By Pam Martens and Russ Martens: February 2, 2023 ~

A showdown in the Delaware bankruptcy proceedings for Sam Bankman-Fried’s collapsed crypto exchange, FTX, before presiding Judge John Dorsey is scheduled for next Monday morning at 9:30. (You can listen to the hearing live at this link. Just turn on your speakers and click on the box with the flag.) The battle lines have been drawn for the showdown – but not in the manner that Big Law firm, Sullivan & Cromwell, had hoped.

The U.S. Trustee, who represents the U.S. Department of Justice in bankruptcy cases, has been asking Judge Dorsey to agree to the appointment of an independent examiner in the case since December 1. And over the past two months, the deeply conflicted Sullivan & Cromwell law firm has been aggressively opposing the U.S. Trustee’s pursuit of an independent examiner.

Yesterday, a Joinder was filed by the securities regulator of Texas, supporting the motion by the U.S. Trustee. The joinder included letters from 15 other state securities regulators and Washington, D.C., also supporting the appointment of an independent examiner. The states included the three largest U.S. states by population: California, Texas and Florida. The states of Wisconsin and Vermont had previously filed their own joinders requesting the appointment of an independent examiner, meaning that the position of the U.S. Trustee is currently being advocated by 18 state securities regulators and the District of Columbia.

In the joinder filed by Wisconsin’s Attorney General and state securities regulator on December 21, it made the following points:

“Here, the [bankruptcy] estate, creditors, and society writ large would benefit from the investigation of a neutral, third-party, as the U.S. Trustee’s motion argues. As part of the broader societal interest, state and federal government regulators would benefit from a neutral fact-finder’s investigation, which would enable them to learn from a disinterested source what happened and how it happened under the current regulatory framework (or lack thereof to address this particular industry). These answers are necessary so that government regulators can put into place an effective regulatory framework to ensure that something like this — a colossal fraud costing billions of dollars in economic waste — never happens again.”

The U.S. Trustee has another pesky detail on its side: the appointment of an examiner is mandatory under U.S. Bankruptcy Code Section 1104 if requested by the U.S. Trustee and the debtor meets the statutory debt threshold of $5 million or greater. (FTX and its more than 100 affiliated companies owe billions of dollars in debts to investors and customers.)

In the latest court filing yesterday by the U.S. Trustee, it explains that every U.S. District Court to publish a decision on this issue has agreed that the appointment of an independent examiner is mandatory under the terms of Section 1104 of the U.S. Bankruptcy Code. The only Court of Appeals to issue a published opinion, the Sixth Circuit, has taken the same view.

Notwithstanding the plain language of the law and legal precedent, Judge Dorsey previously stated in open court during a hearing that he doesn’t believe the appointment of an independent examiner is mandatory. Bench rulings (an unpublished ruling by a Judge which carries no weight in terms of legal precedent) in the Delaware bankruptcy district have also taken the position that the appointment of an independent examiner is not mandatory. (This might explain why Sullivan & Cromwell law partners are arguing their case in U.S. Bankruptcy Court in Delaware instead of in Manhattan where their office is located.)

Damian Williams, the U.S. Attorney for the Southern District of New York, whose office is prosecuting the criminal case against former FTX CEO Sam Bankman-Fried (who has pled not guilty) and two other executives, Caroline Ellison and Gary Wang (who have pled guilty and are cooperating with prosecutors) has called the FTX collapse “one of the biggest financial frauds in American history.” The new CEO of FTX, John Ray, testified to the House Financial Services Committee on December 13 that $8 billion of customer funds are missing.

On the basis of those facts alone, one would think that Judge Dorsey would be anxious to comply with the Justice Department’s U.S. Trustee and quickly agree to the appointment of an independent examiner. Instead, and despite the fact that Sullivan & Cromwell has filed multiple declarations revealing raging conflicts of interest in the case, Judge Dorsey has ignored multiple objectors and signed an order allowing the law firm to become the lead counsel in the bankruptcy proceedings – which effectively puts the firm in charge of investigating its own conduct.

In a filing with the bankruptcy court, an FTX customer, Warren Winter, described the situation as the fox guarding the henhouse, writing:

“Sullivan & Cromwell was one of the FTX Group’s ‘primary external law firms’ before the FTX Group collapsed. To date, the FTX Group has paid the firm more than $20.5 million in fees and retainers. Now, in the most flagrant attempt by a fox to guard a henhouse in recent memory, Sullivan & Cromwell has applied to be appointed the FTX Group’s bankruptcy counsel with duties that would include ‘investigating all potential estate causes of action’….”

Sullivan & Cromwell belatedly owned up in court filings to personally representing Sam Bankman-Fried – the man charged under an 8-count indictment by the Department of Justice with being the kingpin of this alleged international crypto fraud enterprise.

On January 17, Sullivan & Cromwell law partner, Andrew Dietderich, filed a document with the bankruptcy court acknowledging that the law firm had not only done extensive legal work for FTX but personally represented Sam Bankman-Fried from April 14, 2022 through August 5, 2022. The disclosure noted that “This matter was arranged, and paid for, by Alameda,” a reference to Alameda Research, Bankman-Fried’s hedge fund which prosecutors have alleged he used to loot FTX customer funds. The specific nature of the work Sullivan & Cromwell did for Bankman-Fried involved “a position that had been established in the stock of Robinhood Markets, Inc.” according to the Dietderich declaration. That stock position totaled more than half a billion dollars. According to a letter from federal prosecutors recently filed in the criminal case, a foreign special purpose vehicle was set up in the Robinhood stock matter, to “obscure his criminal misuse of FTX customer property.” The independent examiner would certainly want to know what lawyer and/or law firm created that offshore vehicle.

Sullivan & Cromwell has also conceded that it did legal work on a multitude of transactions and regulatory matters for FTX and had collected legal fees and expenses of $8,564,487.50 from FTX and its affiliates over the prior 16 months, plus a $12 million retainer for bankruptcy work.

State attorneys general and state securities regulators representing more than a third of the population of the United States are going to be watching carefully to see what Judge Dorsey has to say at the hearing on Monday.