TEMASEK TO RECOUP FTX LOSSES? – NOT SO FAST

When Ho Ching said Temasek can take the contrarian view, in regards to the FTX investment decision, she meant the sovereign wealth fund has a balance sheet large enough to take the risk. Indeed, writing off the US$275m was no big deal. Now news coming out of the bankruptcy proceeding in Delaware gives hope all creditors and investors may be paid off in full.

According to new CEO John Ray, the records were in total chaos. There was no proper accounting. This seems ironic because Jen Chan, the CFO, was the only one in FTX C-suite who had any direct work experience in the area of the business she oversaw.

Sam Bankmann-Fried himself produced an excel printout of a statement of assets and liabilities. Hardly any accountant can understand what SBF showed unless one has some experience with FX/crypto trading. It is not an asset-liability statement but a statement of spot positions. Basically it is a list of crypto tokens (and some fiat?) FTX holds and what’s payable. There was a massive shortfall of US$8.7b based on valuation on bankruptcy petition date.

Coindesk estimated the balances of tokens as at petition date for chapter 11 bankruptcy protection in 22 November 2022, of assets US$2.5b and liabilities of US$11.2b, showing a massive shortfall of US$8.7b. Everyone ran around with FTX being insolvent to the tune of US$8.7b. It’s the same figure being bandied about in the court hearings.

What a difference 18 months make. The talk now is FTX has more than enough assets to pay fully all creditors and in fact the investors too. Expectations are now running high that investors like Temasek will be paid off. The reason is crypto market has bounced back so current asset valuation has quadrupled. Actually it is much more than this. By now, the debtor committee has much more information on FTX’s portfolio of 416 venture investments. The asset figure now comprise token holdings and investments computed on discounted firesale valuations.

This reversal of FTX financials has brought some criticisms on the bankruptcy proceedings and the legal actions against SBF. Example Ian Ayres and John Donohue published this article “FTX Was Never Really Bankrupt” at Project-Syndicate on 26 Jan 2024. According to the duo FTX suffered a liquidity problem and was never insolvent. They added in fact, SBF is a brilliant businessman.

All those who think post petition valuation now makes FTX in a net asset position are absolutely wrong. Ian Ayres and John Donohue may be excused if they are a Tom Dick and Harry blogger. Ian Ayres is Professor of Law at Yale University and, John Donohue is Professor of Law at Stanford Law School and a research associate at the National Bureau of Economic Research. Let me explain why they, like many others, are wrong.

Of the spot token positions, based on petition valuation, FTX had assets US$2.5b and liabilities of US$11.2b. Today’s valuation the assets have quadrupled to US$10b due to crypto market appreciation. Add to this the discounted values of investments, the assets are enough to pay off all creditors and investors, or so it seems.

This view is incorrect. There are no net assets. If token assets have quadrupled, so too would the token liabilities of US$11.2b be more or less quadruple to US$44.8n (depending on its composition). FTX is as insolvent now as it was prepetition. This really makes professors Ian Ayres and John Donohue look silly.

But the debtor committee is correct that postpetition valuation should be able to pay off creditors because the system is skewed against creditors. Under US Bankruptcy Law, creditors’ claims are fixed at exchange rates on petition dates. Thus with crypto market rising, asset tokens quadrupled to US$10b, while creditors’ claims remained at prepetition US$11.2b. With asset tokens now worth US$10b + investments, debtor committee is proposing 100% payback plus interest for all creditors below US$50,000. This would take care of basically 98% of all creditors who can expect 118% payback.

This unfair valuation practice arises because crypto brokers, like FTX, do not segregate customers’ funds from proprietary funds. They are co-mingled. Crypto traders leave margin deposits and tokens with FTX. While FTX would record the credits due to customers, the cash and tokens they received have no segregated debit asset accounts. And what’s more damaging is FTX made use of these customers’ assets, such as lending to their crypto trading arm Alemada Research. In other words, they were acting like banks, lending out customers’ deposits.

For context, compare to the accounts of a law firm. In accounting for solicitors, clients' money are kept separate from the firm’s own money.

On a side note, the government’s management of investments is like FTX. It co-mingles all the funds that the Ministry of Finance handles, namely proceeds of government securities (ie loans), foreign currency reserves, fiduciary funds (from statutory boards) land sales proceeds and past reserves.

By freezing creditors’ claims at prepetition level, the market talks of a good chance of payback for investors like Temasek. But not so fast.

Distribution in a bankruptcy are made in a certain priority order. First all creditors with claims secured against specific assets will be paid from disposal of said assets, any unmet balance will fall as unsecured creditors. Second are the creditors holding debentures. These are secured against the general assets of the company. Third comes the preferred unsecured creditors. This is itself prioritised to (1) bankruptcy management cost (lawyers, advisors, consultants, manager), (2) employees, (3) government agencies, especially the IRS. Fourth comes the unsecured creditors. Fifth the holders of Preference shares. Lastly, holders of Ordinary Shares.

Debtors’ counsel Andrew Dietderich of Sullivan & Cromwell, projected that customers and general unsecured creditors would be “paid in full” but qualified that his statement should be understood “not as a guarantee, but as an objective.” The Internal Revenue Service has an estimated $24 billion in asserted tax claims, which the court noted was recently reduced to approximately $8 billion. This is pending burden of proof by IRS. The IRS tax claim is so huge it puts in serious doubt that unsecured creditors can be paid in full.

Dietderich said the full payment of creditors is contingent on the voluntary subordination of governmental claims to creditor recoveries, i.e., IRS allowing unsecured creditors priority to distribution.

The debtors’ are also working on establishing billions in tax loss carry forwards. Although not quantified, Dietderich sounded confident that even if IRS do not agree to voluntary subordination of their claims, the tax loss carry forward will reduce IRS claims substantially that will still allow for full recovery by unsecured creditors.

Whether there is any assets left for distribution to Temasek et al depends on how much is the tax claim and the tax loss carry forward allowed. Should Temasek ever make any recovery, the injustice of it all is, it is enabled largely by the assets of FTX customers. The only ones laughing all the way to the bank are the lawyers.  They have paid themselves about US$400m so far. 

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