FTX Debacle: Is History Repeating Itself?

By now, you’ve likely read a headline or two about FTX and the fall, scandal, and now bankruptcy filing by CEO Sam Bankman-Freid. 

Unfortunately, there continue to be examples of what is currently happening with FTX.  An example many are using is Enron. A quick recap on that scandal: Enron used accounting shenanigans to make it appear profitable, essentially hiding its financial losses in shell companies; it also marked future potential profits as actual profits. 

It’s similar to FTX in the following ways:

• The perception of success kept its stock price high (or valuation in FTX's case)
• The use of supposedly separate companies to pull off financial foolishness seems similar to what FTX has done, argues David Z. Morris in a piece on CoinDesk

The Enron scandal was so bad, it led to the passage of the Sarbanes-Oxley Act in 2002, a law that tightened up accounting rules for public companies. Overall, it does feel like history is repeating itself - only with the added intricacy of a Blockchain crypto exchange and colleagues cohabitating in the Bahamas.

What is new and intriguing is John Ray III, now the acting CEO of the bankrupt crypto exchange FTX, also helped clean up the Enron disaster. Ray is considered an expert at the bankruptcy process — and here's what he said Thursday (Nov 17) about FTX in court documents: 

"Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here." 

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Compliance in securities and startup capital management isn’t a ‘nice to have’. Founders are passionate and are founding a company because they want to disrupt and change the status quo. These personalities tend to like to bend the rules, and a charismatic leader can create a lot of buzz and financial backing. However, passion and charm don’t always ensure ethical business practices.  

Navigating compliance for founders is tricky - read our article here about getting legal counsel and the benefits of a Broker-Dealer if you are raising capital and selling securities. 

Startups and disruptors cannot consider themselves above the regulators. Regulations also apply to the likes of Kevin O’Leary or other big influencers in the space if they recommend or promote investment opportunities to the public. As we saw with the Kim Kardashian fine from the SEC, promoting crypto or other securities/investments have regulatory obligations and disclosures that must be met.

So Many Red Flags (We’ll Cover Four of the Most Dramatic)

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Red Flag #1: Little information security or management.

According to Ray, the company had corporate missteps and suspicious management never seen before, including using software to “conceal the misuse of customer funds.” He said there was “an absence of independent governance” between FTX and Alameda, which was owned almost entirely by Sam Bankman-Fried (SBF), and it seems that he wrote himself loans totaling billions of dollars.

Ray also said he could not trust that financial statements assembled under SBF’s leadership were accurate. “The FTX Group did not keep appropriate books and records, or security controls, with respect to its digital assets,” he wrote.

So if you are a VC backing someone with little to no experience running any large company and/or managing millions in capital, why wouldn’t there be any Board oversight or quarterly audits? Did FTX not have a fully functioning Board of Directors? 

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Red Flag #2: FTX refused to form a Board. When oversight was suggested, they rejected it. From a VC or investor standpoint, this move could raise suspicion as a Board of Directors provides critical accountability and oversight in decision-making around the use of capital, hiring and growth, as well as business reporting and planning.

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Red Flag #3: Obvious misuse of funds that any person with a pulse would recognize as wrong.

Here are some of the most dramatic misuse of funds:

• corporate funds had been used to buy homes and other personal items for employees and advisers without proper documentation
• FTX improperly used customer funds to prop up Alameda Research, a trading firm that SBF also founded
• Alameda made loans totaling about $3.3 billion to SBF and an entity he controls, and about $600 million to two other FTX executives, Nishad Singh and Ryan Salame

Since he took over last week, Mr. Ray said his team has secured about $740 million worth of cryptocurrency belonging to various parts of FTX’s business. But he called that sum “only a fraction” of what he hopes to recover, saying the company has hired forensic analysts and blockchain experts to assist in locating any remaining funds. The run on FTX left the company owing an estimated $8 billion, according to people familiar with the matter.

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Red Flag #4: Nine company employees shared a Bahamas mansion and all lived together. If that sounds weird - it’s because it is. The nine housemates/colleagues lived with SBF and ran the cryptocurrency empire from a luxury penthouse. 

Funding with no oversight is a recipe for disaster

Theranos, FTX, Zenefits, and Rothenberg Ventures are all great examples of the damage that little to no oversight in the management of a company newly formed and flush with capital can do.

There is a fiduciary duty to ensure that funds are used how they are presented to be used in company quarterly reporting. It’s not 100% agreed if that duty falls onto the Board of Directors, the accredited investors/VC, or just the CEO - but in the best-case scenarios, it’s actually all three.

Providing funding with no oversight or checks and balances can be a recipe for disaster for a founder with little practical experience running and scaling a company or suddenly having access to large sums of money and answering to no one.

And SBF didn’t do this alone - Ramnik Arora convinced Silicon Valley investors to sink nearly $2 billion into the once red-hot crypto exchange. Arora was the main FTX executive outside of SBF who interacted with investors such as Sequoia Capital, according to investors who worked with him. Officially head of product and investor relations, a role that included leading many of SBF’s venture investments, Arora’s position made him integral to FTX’s expansion and the funding blitz that ultimately valued the exchange at $32 billion.

For the capital markets, regulatory oversight and compliance controls are GOOD things that protect investors and VCs alike.

It’s also notable that FTX raised funds via a Reg D, which doesn’t have the same requirements as other types of capital raises, such as Reg CF or Reg A, which both require ongoing reporting with the regulator.

Conclusions 

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1. Founders need to know the law and their fiduciary obligations when it comes to leveraging the capital they’ve been given
2. Raising Capital is easier than it used to be, but not without crucial compliance checks and balances that cannot be side-stepped
3. Forming a Board of Directors is a great way to ensure accountability and transparency in corporate governance and capital management
4. VCs have an obligation to their LPs to possibly dig a little deeper into unproven startup founders and their business practices ongoing
5. VCs should not ignore red flags or take a fully hands-off approach, especially given the check sizes cut

It’s crucial that startups continue to disrupt, innovate, and challenge the systems and the status quo.  But all within a framework of good governance and legal business practices. Zero oversight can lead to mistakes born out of simply not understanding the intricacies of the law and compliance protocol for securities and shares. This is not the case with FTX - who seemingly crossed almost every line in business protocol.

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Written November 18, 2022 - and much of the above may change as this situation is still unfolding.

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