Professor Jonathan Lipson is a leading expert in corporate reorganization who recently argued and won a matter related to the FTX bankruptcy before the Third Circuit Court of Appeals, which ordered the lower court to appoint an independent examiner and raised specific concerns about the role of law firm Sullivan & Cromwell (S&C), who represented FTX on several prebankruptcy matters and continues to represent FTX in the bankruptcy itself. We checked in with Professor Lipson to learn more about the case and his work on it.  

TLS: Tell us a bit about your work and how you became involved in this case. 

JL: About a dozen years ago, I conducted empirical research on the use of bankruptcy “examiners.” Bankruptcy examiners had gotten a bit of attention after Enron, WorldCom, and Lehman Brothers, but there was a weird disconnect: Bankruptcy Code section 1104 said they were required in all large cases, as a check on management, and yet except for very large, “free-fall” cases like Enron, they were almost never sought or appointed. We documented this and offered observations on how and why this was. Although it dealt with a universal problem—checks and balances—it was also aimed at (and successful with) a very specialized audience, the corporate reorganization world.  

Later, it turned out some folks outside that world found this work and contacted me for help in other cases. I was asked to help a group of activists and survivors in the Purdue Pharma bankruptcy, who were interested in shining light on the role that the Sackler family and other insiders had played at the opioid-maker when it was apparently engaged in drug-marketing fraud before bankruptcy.   

I ended up representing one of these survivors, Peter Jackson, on a pro bono basis in seeking an examiner after other requests for information failed. The bankruptcy judge granted the motion on a very limited basis (because the statute requires it), but he was angry about that, which ended up drawing attention to the case and, indirectly, helping those who were concerned about problems in the case.   

Purdue Pharma is now before the Supreme Court on the question of whether the company’s plan can effectively insulate the Sacklers and other insiders from personal liability, even though they are not in bankruptcy themselves. After my representation of Mr. Jackson ended, I represented a group of about a dozen law professors who submitted an amicus brief to the Supreme Court on how and why this use of bankruptcy was “abusive” as that term has been understood historically. We expect a ruling by June. 

In FTX, I had agreed to write an amicus brief in support of the United States Trustee (the government’s monitor for the bankruptcy system), who had sought an examiner (they can’t do an examination themselves). The bankruptcy court (the lower court) had denied the motion because the insiders who had run the company before bankruptcy had given up control to a restructuring expert named John Ray. Unfortunately, Bankruptcy Judge Dorsey had not been informed of potentially serious issues involving Sullivan & Cromwell, who had done important work for FTX and Bankman-Fried before bankruptcy. I organized a group of eight law professors to support the UST’s appeal before the Third Circuit. In a somewhat unusual twist, I was asked to argue for a few moments, which was an amazing experience. 

TLS: At argument, you told the Court that (paraphrasing) if this case did not merit appointment of an independent examiner, no case merited one. What made this case stand out? 

JL: As mentioned, our research found that, while debtors and creditors fight about all sorts of things, they tend to agree on one thing: they hate examiners, because examiners are outsiders who come into the case. Their investigations may disrupt negotiations about how to reorganize the company. They can also be costly (the examiner in Enron famously cost about $100 million), but creditors ultimately bear that cost. Still, until FTX there had always been an examiner (or independent trustee) in every large “free-fall” case, especially ones that were precipitated by allegations of serious misconduct. Had the Third Circuit not reversed, FTX would have been the first huge case of significant public interest, involving serious misconduct, that had no independent investigation and report on what happened. The fact that S&C was going to run the investigations made it even more problematic, given their prebankruptcy history with the company. 

TLS: What are the criteria for appointing an examiner and where do they come from? 

JL: Section 1104(c) of the Bankruptcy Code provides that an examiner “shall” be appointed if the Bankruptcy Court considers it to be in the interests of creditors or if the company has more than $5 million in certain types of unsecured debt (basically, for borrowed money as distinct from trade credit). This means that if the statutory criteria are satisfied, “shall means shall.” It’s mandatory. 

The role of the examiner was created by Congress when it enacted Chapter 11 in the Bankruptcy Act of 1978, which has been the law governing corporate reorganization ever since. Prior to 1978, bankruptcy law largely required managers to step down and put the company in the hands of a trustee if they thought the company needed bankruptcy protection. Since managers understandably don’t want to give up control—they may plausibly think they can fix the problems—large companies often delayed or tried to avoid bankruptcy under the old law. Congress feared that this produced deadweight losses, because the company’s debt structure often could not be renegotiated outside bankruptcy, and so the company would end up liquidating. That would end going concerns and jobs, and lose shareholder value, and so on.   

So, Congress did something very innovative in 1978, which was permit managers to remain in possession and control of the debtor, a practice which harkened back to railroad receiverships of the 19th and early 20th centuries. That whole approach had been discredited in the Depression because, among other things, it turned out that bankers and lawyers sometimes had conflicts of interest that infected those receiverships.   

Examiners were sort of the Solomonic solution in 1978: managers could remain in possession to renegotiate with creditors and shareholders, but an examiner would investigate and report on the causes and consequences of the failure. Congress recognized that this could be disruptive, so gave bankruptcy courts broad discretion to control the scope of the examination (the scope will be “as is appropriate” to the judge). But, as the Third Circuit reminded us in FTX, whether to appoint an examiner in a large case is not discretionary: shall means shall. 

TLS: What has your research shown about how strictly this language is applied? 

JL: The empirical study showed that examiners were not used as Congress expected. They were very rarely sought and—more troubling—not appointed in about half the cases where sought and where the statute would have required it (e.g., because the debtor had sufficient qualifying debt or there had been fraud). So, even though the Supreme Court has urged us to be “textualists,” bankruptcy judges tended to view themselves as having discretion to deviate from the statute. 

TLS: The Third Circuit agreed with you, sending the case back to US Bankruptcy Judge John Dorsey, who has appointed Unabomber prosecutor Robert Cleary as examiner. What happens next? 

JL: Mr. Cleary will undertake a targeted investigation, including of potential issues involving S&C’s retention in the bankruptcy and file an initial report by around May 20, 2024. He may ask for more time or write subsequent reports if he thinks he has found more to investigate.  

TLS: Meanwhile, Sam Bankman-Fried has been sentenced to 25 years for his role in the collapse. You recently wrote a draft paper with Penn Law professor David Skeel alleging that issues with S&C contributed as well. Are there lessons to be learned from what happened here, and if so, for whom? 

JL: Our paper provides a detailed and careful case study of what is currently known about the work of S&C before, at and during the bankruptcy. There is credible and troubling evidence that S&C may have known, or been in a position to know, about the problems at FTX and yet did nothing about them. More problematic is evidence that certain S&C lawyers may have gone to prosecutors without proper authorization and, instead, fooled Bankman-Fried into giving up control of the company to Ray. If so then, as we say, “two wrongs don’t make a right.” 

Most problematic is that they have been running the bankruptcy, and may have used it to contain further evidence of these problems. It appears that they provided significant levels of support to prosecutors in the Bankman-Fried trial, which creditors would pay for. There have also been some surprising decisions in the case (e.g., low-price sales) which appear to be more consistent with protecting S&C’s interests than the interests of creditors and shareholders.   

The problems with S&C that we identify were not before the Bankruptcy Court when Judge Dorsey was asked to approve the retention of S&C, and we believe that if they had been known, S&C would not have been allowed to run the case, given this history. But, it is probably too late to unwind all of that.   

We also focus on arguments made by S&C, the US Trustee and others that they were all acting in the “public interest” through the bankruptcy in various ways. Mostly, we find those claims confusing—bankruptcy was intended to maximize economic (private) recoveries, not support criminal prosecutions–and so the paper’s real goal is to clarify what we mean by the “public interest” in bankruptcy, and how to better protect it, including by scrutinizing counsel’s potential conflicts a bit more carefully at the beginning of the case.   

To be clear: we don’t challenge the Bankman-Fried verdict, and we have no particular grievance with S&C. We also imagine there is more to the story. We have a few months to revise the draft before it is published, including to account for the examiner’s findings, if we have them in time. We are interested in the proper uses of the chapter 11 system, and worry about using the process to advance vague claims of the public interest, when it appears that the real interests being advanced are those of the lawyers running the process.