March 5, 2024<\/p>\n
\u201cShall\u201d means \u201cshall.\u201d<\/p>\n
The Third Circuit issued this obvious, but necessary, reminder in its decision January 19, 2024 in the much-watched FTX <\/em>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\u2019s main bankruptcy counsel, BigLaw firm Sullivan & Cromwell (S&C).<\/p>\n 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.\u00a0 Its \u201cmath nerd\u201d owner, Sam Bankman-Fried, was a disheveled charmer, showing up on stage and at major media events with large hair and signature cargo shorts.\u00a0 He and his company were the subject of a major Michael Lewis treatment, released last fall as Going Infinite<\/em>.<\/p>\n And then everything became very finite.\u00a0 In June 2022, the market for crypto currency began to collapse.\u00a0 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.<\/p>\n This turned out to be false.\u00a0 A hedge fund known as Alameda, also owned by Bankman-Fried, and run by his on-and-off girl-friend Caroline Ellison, had \u201csecret borrowing privileges\u201d, and had run up a big tab with FTX.\u00a0 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 \u201ctoken\u201d known as FTT (essentially convertible into FTX equity).\u00a0 Panicked depositors began to make withdrawals and Bankman-Fried and the other insiders (including Ellison) were charged with various forms of fraud.\u00a0 The others pled; only Bankman-Fried stood trial.\u00a0 It took a jury four hours of deliberation to convict him. He now faces decades in prison (sentencing is scheduled for March 28, 2024).<\/p>\n Less is known about the parallel bankruptcy of FTX, itself.\u00a0 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.\u00a0 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\u2019 counsel.<\/p>\n 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\u2014Bankman-Fried had his own counsel by that point\u2014but some of S&C\u2019s prebankruptcy work may have revealed the financial problems at the company long before the public knew.\u00a0 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.<\/p>\n 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 \u201cdisinterested\u201d (the Bankruptcy Code requirement), and approved the retention.\u00a0 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.<\/p>\n Not surprisingly, Ray has no complaints about S&C.\u00a0 He did, however, come out swinging hard at Bankman-Fried and the other insiders.\u00a0 He called the company a \u201cdumpster fire<\/a>\u201d and the misconduct \u201cold fashioned embezzlement.\u201d\u00a0 The failure was the product of\u00a0 concentrating control in \u201ca very small group of inexperienced, unsophisticated and potentially compromised individuals<\/a>.\u201d<\/p>\n 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\u2019s prebankruptcy work.\u00a0 In the process, they would bill over $100 million in legal fees, paid for by FTX\u2019s creditors and investors.<\/p>\n Against this backdrop, the United States Trustee sought the appointment of an \u201cexaminer,\u201d an independent investigator.\u00a0 Section 1104(c) of the Bankruptcy Code provides that the bankruptcy court \u201cshall order\u201d the appointment of an examiner \u201cto conduct such an investigation of the debtor as is appropriate,\u201d if the debtor\u2019s unsecured debts exceed $5 million.\u00a0 11 U.S.C. \u00a7 1104(c). There was little doubt that FTX\u2019s debts exceeded $5 million, so the only question should have been what sort of examination would be \u201cappropriate?\u201d<\/p>\n S&C fiercely resisted the request, arguing that Ray was the functional equivalent of an examiner since he was independent of the prebankruptcy insiders.\u00a0 The Bankruptcy Court bought the argument, and held that an \u201cappropriate\u201d examination was \u201cnone.\u201d\u00a0 The statute was not mandatory, Judge Dorsey ruled.\u00a0 Instead, it gave him discretion to deny an appointment under these conditions.<\/p>\n Congress included the examiner provisions when it enacted the Bankruptcy Code in 1978 in order to provide transparency in cases \u201cof great public interest\u201d involving fraud or wrongdoing.\u00a0 Congress expected examiners to be common features of large reorganizations (\u201cautomatically appointed,\u201d in Senator DeConcini\u2019s words).<\/p>\n In fact, that has not happened at all.\u00a0 I conducted an empirical study of examiners about a dozen years ago (main findings here<\/a> and here<\/a>), and we found that they were \u201cvanishingly rare\u201d in most chapter 11 reorganizations regardless of size or venue.\u00a0 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.\u00a0 Delaware bankruptcy judges (where FTX filed) were especially resistant to requests for examiners.<\/p>\n Takeaway: examiners are neither common nor automatic.<\/p>\n Still, there was an exception: large \u201cfreefall\u201d cases precipitated by serious misconduct would have examiners.\u00a0 Thus, although generally rare, examiners played important roles in such huge and notorious cases as Enron<\/em>, Worldcom<\/em>, and Lehman Brothers<\/em>, investigating and reporting on the causes and consequences of those debtors\u2019 collapses.<\/p>\n Had the Bankruptcy Court\u2019s decision stood in FTX<\/em>, it would have been a first: a truly massive, freefall bankruptcy precipitated by misconduct, of great public interest, without an examiner\u2019s investigation and report.<\/p>\n The United States Trustee (UST) appealed the Bankruptcy Court\u2019s denial of their request for an examiner in FTX <\/em>directly to the Third Circuit Court of Appeals.\u00a0 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<\/a> in November of 2023.<\/p>\n We won.\u00a0 In a unanimous opinion<\/a>, the Third Circuit Court of Appeals reversed for two basic reasons.\u00a0 First, that an examiner appointment was mandatory was a matter of \u201cstraightforward\u201d statutory interpretation.\u00a0 The statute says that the court \u201cshall\u201d appoint an examiner if the debtor has more than $5 million in general unsecured debt and a party an interest asks for an examiner.\u00a0 While there is discretion in the scope and budget of the examination, the Bankruptcy Court had no choice on the appointment: it was mandatory.<\/p>\n Second, the mandatory nature of the appointment reflected Congressional intent to protect the public interest.\u00a0 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 \u201cforbade the examiner from acting as or representing a trustee in the bankruptcy and required that the investigation remain separate from the reorganization process,\u201d Judge Restrepo wrote.<\/p>\n The Third Circuit largely left the scope of the examination to the Bankruptcy Court to determine on remand.\u00a0 It noted that a disinterested examiner \u201cis 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.\u201d<\/p>\n