28 Feb 2023

[Crypto-Bankruptcy Series] FTX Bankruptcy – A Failure of Centralized Governance in the Name of Decentralized Cryptocurrencies

by Editor | posted in: Bankruptcy, Corporate Governance, Crypto-Bankruptcy Series, Cryptocurrency, Valuation | 0

By Vivian Fang (University of Minnesota)

Vivian Fang

Note: This post is the sixth post in a series of posts on bankruptcies of cryptocurrency companies and the emerging issues they pose. Previous posts in the series include:

1. The FTX Bankruptcy: First Week Motions, Jurisdictional Squabbling, and Other Unusual Developments, by Megan McDermott

2. Quantifying Cryptocurrency Claims in Bankruptcy: Does the Dollar Still Reign Supreme?, by Ingrid Bagby, Michele Maman, Anthony Greene, and Marc Veilleux

3. The Public and the Private of the FTX Bankruptcy, by Diane Lourdes Dick and Christopher K. Odinet

4. Staking, Yield Farming, Liquidity Mining, Crypto Lending – What are the Customer’s Risks?, by Matthias Lehmann et al. (University of Vienna)

5. The Treatment of Cryptocurrency Assets in Bankruptcy, by Steven O. Weise, Wai L. Choy, and Vincent Indelicato

This series is being managed by the Bankruptcy Roundtable and Xiao Ma, SJD at Harvard Law School, xma [at] sjd [dot] law [dot] harvard [dot] edu.

Check the HLS Bankruptcy Roundtable periodically for additional contributing posts by academics and practitioners from institutions across the country.

***

The fall of the once mighty crypto exchange FTX is sometimes mythologized, but what led to its bankruptcy may be simpler than you think. In a nutshell, FTX transferred a large amount of its native tokens to a closely affiliated trading firm Alameda Research. Using these tokens as collateral, Alameda borrowed real assets, made risky bets, and lost huge sums of money. Then, to cover up mounting losses, FTX and Alameda arranged obscure transactions between themselves. In the end, they went bankrupt for the same reason many other companies do: assets were insufficient to offset liabilities.

So, what lies at the crux of this mess? Let me start with FTT, which is FTX’s native token. It is not uncommon for a crypto exchange to issue a utility token to provide users with a convenient means of accessing features and benefits on the platform, such as discounted trading fees, early access to token sales, and voting rights. By offering such a token, a crypto exchange can create an integrated ecosystem and promote growth.

While FTT may have proven valuable to platform users as a utility token, it differed from open-source cryptocurrencies especially Bitcoin, being the first and most prominent, in two important aspects. First, FTT was issued and centrally controlled by FTX, while Bitcoin is generated and governed by a decentralized community. This means that FTX—a centralized exchange—could freely move large quantities of FTTs to affiliated entities like Alameda. This also means that FTX and Alameda should not have recognized FTT tokens as assets, just like stock should not be booked as assets by the issuing company or its subsidiaries. Second, supply and demand, which ultimately determine an asset’s value, are distinctly different between the two tokens. With FTT, the demand was tied to the performance and popularity of FTX platform, and the supply was tightly controlled by FTX, through its release of tokens, regular repurchases, and token burning. With Bitcoin, the demand comes from its perceived investment value and other utilities by a broad base of investors and users, while the supply is rigidly set by its open-source algorithm. This difference explains why FTT tended to be much riskier and less liquid than Bitcoin and why the announcement of a block sale by Binance, a competing crypto exchange, triggered a sharp decline in FTT’s price.

Unfortunately, the core issues that resulted in FTX’s bankruptcy—the use of illiquid and complicated financial instruments to inflate assets, excessive risk-taking leading to huge debts and losses, and engagement in shady non-arm’s length transactions with affiliated entities—are nothing new in U.S. corporate history. For example, mortgage-backed securities (MBS), another illiquid and complicated financial instrument that packages mortgage debts into bond-like securities, played a key role in driving the 2007–2008 financial crisis. Major financial institutions’ involvement with MBS made it possible for them to inflate assets and take risks, which fueled a real estate bubble and resulted in the largest corporate bankruptcy in U.S. history (Lehman Brothers). Take Enron as another example. The company was a dominant player in the global market for energy derivatives, which are financial contracts that enable transacting companies to manage exposure to energy prices. This market was highly obscure, and Enron assumed huge risks from its counterparties. When Enron’s energy trading business turned unprofitable, it attempted to cover up by creating a network of special purpose entities (SPEs) to raise debt and hide losses.

There are, of course, unique lessons to learn from every epic corporate downfall. Three aspects of FTX’s bankruptcy warrant emphasis. First, FTX is a case of regulator shopping facilitated by the status quo of the U.S. crypto regulation. The U.S. lacks a workable regulatory framework that guides exchange platforms on how to provide crypto-based financial services and store customer funds in a transparent manner. As such, many crypto exchanges set up operations offshore where regulation and enforcement are weaker, and customer protection is likely compromised. Second, FTX is a case of an accounting scandal facilitated by the lack of crypto accounting and disclosure requirements. In the U.S., the Financial Accounting Standards Board (FASB) is reportedly working on finalizing an authoritative rule that would require the use of fair-value accounting for crypto assets. It, however, remains a question as to how well this approach will apply to illiquid tokens like FTT, the value of which could evaporate overnight. It also remains a challenge as to how to consolidate accounting for deeply intertwined crypto entities. Third, FTX is a case of failed centralized governance in the name of decentralized crypto assets. Bitcoin, which is emblematic of decentralization, was created with the mission to circumvent centralized control. However, when decentralized assets are traded on a centrally controlled platform like FTX, the platform itself is no different from a traditional financial institution. To that end, proper governance measures must be implemented to prevent problems like conflicts of interest, excessive risk-taking, and misappropriation of customer funds.

31 May 2022

Bankruptcy Court Ruling Imposes Lender Liability

by Editor | posted in: Bankruptcy, Corporate Governance, Fiduciary Duties, Priority | 0

By Daniel S. Shamah, Jeff Norton, Jennifer Taylor, Sung Pak, and Joshua Chow (O’Melveny & Myers LLP)

“Lender liability” is an umbrella term often used to describe claims against lenders who overstep their boundaries when seeking to enforce a loan. It embraces both contractual and tort-based theories of liability, including claims for breach of contract, breach of the covenant of good faith and fair dealing, and fiduciary duty claims, as well as bankruptcy-based theories like equitable subordination. While courts have historically held that lender liability claims are difficult to sustain, there are cases that give guidance on how lenders cross the line and the consequences of doing so. In this recent article, the authors highlight one recent Texas bankruptcy court decision in which a court determined that a lender engaged in the kind of egregious conduct that could lead to disallowance of a loan and an award of damages and interest. Lenders in particular should study this case closely for tips on how to avoid these landmines.

The full article is available here.

15 Mar 2022

Corporate Bankruptcy Has Lasting Effects on CEO Careers through Frictions in Executive Labor Market

by Editor | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Corporate Governance | 0

By Andreas Kostøl (Arizona State University – W.P. Carey School of Business; Norges Bank), Morten Grindaker (Norwegian Business School; Norges Bank), and Kasper Roszbach (Norges Bank; University of Groningen)

Policymakers have long been concerned about the potential negative effects of bankruptcy for CEOs and business dynamics. Fear of reputational scarring caused by bankruptcy could lead managers to take less risk than desired by owners, which could manifest in lower performance and lower rates of entrepreneurship and job growth.

CEOs influence a wide range of decisions, such as organizational practices, debt financing and whether to file for corporate bankruptcy or not. Empirical studies of Chapter 11 bankruptcy show that CEOs of large bankrupt firms suffer significant financial losses. The prospect of individually-borne income loss due to a corporate bankruptcy carries in it a risk that CEOs take decisions that are not aligned with the interest of the owners.

It remains an open empirical question, however, whether the observed personal costs should be attributed to the selection of CEOs with lower managerial skills, firm-specific human capital, or stigma in the executive labor market.

Our analysis attempts to answer this question by disentangling the stigma and skill effects by examining the causal effects of corporate bankruptcy on the personal income and career of CEOs in small and medium-sized companies in Norway. To this end, we exploit that bankruptcy petitions in Norway are randomly assigned to judges who have different degrees of strictness in their approval of bankruptcy filings. This institutional feature generates variation in firms’ likelihood of being declared bankrupt that is unrelated to firm or CEO characteristics. We use administrative panel data that identifies CEO’s sources of wealth and income and corporate positions to examine the effects of bankruptcy on their careers.

Two broad conclusions emerge from our empirical analysis.

First, we find that corporate bankruptcy has a long-lasting impact on CEOs’ careers. CEOs whose firms are declared bankrupt are 25 percentage points more likely to exit the executive workforce. Displaced CEOs find new employment quickly but do so by moving to lower-ranked positions in new firms. Bankruptcy also has an economically significant impact on CEO remuneration; we document an annual fall in capital income equal to about five percent of annual gross income. While the net present value of the average decline in capital income over the remainder of a CEO’s working-age career is equal to 60 percent of pre-bankruptcy annual income, we find no enduring effect on CEOs’ labor income after five years.

Second, our analysis shows that the displacement effects are much larger when default rates in the firms’ industry are low. For example, a CEOs is five times less likely to remain in the executive workforce if her/his firm experiences a bankruptcy while the bankruptcy frequency in the same industry is low. By contrast, variation in CEO wages is not driven by industry conditions. Post-bankruptcy, we find a greater mobility of CEOs between industries and an increased tendency to move to more productive firms with a higher-paid workforce, suggesting that managerial skills are portable.

Taken together, our findings suggest that negative career effects of bankruptcy can be attributed to stigma. When we eliminate the risk of low-skilled CEOs sorting into bankrupt firms, we find that the executive labor market interprets bankruptcy as a signal of lower managerial talent. This stigma effect is greater during better economic times. More details can be found in the full paper that is available here.

6 Apr 2021

Bankruptcy, Bailout, or Bust: Early Corporate Responses to the Business and Financial Challenges of COVID-19

by Editor | posted in: Bankruptcy Roundtable Updates, Corporate Governance | 0

By Diane Lourdes Dick (Professor of Law, Seattle University School of Law)

Over the last year, publicly traded companies have provided thoughtful commentary in their public company disclosures regarding the financial decisions they have made in response to the COVID-19 crisis. Meanwhile, public and private companies have filed for bankruptcy protection, providing detailed narrative accounts of the events leading up to the filing and the various steps they have taken to stem losses and maintain the company as a going concern.

In a recent article, I use public disclosures and declarations of this sort to take a closer look at the firm-level decision-making process in response to the sudden liquidity crisis caused by the pandemic. Specifically, I analyze the recapitalization and restructuring decisions made by twelve large and mid-sized companies in the cruise, airline, health care, and consumer sectors in the spring and summer of 2020. Although the case studies are mere snapshots in time, they help to shed further light on the key factors that have influenced firm-level bankruptcy, bailout, and other recapitalization decisions.

The case studies reveal that, outside of bankruptcy, corporate managers of the profiled companies have followed a remarkably similar decision pathway. First, firms slashed costs and reduced employee headcount. Of course, many of these cuts are the natural consequence of voluntarily or involuntarily scaling back operations; in other cases, firms likely chose to make reductions of this sort because there are typically few if any legal impediments to doing so. But whether voluntary or involuntary, the choice to scale back operations generally means allocating economic burdens to employees, vendors, suppliers, and, in the case of firms that provide an essential service, the broader communities they serve.

A firm’s subsequent choices appear to be constrained by its overall financial condition and its new or existing legal commitments. For instance, companies with substantial open lines of credit were able to draw down available funds to shore up cash. Meanwhile, those with stronger balance sheets were able to obtain new debt and equity financing from the capital markets. Virtually all of the profiled companies that were eligible to receive governmental bailouts accepted the assistance—in both grant and loan form—with little apparent concern for the conditions and restrictions attached to such funds. Participation in bailout programs, in turn, constrained the firm’s choices regarding how to allocate economic burdens. For instance, the restrictions and limitations in the CARES Act were designed to delay or prevent companies from allocating economic burdens to employees and, in the case of airlines and health care facilities providing essential services, their broader communities.

The case studies suggest that to the extent these other liquidity options are available, corporate managers may view bankruptcy primarily as a legal or strategic tool rather than as a true financial restructuring option. Perhaps because of certain underlying assumptions about bankruptcy, no company seems to have weighed participation in a governmental bailout—with or without strings attached—against the option of filing for bankruptcy. Rather, these alternatives—like all of the major decisions firms make in response to a sudden liquidity crisis—appear to have been independently examined at very different points in the lifecycle of the distressed firm.

The full article is available here.

14 Jul 2020

Bankruptcy Claim Dischargeability and Public Externalities: Evidence from a Natural Experiment

by Editor | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Corporate Governance | 0

By Michael Ohlrogge (New York University School of Law)

In 2009, the Seventh Circuit ruled in U.S. v. Apex Oil that certain types of injunctions requiring firms to clean up previously released toxic chemicals were not dischargeable in bankruptcy. The result of this was to expose lenders, even those with security interests, to larger losses in the event a firm they extended credit to entered bankruptcy with significant outstanding environmental cleanup obligations. I document that lenders tightened the covenants on loans they extended to firms impacted the decision. In particular, lenders added new requirements that borrowers’ facilities and operations be inspected by outside environmental engineering firms in order to assess the safety with which they handle toxic chemicals.

Using an array of statistical tests and data from federal environmental agencies, I show that firms impacted by the decision responded to these new pressures from lenders by taking meaningful steps to reduce their risks of causing catastrophic pollution spills. In particular, firms reduced volume of toxic chemicals they release on-site by approximately 15%. In place of these releases, firms substituted off-site treatment by specialized facilities generally considered to be safer for the environment. These results point to important ways in which bankruptcy law and other legal rules that impact recovery for firms’ creditors can work to shape the positive or negative externalities those firms generate.

The full article is available here.

22 Oct 2019

Corporate Governance, Bankruptcy Waivers and Consolidation in Bankruptcy

by Editor | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Corporate Governance, Cramdown and Priority, Workouts and Pre-Packs | 0

By Daniel J. Bussel (UCLA School of Law)

Bankruptcy law—once the vanguard of enterprise liability —has increasingly tended to kowtow to formalities of corporate law standing in the way of effective reorganization.

In two areas in particular, corporate law is seen by some courts and commentators as imposing rigid and substantive limitations on bankruptcy rights.

First, although bankruptcy courts have long held that access to bankruptcy relief may not be waived in a contract, recent decisions have enforced state corporate law’s choice to defer to contractual governance arrangements baked into corporate charters that hinder or preclude an entity from filing for bankruptcy relief.

Second, influential appellate decisions have pushed bankruptcy courts to respect the legal boundaries between affiliated entities within a corporate group for substantive insolvency law purposes, even as those boundaries are routinely ignored for operational, financial, tax and regulatory purposes.

Professors Baird and Casey, expanding upon earlier work by Professor LoPucki, have noted and embraced this judicial trend toward respecting corporate law formalities. They have coined the term “withdrawal rights” to describe the phenomenon of prebankruptcy contractual arrangements enforceable under state corporate law that operate to allow a particular creditor to opt-out of the bankruptcy process by segregating key operating assets in entities that are effectively precluded from obtaining bankruptcy relief without the creditor’s express consent.

In CORPORATE GOVERNANCE, BANKRUPTCY WAIVERS AND CONSOLIDATION IN BANKRUPTCY, I argue that these techniques, however clever, run smack into traditional and still vibrant bankruptcy doctrines that find contractual waivers of access to bankruptcy relief void as against public policy, and that permit consolidation of entities whose formal separateness is inconsistent with the actual and effective operation of the corporate enterprise under reorganization.

Thus “Golden Share” arrangements in which a creditor is issued a special class of equity (the Golden Share) and the debtor’s charter is amended to preclude bankruptcy filing absent the Golden Shareholder’s consent, fail as unenforceable contractual waivers of bankruptcy rights.

Moreover, constituents with claims against affiliated companies in bankruptcy proceedings that effectively operate as a unified enterprise should not be surprised when they are treated as a claimant against that unified enterprise, except to the extent that the bankruptcy equities themselves demand otherwise, and so long as the value of their rights in property are adequately protected, even if the formalities of entity separateness are otherwise respected. The restrictive approach to substantive consolidation adopted by some appellate courts, notably the Third Circuit in Owens-Corning, that encourages reliance on formal entity separation, should be rejected.

Bankruptcy courts are destined to struggle with the problem of withdrawal rights forever. Powerful creditors have never fully accepted the concept that they can be compelled to participate in a collective proceeding in the event of the common debtor’s insolvency and have sought ways to opt out of those proceedings when it is to their advantage to do so. They show no signs of flagging in efforts to structure bankruptcy-remote relations through statutory exceptions and preferences, the creation of property rights in their favor, and contractual strictures. If they have the political strength to carve out express exemptions in the Bankruptcy Code, courts may have little flexibility to prevent the opt-out.

But absent a federal statutory exemption, to the extent that state law corporate formalities manipulated to the advantage of certain constituencies through special contractual arrangements become impediments to effective bankruptcy reorganizations, those formalities are quite properly overridden by bankruptcy law. Bankruptcy law limits the efficacy of the “Golden Share” and other contractual arrangements incorporated into company charters, and the entity partition techniques observed by LoPucki, Baird and Casey (among others). Those limits should be factored into market expectations surrounding asset securitization and other structuring techniques designed to avoid the ordinary operation of bankruptcy law upon a particular creditor’s claim. If they are properly factored in, it is difficult to believe that securitization of core assets of non-financial operating companies will remain a cost-effective alternative to more traditional financing arrangements. The market should place little value on a bankruptcy withdrawal right that is likely to prove illusory when it matters most.

The full article is available here.

23 Oct 2018

Creditor Governance

by Editor | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Jurisprudence | 0

By William R. McCumber (College of Business, Louisiana Tech University) and Tomas Jandik (Sam M. Walton College of Business, University of Arkansas)

A traditional view of creditors is that they are largely passive investors unless a borrower violates the terms of a loan agreement or misses a payment. However, like institutional shareholders, creditors hold concentrated positions in firm securities (loan shares), are sophisticated investors, and have access to senior management and non-public information. Since debt financing is much more common than equity financing, and because the great majority of credit agreements are honored, it is important to better understand how creditors advise and monitor portfolio (borrower) firms. We find that creditors play a significant role in corporate governance under normal circumstances, i.e. when firms are not in technical violation or default. Borrower firms are less likely than non-borrowers firms to file for bankruptcy in the intermediate future, and borrowers shift financial and investment decisions away from value-reducing policies and toward value-creating investments. Importantly, these changes are profitable for borrower firms since both cash flows and returns on assets improve at least three years after loan origination, which in turn decreases creditor portfolio risk. We also find that when creditors retain a larger proportion of the loan on their books, changes in borrower firm financials are more pronounced, providing evidence that creditors exert a greater governing force when more exposed to borrower risk.

The full article is available here.

Corporate Governance

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