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FTX bankruptcy estate is preparing to file lawsuits on retail customers to claw back withdrawals made during the last days of FTX.

In fact, FTX has already filed one recently.

https://www.coindesk.com/business/2023/09/22/ftx-sues-former-employees-of-hong-kong-affiliate-seeks-157-million/

Here's the court filing

https://restructuring.ra.kroll.com/FTX/Home-DownloadPDF?id1=MjUzMTA1Mw==&id2=-1

FTX Terms Of Services(ToS) is available here

https://gighustlers.com/wp-content/uploads/2022/11/httpshelp.ftx_.comhcarticle_attachments9719619779348FTX_Terms_of_Service.pdf

In FTX Tos 8.2.6, it's stated unambiguously that ownership of the assets remains with the customer at all times and not transferred to FTX. It also says the customer controls the asset and he can withdraw at any time.

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Does FTX have a strong case in filing a clawback lawsuit on the customers if they are withdrawing their own assets and the assets withdrawn are not even part of the bankruptcy estate? Furthermore, the TOS allows the customer to withdraw at any time. Actions to withdraw were done in good faith allowed by the TOS.

Customers had a contract with the pre-bankruptcy FTX. They do not have any contract with the post-bankrupt FTX. FTX went bankrupt as a result of the founder Sam Bankman Fried committing fraud by misusing customer funds. Customers were victims of the fraud.

Does FTX going bankrupt later somehow cause the contract with the defrauded customers to lose its force of law? If yes, why is this so, given that there is nothing unfair and illegal in the TOS clauses.

Clawbacks will cause customers to lose not only the money that they left on FTX but the money that they withdrew as well. They will become victims twice.

If FTX files a clawback lawsuit against the customers, would using the FTX TOS to assert ownership of the assets be a strong legal defence?

Please answer this question based on U.S jurisdiction and English Law. FTX TOS says legal disputes will be arbitrated in SIAC(Singapore International Arbitration Centre) according to English Law.

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  • 1
    "They will become victims twice." - the law is likely to see this as exemplary to others, that you can't partake in frauds (even unknowingly) and then keep the proceeds. The fraudster is the wrongdoer, and there is no reason why victims should be treated differently according to when they withdrew their funds. Their victimhood began at the time of deposit - the withdrawals were fraudulent.
    – Steve
    Sep 30, 2023 at 11:14
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    The crypto exchange business itself is not a fraud. There are similar companies like Coinbase which is listed in U.S. The bankruptcy estate is trying to revive the crypto exchange business calling it FTX 2.0. The fraud was by the Founder himself when he misused customer funds for his other fund business Alameda Research.
    – user768421
    Sep 30, 2023 at 11:20
  • Yes, the FTX business was run by a fraudster. From what I understand of the event, client money was always fraudulently mishandled. Like Madoff, the returns were never legitimate - the money was stolen on deposit, and what was returned to some was the product of fraudulent accounting. I must admit I'm unclear really how crypto investors distinguish themselves from fraudsters, or where they think the returns are coming from if not directly from the capital of other investors. Perhaps, exchanges are careful not to make any representations, but rely on public hype.
    – Steve
    Sep 30, 2023 at 11:43
  • You state that "FTX bankruptcy estate is preparing to file lawsuits on retail customers," however, the links describe lawsuits against "former employees of Salameda, a Hong Kong-incorporated entity affiliated with FTX that it says was controlled by … Sam Bankman-Fried." Do you have evidence that FTX is seeking to clawback withdrawals by retail customers, ie non-insiders?
    – sjy
    Oct 1, 2023 at 12:49

4 Answers 4

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The Terms of Services clearly state that customers own the digital assets on FTX platform. The question is ... how does bankruptcy and commingling of funds affect customers' ownership?

A group of FTX.com defrauded customers hired a legal team to argue their case that they own the digital assets on FTX as stated unambiguously in the Terms of Services. The legal team filed a motion for partial summary judgment on this matter.

I extract the relevant parts from the motion to answer this question.

The Bankruptcy Code does not, by itself, create new legal or equitable interests in property; instead, property interests are created and defined by otherwise applicable non-bankruptcy law. In re ABC Learning Ctrs. Ltd., 728 F.3d 301, 313 (3d Cir. 2013) (“property rights the debtor does not have do not become part of the bankruptcy estate.”).

Property rights are created by the contract according to contract law. Bankruptcy code does not affect ownership rights defined in the contract. FTX going bankrupt does not revoke customers' ownership of the assets as stated in TOS.

The other answers to this question has cast doubt whether customers retain their ownership rights due to commingling of funds. Yes, customers retain ownership. Past legal precedents have shown this to be the case.

If trust property is segregated or otherwise identifiable, it is clearly not property of the estate. However, trust property does not lose its trust character simply because the debtor misappropriated it or commingled it with the debtor’s own property. E.g., City of Farrell v. Sharon Steel Corp., 41 F.3d 92, 102 n.10 (3d Cir. 1994) (“a party should not be able to defeat a trust ‘simply by commingling the withholding funds with its other assets.’”);

Connecticut Gen. Life Ins. Co. v. Universal Ins. Co., 838 F.2d 612, 619 (1st Cir. 1988) (“mere comingling of the trust property with other property of the [debtor] … does not defeat [trust beneficiary’s] claim”);

If customers own the assets on FTX, the bankruptcy estate has no right to claw back withdrawn assets since the assets do not belong to the estate in the first place.

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The term of the contract are relevant, but so are the actual facts of what FTX was holding.

It will matter whether FTX was in fact holding a discrete asset, attributable to the owner/user, in trust for their sole benefit, that were not comingled with general funds. If there was such an asset, such that even in bankruptcy no other creditor could claim any interest in it, then a clawback will likely be unsuccessful: the owner/user would have ended up with the asset in any case.

This manner of segregation is required of regulated brokerages. See e.g. the segregation rules here and a more general description here.

However, if FTX did not structure its holdings that way, a clawback may very well be successful, no matter what the contract required or assumed. I note the contract talks about title to "your Digital Assets," but does not promise that FTX actually acquires or holds assets in a way that they would be "your Digital Assets." Even if there were such a promise that FTX failed to follow through with, that would not change the clawback analysis, but would leave FTX open to a breach of contract claim (or arbitration, given the arbitration term).


For example, if at the end of each hour or day or whatever period, FTX just bought a bulk amount of cryptocurrency that matched the aggregate purchases of its users across the period, and then dispersed from that block for various uses, any withdrawals from that bunch of crypto would likely be vulnerable to a clawback. It was never an asset that belonged to the user. The user may have had contractual or equitable rights to be returned the market value of what the user wants to sell as long as FTX was a going concern, but that does not make their allocation a clawback-proof property right.

That is just an example of how the assets could become co-mingled, with no suggestion that this is how FTX was operating. The New York Times notes that we have little insight into exactly how assets were held:

FTX’s terms of service made no mention of how, or where, client assets would be stored.

And

While crypto currency transactions are meant to be recorded on the blockchain, a public digital “ledger,” any trading that happened using those crypto holdings within the FTX platform did not get publicly recorded — only customer deposits or withdrawals hit the blockchain.

This leaves significant room for what one might consider to be "your Digital Assets" to never actually be held separately and distinctly for a user's benefit and instead simply represented as a ledger entry on some general account.

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  • So in analogy, if I buy some stock through a broker, then sell it and then the broker goes bankrupt, my proceeds may be clawed back, depending on whether the broker ever actually bought stock in my name or how the broker managed their own accounting?
    – quarague
    Oct 2, 2023 at 9:22
  • @quarague that fails at a crucial step: Brokers that trade in stocks are regulated so that is not possible. FTX was a dubious internet site suggesting to people that they would own numbers on a blockchain.
    – Trish
    Oct 2, 2023 at 9:50
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    @Trish So the difference is that if I use a proper legally authorized broker, then there is explicit regulation that protects me. If the 'broker' is just an internet website, they could still emulate an actual stock broker without ever actually buying or selling any realstock. As long as they do that, it would make no financial difference to me but I would be on the hook if the website goes bankrupt.
    – quarague
    Oct 2, 2023 at 10:04
  • How does commingling of assets by the fradulent party take away the innocent customer's ownership of his own assets according to the TOS? How does commingling gives the bankruptcy estate the right to claw back? I don't understand how the law can accept this. It also sounds downright unfair, given that the customer was the innocent party.
    – user768421
    Oct 5, 2023 at 5:18
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    @Trish Nope. Two words: Bernie Madoff. Madoff was a regulated brokerage firm and was insured by SIPC. Madoff did not purchase any of the securities he claimed he did. SIPC took the position that customers were only entitled their original principal back, without any compensation for inflation or opportunity cost. Thus any gains which were cashed out were clawed back. This was catastrophic to investors who, like you, thought they were protected.
    – user71659
    Oct 7, 2023 at 17:01
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+50

The case referred to, FTX Trading Ltd. v. Michael Burgess and others (22-11068-JTD), is a claim to recover $157 million of assets withdrawn by former employees who "leveraged their connections to FTX Group personnel to ensure that they would be prioritized over other customers" during the collapse. The withdrawals are alleged to be unfair preferences under 11 U.S.C. § 547 and fraudulent transfers under 11 U.S.C. § 548. These claims would not apply to a normal customer withdrawing assets in the ordinary course of their business with FTX.

However, the question raises a more fundamental issue about FTX's legal interest in customer funds. Property held on trust for another is not property of the bankrupt estate under § 541 and cannot be "clawed back" under § 547: Begier v. IRS (1990). The Burgess complaint alleges wrongdoing, which may prevent the defendants from claiming any trust over the withdrawn assets. However, innocent FTX customers, relying on the terms of service, could claim that their funds were held on trust and therefore (as the question asserts) not part of the bankrupt estate.

The customer would need to trace their FTX account balance into the assets held by the trustee, a complex legal process which would involve forensic analysis of FTX's "accounting records." Such a claim was made by an Ad Hoc Committee of Non-US Customers of FTX on 28 December 2022, and supported by an opening brief on 24 March 2023. However, the liquidators argued that the claim was premature and the parties agreed to stay it indefinitely on 2 August 2023. So, it is still too early to say whether the language of "ownership" in the FTX terms of service will affect the distribution of the remaining assets.

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  • Since the customer is an owner according to TOS, he is not a creditor and his funds should not be distributed to other creditors on the grounds of equality of distribution.
    – user768421
    Oct 5, 2023 at 5:20
  • could you take a look at this new answer? It seems to provide good legal defences against the commingling argument. Thanks. law.stackexchange.com/questions/95861/…
    – user768421
    Oct 8, 2023 at 0:32
  • Does it look like a viable legal defense for customers who already withdrew most of their funds from FTX before it filed for bankruptcy? No tracing needed for these customers since these customers have already withdrew
    – user768421
    Oct 8, 2023 at 0:40
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FTX never bought the "assets"

That's the problem. They took the investor's money and didn't buy what the investors thought they were buying. For analogy, if you gave your agent $500,000 to buy real estate and, instead, they took the money and didn't buy the real estate, you wouldn't own the real estate. Or, if you gave your child $50 to fill your car with petrol and instead they blew it on chocolate, you wouldn't own the petrol they didn't buy. In either case, you have been the victim of fraud (or, at the very least, a breach of contract) by the person you gave your money to.

Now imagine that, in either case, instead of 1 victim, there are thousands. The law says that for 90 days before the bankruptcy, any repayments made to one victim are to be clawed back for the benefit of all victims.

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  • 1
    Your assumption that FTX did not buy the assets is wrong. FTX did buy the assets. This can be verified by the customers who bought assets on FTX platform and then transferred out elsewhere through the blockchain since day 1 of operation. Blockchain doesn't lie. If customers couldn't transfer to other platforms, FTX would not have grown to become one of the largest crypto exchanges in the world. The crypto exchange business was not a fraud. The fradulent part was misuse of customer funds. Not the crypto exchange business itself.
    – user768421
    Sep 30, 2023 at 12:06
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    @user768421 did they buy the assets when the customer deposited? Or did they buy them when the customer withdrew?
    – Dale M
    Sep 30, 2023 at 12:16
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    Crypto exchange is like a stock brokerage business. Customers place buy/sell orders. The broker buy and sell accordingly. If stuff was not bought, any subsequent withdrawal will fail. The transaction will not even appear on the blockchain
    – user768421
    Sep 30, 2023 at 12:19
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    @user768421 it will not fail if the broker buys just to satisfy the sell order
    – Dale M
    Sep 30, 2023 at 13:37
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    I don't know whether you have tried withdrawing from a crypto exchange before. If yes, you will know what I mean that a transaction can only appear on the blockchain if the items are real, not fake. If you don't have much experience with crypto, you may want to check with friends who do.
    – user768421
    Sep 30, 2023 at 13:41

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