An Executive Voices Blog by Jed Ferdinand

 How does the second largest cryptocurrency exchange in the world, once valued at $32 billion, collapse virtually overnight? It’s a tale of fraud as old as time, and Sam Bankman-Fried will now take his place in history along with Charles Ponzi, Bernie Madoff, and the other rogues’ gallery of hucksters who promised guaranteed financial returns with no risk.

What makes this story so noteworthy is the size and scale of the apparent embezzlement by Bankman-Fried and FTX management, and that it involves the opaque and mysterious world of cryptocurrency, which is difficult to fully comprehend even for sophisticated investors.

The story of how FTX collapsed has been widely reported. As a cryptocurrency exchange, FTX had billions in customer deposits under management. Other U.S. crypto exchanges, like Coinbase, pledge to protect 100% of customer deposits as a means to ensure customer and market confidence. FTX, based in the Bahamas, did not adhere to this practice. FTX lent billions of dollars in customer deposits to an affiliated hedge fund called Alameda Research to cover bad trades by that firm. When FTX experienced a classic “run on the bank” of customer withdrawals in early November after some negative articles were published about the company’s risky trading practices and poor management, FTX simply didn’t have the funds to refund back to customers. FTX filed for bankruptcy and $32 billion in market capitalization disappeared in the blink of an eye.

The story of why FTX collapsed is equally troubling. According to John Ray, the well-respected executive brought in to wind down FTX’s assets, it was a case of “old-school embezzlement” by FTX management and a total lack of institutional controls over company spending and asset management. The more interesting question is how FTX’s institutional investors—which included some of the largest and most respected investment firms in the world, like Sequoia Capital, BlackRock, and Third Point—allowed the mismanagement to happen on their watch?

One theory is that the institutional investors simply failed to perform adequate due diligence because they assumed that other firms had already done the work. Another theory is that the institutional investors were simply enamored with Bankman-Fried and his rockstar persona. Because he was perceived to be a genius, most assumed he could do no wrong. How and why the top institutional investors in the world got hoodwinked by a 30-year-old who they witnessed exhibit unprofessional behavior, such as playing videogames during critical investor and business meetings, will be taught as a business school case study for years to come.

FTX’s dramatic collapse is having significant repercussions in the broader crypto market, adding fuel to the fire of crypto critics and naysayers. Additionally, FTX was a counterparty to financial transactions with many other crypto companies. At least one large crypto finance firm, BlockFi, has already filed bankruptcy as a direct result of FTX’s failure. Its bankruptcy also has far-reaching implications for the licensing industry in a number of important ways.

First, FTX had endorsement deals with A-list athletes and celebrities such as Tom Brady, Steph Curry, Naomi Osaka, Larry David, and Shark Tank’s Kevin O’Leary. Since FTX’s bankruptcy, these celebrities have been sued personally for false and misleading representations about their support for FTX. All celebrity endorsement deals carry a certain level of risk but that legal risk is usually mitigated by a contractual obligation requiring the company to defend and indemnify the celebrity for any brand-related legal exposure. From a practical standpoint, however, that indemnity is worthless when a company like FTX files for bankruptcy.

Moreover, there is a vast difference in the risk of legal exposure from a normal product endorsement deal in fashion, fragrance, or jewelry, and crypto endorsements because they are investments and therefore subject to greater legal scrutiny. Moving forward, one consequence of FTX’s bankruptcy is a likely decline in celebrity endorsements for crypto companies.

Second, some of the top finance firms in venture capital, private equity, and hedge funds suffered substantial losses by investing in FTX. These losses, coupled with a decline in the crypto market, have resulted in these firms cutting back investments in new ventures. As a result, startup companies that may have involved licensing-related ventures—such as metaverse projects—will find it much more difficult to secure financing.

Finally, FTX’s collapse is also having a negative impact on the NFT market. Non-fungible tokens are unique digital assets that exist on a blockchain and draw their value from scarcity. NFTs emerged as an exciting new asset class for licensed properties in 2021, and licensed NFT sales showed considerable promise with the rise of platforms for characters and sports such as VeVe, Autograph, NBA TopShot, and others.

NFT sales had already suffered a dramatic drop in 2022 because of the decline of crypto prices, with the firm Dune Analytics reporting that the NFT market had declined a whopping 97% in September 2022 compared to the year prior. The demise of FTX has caused further damage to the already decimated NFT market since most NFT platforms require purchases to be in a cryptocurrency. With crypto prices falling due to FTX’s collapse, NFT purchasers have far less buying power and are more likely to stay on the sidelines until the crypto market recovers.

Some have predicted it may take years for the cryptocurrency market to recover from the loss of confidence caused by FTX’s collapse. Aspects of the digital marketplace that are key for the licensing industry—such as NFTs and the metaverse—will need a rebound in the overall crypto market before they can even approach a return to the glory days of 2021.

Jed Ferdinand is the founding member of Ferdinand IP Law Group, an intellectual property and licensing boutique law firm with offices in New York, San Diego, Silicon Valley, and Westport, CT. Ferdinand also serves as an Adjunct Professor at Fordham Law School in New York.