Can FTX Clawback Customer Withdrawals as Voidable Preferences?

On November 11, 2022, one of the largest cryptocurrency exchanges, FTX Trading Ltd., and over 100 affiliated companies filed Chapter 11 bankruptcy cases in Delaware. FTX’s collapse and bankruptcy were precipitated by a $5 billion “run on the bank” in customer withdrawals, according to FTX co-founder Sam Bankman-Fried.

Customers who withdrew their crypto assets in the 90 days before bankruptcy may be subject to suits by the FTX debtors seeking repayment of those withdrawals as preferential transfers pursuant to Section 547 of the Bankruptcy Code. For example, Celsius, another large crypto exchange that filed for Chapter 11 bankruptcy protection in July 2022, identified the recovery of customer withdrawals completed within the 90 days before bankruptcy as a critical legal issue in its bankruptcy case.

To recover customer withdrawals as a preferential transfer, a debtor such as FTX must establish that the transfer (1) was of the debtor’s property; (2) was made on account of an antecedent debt; (3) was made while the debtor was insolvent; (4) was made within 90 days before the bankruptcy filing; and (5) enabled the creditor to receive more than it would have received in a Chapter 7 case if the transfer had not been made.

Given the cost and complexity of challenging the Bankruptcy Code’s presumption of insolvency, for most customers facing preference suits, the key questions will be whether the withdrawn crypto assets are property of the debtor or the customer’s property, whether an affirmative defense such as ordinary course of business applies, and whether the safe harbor provisions related to securities and commodities trading set forth in Section 546(e) of the Bankruptcy Code apply.

Customer Property or Exchange Property?

A central question to answer is who has title to the crypto assets held on the exchange. If withdrawn assets are not exchange property, then those assets cannot be clawed back from customers as a preference. Whether crypto assets are property of a bankruptcy estate or not is fact-specific and will depend on several factors, including the terms of the customer agreement and the manner in which the crypto assets are held. If title to the crypto is with the customer, the assets may be outside of the estate and remain the property of the customer. Conversely, if such assets constitute estate property, the withdrawal of such crypto may be susceptible to clawback as a preference.

According to FTX’s terms of service, the title to crypto assets on the FTX platform remains with the customer. However, the issue is a facts and circumstances determination, given the FTX’s apparent diversion and commingling of assets. Similar to Celsius and other prominent exchanges, FTX disclaims the existence of a fiduciary relationship with its customers, which might be regarded as inconsistent with FTX serving as a custodian or trustee in respect of crypto assets.

Does ‘Ordinary Course’ Save You?

Where the elements of a preferential transfer are met, preference defendants may prove an affirmative defense set forth in Section 547(c) to shield their withdrawals from recovery. Potentially the most applicable defense for large crypto customers will be the ordinary course of business defense. The ordinary course of business defense is a fact-specific inquiry that will consider the terms of the customer agreement, the relationship’s length, and the size, timing, and circumstances surrounding the customer withdrawals. Large “run on the bank” withdrawals in reaction to negative media reports may weigh against a finding that withdrawals were made in the ordinary course.

Settling Trades as a Defense?

The Bankruptcy Code’s safe harbor provisions in Section 546(e) exempt certain transactions involving securities and commodities contracts from preference liability. Although certain regulators have indicated that some crypto assets are, in fact, securities or commodities, each digital asset has to be reviewed separately as to whether it constitutes a commodity, currency, security, or something else. If a particular crypto asset is a security or otherwise subject to commodity contracts or forward contracts, then the safe harbor may shield a customer’s withdrawals from clawback as a preference. Individual matters will turn on their own facts according to the crypto asset in question and the terms that have been agreed upon between the parties.

Given the complexity of the legal issues as the bankruptcy process unfolds, it is important to seek the advice of knowledgeable counsel if you believe your rights may be affected. Sterlington’s team is composed of experienced legal professionals, including corporate bankruptcy, litigation, and cryptocurrency attorneys, who are available to assist while the extent of the debtors’ financial collapse continues to unfold. Please feel free to contact any of our experienced professionals if you have questions.