Grayscale Faced with New Lawsuit as it Prepares to Issue Oral Arguments in Battle with SEC

Hedge fund Alameda Research, the trading arm of the now-bankrupt crypto exchange FTX, announced on Monday that it had sued cryptocurrency management company Grayscale and its owner Digital Currency Group (DCG), over the structure of their Bitcoin and Ethereum trusts, dealing another blow to the SoftBank-backed crypto conglomerate.

The leadership at Grayscale and DCG are accused of being “self-serving” and enriching themselves “at the expense of the trust shareholders” by refusing to allow redemptions and charging excessive fees.

The complaint was filed in Delaware's Chancery Court, stating that if Grayscale reduced its fees and stopped blocking redemptions, the value of the FTX shares would be worth at least $550 million, about 90% higher than the value they currently are.

FTX is also claiming that Grayscale has earned $1.3 billion in management fees, which is a breach of trust agreements.

“Our goal is to unlock value that we believe is currently being suppressed by Grayscale's self-dealing and improper redemption ban,” said FTX's interim CEO John J. Ray III in the press release.

FTX went bust in November after its team was found to have mismanaged the exchange, mixing funds, and making risky bets, with customers' money through Alameda. Hundreds of millions of dollars of customer cash are now missing, and its former CEO and co-founder, Sam Bankman-Fried (SBF), is facing a litany of criminal charges in US courts.

Last week, FTX said it was facing a significant deficit. And now, in its case against Grayscale and DCG, it is seeking injunctive relief to wipe out the discounts on every asset it holds while also permitting redemptions.

FTX said that relief would “unlock $9 billion or more for shareholders” and a quarter billion dollars for the failing company.

“FTX customers and creditors will benefit from additional recoveries, along with other Grayscale Trust investors that are being harmed by Grayscale's actions,” said Ray in the official announcement.

Grayscale Trusts Trading at a Significant Discount

Grayscale is the asset management business of DCG, which operates multiple crypto trusts, out of which it collects profitable fees to manage Bitcoin, Ether, and other tokens for clients. Investors can purchase shares of trusts via their brokerage accounts instead of holding crypto directly. Since late 2015, when the trust was listed, it has gained over 19-fold in overall returns.

Alameda owns over 22 million shares in GBTC, the flagship Bitcoin Trust from Grayscale, the complaint said. It has an additional 6 million shares of Ethereum Trust (ETHE), which amounts to over 3% and 2% of the overall shares outstanding, respectively.

These holdings were worth $290 million in the secondary market at the end of last week, the complaint added. But they could be worth nearly twice as much if Grayscale lowers its fees and allows investors to redeem their shares for the equivalent value of the underlying cryptocurrencies.

“Due to (Grayscale and DCG's) malfeasance . . . the only way for shareholders to exit their investments is by selling their shares in the trusts in the secondary market, where shares are trading at a fraction of their proportionate interest in trust assets,” FTX alleged in its filing to a Delaware court on Monday.

These closed-end funds are trading at a substantial discount from the value of crypto assets held by each since February 2021.

Grayscale's flagship Bitcoin Trust (GBTC) holds roughly 3% of all Bitcoin, valued at $14.7 billion, of which asset managers receive a 2% fee. GBTC is currently trading at a 45% discount to the price of bitcoin after going to nearly 50% in December 2022, according to YCharts. Over the last five years, GBTC has lost over 25%, while Bitcoin has gained 126% in value during the same period, according to data collected by Bloomberg.

Grayscale earns a 2.5% fee on the 3 million ETH in its Ethereum Trust (ETHE), which is worth $4.7 bln.

“We will continue to use every tool we can to maximize recoveries for FTX customers and creditors,” Ray said in a statement.

Facing Mounting Pressure

Alameda's lawsuit against Grayscale marks the latest issue for Connecticut-based DCG, one of the largest and oldest cryptocurrency investors. DCG's chief executive Barry Silbert and Grayscale's chief executive Michael Sonnenshein, are also named in the complaint.

DCG has been struggling with the effects of plunging cryptocurrency prices and FTX's fall from grace since last year. The credit arm of its cryptocurrency brokerage, Genesis, filed for bankruptcy early in the year. The group is also considering selling off its CoinDesk news website to try and raise cash and pay back creditors.

Grayscale has also been facing opposition from many investors. The FTXs legal action against Grayscale followed a public request from hedge fund Fir Tree in December, along with proposals by asset managers Osprey Funds, Valkyrie, and 3IQ, for GBTC.

Osprey is also suing Grayscale, alleging that the asset manager has engaged in “false and misleading” promotion of its GBTC, according to the complaint filed in the Connecticut Superior Court.

Grayscale's flagship product GBTC has been trading with an increasing, largely unbroken discount from its Net Asset Value (NAV) for almost two years. However, some investors hope the discount will continue its recent trend of shrinking if the courts are sympathetic to Grayscale's arguments in favor of an Exchange Traded Fund (ETF).

Grayscale has said on multiple occasions that it cannot correct the discounts for the way shares in its Bitcoin Trust are trading without seeking US Securities and Exchange Commission (SEC) approval for converting its Bitcoin Trust to an ETF.

As such, Grayscale called the suit filed by Alameda Research as “misguided,” adding that the firm had been “transparent” throughout its efforts to get regulatory approval for the conversion of GBTC into an ETF — “an outcome that is undoubtedly the best long-term product structure for Grayscale's investors.”

Meanwhile, Grayscale shareholders have pointed to how shares could be redeemed if the company sought Regulation M status. However, Grayscale has said it would not seek Regulation M status without first trying to prevail in a suit against the SEC over its failure to approve an application for the trust's conversion into an ETF.

The complaint filed by Alameda comes just one day before oral arguments in Grayscale's lawsuit against the SEC are scheduled for March 7. A federal appeals court will hear the oral arguments on Tuesday before three judges in a Washington, DC, court.

“The courts recognize that the agencies have the expertise, but they don't have a blank check,” said Don Verrilli, a former US Solicitor General hired by Grayscale for its lawsuit, in an interview with media outlets last week.

Grayscale's Argument

The asset manager sued the SEC over blocking the conversion of GBTC into a spot bitcoin ETF, arguing that this would benefit investors and allow redemptions. Grayscale's application for the same was denied in June.

In its argument, Grayscales's team will contend that the regulator has played a limited role here and did not follow logic with the denial, having approved multiple Bitcoin futures ETFs with similar risk profiles.

“It is just a classic case of taking similar cases and treating them in different ways…,” said Verrilli, adding that “the more you get into the specifics, the stronger our case gets.”

According to Grayscale's chief legal officer, Craig Salm, this case has clear major implications for Bitcoin, and “winning it would be very good” for BTC and the crypto market. But if the firm loses, they would fully exhaust their appeals — even if it takes the matter all the way to the US Supreme Court, he said.

But if this ETF path comes to an impasse, Grayscale is considering a tender offer to redeem shares of the trust, said the company CEO Michael Sonnenshein.

In an interview last month, Sonnenshein had said that he could not imagine why the SEC would not want to protect Grayscale investors and restore the real value of their assets.

At the time, he explained, the SEC had “violated” the administrative procedure laws in refusing to approve the GBTC as a bitcoin spot-traded ETF. This act ensures that the regulator does not exhibit prejudice or behave in an arbitrary manner, said Sonnenshein, adding that the SEC acted “arbitrarily” by approving Bitcoin Futures ETFs while rejecting GBTC's conversion.

Sonnenshein then went on to say that if GBTC is approved as a Bitcoin spot ETF, a “couple of billions” of capital will instantly return into investors' pockets on an “overnight basis” because the fund will “bleed back” up to its NAV.

He further explained that the discount on GBTC is due to its current trading status. But if it is converted to an ETF, there will “no longer” be any discounts or premiums as there will then be a built-in “arbitration mechanism.”

With more than a “million investor accounts” worldwide, who trust Grayscale to act in their best interests, Sonnenshein said, the SEC should protect investors and restore value to them.

SEC's Argument

Back in December 2022, the SEC filed a 73-page brief in the United States Court of Appeals for the DC Circuit outlining the reasons it denied a Grayscale petition in June 2022 for the conversion of its bitcoin trust to a sport Bitcoin ETF.

The SEC said that its decision was based on the conclusion that Grayscale's proposal did not adequately protect against fraud and manipulation. While citing concerns about market manipulation, the SEC noted a lack of a surveillance-sharing agreement between a regulated exchange and a regulated marketplace of substantial size.

The agency has made similar concerns on multiple prior applications for creating spot-based Bitcoin ETFs.

According to court documents, the SEC has repeated its position that Grayscale's bitcoin ETF proposal should be rejected and has again asserted that such products are subject to manipulation and fraud.

According to Max Schatzow, partner and co-founder at RIA Lawyers, there is “less than a one-in-four chance” for Grayscale to win the case against the SEC while pointing to the implosion of the FTX crypto exchange.

Elliot Stein, a senior litigation analyst with Bloomberg Intelligence, echoed similar sentiments and gave Grayscale a 40% chance of winning. According to him, Grayscale faces “an uphill battle” in its fight against the SEC.

Nonetheless, if Grayscale emerges victorious, it has the potential to release billions of dollars in value for investors in GBTC, said Stein.