morning hours of November 11, 2022, Bankman-Fried conveyed all of his corporate powers to John Ray, a turnaround expert who Sullivan & Cromwell had recruited on behalf of FTX. Ray immediately put almost all of the 100+ FTX entities into a chapter 11 bankruptcy in the District of Delaware and caused FTX to hire Sullivan & Cromwell (S&C) as debtors’ counsel.
Bankman-Fried has long claimed that S&C (who had become company counsel about a year and a half before bankruptcy, in 2021) pressured him into relinquishing control of the crypto empire to Ray. This would not necessarily be problematic—Bankman-Fried had his own counsel by that point—but some of S&C’s prebankruptcy work may have revealed the financial problems at the company long before the public knew. If S&C knew, or should have known, about these problems and did nothing about them, the company may have claims against the firm, just as it has asserted against Bankman-Fried.
Yet, until pushed, S&C said almost nothing about its prebankruptcy work, which involved about 20 transactional and regulatory matters, and some work for Bankman-Fried personally. Despite this, the Bankruptcy Court concluded that S&C was “disinterested” (the Bankruptcy Code requirement), and approved the retention. As a practical matter, this put S&C in control of the bankruptcy proceeding and the company under the control of a CEO (Ray), whom S&C had picked.
Not surprisingly, Ray has no complaints about S&C. He did, however, come out swinging hard at Bankman-Fried and the other insiders. He called the company a “dumpster fire” and the misconduct “old fashioned embezzlement.” The failure was the product of concentrating control in “a very small group of inexperienced, unsophisticated and potentially compromised individuals.”
S&C and Ray would later devote hundreds, perhaps thousands, of attorney and company hours to support the prosecution of Bankman-Fried. This may have distracted attention from any problems with S&C’s prebankruptcy work. In the process, they would bill over $100 million in legal fees, paid for by FTX’s creditors and investors.
Against this backdrop, the United States Trustee sought the appointment of an “examiner,” an independent investigator. Section 1104(c) of the Bankruptcy Code provides that the bankruptcy court “shall order” the appointment of an examiner “to conduct such an investigation of the debtor as is appropriate,” if the debtor’s unsecured debts exceed $5 million. 11 U.S.C. § 1104(c). There was little doubt that FTX’s debts exceeded $5 million, so the only question should have been what sort of examination would be “appropriate?”
S&C fiercely resisted the request, arguing that Ray was the functional equivalent of an examiner since he was independent of the prebankruptcy insiders. The Bankruptcy Court bought the argument, and held that an “appropriate” examination was “none.” The statute was not mandatory, Judge Dorsey ruled. Instead, it gave him discretion to deny an appointment under these conditions.
Congress included the examiner provisions when it enacted the Bankruptcy Code in 1978 in order to provide transparency in cases “of great public interest” involving fraud or wrongdoing. Congress expected examiners to be common features of large reorganizations (“automatically appointed,” in Senator DeConcini’s words).
In fact, that has not happened at all. I conducted an empirical study of examiners about a dozen years ago (main findings here and here), and we found that they were “vanishingly rare” in most chapter 11 reorganizations regardless of size or venue. In a sample of 1225 cases from 1991 to 2010, they were sought in only 104 (8.5% of) cases, and appointed in forty-eight, fewer than half of cases where requested, and less than 4% of the sample. Delaware bankruptcy judges (where FTX filed) were especially resistant to requests for examiners.
Takeaway: examiners are neither common nor automatic.
Still, there was an exception: large “freefall” cases precipitated by serious misconduct would have examiners. Thus, although generally rare, examiners played important roles in such huge and notorious cases as Enron, Worldcom, and Lehman Brothers, investigating and reporting on the causes and consequences of those debtors’ collapses.
Had the Bankruptcy Court’s decision stood in FTX, it would have been a first: a truly massive, freefall bankruptcy precipitated by misconduct, of great public interest, without an examiner’s investigation and report.
The United States Trustee (UST) appealed the Bankruptcy Court’s denial of their request for an examiner in FTX directly to the Third Circuit Court of Appeals. Given my studies of examiners, I agreed to act as counsel to a group of law professors in writing and arguing a brief in support of the UST in November of 2023.
We won. In a unanimous opinion, the Third Circuit Court of Appeals reversed for two basic reasons. First, that an examiner appointment was mandatory was a matter of “straightforward” statutory interpretation. The statute says that the court “shall” appoint an examiner if the debtor has more than $5 million in general unsecured debt and a party an interest asks for an examiner. While there is discretion in the scope and budget of the examination, the Bankruptcy Court had no choice on the appointment: it was mandatory.
Second, the mandatory nature of the appointment reflected Congressional intent to protect the public interest. This interest was reflected not only in the public reporting of the results of the investigation, but also in the independence of the examiner, itself. Congress “forbade the examiner from acting as or representing a trustee in the bankruptcy and required that the investigation remain separate from the reorganization process,” Judge Restrepo wrote.
The Third Circuit largely left the scope of the examination to the Bankruptcy Court to determine on remand. It noted that a disinterested examiner “is particularly salient here, where issues of potential conflicts of interest arising from debtor’s counsel serving as pre-petition advisors to FTX have been raised repeatedly.”
In a status conference before the Bankruptcy Court (transcript at docket no. 6552) soon after the Third Circuit decision, it appeared that Bankruptcy Judge Dorsey was surprised by the concerns about S&C’s potential conflicts, but agreed that an examiner should look into them, stating “I think the examiner should look at whether there . . . are conflicts of interest involving Sullivan & Cromwell.”
On February 27, 2024, the UST filed a motion (docket no. 8048) seeking approval of their appointment of former prosecutor Robert Cleary to act as examiner. The scope would include at least an initial investigation into concerns about S&C’s potential conflicts. A hearing on this motion is scheduled for March 20, 2024.
Jonathan C. Lipson is the Harold E. Kohn Chair and Professor of Law of Temple University—Beasley School of Law. He is also a founding faculty editor of The Temple 10-Q.