Thanks for sharing this. I think a good bit of this depends on further factual development—mainly figuring out when FTX became insolvent. If everything was OK at FTX when a transfer was made, I don’t think the grantee has any ethical obligations because FTX ran aground later.
From a rule utilitarian approach, it is rather undesirable for insolvent debtors to be allowed to preference their preferred charities over their legitimate creditors. Credit and insolvency are significant parts of modern economic life, and honoring the reasonable expectations of creditors is an important part of growing the economic pie for everyone. Creditors come in all shapes—from the employee who has performed work but hasn’t been paid yet, to the supplier whose invoice you haven’t paid yet, to someone who got burned when the toaster you manufactured blew up due to a manufacturing defect. To the extent a business or individual can get away with just dumping money to a charity at the cost of their creditors, it is going to be a lot harder for businesses and individuals to access credit (which is an oil that makes the economic system run). That is an undesirable state for everyone (including charities which are dependent on corporate donations).
To give two simpler examples:
John’s restaurant is not doing well and will likely have to liquidate sooner or later. John would prefer that money end up in the pockets of his church rather than in the pockets of his lender, his suppliers, and his employees. So he decides to have his business keep making—or even increase—donations to his church rather than manage his business cashflow in a way that honors his commitment to his lender, his suppliers, and his employees as best his restaurant can with its assets.
Jane is driving negligently and inflicts disabiling injuries on a law firm partner. Like most people, Jane doesn’t carry enough insurance to cover decades of lost wages for . . . anyone, much less a law firm partner. Jane decides that she would rather her assets end up in the pockets of her alma mater (whose football team she absolutely adores) rather than the person she ran over.
Unfortunately, I don’t think there is any way to effectively prevent creditor-screwing charitable transfers other than a system of clawback liability. Experience teaches us that requiring proof of an actual intent to defraud creditors allows a lot of problematic transfers to stand. The corporate executives should have known that the corporation was insolvent—and making charitable donations while insolvent is itself a problematic behavior even if there is no affirmative intent to defraud (as it may prove to have been the creditors’ money the executive was handing out). Thus, applying the clawback rule to generally all corporations that were insolvent at the time of charitable transfer makes sense.
The bankrupt corporation is dead—it will either be carved up (liquidation) or sold as a going concern for the benefit of the creditors (reorganization). If you saddle the reorganized corporation with liability for the old corporation’s misdeeds, you merely reduce the amount the reorganized corporation can be sold for by that amount (which defeats the purpose of selling it). So “punish FTX for making inappropriate charitable transfers” is not a viable option.
You could argue for a system of personally punishing the corporate officials who approved the charitable transfers while the corporation was insolvent . . . but everyone is worse off under that scenario (corporate officials will be too conservative if they fear facing personal liability for erroneous corporate decisions, meaning they will err strongly on the side of never approving charitable transfers).
Since neither of these options is viable, I don’t see any other way to sufficiently discourage these kinds of transfers other than clawing them back from the charities.
Thanks, this is a really great summary of the principles.
I definitely agree that it will depend on further factual development. But I think the facts that are out imply that the insolvency period could go back a very long way. It sounds like the user deposits was intermingled with FTX and Alameda operating capital from the very beginning, and the accounting practices were such that they wouldn’t necessarily have known their overall position.
Do you happen to know whether the bankruptcy court just looks at when the executives knew (or negligently failed to find out) that the company was insolvent? It seems kind of weird to expect the court to decide the true value of all the assets at each point in time.
The most relevant statutory text is 11 USC 548(a)(1)(B)(ii), which requires that one of four financial criteria be met for a constructive fraudulent conveyance—one of which is that the debor “was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation.” That does not seem to require knowledge/negligence on the part of the executives.
I would argue that making corporate charitable contributions when you have any reasonable doubt about whether the company is solvent is itself irresponsible behavior. So I’m not that worried about possibly sweeping in a few cases in which the executives non-negligently believed the corporation was solvent. As a general rule, I don’t think most pre-bankrupt corporations are rapidly fluctuating between solvency and insolvency, so I don’t think the Code’s directive to look at the date of transfer/obligation is that burdensome to bankruptcy courts.
Also, I was using “insolvent” as the primary example of circumstances in which it is utility- maximizing to have a rule to discourage and clawback transfers. I think the other three financial criteria in 548(a)(1)(B)(ii) meet that description too. As relevant here, to the extent that FTX was misappropriating customer funds that did not belong to it, it arguably also meets the criteria that it was “engaged in business or a transaction . . . for which any property remaining with the debtor was an unreasonably small capital.”
Thanks! It really should have occurred to me to just look this up and read the statute, it definitely makes things a lot clearer.
I’ll be interested to see what value gets ascribed to the various cryptocurrency assets.
Let’s say I’m running some business and it’s maybe going under. On behalf of the business, I create 101 finger paintings, sell one to my friend’s uncle’s golf buddy for $10,000, and book the rest as $1m in fine art assets. With my balance sheet shored up, I go on trading, but eventually things don’t work out and I file for Chapter 11.
Does the court have to accept the value I put on the paintings at the time, and regard me as solvent for that period? After all, sure, eventually it turned out I couldn’t sell the paintings. But that could just be because by then my name was in the news and that tanked the market for my art.
Nope. See 11 USC 101(32) for a statutory definition of insolvency—a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation . . . .” (emphasis mine).
Thanks for sharing this. I think a good bit of this depends on further factual development—mainly figuring out when FTX became insolvent. If everything was OK at FTX when a transfer was made, I don’t think the grantee has any ethical obligations because FTX ran aground later.
From a rule utilitarian approach, it is rather undesirable for insolvent debtors to be allowed to preference their preferred charities over their legitimate creditors. Credit and insolvency are significant parts of modern economic life, and honoring the reasonable expectations of creditors is an important part of growing the economic pie for everyone. Creditors come in all shapes—from the employee who has performed work but hasn’t been paid yet, to the supplier whose invoice you haven’t paid yet, to someone who got burned when the toaster you manufactured blew up due to a manufacturing defect. To the extent a business or individual can get away with just dumping money to a charity at the cost of their creditors, it is going to be a lot harder for businesses and individuals to access credit (which is an oil that makes the economic system run). That is an undesirable state for everyone (including charities which are dependent on corporate donations).
To give two simpler examples:
John’s restaurant is not doing well and will likely have to liquidate sooner or later. John would prefer that money end up in the pockets of his church rather than in the pockets of his lender, his suppliers, and his employees. So he decides to have his business keep making—or even increase—donations to his church rather than manage his business cashflow in a way that honors his commitment to his lender, his suppliers, and his employees as best his restaurant can with its assets.
Jane is driving negligently and inflicts disabiling injuries on a law firm partner. Like most people, Jane doesn’t carry enough insurance to cover decades of lost wages for . . . anyone, much less a law firm partner. Jane decides that she would rather her assets end up in the pockets of her alma mater (whose football team she absolutely adores) rather than the person she ran over.
Unfortunately, I don’t think there is any way to effectively prevent creditor-screwing charitable transfers other than a system of clawback liability. Experience teaches us that requiring proof of an actual intent to defraud creditors allows a lot of problematic transfers to stand. The corporate executives should have known that the corporation was insolvent—and making charitable donations while insolvent is itself a problematic behavior even if there is no affirmative intent to defraud (as it may prove to have been the creditors’ money the executive was handing out). Thus, applying the clawback rule to generally all corporations that were insolvent at the time of charitable transfer makes sense.
The bankrupt corporation is dead—it will either be carved up (liquidation) or sold as a going concern for the benefit of the creditors (reorganization). If you saddle the reorganized corporation with liability for the old corporation’s misdeeds, you merely reduce the amount the reorganized corporation can be sold for by that amount (which defeats the purpose of selling it). So “punish FTX for making inappropriate charitable transfers” is not a viable option.
You could argue for a system of personally punishing the corporate officials who approved the charitable transfers while the corporation was insolvent . . . but everyone is worse off under that scenario (corporate officials will be too conservative if they fear facing personal liability for erroneous corporate decisions, meaning they will err strongly on the side of never approving charitable transfers).
Since neither of these options is viable, I don’t see any other way to sufficiently discourage these kinds of transfers other than clawing them back from the charities.
Thanks, this is a really great summary of the principles.
I definitely agree that it will depend on further factual development. But I think the facts that are out imply that the insolvency period could go back a very long way. It sounds like the user deposits was intermingled with FTX and Alameda operating capital from the very beginning, and the accounting practices were such that they wouldn’t necessarily have known their overall position.
Do you happen to know whether the bankruptcy court just looks at when the executives knew (or negligently failed to find out) that the company was insolvent? It seems kind of weird to expect the court to decide the true value of all the assets at each point in time.
The most relevant statutory text is 11 USC 548(a)(1)(B)(ii), which requires that one of four financial criteria be met for a constructive fraudulent conveyance—one of which is that the debor “was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation.” That does not seem to require knowledge/negligence on the part of the executives.
I would argue that making corporate charitable contributions when you have any reasonable doubt about whether the company is solvent is itself irresponsible behavior. So I’m not that worried about possibly sweeping in a few cases in which the executives non-negligently believed the corporation was solvent. As a general rule, I don’t think most pre-bankrupt corporations are rapidly fluctuating between solvency and insolvency, so I don’t think the Code’s directive to look at the date of transfer/obligation is that burdensome to bankruptcy courts.
Also, I was using “insolvent” as the primary example of circumstances in which it is utility- maximizing to have a rule to discourage and clawback transfers. I think the other three financial criteria in 548(a)(1)(B)(ii) meet that description too. As relevant here, to the extent that FTX was misappropriating customer funds that did not belong to it, it arguably also meets the criteria that it was “engaged in business or a transaction . . . for which any property remaining with the debtor was an unreasonably small capital.”
Thanks! It really should have occurred to me to just look this up and read the statute, it definitely makes things a lot clearer.
I’ll be interested to see what value gets ascribed to the various cryptocurrency assets.
Let’s say I’m running some business and it’s maybe going under. On behalf of the business, I create 101 finger paintings, sell one to my friend’s uncle’s golf buddy for $10,000, and book the rest as $1m in fine art assets. With my balance sheet shored up, I go on trading, but eventually things don’t work out and I file for Chapter 11.
Does the court have to accept the value I put on the paintings at the time, and regard me as solvent for that period? After all, sure, eventually it turned out I couldn’t sell the paintings. But that could just be because by then my name was in the news and that tanked the market for my art.
Nope. See 11 USC 101(32) for a statutory definition of insolvency—a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation . . . .” (emphasis mine).