FTX Liability Tentacles Spread Far

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By Russ Banham

Carrier Management magazine

As the spectacle knowingly or unwittingly orchestrated by Sam Bankman-Fried, cofounder of bankrupt cryptocurrency exchange FTX Trading and cryptocurrency trading firm Alameda Research, plays out on the global stage, plaintiff attorneys are eyeing a bonanza from knock-on lawsuits.

This contagion effect, where FTX/Alameda’s legal quagmire spreads widely to affect the hundreds of crypto exchanges and companies operating worldwide, as well as businesses that invested in cryptocurrencies and financial advisers who promoted high-risk crypto investments, is expected to produce claims against insurers providing directors and officers (D&O) liability, errors and omissions (E&O), and employment practices liability (EPL) insurance.

How many claims and their potential payouts is largely open to conjecture at this point, but with crypto values roughly half what they were a year ago, carriers are likely girding for the worst. This posture is evident in how the D&O, E&O and EPL insurance markets are treating crypto-related entities at policy renewal—in a word, harshly.

“Depending on the buyer, there are likely to be sublimits, co-insurance language, high deductibles and premiums that may be five to 10 times more than [buyers] thought possible, partly because of the dwindling supply of capacity,” said Matthew Studley, executive vice president, Complex Risks, at global insurance broker Hub International. “A startup crypto company will find that D&O and other liability policies will be prohibitively expensive from an operational standpoint.”

Bankman-Fried is the recipient of a Department of Justice criminal indictment and civil charges brought by the Securities and Exchange Commission for coordinating a scheme to defraud equity investors in the FTX exchange. He also has been named as a defendant in at least seven class action lawsuits following the exchange’s bankruptcy filing in November.

These legal miseries are projected to infect third-party financial advisers that misrepresented the inherent volatility of investing in one or more of the approximately 10,000 cryptocurrencies, from well-known Bitcoin and Ethereum to coins and tokens created and listed on an exchange in a matter of minutes. Advisers that failed to adequately monitor the see-saw movements in crypto value and caution clients about growing risks may confront E&O litigation for alleged negligence, malpractice and misrepresentation.

There is also the potential for EPL claims to arise against crypto-related entities forced to lay off people in the aftermath of the FTX collapse in November 2022. The blowup of the exchange, formerly valued at $32 billion, reverberated across the industry, which reportedly lost billions of dollars, plummeting from a peak $3 trillion valuation to below $1 trillion. At press time, crypto-market capitalization was in the $820 billion range.

The number of lawsuits filed so far against crypto-related entities and third-party “enablers” like audit, consulting and investment firms is noteworthy. F. Douglas Raymond, senior partner in the corporate practice of law firm Faegre Drinker Biddle and Reath, conducted a Lex Machina search in federal courts on behalf of Carrier Management. Raymond searched for mention of the word “cryptocurrency” in complaints filed over the past year, finding 475 cases. “Given the spectacular collapse of FTX and all the publicity around it, a lot of litigation has been filed,” Raymond said. Lex Machina is a provider of legal analytics.

The spate of lawsuits is not surprising, said economist Robert Hartwig, associate finance professor at the University of South Carolina. “I have warned my students repeatedly that cryptocurrencies have no inherent or intrinsic value,” said Hartwig, who also leads the university’s Risk and Uncertainty Management Center.

“Crypto supposedly accounts for 7 percent of the world’s money, according to a recent statement, but the reality is that it accounts for 0 percent of the world’s money. That’s because it doesn’t meet the standard criteria for a currency—a medium of exchange, a store of value or a unit of account. Its value is driven entirely by market demand, prices correspondingly rising and falling as people buy and sell. In my opinion, demand is driven by the ‘greater fool’ principle, someone willing to pay a higher price on an already overvalued security.”

The chill in demand that began in November is not the first time the market has frozen, enduring a handful of other “crypto winters,” a term that is analogous to a bear market in traditional securities. No one expects this brutal crypto winter to be over any time soon. “Will it become an ice age?” a recent headline in The Washington Post speculated.

What is heating up are crypto lawsuits. As Douglas put it, “It’s very easy to file a lawsuit. More are likely.”

“FTX is like a stone tossed into a pond that sends these ripples out,” said Jonathan Ziss, co-chair of law firm Goldberg Segalla’s Management and Professional Liability Practice Group. “Anyone who invested in FTX or was involved as an adviser or a partnering firm is potentially exposed to litigation, the energy generated sent out to pursue third parties.”

D&O Dilemmas

On Jan. 18, FTX stated that it had recovered more than $5 billion in liquid cash, securities and crypto assets. The previous month, federal prosecutors maintained that more than $8 billion in customer funds were missing. Assuming the numbers are accurate, $3 billion dollars remains missing.

“Who among [the more than 9 million] FTX customers and investors will be made whole is unclear,” said Studley. “Since Bankman-Fried has pled not guilty, until he is proven guilty or not guilty, his legal bills are paid by the insurers. Not a whole lot will be left over for the customers, possibly nothing.”Related article: “We Insured FTX”

“The legal fees alone have a high chance of blowing through the reported limits,” Studley said, referring to reports in crypto-focused publications such as crypto.news and protos.com stating that FTX and Alameda-related companies have insurance policies from a Bermuda specialty insurer, Relm Insurance Ltd., with limits north of $15 million. Separately, the chief executive officer of Relm confirmed that his company “provides insurance coverage to West Realm Shires Inc. (commonly known as FTX.US) and FTX Australia Pty Ltd” in a message posted on the company’s website in December but didn’t disclose the amount of coverage. (See related sidebar: “We Insured FTX”) The crypto-focused publications attribute the origin of the $15 million figure to the insurance trade publication, The Insurer. (Carrier Management has not discovered information about additional insurance limits provided to FTX by other insurers or reinsurance on the Relm coverage.)

Ziss agrees with Studley’s assessment. “It’s a given that the D&O insurance surrounding the FTX entity isn’t enough; it’s up in smoke,” he said. “The plaintiff bar needs to see who else in the line of fire is potentially liable.”

In this path are companies that may have invested in cryptocurrencies that plummeted in value following the revelations about FTX. “One angle is potential D&O claims filed by shareholders of companies that invested in crypto, including shareholders of InsurTechs holding significant investments in Ethereum,” said Lawrence Fine, management liability coverage leader in insurance broker Willis Towers Watson’s FINEX North American division. At press time, the price of Ethereum was approximately half what it was a year before.

Another potential legal path is audit firms. Ziss cited a recent class action lawsuit in California Northern District Court, Papadakis v. Bankman-Fried et al, filed against FTX’s auditor for reportedly issuing certified reports that “purportedly found the FTX Entities to be in good financial health,” the court document reads.

Another class action lawsuit filed in California’s Southern District Court seeks to hold Silvergate Bank and its CEO accountable for allegedly putting FTX customer deposits in Alameda’s bank accounts, producing panic in the crypto market that resulted in the bankruptcy declarations by FTX and Alameda.

Claims against the directors and officers of non-crypto companies for crypto-related matters are less likely but still possible. “For example, if a non-crypto company invests money in a cryptocurrency or a crypto company, or publicly supports and/or endorses a crypto company, resulting in losses to the non-crypto company, the directors and officers involved in these decisions could be targets of litigation,” said a D&O attorney off the record, as the person is engaged in a crypto-related D&O lawsuit.

Other possible avenues of litigation include FTX advisers and business partners. An August 2022 survey sent by Forbes to FTX unearthed what the magazine called “a long list of top tier” firms (53 vendors, bankers and advisers, in all) “apparently eager to do business with FTX.” Questions remain “as to whether some of them should have suspected trouble,” Forbes stated.

Nevertheless, the aforementioned D&O attorney said that claims against directors and officers of crypto-related companies are most likely, assuming two contexts: The company and its directors and officers misrepresented material information to customers or investors; or the directors and officers mismanaged the crypto company, resulting in harm, such as insolvency, loss of assets or litigation losses, the person said.

As with most litigation, it is likely that potential D&O crypto litigation will be settled before the lawsuits reach trial. Raymond said that if a trial does proceed in a class action involving companies that invested assets in cryptocurrencies that fell sharply in value, plaintiff attorneys will allege that the board directors either failed to make a good faith effort to exercise their duty of care, failed to properly oversee a substantial and known risk, or failed in their duty of oversight, also known as “Caremark claims” from a seminal court decision.

“This is a situation where there is a risky asset or a novel risk,” he said. “The question is whether the board had adequate oversight of the risks…and pushed management to have adequate procedures in place to supervise the risks. If this is not the case, the argument will be that the company wrongly invested in cryptocurrencies and the directors breached their duty of oversight.”

E&O Tight Spots

Several interviewees commented on the potential for E&O claims filed against financial advisers that downplayed the risks of investing in cryptocurrencies and/or failed to adequately monitor and expeditiously alert investors about a downturn in value.

“We live in a very litigious society, so I would expect that financial advisers will be targeted,” said Hartwig. “Their potential legal liability could be a function of how much disclosure was provided to their clients insofar as the risks of investing in crypto and NFT [non-fungible tokens], which also have taken a dive since the FTX implosion.”

Raymond offered a similar perspective. “If someone is investing in crypto, the standard legal issues have to do with disclosure of the risks and adequate warning of potential troubles,” he said. “This is especially the case for financial advisers who are fiduciaries that must act in the customer’s best interest.”

Jacqueline Quintal, managing director in insurance broker Marsh’s Financial Institutions Group, also commented on the need for financial advisers to provide clients with adequate warning. “I haven’t seen any claims for this, but it makes sense that if you’re giving investment advice, you should communicate to clients that now might be a good time to sell,” she said.

Raymond said that professional liability for a financial adviser is hinged to what is known as the suitability standard, the recommendation of specific investments deemed suitable for a particular client.

“A 97-year-old advised to stick all his money into cryptocurrencies would fail the suitability question, but someone who understands the nature of the risk and the fact that there is no underlying value to a cryptocurrency would potentially pass the test, as they knew from the beginning what they were getting into,” he explained. “Nevertheless, lawsuits are likely to be filed by investors who say they were misled by their financial adviser into thinking that crypto was safer than it turned out to be.”

Some investors will “make the legal argument” that their financial adviser performed “insufficient due diligence” into the risks of investing in a particular cryptocurrency or several of them, said Ziss. “Crypto is not like investing in commercial warehouses. Because it’s an innovative, largely unregulated and little understood asset class without much of a track record, the adviser’s fiduciary duty begets an obligation to ask enough questions about the risks, to do the homework.”

E&O claims are also likely to be filed against audit and accounting firms. “There are a vast number of accounting firms involved [with companies that did business with] FTX and Alameda that should be on the lookout for potential claims,” said Kelly Johnson, senior vice president at GB Specialty, a division of third-party administrator (TPA) Gallagher Basset that focuses on high-risk liability claims. “Plaintiff attorneys can be expected to cast a wide net.”

That net has captured the likes of wealthy athletes and celebrities paid to promote the safety of FTX investments in television commercials and other marketing campaigns. A civil complaint brought by an FTX investor in November alleging that FTX’s interest-bearing cryptocurrency accounts were illegally offered securities “targeting unsophisticated investors” seeks to hold liable such well-known public figures as Tom Brady, Shaquille O’Neal, Naomi Osaka, Larry David and Kevin O’Leary, a judge on the TV-show “Shark Tank,” among others. The plaintiff’s attorneys have proposed a class action lawsuit.

Asked about the case, Hartwig said that O’Leary, a successful businessman and entrepreneur who calls himself Mr. Wonderful, “willingly testified to Congress that he did not fully understand what FTX was up to until it was too late. He lost money he’d invested in the exchange and said he was duped. In my opinion, it will be difficult to prove the liability of a spokesperson paid to promote a product. Celebrities endorse a variety of inherently unsafe products like alcohol and foods that cause obesity.”

Aside from D&O and E&O litigation, one interviewee commented on the possibility of EPL litigation involving employees laid off at crypto-related entities and other types of digital asset firms. For example, large crypto lender Genesis Global Trading, which was reportedly hit hard by the collapse of FTX, laid off 30 percent of its workforce in January on top of 20 percent last August and filed for bankruptcy. The company reportedly suffered significant losses from loans provided by Alameda Research.

“Disgruntled employees terminated at a company caught up in the FTX implosion may assert that the company didn’t act in their best interests, failing to take proper precautions that resulted in their loss of employment,” said Jeffrey Lattmann, executive managing director, Executive Liability, at insurance broker Brown & Brown.

The varied litigation scenarios are not unusual. Several interviewees pointed out similarities to the chain reaction of lawsuits that emerged in the aftermath of the savings & loan debacle in the early 1990s, the collapse of Enron in the early aughts, and the subprime mortgage fiasco in 2007. As Ziss described the potential for crypto-related litigation, “There are many meteorological indicators of a significant storm to come.”

The Market Response

If there is good news for the broader insurance marketplace, it’s that just a few carriers sold D&O insurance to crypto-related entities. “There was limited appetite in the markets for the industry, which will now become even more limited in the amount of capacity provided, not to mention higher deductibles, lower limits, much higher premiums, tighter fraud exclusions, and possible bankruptcy and regulatory exclusions,” Lattman said.

Fine from Willis Towers Watson offered a similar assessment. “At the moment, only a limited number of carriers will write crypto-oriented companies, often with low limits like $2.5 million or less,” he said. “Some D&O insurers of financial institutions are adding crypto and NFT exclusions, but not yet for commercial [entities]. This may eventually change.”

Undoubtedly, crypto companies and exchanges, as well as businesses that invest in, advise or partner with crypto entities, are looking at a tough D&O and E&O policy renewal. Regarding the possibility of newer insurance market entrants augmenting capacity, Studley said, “Now is not the time for insurers [not in crypto] to consider—in the middle of an economic downturn, following the blowup of FTX—[getting] into it.”

Fine offered a shred of hope for the future. “D&O insurers are scrambling to make up for lost revenue from the drop-off in SPACs and IPOs, which may motivate them to move past the headlines [to] distinguish intelligently between the good and bad crypto risks,” he said.

Indeed, no interviewee predicted the demise of the larger crypto industry, which has proven its resilience to thaw from previous crypto winters. “I don’t believe crypto as an industry will disappear, given the strength of the backbone blockchain technology,” said Studley.

Ziss concurs. “My sense is that FTX does not sound the death knell for crypto as an investment class,” he said. “In some ways, the regulatory lattice bound to be built around crypto may lead to a reinvention of crypto as an asset class. And if Bankman-Fried is the class clown he’s made out to be, it will make everyone else look a lot better by comparison. The party isn’t over.”

He’s right about that. On Jan. 19, the Wall Street Journal reported that FTX’s new CEO said the bankrupt exchange may come back from the dead.

Even brutal winters thaw.

Russ Banham is a Pulitzer-nominated financial journalist and best-selling author.

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