One More Hurdle Jumped Over: FTX’s Recent Battle to Keep Its Bankruptcy Counsel

Once valued at $32 billion, crypto exchange FTX Trading Ltd. (“FTX”) shocked the world as it collapsed and filed for bankruptcy at the end of 2022. (Max Zahn, ABC News). An article by CoinDesk initially triggered the crypto exchange fall when it reported that FTX and Alameda Research—a crypto trading firm founded by FTX founder, Sam Bankman-Fried—shared excessively close relationships and blurred finances. (Ian Allison, CoinDesk). Following the report, concerned investors requested withdrawals from the exchange, which caused the value of FTT—FTX’s native token—to nosedive. (Dalia Ramirez, Nerd Wallet). After a bail out attempt by Binance failed, FTX filed for Chapter 11 bankruptcy.Id. As the bankruptcy proceedings unfold, FTX continues to make headlines, including as to whether the New York law firm Sullivan & Cromwell can remain as FTX’s lead bankruptcy counsel. (Nelson Wang, CoinDesk).

After Sullivan & Cromwell stated that it only worked on a “limited number of matters” for FTX in the initial disclosure, the law firm drew fire from multiple parties citing potential conflicts of interest. (Justin Wise, Bloomberg Law). A bipartisan group of four senators sent a letter to Judge John T. Dorsey, the judge overseeing FTX’s bankruptcy, requesting an independent examiner be appointed. Id. In the letter, the senators claimed Sullivan & Cromwell is not a “disinterested party” and it has "advised FTX for years leading up to its collapse." (Nelson Wang, CoinDesk).

Daniel Friedberg, FTX’s former Chief Compliance Officer, said Sullivan & Cromwell should be disqualified because its former partner, Ryne Miller ,worked as a high-ranking lawyer at FTX and was “channeling business” to the law firm. (Matthew Goldstein & David Yaffe-Bellany, New York Times). The U.S. Trustee, Andrew Vara, voiced similar concerns in a motion to the judge and stated that the law firm’s disclosure in its application to represent FTX in the bankruptcy was “wholly insufficient to evaluate whether [Sullivan & Cromwell] satisfies the Bankruptcy Code’s conflict-free and disinterestedness standards.” (Andrew R. Vara, January 13th Objection; Jack Schickler, CoinDesk). Judge Dorsey, however, overruled the objection by issuing an order approving Sullivan & Cromwell’s representation because “there’s no evidence of any conflict.” (Alexis Keenan & David Hollerith, Yahoo Finance). Judge Dorsey explained that the potential conflicts stemming from the firm’s former representation of FTX on transactional matters did not merit concern. Id.

Though Sullivan & Cromwell is able to continue as FTX’s lead counsel, the recent controversy cautions attorneys and companies of the threat of disqualification in bankruptcy proceedings, which the Bankruptcy Code and state ethics rules govern. (Practical Law Bankruptcy & Restructuring). Section 327(a) of the Bankruptcy Code requires that the professionals employed by the debtor-in-possession, including bankruptcy counsel, must not hold or represent an interest “adverse” to the estate and must be “disinterested” as defined in Section 101(14). (11 U.S.C. § 327; Ira L. Herman, Blank Rome). In the application to be retained as counsel, the professional must disclose all facts pertinent to the professional’s qualification for retention. In re Diamond Mortg. Corp. of Ill., 135 B.R. 78 (1990). The Bankruptcy Code does not define "adverse" interest, but several courts have explained that any “economic interest that tends to lessen the value of the bankruptcy estate” or “predisposition under circumstances that renders a bias against the estate” would be an interest against the estate. (Practical Law Bankruptcy & Restructuring).

Currently, courts are divided on whether potential conflicts of interest must result in disqualification. Id. The majority approach is that potential conflicts or the appearance of conflicts warrant disqualification, and the minority approach defers to the court’s discretion when dealing with potential conflicts or the appearance of conflicts. Id.

In addition to disqualification based on the Bankruptcy Code, violating state ethics rules can also lead to disqualification. (Practical Law Bankruptcy & Restructuring). Each state has different ethics rules, but most states have adopted the American Bar Association Model Rules of Professional Conduct (“Model Rules”) with minor adjustments. (American Bar Association). Specifically, Model Rule 1.7 prohibits an attorney’s representation when presented with concurrent conflicts of interest. (American Bar Association). Concurrent conflicts of interest can either arise from direct adverse conflicts between or among current clients, or arise if the attorney’s personal interests pose a significant risk of materially limiting the attorney’s representation. Id. However, the attorney can cure conflicts of interest if the attorney believes they can provide competent and diligent representation. Id.  

Chapter 11 bankruptcy is complex and involves many interlocking interests. Getting the judge to approve its choice of counsel is only one of the first steps that a debtor-in-possession must take to confirm a restructuring plan. So far, Sullivan & Cromwell has played an important role in the FTX bankruptcy process, including proposing Chapter 11 plans to company executives and recommending restructuring experts. (Matthew Goldstein & David Yaffe-Bellany, New York Times). Now, with the judge’s order supporting its lead counsel position, the firm can continue to untangle the crypto exchange bankruptcy.