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States put conditions on Character.AI's sale, and AI user data becomes a liability

About 40 attorneys general told a Delaware court that any buyer of Character.AI must inherit its child-safety duties. For AI investors, the lesson is that regulators now follow the data into bankruptcy.

· · 6 min read
Photograph for: States put conditions on Character.AI's sale, and AI user data becomes a liability
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When Character.AI walked into the US Bankruptcy Court in Wilmington, Delaware, for its first hearing on October 14, the most consequential voice in the room did not belong to a creditor. A bipartisan group of about 40 state attorneys general, led by New York's Letitia James, filed a notice with Judge Brendan Shannon setting out what they expect from any sale of the chatbot company: working age assurance, limits on what minors can reach, crisis safeguards and a way for users to delete their data. Their lawyer, Abigail Ryan, told the court the states did not want past problems to "start over with a new purchaser."

The filing matters well beyond one fallen consumer app. It is the clearest sign yet that state regulators intend to treat the conversational data held by AI companies as something closer to an encumbered asset than a saleable one. For investors who have underwritten consumer AI on the assumption that engagement and the data it produces carry value in a downside case, that assumption has just been tested in open court.

From unicorn to stalking horse

Character Technologies, the company behind Character.AI, filed for Chapter 11 late on Monday, October 12. Its petition put both assets and liabilities in a range of $50m to $100m. Chief executive Colin Adams, a turnaround specialist, attributed the decision to "significant legal, regulatory and operational headwinds" over the past year, and said a court-supervised sale offered the best chance to maximise value. The company told users that if no viable bid emerges, the platform will be wound down. It expects the process to conclude by late November or early December.

The fall is steep. Founded in late 2021 by two former Google engineers, Noam Shazeer and Daniel De Freitas, the startup reached a unicorn valuation in 2022 after a $150m round and has raised more than $193m in total, according to PitchBook data cited by TechCrunch, from backers including Andreessen Horowitz, Lightspeed, Greycroft and SV Angel. In August 2024 Google paid $2.7bn to license its models, and both founders returned to Google. Monthly active users reached 20 million by October 2024.

Those users were unusually devoted. Active users spend about two hours a day talking to the company's characters, according to Reuters. Yet the business never covered its costs. Court filings describe losses of $8m to $9m a month before the filing, driven by legal expenses and the high price of computing power and AI talent.

The opening bid tells its own story. Walt Disney has agreed to pay $20m for a non-exclusive, perpetual licence to Character.AI's technology and intellectual property, subject to court approval and higher offers. Disney had already hired most of the company's staff in September, and Character.AI's former chief executive, Karandeep Anand, joined Disney as chief technology officer. Erin Fay, the company's bankruptcy lawyer, told the court that Disney has no interest in the user data and that no buyer has yet offered for the data or the operating chatbot business.

The regulators' claim on the buyer

The states' notice is, formally, a reservation of rights. They reserve the ability to object to any sale or plan and to seek further protections for personal information. In practice it functions as a term sheet that any bidder for the consumer business must read first.

The underlying exposure is real. Families have sued over chatbot interactions they say contributed to the suicides of two children and exposed minors to sexualised and abusive conversations; the company has reached preliminary settlements with five of those families. Kentucky's attorney general sued in January 2026, and Pennsylvania followed in May with claims that a chatbot posed as a licensed psychiatrist. A multistate investigation has been under way since late 2025, and the company also faces inquiries by the US government and authorities in the UK, Italy, Russia and Australia. Ms Ryan told the court that settlement talks with the states continue.

James framed the stakes in commercial terms, saying the company had collected "some of the most private thoughts children have ever shared" and warning that those conversations could pass to the highest bidder. California's attorney general, Rob Bonta, announcing his state's participation on October 15, made the more technical point that matters to buyers: the restrictions Character.AI recently placed on minors are voluntary, incomplete and could be circumvented or reversed by a new owner. California law already lets residents ask chatbot companies to delete their information and close accounts.

Why the data is worth less than it looks

The usual logic of a distressed technology sale is that the code may be dated and the staff gone, but the user base and its data remain. The Character.AI case inverts that. The most distinctive asset, a vast archive of intimate conversations about mental health, relationships and emotional struggles, is precisely the asset regulators have singled out. A buyer that wants it must expect to negotiate conditions with dozens of state enforcers, accept limits on using it to train models, and honour deletion requests from users who may well choose to leave.

That helps explain the shape of the Disney bid. A non-exclusive licence to technology and characters, paired with the team already on the payroll, is the part of the company that carries the least regulatory baggage. It is also, at $20m, a small fraction of what Google paid for a model licence little more than two years ago. The structure echoes the licence-and-hire deals that large technology companies have used to absorb AI startups without buying them outright, but this time it is the residual company, not the acquirer, that is left holding the liabilities.

A template other states will reuse

Bankruptcy courts have long had tools for personal data, and US law already limits the sale of personally identifiable information that conflicts with a debtor's own privacy policy. What is new is the subject matter and the coordination. A coalition of this size, acting within days of a filing, signals that attorneys general now regard AI companion and chatbot services as a distinct enforcement category, one in which the duty of care is meant to travel with the asset.

That has consequences for how the sector is financed. Consumer AI companies collect sensitive data by design, and many operate with the same combination of high engagement, heavy compute bills and thin monetisation that Character.AI displayed. Lenders and later-stage investors will increasingly ask what that data is worth if the company fails, and the honest answer after this week may be: less than nothing, once compliance costs are counted.

Our view

Character.AI's collapse is not mainly a story about one company's safety record. It is a story about how regulation reprices the downside of consumer AI. For a decade, venture investors could tell themselves that a failed consumer platform still left behind a user base worth selling. The attorneys general have now made clear that, where minors and intimate conversations are involved, the obligations stay attached to the data and pass to whoever buys it.

Founders building companion, coaching or wellness chatbots should treat age assurance, deletion tools and limits on training use as part of the enterprise value, not as a cost to be deferred until revenue arrives. Investors should model regulatory settlements as a line item and stop counting user data as recoverable collateral. The things to watch are whether any bidder emerges for the operating business, what conditions Judge Shannon attaches to a sale, and whether a negotiated settlement with the states becomes the price of admission for future buyers of distressed AI assets. The answers will set the template well beyond this case.

Sources

Filed under AI. Written by Invest Times Editorial under our editorial standards. Commentary and analysis for information only, not investment advice.

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