[co-author: Trey Smith]*

A lawsuit stemming from the collapse of multibillion-dollar cryptocurrency exchange FTX seeks to recover a billion dollars from FTX’s founder and former CEO Sam Bankman-Fried, along with 11 paid endorsers, including Tom Brady, Naomi Osaka, Kevin O’Leary, Gisele Bündchen, Larry David, and Steph Curry. The plaintiffs allege the defendants were involved in a fraudulent scheme that used celebrity promotion to “funnel investors into a Ponzi scheme and to promote … unregistered securities.”[1]

Founded in 2019 by Bankman-Fried, FTX quickly became the cryptocurrency industry’s darling. Its cryptocurrency exchange services, available via a mobile application, widely appealed to retail investors, in part because of the exchange’s massive, highly visible promotional deals. In the past two years, FTX served as the MLB’s “Official Cryptocurrency Exchange” brand, bought the (now terminated) naming rights to the NBA’s Miami Heat arena, and promoted itself through countless other advertising channels, including through celebrities, athletes, and YouTube influencers.

This month, however, a series of cataclysmic events resulted in FTX’s collapse, causing Bankman-Fried to resign and the exchange to declare bankruptcy. Chief among the allegations against FTX is that Bankman-Fried secretly engaged in high-risk trades, using customer funds. While the extent of the exchange’s losses is unknown, industry observers estimate the figure to be at least $10 billion.

The CoinDesk Report

FTX’s downfall began with a November 2 CoinDesk report on a leaked balance sheet that belonged to FTX’s subsidiary and trading arm Alameda Research. The CoinDesk report alleged that FTX’s native token,[2] FTT, made up at least $11.62 billion of Alameda’s assets. According to the report, this caused concern because it raised suspicion that a “majority of the net equity in the Alameda business [was] actually FTX’s own centrally controlled and printed-out-of-thin-air token.”[3]

A Competitor Responds

Subsequently, on November 6, Changpeng Zhao, the CEO of Binance (a competitor cryptocurrency exchange and early FTX investor), announced that “due to recent revelations,” it intended to liquidate its roughly $530 million in FTT holdings. The announcement, which came in the aftermath of the CoinDesk report, caused panic in the market: The value of FTT plummeted, and over the next 72 hours, users withdrew an estimated $6 billion from the exchange.[4] Bankman-Fried attempted to assuage customer concerns, tweeting: “FTX is fine. Assets are fine.” Yet, a day later, on November 8, Binance announced it had signed a nonbinding letter of intent with FTX to acquire the exchange. The announcement caused the value of FTT to plunge even further, and sparked concerns that Alameda would be liquidated as the falling price of FTT triggered margin calls. Worse, Binance backed out of the deal just 24 hours later, citing corporate due diligence and news reports, alleging that FTX mishandled customer funds. Binance’s exit from the deal sent FTT into a death spiral as investors lost confidence in the exchange’s abilities to fulfill withdrawals.

FTX Collapses

Initially, FTX, via Bankman-Fried, attempted to project confidence in the face of the liquidity crisis. However, after Binance decided against the acquisition, FTX ultimately suspended withdrawals and stopped onboarding new users — a sign that the exchange could not honor customer funds. Around the same time, Reuters reported that earlier this year, Bankman-Fried secretly transferred at least $4 billion in customer funds to Alameda and that FTX lent more than half of its $16 billion in customer funds to Alameda, with more than $10 billion in loans outstanding.[5]

On November 11, Bankman Fried resigned as CEO of FTX, and the company declared bankruptcy.

The Upshot

Over the past few years, cryptocurrencies have exploded in popularity. In 2017, the market capitalization of all cryptocurrencies peaked at $759 billion. In 2021, that number peaked at $2.1 trillion. Several countries, including the United States, have even explored using blockchain technology to implement a central bank digital currency.[6] Yet, despite cryptocurrency’s rapid growth and adoption, lawmakers have been slow to implement comprehensive regulation.

With the collapse of FTX, however, lawmakers will find themselves under increased pressure to implement investor protections, especially because FTX is the latest of a string of bankruptcies seen in the cryptocurrency industry this year. With billions of dollars of investors’ money lost to date, lawmakers will face more pressure than ever to regulate the space. Indeed, given the industry’s growing ties to conventional finance, cryptocurrency “could raise broader financial stability concerns” if not regulated, according to Treasury Secretary Janet Yellen.

Troutman Pepper will continue to monitor FTX and related litigation.

[1] Garrison v. Sam Bankman-Fried, 1:22cv23753 (D. Fla., Nov. 15, 2022), https://docs-cdn-prod.news-engineering.aws.wapo.pub/publish_document/12afdf1a-a614-48a8-88e5-aa0e9e581c6f/published/12afdf1a-a614-48a8-88e5-aa0e9e581c6f.pdf.

[2] A “token” refers to a digital item whose ownership is recorded on a blockchain’s ledger. Users transfer tokens to other users by initiating a transaction that creates a record of the transfer on the blockchain. Typically, a token is a digital representation of monetary value, but a token can also represent ownership of a digital item or the right to exercise a privilege. A “native token” is the token that a network issues for use within the network’s protocol. For example, FTX’s “native token” is FTT. The FTX network issued FTT; FTT holds monetary value; FTT is transferable; and users who own FTT are entitled to reduced trading fees on the FTX network. See ByBit Learn, “FTX Token (FTT): What It Is & Why You Should Care,” https://learn.bybit.com/crypto/what-is-ftt/ (last visited Nov. 18, 2022).

[3] Ian Allison, “Divisions in Sam Bankman-Fried’s Crypto Empire Blur on His Trading Titan Alameda’s Balance Sheet,” CoinDesk (Nov 2, 2022), https://www.coindesk.com/business/2022/11/02/divisions-in-sam-bankman-frieds-crypto-empire-blur-on-his-trading-titan-alamedas-balance-sheet/.

[4] Angus Berwick and Tom Wilson, “Exclusive: Behind FTX’s fall, battling billionaires and a failed bid to save crypto,” Reuters (Nov. 10, 2022), https://www.reuters.com/technology/exclusive-behind-ftxs-fall-battling-billionaires-failed-bid-save-crypto-2022-11-10/.

[5] Berick and Wilson, supra note 4.

[6] Dr. Alondra Nelson et. al, “Technical Possibilities for a U.S. Central Bank Digital Currency,” The White House: OSTP Blog (Sept. 16, 2022), https://www.whitehouse.gov/ostp/news-updates/2022/09/16/technical-possibilities-for-a-u-s-central-bank-digital-currency/#:~:text=A%20United%20States%20central%20bank%20digital%20currency%20%28CBDC%29,implications%20of%2C%20and%20options%20for%2C%20issuing%20a%20CBDC.

*Trey Smith is not licensed to practice law in any jurisdiction; application pending for admission to the Virginia Bar.