FTX to Face Independent Investigation

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  • The Third Circuit Court of Appeals recently mandated an independent investigation for FTX, overturning a prior denial by the Delaware bankruptcy judge
  • The US Trustee sought an external examination over a year ago due to concerns about a conflict of interest within the company
  • Judge Luis Restrepo also expressed concerns over the efficacy of the current probe being led to CEO John Ray III

The Third Circuit Court of Appeals in Philadelphia ruled last week that FTX must face an independent investigation, overturning a previous denial by the Delaware bankruptcy judge overseeing the case. The US Justice Department’s bankruptcy watchdog, the US Trustee, initially sought an external examination more than a year ago, citing concerns about potential fraud within FTX. However, Judge Luis Restrepo ruled that a third party must investigate the company, citing concerns regarding the connection between FTX employees and FTX’s lawyers to the company.

Appeal Judge Has Conflict of Interest Concerns

Andrew Vara, who heads up the US Trustee office, urged the court in December 2022 to approve an independent investigator, saying that, “An examiner could — and should — investigate the substantial and serious allegations of fraud, dishonesty, incompetence, misconduct, and mismanagement” by FTX. Vara also suggested that the examiner should probe “the circumstances surrounding the debtors’ collapse, the apparent conversion of exchange customers’ property, and whether colorable claims and causes of action exist to remedy losses.”

Vara was concerned that an internal review could be tainted by the presence of those still within the company or those representing it, and Judge Restrepo agreed, stating that FTX employees who may have engaged in fraud could still work for FTX Group, while FTX’s lawyers, Sullivan & Cromwell, used to be pre-petition advisors to FTX.

These facts increased the possibility of a conflict of interest, Judge Restrepo believed, and so ordered a third-party investigation.

Judge Raises Doubts About Current Probe

The appellate decision naturally emphasized the necessity for an impartial examiner, with Judge Restrepo also expressing reservations about the ongoing internal probe led by FTX’s CEO, John Ray III. These included the aforementioned issues with FTX employees and the company’s legal representation. 

The judge underscored that appointing an examiner is mandated by the Bankruptcy Code when a debtor’s debts surpass $5 million, a criterion easily met by FTX, while he also argued that an independent investigation could bring transparency to crypto industry practices, citing FTX Group’s use of its own cryptocurrency tokens (FTTs) to potentially inflate values.

The initial request for an external investigation was denied by bankruptcy judge John Dorsey in February 2023, with Judge Dorsey expressing concerns about the increased costs associated with parallel investigations, emphasizing the need to conserve funds for the creditors.

The appellate decision could shed light on issues such as the use of proprietary tokens to influence company valuations, serving as a cautionary note for other entities either doing or considering doing the same.