Character.AI Bankruptcy Raises Questions About Consumer Data and AI Privacy

On October 14, thirty-seven states and the District of Columbia filed a notice in the Chapter 11 case of Character Technologies, Inc., reserving their right to object to any sale of the company’s assets.

The concern is the chat logs. Section 363(b)(1) of the Bankruptcy Code bars a sale of personally identifiable information that conflicts with the privacy policy in force when it was collected, unless the court appoints a consumer privacy ombudsman under § 332 and finds the sale consistent with factors that section sets out. The states also note that the restrictions on minors’ access the company adopted this year were voluntary, and that a buyer could reverse them.

For anyone looking at distressed AI assets, that is the point worth taking. A user database is not a clean asset where the privacy policy promised something the buyer does not intend to keep, and the states have said they will be in court on it.

Why States Are Intervening in Character.AI's Bankruptcy

A coalition of state attorneys general filed a notice in Character Technologies' bankruptcy proceedings, raising concerns about consumer privacy and chatbot safety. The filing follows investigations into potential consumer protection violations and allegations involving harmful interactions between AI chatbots and minors.

Sensitive Chatbot Conversations Are a Central Concern

Character.AI has collected private conversations involving users' mental health, relationships, and personal experiences. State regulators are concerned about how this information could be protected if the company's business or assets are sold.

What Happens to Consumer Data During Bankruptcy?

When a technology company enters bankruptcy, its data holdings may raise significant legal questions during asset sales. Privacy policies, applicable consumer protection laws, and bankruptcy requirements can affect whether and how personal information may be transferred. The states are seeking safeguards for Character.AI users before any transaction involving sensitive information proceeds.

AI Companies Face Growing Privacy and Safety Scrutiny

The Character.AI proceedings highlight regulatory concerns involving AI chatbots that interact with minors and collect sensitive personal information. California's recently enacted Adam's Law, SB 1119, is scheduled to take effect in 2027 and will establish additional requirements addressing AI chatbots and child safety.

Voluntary Safety Measures May Not Resolve Regulatory Concerns

Although Character.AI has voluntarily restricted minors' access to certain chatbot features, state attorneys general argue that these protections may be incomplete or subject to reversal by a future purchaser.

What AI Businesses and Potential Buyers Should Consider

Companies acquiring AI platforms or other data-intensive businesses should evaluate privacy obligations, data retention practices, user consent, children's safety measures, and regulatory investigations before completing a transaction. Existing legal obligations and commitments concerning personal information may affect how acquired data can be used or transferred.

How SJKP Can Help

SJKP can assist technology companies, investors, and businesses with corporate transactions, data privacy considerations, regulatory compliance, and legal risks involving AI technologies. Companies evaluating acquisitions or restructuring transactions involving sensitive consumer information can work with counsel to assess applicable privacy obligations and potential regulatory exposure.