Insurers Beware of “Silent Crypto” Exposure: PART I, Silent Crypto for D&O and Corporate Liability Insurance
Monday, January 9, 2023

The recent implosion of crypto firm FTX and its affiliates provides a case study for potential crypto exposure under traditional insurance policies in this series of four articles: Silent Crypto for D&O and Corporate Liability Insurance (Part I), Silent Crypto Exposure for Accountants (Part II), Silent Crypto Exposure for Lawyers (Part III), and Crime and Custody Coverage for Crypto Assets (Part IV).

Silent Crypto for D&O and Corporate Liability Insurance

The fallout from the FTX debacle highlights potential “silent crypto” exposure for insurance carriers in the evolving and largely misunderstood world of cryptocurrencies and digital assets that has duped even some of the most sophisticated investors and financial services firms.1

Many public and private companies purchase Directors and Officers and Company liability insurance coverage, also known as “D&O” and/or Management Liability Insurance. D&O policies typically provide coverage for third-party claims made against the directors and officers of a company for a Wrongful Act while acting in their official capacity as such. Wrongful Acts may broadly include any breach of duty, neglect, error, misstatement, misleading statement, omission or act by such individual. Such policies also afford coverage for third-party claims made against the company.

However, the scope of such coverage is vastly different for publicly traded companies versus private companies. In the case of a private company, coverage may extend to claims for any corporate wrongful acts or omissions. In contrast, coverage for claims against public companies are generally limited to so-called Securities Claims alleging a violation of any state, federal or foreign law regulating the purchase, sale or offer or solicitation of the purchase or sale of securities of the company.

For instance, in the case of FTX, the plaintiff alleged that he purchased an unregistered security from FTX in the form of a yield-bearing account (YBA) and funded the account with a sufficient amount of crypto-assets to earn interest on his holdings, in reliance of false and misleading representations by defendants. FTX’s former CEO, Sam Bankman-Fried (SBF), is named as a defendant in the lawsuit. If FTX purchased D&O insurance, SBF potentially would be covered with respect to any claims asserted against him in his official capacity as the CEO.

While D&O policies routinely exclude coverage for criminal or fraudulent acts or unlawful profit obtained by an insured’s wrongdoing, such exclusions may apply only in the event of a final, non-appealable adverse adjudication finding that the director or officer engaged in such acts. At a minimum, SBF likely would be entitled to advancement of his defense costs until such a finding occurred. In some instances, D&O policies also afford limited coverage for regulatory investigations of individual insureds. Thus, to the extent SBF is subpoenaed or otherwise called to testify or produce documents to the SEC, Department of Justice (DOJ) or other regulatory body, he might be covered in his capacity as a former officer of FTX.

Here, FTX is not named as a defendant in the subject class action, likely due to the automatic stay of suits filed against bankrupt debtors. However, if such stay were lifted by the bankruptcy court, FTX theoretically could seek coverage under a Management Liability Insurance (MLI) policy issued to privately held companies. Notably, MLI and other corporate liability insurance policies afford worldwide coverage. Thus, to the extent investors file legal proceedings against FTX or SBF outside of the United States, such claims may be covered. Moreover, the bankruptcy filing of the insured corporate debtor does not automatically extinguish the company’s rights under the policy.

Are Cryptocurrencies “Securities”?

With respect to D&O and Company liability insurance coverage, a key issue is whether the alleged wrongful acts occur in connection with the offer or sale of “securities.” In the case of FTX, plaintiffs allege that the YBAs were in fact unregistered securities subject to state or federal securities laws.

One hotly debated issue is whether cryptocurrencies, tokens and other digital assets constitute “securities” within the meaning of U.S. federal and state securities laws and otherwise subject to regulatory oversight and enforcement. For now, crypto markets in the United States are largely unregulated. Prior to the collapse of FTX, SBF was lobbying Congress to give primary oversight to the Commodities Futures Trading Commission (CFTC), which is considered by some in the industry to have a lighter touch than the SEC, which has more resources and has taken a more aggressive stance in pursuing enforcement actions against crypto firms. In the wake of the FTX collapse, there is an increased urgency for regulatory oversight of the crypto industry.

The battle between SEC and CFTC is now front and center. Recently, in remarks to the Senate, CFTC Chairman Rostin Behnam reiterated his support of proposed legislation that would give his agency oversight of trading in certain cryptocurrencies, including Bitcoin and Ether (ETH) in addition to other digital assets that could be classified as “commodities” within the purview of the CFTC. However, skeptics have questioned the cozy relationship between SBF and CFTC prior to the fall of FTX.

Meanwhile, earlier this year, the SEC announced that it had doubled the size of its dedicated Crypto Assets and Cyber Unit within the SEC’s Division of Enforcement. Since its creation in 2017, the SEC has brought 80 enforcement actions regulated to fraudulent and unregistered crypto asset offerings and platforms for violations of federal securities laws.

SEC Chairman Gary Gensler has been vocal in his position that most cryptocurrencies are securities under the Supreme Court’s Howey test, and the SEC should be the primary regulator for the crypto markets. According to Gensler, most crypto tokens are investment contracts under the Securities Act and under the Howey test because they involve (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits to be derived from the efforts of others. For instance, in prior enforcement actions, the SEC has taken the position that the offers and sales of tokens involve an investment of money – through USD, Bitcoin, ETH or other cryptocurrency – by investors.

These investors’ fortunes are tied to other investors in the same tokens, because if the value of the tokens increase, all investors share in that increased value on a pro rata basis. Furthermore, such investors reasonably expect to profit from their investments in the tokens based on managerial efforts and representations by the company. The SEC has found crypto firms and their management liable for violations of federal securities laws, regardless of whether such entities or crypto assets are formally registered with the SEC.

For now, even in the absence of crypto-specific legislation, crypto firms, exchanges and investors alike should assume that the SEC and other state and federal regulators will continue to rely on existing laws and regulations governing the financial markets to exercise oversight.

SEC Sues Sam Bankman-Fried

In yet another unexpected twist in the ongoing saga of FTX, on December 13, 2022, the SEC filed a Complaint against FTX co-founder and former CEO SBF in the U.S. District Court for the Southern District of New York for violations of federal securities laws.2

As noted by SEC Chairman Gary Gensler:

We allege that Sam Bankman-Fried built a house of cards on a foundation of deception while telling investors it was one of the safest building in crypto.

The alleged fraud committed by Mr. Bankman-Fried is a clarion call to cypro platforms that they need to come into compliance with our [securities] laws... To those platforms that don't comply with our securities law, the SEC's Enforcement Division is ready to take action.3

As noted in the Complaint, SBF created a complex web of more than 100 entities centered on FTX and Alameda Research. FTX Trading Ltd. is a global crypto-asset trading platform that was formed as an Antigua and Barbuda limited corporation with its principal place of business in Hong Kong and the Bahamas. Alameda Research, LLC, a crypto trading firm specializing in crypto assets, is a Delaware company that had operations in the United States, Hong Kong and the Bahamas.

According to the SEC, SBF raised $1.8 billion from investors for various classes of FTX stock through multiple fundraising rounds, including $1.1 billion invested by 90 U.S. investors. The SEC alleges that SBF defrauded FTX equity investors by concealing the company’s deceptive business activities, including:

  • Diverting FTX customer funds to Alameda

  • Providing Alameda with an unlimited line of credit funded by FTX customer deposits

  • Exempting Alameda from complying with FTX’s highly touted, sophisticated automated risk mitigation measures

  • Tying FTX’s financial exposure to Alameda’s holdings of illiquid, over-valued assets, including FTT crypto tokens issued by FTX

  • Using FTX customer funds to make undisclosed personal loans to SBF and other FTX executives.

Everything came to a head when FTX and its affiliates were forced to file for bankruptcy protection.

The SEC Complaint charges SBF with fraud in connection with the offer or sale of securities in violation of section 17(a) of the Securities Act of 1933 and section 10(b) of the Securities Exchange Act of 1934. By way of relief, the SEC seeks:

  • Injunctive relief

  • Disgorgement of ill-gotten gains

  • Civil money penalties

  • Imposition of a director and officer bar order

  • Prohibition of SBF from participating in the offer or sale of securities.

Notably, the SEC’s claims against SBF stem from the sale of more than $1 billion of FTX stock to U.S. investors – including FTX Series A preferred stock, FTX Series B preferred stock, FTX Series B-1 stock and FTX Series C stock – in connection with a series of fundraising activities by FTX and SBF between August 2019 and January 2022. The SEC Complaint does not, however, specifically address the issue of whether cryptocurrency (such as the FTT tokens) or other digital assets held in custody, sold, traded or loaned by FTX or Alameda constitute “securities” within the meaning of U.S. securities laws. However, in other cases, the SEC has made it clear that it believes many cryptocurrencies and digital assets may be viewed as securities.

Moreover, the SEC has instituted enforcement actions against crypto firms and their principals regardless of whether such securities are registered with the SEC. Here, the SEC Complaint and prayer for relief does seek to enjoin SBF from ever engaging in the “issuance, purchase, offer, or sale of any securities, including crypto asset securities.” This underscores the SEC’s long-standing belief that the agency has regulatory oversight of crypto assets. While the FTX saga continues to unfold, it is clear that SBF and others will continue to face the wrath of regulators, Congress and prosecutors.

Interestingly, on the same day, the CFTC sued SBF, FTX and Alameda for violations of the Commodity Exchange Act (CEA).4 It is the position of the CFTC that certain digital assets and virtual currencies, including Bitcoin and ETH, are “commodities” as defined by the CEA.5 According to the CFTC, defendants’ now widely publicized activities “had a significant, observable negative impact on digital commodity markets.”6 In particular, defendants’ conduct caused a “significant negative price impact on the value of commodities in interstate commerce in the United States, including Bitcoin and Ether spot and futures prices.”7

These suits filed in tandem by the SEC and CFTC against SBF and FTX merely underscore the ongoing “tug of war” between and among regulators seeking to stake out their respective roles in oversight of the crypto market ecosystem. This highlights the need for greater clarity and laws specifically addressing the nuances and complexities of this new crypto world order.


FOOTNOTES                                                                            

1 The coverage discussion set forth in this article is solely for illustrative purposes and is not intended to provide an official opinion with respect to any insurance coverage available to FTX, SBF or any other persons or entities.

SEC v. Samuel Bankman-Fried, Case No. 1:22-cv-10501 in the U.S. District Court for the Southern District of New York filed on December 13, 2022.

3 SEC Press Release 2022-219: “SEC Charges Samuel Bankman-Fried with Defrauding Investors in Crypto Assets Trading Platform FTX,” December 13, 2022.

CFTC v. Samuel Bankman-Fried, et al., Case No. 1:22-cv-10503 in the U.S. District Court for the Southern District of New York filed December 13, 2022.

5 Id., Complaint, par. 21.

6 Id., Complaint, par. 112.

7 Id., Complaint, par. 114.

 

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