Failed Oversight, Celebrity Endorsements and Liability for the Crumbling of the FTX Crypto Exchange

Failed Oversight, Celebrity Endorsements and Liability for the Crumbling of the FTX Crypto Exchange

On November 11, 2022, the cryptocurrency exchange FTX declared bankruptcy, and its founder and CEO, Sam Bankman-Fried, resigned his position. This followed a turbulent week which started when reports emerged abouts dubious business practices by FTX and Bankman-Fried that cast doubt on the financial stability of FTX.[1]

In the course of three days following the report, investors withdrew $6 Billion from their FTX accounts, leaving FTX unable to cover its obligations, leading to the bankruptcy of the $32 billion company. The sudden downfall of one of the world leading cryptocurrency exchanges, and the newly revealed business practices of what was considered a stable and well-capitalized company, has shaken the crypto world, and is expected to have ongoing repercussions throughout the industry.[2]

FTX, founded in 2019 by Bankman-Fried, was one of the largest digital currency exchanges in the world at the time of its collapse, with a trading volume of over $600 billion in 2022.[3]

In addition to the buying and selling of cryptocurrencies, the FTX platform allowed for highly-leveraged trades and futures contracts on the movements in the value of cryptocurrencies. Such high-risk, high-reward bets on the price of crypto is prohibited in the United States, but it attracted investors to FTX, which operates out of the Bahamas.[4]

FTX also promised investors that money deposited in FTX accounts would return an annual interest of up to 8%.[5]

FTX issued it own cryptocurrency, known as FTT tokens. Purchase of these tokens provides a trader with benefits on the FTX exchange, such as reduced trading fees and increased leverage on trades. The price of FTT increased dramatically since its launch in 2021, as FTX became a leading digital currency platform.[6]

Prior to establishing FTX, Bankman-Fried had also founded a quantitative trading firm, Alameda Research, which employed algorithms to trade in the cryptocurrency market.

The news that initiated the sudden collapse of FTX was a leaked balance sheet from Alameda, showing that a substantial portion of Alameda’s assets consisted of FTT tokens. Since FTX and Alameda are two separate companies, the report that Alameda was heavily dependent on FTX undermined belief in the independence of the companies. Further, it suggested that Alameda, which is a very important crypto trading firm, rested on a financial foundation of cryptocurrency invented by a fellow Bankman-Fried company, rather than an independent asset.[7]

This revelation undermined confidence in the financial stability of both companies, leading a rival cryptocurrency exchange, and major holder of FTT tokens, to sell their FTT holdings, triggering the mass withdrawal, and the FTX shortfall and bankruptcy.[8]

Since the bankruptcy announcement, further reports of questionable conduct emerged, including evidence that Alameda used FTX customer funds to meet its loan payments.[9] It has also been reported that the Department of Justice and the Securities and Exchange Commission are investigating whether there is evidence of misuse of customer funds.[10]

On November 15, a class-action lawsuit was filed in federal court in the Southern District of Florida, seeking damages on behalf of investors in FTX. The suit alleges that FTX maintained a deceptive platform which was “a house of cards, a Ponzi scheme where the FTX Entities shuffled customer funds between their opaque affiliated entities, using new investor funds obtained through investments in the YBAs and loans to pay interest to the old ones and to attempt to maintain the appearance of liquidity.”[11]

The suit names not only Bankman-Fried, but FTX brand ambassadors, which includes a long list of celebrities from the world of sports and entertainment. The lawsuit alleges that these ambassadors like NBA star Steph Curry and Television personality Larry David, among others, failed to perform due diligence before marketing FTX products, and “promoted, assisted in, and actively participated in” making misrepresentations about FTX, for which they should be held liable.

The plaintiff alleges on behalf of the class that FTX and the other defendants violated Florida law by selling unregistered securities.[12]

A security is a tradable financial instrument, a monetary contract between parties that has value, and that can be exchanged. Common forms of securities are stocks and bonds, but there are many types of securities.

Securities are regulated by the federal government in order to protect investors from fraud, and misrepresentations about the company they are investing in, so they may make informed judgments about their investments.

The securities regulatory infrastructure includes disclosure requirements, civil liability for material misrepresentations, prohibitions on insider trading, and a requirement to register securities with the Securities and Exchange Commission.[13]

Federal law defines “security” broadly, listing a substantial number of categories of financial instruments which qualify as a security, including an “investment contract.”[14]

While the statute does not define “investment contract,” the Supreme Court, in SEC v. Howey, held that an investment contract exists when there is 1) an investment of money 2) in a common enterprise 3) with the reasonable expectation of profits 4) derived from the efforts of another.[15]

A contract for beneficial interest or ownership in a company is an investment contract if it meets this test, and is subject to securities regulations.

According to the complaint, FTX pooled the assets deposited in FTX interest-bearing accounts to use for lending and “staking”- a crypto practice in which rewards are earned by allowing vested crypto assets to be used to facilitate the blockchain, which records cryptocurrency transactions. FTX then used the resulting revenue to cover the variable interest up to 8% interest on the accounts. The plaintiff contends that the pooling of invested assets deposited in the accounts that FTX offered to the public, in order to generate profit for the FTX and for the investors, renders the accounts as investment contracts, subject to securities regulation.[16]

Since FTX accounts were not registered as securities, the offer of the accounts to the public violates Florida’s prohibition on the sale of unregistered securities.[17]

Support for the plaintiff’s contention can be found in a prior case involving cryptocurrency. A court applying the Howey test and Florida state law found that the offer of an investment of cryptocurrency in exchange for an initial coin offering, in which investors would receive a new cryptocurrency token, constituted the sale of an unregistered security.

The court reasoned that the “common enterprise” element is aimed at “investors [that] have no desire to perform the chores necessary for a return, and are attracted to the investment solely by the prospects of a return." 

Since the defendant pooled the invested funds to generate a profit for the defendant and for the investors, the investors shared the risks and benefits of the investment, and their fortunes “were directly tied to the failure or success of the products the Defendant purported to develop.”[18]

Likewise, even prior to the collapse of FTX, the Texas State Securities Board filed a declaration in the bankruptcy proceedings of Voyager Digital, a different crypto currency exchange, in which they argued that yield-bearing accounts offered by such exchanges are offerings of unregistered securities by law. In that context, he noted that FTX” may be offering unregistered securities in the form of yield-bearing accounts… similar to the yield-bearing depository accounts offered by Voyager Digital LTD et al., and the Enforcement Division is now investigating FTX Trading, FTX US, and their principals, including Sam Bankman-Fried.”[19]

Importantly, the plaintiff seeks to hold the brand ambassador defendants liable for the same sale of unregistered security. Though they were not involved in the running of FTX or making managerial decisions, the plaintiff points to the language in the statute that extends joint and several liability for the sale of unregistered securities to any “director, officer, partner, or agent of or for the seller, if the director, officer, partner, or agent has personally participated or aided in making the sale.”[20]

The complaint contains quotes and video clips of advertisements and statements from the celebrity defendants, acting in their capacities as brand ambassadors, in which they encourage their fans to invest in FTX.

The plaintiff maintains that the statements made by brand ambassadors, broadcast on television and through the internet, make them liable as partners or agents of FTX for the losses suffered by investors.[21]

Under precedential case law in Florida, an agent has “personally participated or aided” in the sale of unregistered securities when they “actively and directly” influence or induce the investor to buy unregistered securities. The law requires some personal activity and involvement in the sale. An agent that acts “passively, derivatively, or by attribution or imputation” influences or induces a sale is not considered to have “personally participated” in the sale of unregistered securities. [22]

This suggests that the plaintiffs face a high bar to demonstrate that the celebrity defendants, most of whose participation in FTX seems to amount to brief advertisements for the company generally, should qualify as agents or partners of FTX who personally participated in the sale of unregistered securities.

The lawsuit also alleges that the defendants’ business practices, and misrepresentations about the FTX platform, ran afoul of Florida’s Deceptive and Unfair Trade Practices Act, and constituted a civil conspiracy to commit fraud.

Specifically, they contend that the FTX platform - in combination with Alameda - operated as a Ponzi scheme, shifting newly deposited investor to pay interest on existing accounts. The contention is that these practices amount to “unfair methods of competition, unconscionable acts or practices, and unfair or deceptive acts or practices in the conduct of any trade” under the Florida statute.[23]

Finally, the plaintiff charges the defendants with entering into agreements for the purpose of making misrepresentations to induce customers to invest in a fraudulent scheme by giving the false impression that the cryptocurrency assets held on the FTX Platform were safe and were not being invested in unregistered securities.[24]

Such conduct, it is alleged, constitutes civil conspiracy under Florida law, which occurs when there is (a) a conspiracy between two or more parties, (b) to do an unlawful act, (c) with an overt act in pursuance of the conspiracy, and (d) damage to plaintiff as a result of the conspiracy.[25]