Legal advisers wade into crypto contagion

Last month’s collapse of cryptocurrency exchange FTX has threatened another avalan­che of corporate failures, in an already torrid year for the digital assets industry.

The downfall of Sam Bankman-Fried’s crypto empire resulted in the demise of the beleaguered BlockFi, as the crypto lender finally followed peers Voyager Digital and Celsius Network into Chapter 11 bankruptcy.

These, and other failures of highly exposed companies — such as hedge fund Three Arrows Capital earlier in the year — have transformed the roles of lawyers, investment banks, and other professional advisers in the arena.

Until recently, many had been involved in continual tussles with authorities over how, if at all, crypto should be regulated as demand for virtual currencies and other digital assets boomed. Now, some of the same firms are being hired to rescue what value remains for creditors, alongside other bankruptcy and restructuring experts.

“This does feel quite a bit like the 2008 financial crisis . . . and those were, for the most part, public companies with all kinds of oversight, and we had no idea how far that contagion spread,” says Chris Brendler, senior analyst at DA Davidson, an investment bank.

Recommended

It had already been a busy year for some leading law firms ahead of FTX’s collapse, as they became embroiled in attempts to support other faltering crypto businesses.

Restructuring experts from Akin Gump Strauss Hauer & Feld were hired by Celsius Network in June, only to be replaced within the month by rivals Kirkland & Ellis after the exchange filed for Chapter 11 in July and sought bankruptcy protection. Kirkland & Ellis was also brought in to advise struggling crypto lender Voyager before it sought bankruptcy protection in early July, and helped to negotiate an abortive attempt to rescue its operations with a financial injection from FTX.

Sullivan & Cromwell worked with BlockFi — which filed for Chapter 11 last month — helping it to reach a landmark $100mn settlement with the SEC and state regulators earlier this year, as it won putative approval from the regulator to market its products once compliant. Lawyers from the firm are now working for FTX and its affiliated companies on its bankruptcy proceedings to recoup funds. Meanwhile, Kirkland & Ellis has emerged once more, alongside Haynes and Boone, to act for BlockFi in Chapter 11 proceedings as it seeks to recoup money from FTX businesses on behalf of its own creditors.

For Daniel Gwen, partner at global law firm Ropes & Gray, the collapse of FTX will have long-term ramifications for the crypto ecosystem.

“FTX’s failure is a disaster for the long-term acceptance and growth of cryptocurrencies as a mainstream instrument,” he says.

FTX’s failure is a disaster for the long-term acceptance and growth of cryptocurrencies

The exchange’s collapse follows a protracted downturn in which the market cap of the crypto industry also fell from more than $3tn at the height of last year’s bull market to less than $1tn this year.

Yet, despite troubles across the crypto market for most of 2022, FTX once stood tall as a bastion of crypto stability and Bankman-Fried drew praise for coming to the aid of flailing crypto companies, such as BlockFi, earlier this year.

The scale of damage caused by FTX’s collapse is still unclear but early court documents suggest the failed platform may face more than 1mn creditors. Celsius’s bankruptcy filing listed more than 100,000 creditors, while early Three Arrows filings cited a “significant number” of creditors.

These figures demonstrate that protecting consumers is likely to emerge as a core concern of politicians and regulators as they respond to the wave of crypto insolvency cases. “Number one is consumer protection — these types of cases are consumer-facing,” Gwen adds.

However, Amy Harvey, litigation partner at Ontier, says consumers remain at risk in recovering assets that are not clearly understood or audited. “With crypto firms, because of the lack of regulation of the industry, sometimes these assets are completely opaque,” she says, adding that FTX’s new management is “having to completely rework and work out what the audited accounts are because nothing that is filed is reliable”.

FTX’s collapse has also prompted renewed concern over the industry’s interconnected nature. In much the way that the financial strain experienced by Celsius, Three Arrows Capital and other ventures including Voyager Digital and BlockFi were intertwined, FTX’s bankruptcy has renewed fears of another, larger contagion.

“This industry is made up of a group of firms that trade each other’s tokens, that invest in each other’s products, that offer trading platforms for the transaction of those products, and they custody each other’s products,” says Charley Cooper, managing director at blockchain firm R3. “If one piece of the puzzle falls apart, they are all dramatically impacted.”

Worries over the safe handling of virtual assets subject to Chapter 11 proceedings have also been raised.

“There has been a failure to get on top of the potential for hacks to occur in circumstances where there is a changing of the guard between owners of the exchange to an insolvency practitioner”, says Darragh Connell, commercial barrister at London-based Maitland Chambers, with expertise in crypto disputes.

In the short term, legal experts look set to benefit from a wave of lucrative bankruptcy and restructuring work as billions of dollars worth of investments in virtual assets are pursued.

But the gravy train of work advising free-spending clients in a previously booming sector may have already ended.

FTX’s collapse may have set back crypto for years, suggests Gwen at Ropes & Gray.

“Now that our leading vanguard has failed on its own front, in large part due to its own corporate oversight . . . it’s set crypto back to the Stone Age almost.”