...though if they have already agreed to a settlement otherwise, they would likely not.

If you've been asked to return money that you received from FTX to the bankruptcy estate, you absolutely should seek legal advice. If that legal advice suggests that you should give it back, you could consider seeking a second opinion.

(I am not a lawyer. I am not your lawyer. An org that I'm involved with was contacted in the last year by the good folks at Sullivan & Cromwell regarding a return of funds, and I thought that some of the specific things I learned in the process should be better-known in our community. I'm writing as a throwaway account because I don't feel comfortable poking Sullcrom in the eye under my name, even with the defense that it's just spreading knowledge of the law.)

1. Avoidance actions as explained by Claude 3.5 Sonnet

Here's a conversation with Claude 3.5 Sonnet. It's unabridged, except that I will move some side questions to footnotes from the main text. It has not been endorsed by my legal knowledge, because I am not a lawyer.

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In the case that company A gives a grant to organization B on October 1, 2022, and on November 11, 2022 it is discovered that company A had a huge fraud and it enters bankruptcy. Let's say that the A estate brings an avoidance action against organization B, and is successful in avoiding the transfer. Please first explain what an avoidance action is, and then explain what might happen subsequently in the case that general unsecured creditors of A become eligible for payouts in the reorganization plan.

(Claude 3.5 Sonnet answers:) I'll explain avoidance actions and then address the scenario you've described.

Avoidance action:

An avoidance action is a legal proceeding in bankruptcy law where the bankruptcy trustee or debtor-in-possession seeks to "avoid" (cancel or undo) certain transfers of property or obligations incurred by the debtor before filing for bankruptcy. The purpose is to recover assets for the benefit of the bankruptcy estate and ensure fair distribution among creditors. Common types of avoidance actions include:

1. Preferential transfers
2. Fraudulent transfers
3. Post-petition transfers
4. Statutory liens
5. Setoffs

In your scenario, the avoidance action was successful, meaning the transfer (grant) from Company A to Organization B was voided.

Subsequent events:

If general unsecured creditors of Company A become eligible for payouts in the reorganization plan, the following might occur:

1. Asset recovery: The avoided transfer (grant money) would be returned to Company A's bankruptcy estate.
2. Claim reassessment: Organization B may now be considered an unsecured creditor of Company A for the amount of the grant they had to return.
3. Pro rata distribution: The recovered funds, along with other assets of Company A, would be distributed among all eligible unsecured creditors on a pro rata basis according to the reorganization plan.
4. Potential reduction in payout: The inclusion of Organization B as an unsecured creditor might slightly reduce the percentage payout to other unsecured creditors, as there would be more parties sharing in the distribution.
5. Timing considerations: The payout to creditors would occur according to the timeline established in the reorganization plan, which could be months or even years after the initial bankruptcy filing.
6. Possible preference claim defense: Organization B might argue that the transfer falls under one of the preference claim defenses, such as the "ordinary course of business" defense, potentially affecting their status in the creditor hierarchy.
7. Tax implications: Both Company A and Organization B may need to address tax consequences related to the avoidance and subsequent inclusion in the reorganization plan.

It's important to note that the specific outcomes would depend on various factors, including the total value of Company A's assets, the number and value of other creditor claims, and the details of the approved reorganization plan.

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Please expand on your answer #6 -- you said it could "affect their status in the creditor hierarchy"; would the effect be positive or negative?

(Claude 3.5 Sonnet answers:) I apologize for the ambiguity in my previous response. Let me clarify and expand on point #6 regarding the potential effect of a successful preference claim defense on Organization B's status in the creditor hierarchy.

If Organization B successfully argues that the transfer falls under one of the preference claim defenses, such as the "ordinary course of business" defense, the effect on their status would generally be positive. Here's why...^[1]

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What are some conditions that might lead to organization B not receiving a claim reassessment to become considered an unsecured creditor of Company A for the amount of the grant they had to return?

(Claude 3.5 Sonnet answers:) There are several conditions that might lead to Organization B not receiving a claim reassessment to become an unsecured creditor of Company A for the returned grant amount. Here are some potential scenarios:

1. Fraudulent involvement: If Organization B is found to have been complicit in Company A's fraud or had knowledge of it when accepting the grant, they might be denied creditor status as a form of penalty.
2. Violation of grant terms: If Organization B violated the terms of the grant agreement in a significant way before Company A's bankruptcy, they might lose the right to claim creditor status.
3. Statute of limitations: If Organization B fails to file a claim within the specified time frame set by the bankruptcy court, they may lose the right to be considered a creditor.
4. Equitable subordination: The bankruptcy court might subordinate Organization B's claim below other creditors if it finds that Organization B engaged in inequitable conduct related to the grant.
5. Regulatory restrictions: Depending on the nature of Organization B (e.g., if it's a non-profit or government entity), there might be regulatory restrictions preventing it from becoming a creditor in a commercial bankruptcy case.
6. Waiver of claims: If Organization B signed an agreement waiving their right to become a creditor in case of avoidance, they might be prevented from claiming creditor status.
7. Court determination of no value given: If the bankruptcy court determines that Organization B provided no value or consideration in exchange for the grant, it might deny creditor status.
8. Specific exclusion in reorganization plan: The approved reorganization plan might specifically exclude certain types of avoided transfers from being eligible for claim reassessment.
9. Prior settlement agreement: If Organization B had previously entered into a settlement agreement with Company A that included provisions about potential bankruptcy scenarios, this might prevent them from claiming creditor status.
10. Lack of good faith: If the court determines that Organization B did not receive the grant in good faith, it might deny creditor status as a remedy.

These scenarios highlight the complex nature of bankruptcy proceedings and the various factors that can influence creditor status. The specific outcome would depend on the details of the case, applicable laws, and the court's interpretation of the circumstances.

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Please expand on answer #5 -- what kind of regulatory restrictions might prevent a non-profit from becoming a creditor in a commercial bankruptcy case?

(Claude 3.5 Sonnet answers:) While it's relatively uncommon for regulatory restrictions to completely prevent a non-profit from becoming a creditor in a commercial bankruptcy case, there are some situations where regulations could complicate or limit a non-profit's ability to participate as a creditor. Here's an expanded explanation...^[2]

...It's important to note that these restrictions typically don't outright prohibit a non-profit from becoming a creditor, but they may create hurdles or require careful consideration and possibly legal counsel to navigate. In many cases, a non-profit can participate as a creditor in a commercial bankruptcy case, but it must do so in a way that aligns with its charitable purpose and complies with applicable regulations.

2. FTX's plan of reorganization as disclosed by Sullivan & Cromwell

Docket item #19143 on the docket of in re: FTX Trading Ltd. (download link) is the "Disclosure Statement for Debtors' Joint Chapter 11 Plan of Reorganization of FTX Trading Ltd. and Its Affiliated Debtors and Debtors-in-Possession".

In particular, pages 19 through 28 of the pdf (pages 13 through 22 of the document) give a "Summary of Treatment of Claims and Interests and Estimated Recoveries", giving an estimated more-than-full recovery to Class 6A General Unsecured Claims (pdf page 22).

Note that Claude's answer above was that the organization would typically become an unsecured creditor in the amount that they returned, and receive an (eventual) payout pro rata with unsecured creditors. I can't endorse that prediction, because I am not a lawyer.

3. Talk to your lawyer

At least one org executive that I talked to was not aware that a recipient who has funds "clawed back" by FTX is in most cases legally entitled to get in line to receive them back with general creditors (who are estimated to get paid more-than-in-full). They had assumed that if they were required to return money, it would be lost to them forever.^[3] I recommended that they talk further with their lawyer. Last I heard, their lawyer was investigating whether they would have to return the funds at all, given that the rigamarole of returning and then re-receiving funds would be economically pointless and not to the benefit of any of the other creditors anyway.

If you are looking for a recommendation for a lawyer -- given by a throwaway account on the EA Forum -- I have been impressed by the lawyer my org retained to work on the case. He now has rather a lot of context on the FTX bankruptcy (which is billable hours you won't pay for!) and I have found interactions with him to be remarkably productive and effective. DM this account and I can have his firm reach out to you to schedule a free consult. (I'm not getting anything from the referrals, as you can verify in writing with them if you like.)

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1. Please expand on your answer #6 -- you said it could "affect their status in the creditor hierarchy"; would the effect be positive or negative?

   (Claude 3.5 Sonnet answers:) I apologize for the ambiguity in my previous response. Let me clarify and expand on point #6 regarding the potential effect of a successful preference claim defense on Organization B's status in the creditor hierarchy.

   If Organization B successfully argues that the transfer falls under one of the preference claim defenses, such as the "ordinary course of business" defense, the effect on their status would generally be positive. Here's why:

   1. Retention of funds: If the defense is successful, Organization B might be able to keep the grant money, as the transfer would not be avoided. This means they wouldn't have to return the funds to Company A's bankruptcy estate.
   2. Avoiding unsecured creditor status: By successfully defending against the avoidance action, Organization B would avoid being relegated to the status of an unsecured creditor. They would not have to "get in line" with other unsecured creditors to receive a potential partial repayment.
   3. Full value retention: Instead of potentially receiving only a fraction of the grant amount as an unsecured creditor in the bankruptcy proceedings, they would retain the full value of the original grant.
   4. No participation in pro rata distribution: They would not be part of the pro rata distribution among unsecured creditors, which often results in creditors receiving only a small percentage of their original claim.
   5. Improved financial position: Retaining the grant funds would leave Organization B in a better financial position compared to having to return the money and then wait for a potentially smaller payout through the bankruptcy process.
   6. Reduced legal and administrative burden: Successfully defending against the avoidance action would eliminate the need for Organization B to file a claim in the bankruptcy case and participate in potentially lengthy proceedings.

   It's important to note that successfully arguing a preference claim defense can be challenging and depends on specific circumstances and evidence. The "ordinary course of business" defense, for example, typically requires showing that the transfer was consistent with the ordinary business practices between the two parties or within the relevant industry.

   In summary, if Organization B can successfully defend against the avoidance action, the effect on their status would be positive, allowing them to retain the full grant amount and avoid becoming an unsecured creditor in Company A's bankruptcy proceedings. ↩︎

2. Please expand on answer #5 -- what kind of regulatory restrictions might prevent a non-profit from becoming a creditor in a commercial bankruptcy case?

   (Claude 3.5 Sonnet answers:) While it's relatively uncommon for regulatory restrictions to completely prevent a non-profit from becoming a creditor in a commercial bankruptcy case, there are some situations where regulations could complicate or limit a non-profit's ability to participate as a creditor. Here's an expanded explanation:

   1. Tax-exempt status considerations: Non-profits, especially those with 501(c)(3) status, must be careful about their involvement in activities that could be seen as furthering private interests rather than their charitable purpose. Becoming a creditor in a commercial bankruptcy might raise questions about whether the non-profit is operating within its charitable purpose.
   2. Grant restrictions: If the non-profit received the funds from Company A as part of a restricted grant, there might be limitations on how those funds can be used or reclaimed. Some grant agreements explicitly prohibit the grantee from becoming a creditor of the grantor.
   3. State-specific non-profit laws: Some states have laws governing how non-profits can engage in financial transactions. These laws might limit a non-profit's ability to claim creditor status, especially if doing so could be seen as engaging in commercial activities outside their stated mission.
   4. Bylaws and charter restrictions: A non-profit's own bylaws or charter might contain restrictions on participating in certain types of financial transactions or legal proceedings, which could include becoming a creditor in a commercial bankruptcy.
   5. Funder or donor restrictions: If the non-profit uses funds from other sources (e.g., government grants or major donors) to operate, there might be restrictions on how those funds can be used, potentially limiting the organization's ability to engage in bankruptcy proceedings.
   6. Conflict of interest regulations: If there are any overlapping board members or other close ties between the non-profit and the bankrupt company, conflict of interest regulations might prevent the non-profit from participating as a creditor.
   7. Public charity status preservation: For non-profits classified as public charities, there are rules about maintaining public support. Becoming a major creditor in a commercial bankruptcy could potentially affect this status if it significantly changes the organization's funding structure.
   8. Lobbying and political activity restrictions: If the bankruptcy case has political implications, non-profits (especially 501(c)(3) organizations) need to be cautious about how their involvement might be perceived in light of restrictions on lobbying and political activities.
   9. Unrelated business income concerns: If pursuing creditor status could be classified as unrelated business activity, it might raise issues with the non-profit's tax-exempt status or result in unrelated business income tax.
   10. International non-profit regulations: For international non-profits, there might be additional regulations from multiple jurisdictions that complicate their ability to become creditors in a foreign bankruptcy case.

   It's important to note that these restrictions typically don't outright prohibit a non-profit from becoming a creditor, but they may create hurdles or require careful consideration and possibly legal counsel to navigate. In many cases, a non-profit can participate as a creditor in a commercial bankruptcy case, but it must do so in a way that aligns with its charitable purpose and complies with applicable regulations. ↩︎

3. I am, for one final time, not a lawyer, but my understanding is that if an org executes a written agreement to return funds and that agreement does not explicitly make them a creditor, the agreement probably also has a general release that prevents them from becoming a creditor even if they didn't realize at the time what they were giving away. But they should talk to their lawyer if they wanted to be sure. ↩︎