On Background: A History of Bankruptcy in the US

than a month after taking control of FTX. The FTX group's collapse appears to stem from absolute concentration of control in the hands of a small group of grossly inexperienced, unsophisticated individuals who failed to implement virtually any of the systems or controls that are necessary for a company and trusted with other people's money year assets. Raise the guy who oversaw the liquidation of big companies such as Enron and Nortel. The shady throws on Sam Bankman Freed is

like a cloud of ash from Mount Vesuvius. Bankruptcies can be placed in the same legal category as divorces. They let the world know that something has gone really wrong, and the proceedings rarely leave anyone happy, except maybe for the lawyers who get paid no matter what. Also, it can be hard to figure out what actually went wrong. Everyone has a different version of events when it comes to the bankruptcy of FTX and bankruptcy in general. There's a lot I need to learn, So welcome to on

background from Against the Rules. I'm Michael Lewis. I've had a front row seat to the meltdown at FTX, and my next book will be all about that. In this series, I get to take you along as I interview scholars and other journalists for background context I need. Today we're going deep into the bankruptcy system in the United States. How did it come about, how does it work now? Who's harmed really when a company declares bankruptcy and who benefits?

And why are people now calling for changes to the system. To answer these questions, I turned to David Skale. He's a corporate law professor at the University of Pennsylvania and an expert on bankruptcy law in the United States. The first thing I wanted to know was why and when did he get so interested in bankruptcy. I went to law school, thinking about literature, never dreaming I would have an interest in business law at all. But I've fallen in love with it. And there were two reasons that

I fell in love with it. One was I had never realized just how important bankruptcy is to American history. If you look back over the nineteenth century and ask the question, what were the most important shoes in American life in the nineteenth century, not just for a few years, but for the whole century. Obviously you would say slavery was number one, but bankruptcy might have been number two.

Defend that there was a pitched battle over whether to have a federal bankruptcy law for a century, and pretty much every major figure in American politics came out on one side or the other side of the pro or anti bankruptcy divide. So, starting in the beginning, Alexander Hamilton was the leading pro bankruptcy person. His view was, if America was to be a commercial nation, we needed a bankruptcy system to make sure that creditors got treated fairly

if debtors defaulted. Thomas Jefferson was vehemently anti bankruptcy. His view was bankruptcy would just be away for Northeastern creditors to take advantage of a bad farm year or a blip that caused somebody to go into debt and kick them off their farm or off off their homestead, and so all through the nineteenth century there was this fierce battle about whether to have a federal bankruptcy law or not, and it wasn't until the end of this century that

we got a permanent law. Back up A second, for me, in Jefferson's mind, what would happen in place of bankruptcy, Like if I was effectively bankruptcy, if I was, you know, had no money in lots of debts, what did he think should happen? Then? Well, there were there were state procedures, but they were quite limited, so a state procedure would not have effect across state lines. But I think the thinking would have been that if a debt or defaults,

it'll be a messier process. There is room to take care of people locally, even if that's at the expense of northeastern creditors. One of the big complaints about the absence of a federal bankruptcy law throughout the nineteenth century is there was a kind of home court advantage that the debtor and people close to the debtor had and so it'd be a little bit more likely that your brother got repaid than a department store in the northeast. And the and the Hamilton argument is with a bankruptcy

law in place, credit might flow actually more freely. Oh, no question, Distant creditors would know that they were protected by the law. That's exactly right. And there were two kinds of concerns that creditors had. One is that they wouldn't be protected, and that local credit creditors would be protected more. And there were people in the legislative debates

in the nineteenth century who defended that. They said, as a moral matter, you should repay your your brother or your neighbor before you you repay some out of town creditors. So there was a concern about even handedness. There also was a concern that debtors would just abscond, that if you're a debtor here in Pennsylvania you run into financial trouble,

that you'll go west. And in fact, if you look at the court records in the nineteenth century, you will sometimes see in a Northeastern state like Pennsylvania or a Delaware on a file, you'll see the letters g T T, which stands for Gone to Texas. And one of the virtues of a federal bankruptcy law is it can reach people nationwide, so it's not people cannot escape by moving to another state. So creditors wanted there to be a

fair distribution of the debtor's assets. They wanted to limit debtor's abilities to abscond when they defaulted, and they thought a bankruptcy system was the way to do it. So you become enamored of bankruptcy law because you see bankruptcy laws sits right in the middle of American history. That

was the first reason. And then the other reason I became enamored of it is it's about meat individuals and institutions in a period of distress, and if this system works well, they can end up in a better place. And I found that cool forty years ago, thirty five years ago. I still find it cool today. It's about people whose lives and institutions better in a shambles and trying to put them in a better place. And I've

got a big defender of the American bankruptcy system. Maybe too much of a defender, but I really think it's a great system. So theres a controversy argument through the thirties that leads to changes in the bankruptcy laws. They kind of echo something that I'm dealing with now, and I want you to talk about that a little bit, like what are the tensions that build up in the

system that lead to it having to change. What really drove the populist side of the nineteen thirties was the large scale corporate side of things, the big corporations, and so that was evolving on a separate track. So I've been talking about the federal bankruptcy law didn't or wasn't used by large corporations. With large corporations, the way things evolved was the first large corporations were railroads. Railroads were privately run in this country, as you know, unlike in

many countries. There was a gold rush to control important railroad lines, a lot of mergers and cobbling things together, sort of like the telecom boom of the early two thousands and before then. And whenever we had an economic crisis, a lot of the railroads would fail. And when they failed, it created a very odd dilemma, which is everybody thought that we needed the railroads. They needed to be reorganized.

They needed to be kept in place on the one hand, but it wasn't clear that there was a legal basis for doing that. It wasn't clear Congress could step in and put a railroad reorganization statute in place. And the reason for this was there was bankruptcy clause in the Constitution, but in the nineteenth century a lot of people didn't think that applied to corporations. They thought corporations are governed by the states. They're not governed by Congress. Bankruptcy clause

must not have corporations in mind. That argument eventually lost, but it was a very serious argument for a long time. What ended up happening was Wall Street lawyers and Wall Street bankers cobbled up this incredibly ingenious use of ordinary foreclosure law and turned it into a way to restructure large corporations. And what they did was when a railroad defaulted, some of the bondholders would ask the court to foreclose

on their bonds, which had mortgages on railroad property. They were secured by mortgages, so the bond holders would ask the court to start a foreclosure proceeding. But they would say, but court don't have the sale now we'll tell you when we're ready for the sale. And then the Wall Street bankers would form committees of the bonds of the stocks that they had underwritten. They would negotiate with one another and with the debtor. They would work out the

terms of the reorganization. They would then form one big committee called the reorganization Committee. Then they'd go back to the court and they'd say Court, we're ready for our foreclosure sale now. And there would be exactly one bidder at the foreclosure sale, which would be the reorganization committee, and it would bid all of the old stock, all of the old bonds, plus a little bit of cash to pay off the people who couldn't be persuaded to

go along. So it was this incredibly ingenious distortion of ordinary foreclosure law that was turned into a reorganization framework. So it was this kind of informal reorganized strategy which was called railroad receivership or equity receivership, and it was used for decades with no statute at all until the nineteen thirties, and then it finally got codified in the nineteen thirties. In the early nineteen thirties and about the time it was getting codified. The New Deal reformers said,

wait a second, this is outrageous. These Wall Street banks and lawyers are ripping everybody off. And that's what led to the big overhaul in nineteen thirty eight. And what happens in that they essentially destroy the Wall Street practice. So what the nineteen thirty eight law did was called

the Chandler Act of nineteen thirty eight. Is it said, if you are a bank or if you are a law firm that represented the debtor before they filed for bankruptcy, you can't have anything to do with them in bankruptcy. Which makes the old railroad receivership process impossible because it was based on the original bankers who'd underwritten the stock were bonds in the Wall Street lawyers being the same people who would work things out after default. But they

were kicked out of the process. And then finally in nineteen seventy eight, Congress overhauled the bankruptcy laws again and we essentially went back to the old practice where the managers of the company are not kicked out when it files for bankruptcy. They continue running the company. The fact that you were a banker or a lawyer for the company before bankruptcy does not preclude you from representing it. Interestingly, there's a little FTX angle there. There was a bit

of a firestorm about let's let's wait on that. Let's wait on that. We'll be right back. I'm back with bankruptcy expert David Skale. So I want to turn you to my purposes now. I want to talk about it now. I want to talk about FTX, and I want to walk you through just like some specific questions I have as I've watched, because i've I've watched kind of watched

it unfold. I was there the day that Sam Bankman Freed signed the bankruptcy papers, and he was He says it, you know, he said this publicly that he's the worst thing he ever did and he shouldn't have done it, and he only did it because the internal council was yelling at him. Everybody's yelling at him. He so he signs these things at four in the morning and five minutes later changes his mind and says he wished he wants it back, and they say it's too late, you

can't You've already signed them. So first question is, so you basically understand, you have a sense of what FTX was as a business, It was a it was a cryptocurrency exchange. They were a hundred and something different entities that had you know, exchange in Japan and exchange in Turkey. It had an exchange in the United States, but the bulk of the business was in the Bahamas. And he's in the Bahamas and most of the important employees are

in the Bahamas. What would happen if he doesn't sign it, Like he's being asked to declare bankruptcy in the United States, even though the vast majority of what he's doing is outside of the United States, and the vast majority of what he's doing is even illegal for Americans to participate in. If he doesn't sign, what would have happened? Probably what happens is FDx gets thrown into bankruptcy in the US, not in the Bahamas. Well though it's there's got to

be a proceeding in the Bahamas as well. I believe the Bahamas liquidators initiated that themselves. That's true. That's true, So that probably why what would how would it have gotten thrown into bankruptcy in the United States? As a as a technical matter, it is very easy to put a company into bankruptcy. All it takes is you have to have three creditors that sign the petition, and they have to have roughly nineteen thousand dollars in general obligations

general unsecured claim so you could take three customers. The American creditors were such a trivial part of the business, they could easily have just paid them off. Presumbly, these would have to have been American creditors in the United States. No, not necessarily. What they need is an American presence, and FTX did have an American presence, so they would not need to be American creditors. He couldn't pay off enough people to stop it, I don't think, I mean it is.

It's a little trickier with something like FTX because they don't have a lot of the ordinary creditors, you know, the big bank lenders who are sophisticated working together and

would plot something like this out. I mean, there might have been that there were not three creditors who were ready to file a petition right away, but there would have been a petition almost certainly filed in the US because typically, if you have a choice, you probably want to have a US proceeding because people like the US bankruptcy system. He didn't have the power to control where

he went bankrupt. He could have conditioned his willingness to sign on it being filed in a particular play, so he would have had power in that sense within the United States. But he couldn't have said, I'm bankrupt in the Bahamas, and the Bahamas is going to deal with my case, and the assets are here and everybody else. You can screw yourself. He can say that, but the

world doesn't have to listen to him. I think there was a concern that I've heard about that he was moving assets away and the longer it took to get into bankruptcy, the more risk there was that assets would be gone by the time they got into bankruptcy. Or so let me let me let me ask you this, then, what are the checks on the insiders who are now controlling the bankruptcy process from just bleeding the firm for fees rather than getting the assets back to the owners.

Are there are a handful of checks of varying degrees of effectiveness. So there is a watchdog. There's an entity called the US trustee. Ah, Okay, who is that person? Like where did that role come from and what powers do they have. It's an arm of the Justice Department, and they were put in places as a watchdog. They were created in nineteen seventy eight when the when the current bankruptcy laws went into plays kind of as a

replacement for the Securities and Exchange Commission. Before nineteen seventy eight, the Security is an exchange Commission played a major role in large bankruptcies. They were kind of kicked out in nineteen seventy eight. In the US Trustee is to some extent their replacement. So they're a government entity. They're a watchdog. One of the things they do look at is fees

and conflicts of interest in things of that sort. One of the problems in one of the reasons why the US Trustees is needed is the most obvious check on attorneys or financial advisors churning, you know, wasting money, would be other attorneys and financial advisors, because they can see it, they understand it. But because all of these folks are repeat players and they're all part of the same inside group of attorneys and financial advisors, they don't have an

incentive to be a check on each other. So it does require somebody else. And so the US Trustee is one check. Let me stop you in one second. There does the Department of Justice have any recourse? They really don't. They really don't, don't. All right, There isn't a real check. There's a person who can kind of do journalism, and the judge can read the journalism and decide whether he's going to believe it or not. Those are your word's not mine. But but there are limits to the check.

And I will, kind of consistent with what you're saying, say that the US Trustee is often seen as a gad fly, you know, kind of a past that that we insiders need to have to put up with. Not always, It really depends on who the US Trustee is. But

it's not a complete check. And the other check that's emerged in recent years is in a lot of cases there are fee examiners, So there is somebody who's brought in to look at the fees and to raise questions about the fees and to challenge the fees where they're problematic. I don't know if there's a fee examiner and FTX. I would think there probably will be one if there's

if there's not, but that that's another check. But you know your follow up question will be at the end of the day, how much of a check is this? And you know my answer would be it's not a huge check. You know there there is a potential issue issue there. I I think by and large, the professionals do a good job and they don't tend to just drag out a case to drag it out, but there there is opportunity to run up fees. There's there's no

denying that. What kind of person becomes a bankruptcy judge, it's usually a bankruptcy lawyer that becomes a bankruptcy judge. So it's someone who's pretty sympathetic to the fees that bankruptcy lawyers get paid. It's somebody who tends to be pretty sympathetic to the system. If I'm gonna have you moneyball bankruptcy judges, all right, and and and figure out who the good wines are, who the bad ones are, what trade? What would you look for? One thing I

would look for is thick skin. Some some bankruptcy judges take things a little bit too personally in my views, So thick skin is a nice quality. Another good quality is not being in a rush to pass judgment on whatever the issue is. A lot of bankruptcy judges put a premium on encouraging the parties to settle, you know, I think sometimes there can be a little too much

of that. The judge is at an informational disadvantage. There's a huge amount of information floating around, but the judge doesn't know as much as the insiders do about what's going on in a case, and so they really have to have kind of a sixth sense or a nose for problems because most of bankruptcy judge is power is veto power or power to say no. The bankruptcy judge doesn't make the deal. The bankruptcy judge doesn't decide what the terms of the restructuring are. The bankruptcy judge either

approves it or doesn't approve it. So they have to really know when to call bs essentially, and that's hard because it's a it's a system that's run by insiders. They're incredibly sophisticated, they're incredibly smart, and they are very good at putting the judge in a position where the judge feels like they don't have any choice. Companies come

to bankruptcy, they're out of cash. Their lender says, you've got to sell the assets to this buyer right now, or the company is going to go up in smokes. And the judge has to make a decision do I call their bluff or do I just say okay? And it's really hard because if you call their bluff and it turns out it's not just a bluff, there can be you know, a lot of a lot of value destroyed and a lot of lives made worse, and so

it's very tough. After a quick break, David Skeel and I get into what may turn out to be one of the harriest hair balls in the FTX bankruptcy proceedings, all those generous donations that Sam Bankman Freed made the charity. I'm back with David Skeel on background. There's one other

big subject I'm really curious about now. I'm sure it's going to change, and I want to bother you again later, but clawbacks so FTX is not just in bankruptcy, but it's in bankruptcy, and the people who ran being charged with fraud, and anybody who received money from this place, employees, people who did sponsorship deals with them, people who receive philanthropic dollars from them. People who got investment returns from them are now facing the possibility they're gonna have to

give the money back into the bankruptcy. And some of these amounts are quite astonishing. Like Sam Bankmanfrey wrote a check for a couple of billion dollars to buy out his rival and competitor eighteen months ago, And the question is what right does the bankruptcy have to claw money back that went out? Like is there a lot of pressing it for this? Sam Bankmanfrey gave me a million dollars a year ago or six months ago to cure cancer.

And I'm just I'm just a cancer researcher. And now they come knock on my door and they say they want the million dollars back. What's the likeli to I have to give it back? It's it's really high. It's the likely is it really? I didn't know that it is the claws? But if I spent it on cancer research, then you've got a problem. Assuming that we can link it to FTX, then the clawback stuff goes into motion.

If somehow he gave money that was truly his money, that wasn't FTX money, then he's not in bankruptcy at this point at least, and so the clawb X wouldn't apply. But to the extent it's commingled and it's it's FTX money, there is a very high risk that this has to come back, and the way it comes back is as what's called a fraudulent conveyance. And there there are two

ways that transfer can be a of fraudulent conveyance. One is if Sam bankman fried and FTX was was trying to stiff creditors, you know, wanted to give it to the cancer researcher because he just really didn't like his creditors, thought there were a bunch of jerks. That would be actual fraud. The other form of fraudulent conveyance is what's called constructive fraud or constructive fraudulent conveyance, and you have

to show two things. One is that the dator FTX was insolvent at the time or nearly insolvent at the time, and the second is that the transfer was made for less than reasonably equivalent value. So if you're transferring money to a cancer research or you're not getting anything for it, so there's there's no value being received, but if I

came in as a plumber and fixed your plumbing. That would be different if you were paying me for some service that I provided, right, you know, assuming that that I paid you the dat are paid the reasonable value for the service, not five times what the service is. What. Yes, that would be fine. You can do new transactions. What you can't do is sell assets for less than their worth within two years before bankruptcy or give assets away.

And charitable contributions look like giving assets away. And what a lot of folks seem to have done, or at least some folks seem to have done with Sam Bankman freed contributions has treated them like hot potatoes. You know, when there were problems, they thought, oh my, they might come after me, and some people, like politicians I think, turned around and gave the money to some other charity.

But that doesn't solve their problem. It doesn't solve the problem at all, and it makes it worse in a way because you don't have the money and you still have to give it back. Right, Sam bankmfree was handing out money left and right. To believe, the most open handed person in our hemisphere, and everybody on the receiving end was so grateful, and they were so happy they were getting all this money, and now they've got the

biggest headache of their lives. Oh, it's really true. And one of the big legal ethical dilemmas of the case I think is gonna be do you go after everybody you know? Do you go after the little people? The people that you know? Somebody they got twenty five thousand dollars, that's that's a lot of money for them, but not much money for the customers and other creditors of FTX. They're gonna be some real difficult decisions I think about who to go after and who not to go after.

But the norm is that you go after everybody. If just hypothetically, if he had paid me to write his biography, and like say, he paid me a fortune to write his biography and I was still writing the biography, would they come after me or would they wait to see if the biography was worth it? I mean, they might go after you even if if the biography is going to make millions of dollars. I am so glad this

isn't an authorized biography. I mean, it's just what a terrible I mean, he's he's affected precisely all the things he cares about most because that's where the money went. I think that's right. I mean, everybody that he was kind of trying to help and do good things, as

you said, they now have a very big problem. He said something earlier that was interesting to me that you have to show not only that you didn't get value for it or equivalent value, but you have to show that when the money changed hands, the enterprise was insolvent. So you need to identify the moment of insolvency. That's the big sticking point with fraudulent conveyance actions. There are two or three different things that you can show, each of which is related to insolvency, and it can be

very very difficult to show. So that will be a big issue. That's going to be that's going to be where the arguments happen. So I have one more twist for you on the fraudulent conveyance stuff, which I don't think is going to change that answer. But the one more interesting quirk of fraudulent conveyance is if you are running a Ponzi scheme, you know, like the made Off Ponzi scheme, there is a presumption that any money you transferred was actual fraud. Now pretty unfathomable that a court

would conclude FTX was a Ponzi scheme. You know, it's not a true Ponzi scheme. But if somehow they did, all of these transfers might be actual fraud rather than constructive frauds, so that you wouldn't even have to show the insolvency. It won't happen, I don't think but yeah don't. Yeah, I don't. I don't think so either, because it was actually a legitimate, profitable business on its own. All right,

this was really interesting, David, Thank you so much. You are quite welcome, Take care, take care of by bye. Let's end to day by answering our question from one of our listeners, or maybe more than one, Caleb. Caleb asks, Hi, Michael, can you let us know what podcast you're listening to right now and the best books you read in two thousand twenty two? Thank you, Cale, Thanks for being so polite. You know, I'm right now in a funny creative place.

I've just handed in a screenplay for a TV show, a pilot for a TV show, and I've just, at the same time I started writing a book, and I'm writing, writing, writing, and when I really start writing, I tend not to read or listen to anything, and it's just like I'm bored with everything. But what I'm working on board's wrong word that I'm annoyed by it. I don't want to be distracted by it. So I'm not really listening to any podcasts right now. The solve I'm gonna change your

question a little bit. What's the last podcast that just absolutely riveted me? And I was a little late to it, but there was a podcast called The Just Enough Family by Ariel Levy or Levy, I don't know how you pronounce her last name, but it's a nineteen eighties story about Saul Steinberg, the tycoon, the takeover person, and essentially

the aftershocks of both his rise and his fall. It's told through members of his family, and it's the most extraordinary act of reportage because what Aeron Levy does, she essentially gets the characters in this family to talk to you about their experiences and about each other. You can barely imagine them talking about themselves and each other to

their therapists. I mean, you're just like in the middle of the mess, and you know, the whole thing about all happy families are the same, and every unhappy family is different in its own way. This unhappy family has just an extraordinary way of being unhappy. And I just thought, you know. Brava A Brava. All Right. On Background is hosted by Me Michael Lewis and produced by Catherine Gerardo and Lydia Jane Cotton. Our editor is Julia Martin. Our

engineer is Sarah Brugaire. Thanks to our SVP of production Greta Cone, our show is recorded by Tofa Ruth at Berkeley Advanced Media Studios. Our music was composed by Matthias Bossy and John Evans a Stellwagon symphonette. My old friend Nick Brettel composed our theme song. On Background is a production of Pushkin Industries. Don't forget that we have a website atr podcast dot com in case you want to send me a question or a complaint or anything at all.

I'll read the questions, I won't read the complaints. That's atr podcasts dot com. Define more Pushkin Podcasts. Listen on the iHeartRadio app, Apple Podcasts, or wherever you listen to podcasts, and if you'd like to listen, add free and learn about other exclusive offerings. Don't forget the sign up for a Pushkin Plus subscription at pushkin dot Fm, Backslash Plus, or on our Apple Show pay te