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For Crypto Attorneys, FTX Bankruptcy Is a ‘Black Swan Event’

By Justin Henry and Alexander Lugo for Law.Com

After a tumultuous week for cryptocurrency trading giant FTX culminated in a bankruptcy filing Friday, the reputation of the emerging asset class is bruised and battered. But the battle set to unfold in Delaware court will likely provide a venue for bankruptcy and regulatory attorneys to air the grievances of an under-regulated industry.

One of the largest crypto trading platforms in the world, FTX was ranked number five on Forbes’ list of the “best global crypto exchanges” as late as March. The company built a recognized name that even adorns the Miami Heat’s basketball arena after purchasing naming rights last year for $135 million.

But lawyers say the U.S.’s regulation-through-enforcement has driven more than 90% of cryptocurrency trading offshore, where companies like FTX have evaded customer protections. FTX, whose former CEO Sam Bankman-Fried has advocated for tighter rules, has amassed a complex network of affiliated companies, including those who filed for bankruptcy Friday and have come under investigations by U.S. regulators.

“FTX is so prominent in this industry as one of the top exchanges as well as its high-profile in its regulatory community as far as pushing regulatory laws…it’s going to take a long time to work back and gain the trust of the investment community,” said Jared Gianatasio, head of the cryptocurrency and digital assets practice at Kleinberg Kaplan, one of many firms gearing up to represent investors in the bankruptcies. “That’s both retail and institutional by the way.”

FTX’s image as an honest broker calling for more regulation was shattered in less than a week when an ill-fated buy-out by another trading platform was halted. Potential buyer Binance, in talks to save the liquidity-starved FTX, cited news reports of the platform’s balance sheets that revealed “mishandling customer funds” to prop up an affiliated trading firm.

On Friday, the company and its affiliates filed for bankruptcy, though it’s not clear how creditors are going to be repaid.

Gianatasio said his firm is planning to file appearances in the bankruptcy proceedings that were initiated on Friday on behalf of direct equity holders in FTX and account holders using FTX to trade. He added the firm is looking into whether preferences were given to some creditors over others before filing for Chapter 11 bankruptcy protection.

“We anticipate seeing increased volumes of client outreach on various aspects of FTX’s bankruptcy filing,” he said. “The issues that our clients will face range from direct customer trading exposure, exposure as shareholders, and indirect counterparty exposure as the FTX ripple effects are felt throughout the market.”

The extent of the ripple effect this bankruptcy will have is not entirely known yet, because there can still be large entities with exposure to the exchange who have not made it public yet, Jeffrey Leavitt, an attorney involved with Kozyak Tropin & Throckmorton’s cryptocurrency practice, said.

“It’s going to bring a rush of demand for bankruptcy lawyers who have knowledge of the crypto space because this is a black swan event that doesn’t really have a lot of precedents,” said Leavitt. “There’s probably going to be a lot of people and entities affected by this that will need that experience as this continues unfolding.”

Broader Exposure Risks

Several of Wall Street’s most prominent legal industry players have done business with FTX, according to a survey conducted by Forbes for its “best exchanges” rank. Sullivan & Cromwell, Morrison Foerster, Skadden, Arps, Slate, Meagher & Flom and Quinn Emanuel Urquhart & Sullivan have all done business in some capacity with FTX, Forbes said in a report last week. The firms did not respond to requests for comment.

The scale and complexity of FTX’s business, including several affiliate companies registered under international and domestic jurisdictions, led several firms with large cryptocurrency practices to decline to comment for this report.

Talks of U.S. regulations on the crypto space have been increasing lately, many of which have been spearheaded by FTX leaders, adding another layer of awe to last week’s revelations.

“For a group that’s been so high profile and so public on risk management and prudent supervision, this comes as a shock to everyone that not only were they out in front talking about bringing regulation to the market, but they were so high volume in their exchange activity,” Gianatasio said.

Almost exactly a year ago, the bipartisan Infrastructure Investment and Jobs Act was signed into law, which contained a provision that requires reporting of digital assets. The Senate also introduced the Digital Commodities Consumer Protection Act, which would give the Commodity Futures Trading Commission oversight on the market. But there’s room for even more regulatory oversight.

A best-case scenario to come out of FTX’s current problems would be for a formalization of the rules governing crypto investments, according to Gianatasio.

“The best way to instill more confidence in this space is to get more rules of the road written and rules that are seen as protective to investments,” he said.

And in spite of the current travails surrounding cryptocurrency, the industry continues to generate tremendous curiosity, particularly among rising attorneys.

Daniel Stabile, partner at Winston & Strawn’s Miami office in the crypto practice group, said the evolving legal landscape of cryptocurrency is fueling the interest of a generation of rising lawyers. Stabile teaches a class at the University of Miami where he’s educated students on blockchain regulation since 2018.

“For all of the same reasons that we have an uncertain and evolving regulatory environment, those things make it an attractive area to practice in because we can actually see the law and recommendations develop in real time, and we can play a role based on our advocacy for our clients,” he said. “That doesn’t happen all the time.”