Lessons Learned from the Fall of FTX
John Powers recently discussed the fallout from the criminal fraud prosecution of Sam Bankman-Fried and the bankruptcy of FTX in an interview with Paul Kilby, editor-in-chief of Fraud Magazine.
Excerpts of their conversation are featured in the March/April issue of the magazine, published by the Association for Certified Fraud Examiners (ACFE).
Below is a partial transcript of their interview in December 2022.
From what you have seen, what are the mechanics of what happened at FTX and Alameda?
While FTX was raising $1.8 billion from equity investors, Sam Bankman-Fried reportedly represented the company as safe and responsible, with appropriate risk mitigation and internal controls in place to protect customer and shareholder interests. Yet at the same time – according to the SEC, DOJ and CFTC – he was allegedly diverting billions of dollars of FTX customer funds to his privately-held hedge fund, Alameda Research, and generally using FTX as a piggy bank for Alameda with an unlimited “line of credit” from FTX, while exempting Alameda from risk monitoring and mitigation measures.
At Alameda, Sam Bankman-Fried allegedly used comingled FTX customer funds for venture investments in other firms, real estate purchases, major political campaign contributions and personal loans to himself and other insiders, according to the complaints filed against him.
These claims against SBF highlight the extent to which FTX allegedly violated its own terms and commitments to investors. He allegedly touted the fraud prevention protocols at FTX, including its “best-in-class” controls, a proprietary “risk engine,” and specific investor protection measures outlined in its terms of service. Ironically, his firm’s alleged failure to live up to these promises are a key feature of the cases against him.
Is this fraud?
Publicly, SBF presented himself as an advocate of regulation and accountability in the crypto industry. He presented FTX as a mature, well-grounded firm. That is one of the many ways in which he calls to mind Bernie Madoff, who at one time served as the chair of NASDAQ.
If SBF is truly the Bernie Madoff of Bitcoin, then his prosecution should inevitably trigger stronger regulations and much-needed reforms within the cypto industry, with a more unified regulatory and enforcement regime. It could bring about a sea change, akin to a crypto version of the Dodd-Frank Act.
After Dodd-Frank, the SEC restructured its enforcement division, and changed how it handled ‘tips’ from cooperating insiders. There were more stringent capital and reporting requirements for financial institutions. Whistleblower provisions were introduced, which — from an anti-fraud perspective — have been relatively spectacular.
Was it as John Ray said: plain old-fashioned embezzlement, taking money from others and using it for your own purposes? Or is there something more sophisticated taking place?
Cryptocurrency, at least in the popular imagination, is a complex environment involving non-traditional derivatives, companies minting their own money, and more than a trillion dollars in digital assets zipping anonymously around the globe through a dizzying web of decentralized nodes.
By contrast, the SEC complaint relegates its discussion of crypto assets and blockchain technology to a mere footnote. It doesn’t waste any time on the technical aspects. It describes a “house of cards” built with billions of dollars in misappropriated customer funds, which simply fell apart when the market turned. This is a familiar story. If anything, the apparent lack of sophistication in this case is perhaps what’s most surprising.
Damian Williams, the top federal prosecutor in Manhattan, has described FTX’s collapse as one of “the biggest financial frauds in America history.” Do you think this is true?
The alleged misconduct would certainly constitute one of the biggest investor frauds in U.S. history.
If convicted, SBF will join the ranks of Bernie Madoff, whose Ponzi scheme was responsible for nearly $20 billion in investor losses, and Allan Stanford, whose offshore bank sold more than $7 billion in fraudulent Certificates of Deposit. Madoff and Stanford are generally regarded as the two biggest investor frauds in U.S. history.
Dollar-for-dollar there have been larger scandals at publicly traded companies such as Enron, WorldCom and Lehman Brothers. Those scandals generally involved deceptive accounting – such as overstating assets, concealing debts, and other forms of balance sheet manipulation. Those investor losses – in the tens of billions – played out in the stock market. It’s a different game when you are orchestrating a Ponzi scheme or plain old embezzlement.
Alameda used FTX’s inhouse FTT token as collateral when borrowing from FTX and other lenders. Does this strike you strange? After all, isn’t collateral typically something that is less volatile and has some solid tangible worth?
It is quite strange that this practice was evidently accepted by the external lenders.
Among the critical pieces that led to the implosion of FTX were the public statements by the head of Binance, CZ Zhao, who announced via Twitter that Binance would liquidate all of its holdings of FTT tokens, the native token of FTX, due to “recent revelations,” in November 2022.
That basically led to an old-fashioned bank run at FTX. Customers reportedly withdrew $6 billion of assets from the exchange within 72 hours.
Acknowledging the ensuing liquidity crunch, CZ Zhao and Binance stepped in with a non-binding Letter of Intent (LOI) to acquire FTX.
Foreshadowing what was to come, Zhao then tweeted two big lessons:
Never use a token you created as collateral.
Don’t borrow if you run a crypto business. Don't use capital “efficiently.” Have a large reserve.
The next day, Zhao reported that “as a result of corporate due diligence” as well as news reports regarding “mishandled customer funds and alleged US agency investigations” Binance balked at the acquisition of FTX.
Are there other crypto exchanges we should keep an eye on?
We are at a moment of reckoning for the cryptocurrency industry – and its nascent regulatory and enforcement regime. There have been public reports that the Department of Justice has been conducting a criminal investigation of Binance and various executives since 2018, focused on potential violations of anti-money laundering laws and sanctions. The SEC is reported to be investigating Coinbase over the possible sale of unregistered securities. A Congressional staffer has said every major U.S. crypto exchange is some stage of being investigated, according to Forbes. The investigations are not limited to exchanges. For example, the DOJ has also reportedly been conducting a bank fraud investigation of the stablecoin-issuer Tether. An aggressive push by prosecutors and regulators on these cases could have serious implications industry-wide, particularly in light of what has occurred at FTX and the multibillion dollar implosion of Terra/Luna earlier in 2022.
Will there be a call for greater transparency and more audits?
There’s a great piece by Lane Brown at New York Magazine, where he breaks down what happened at FTX. In the simplest terms, SBF is described as a “silly-haired wizard [who] sold magic beans.” Everything he did seemed amazing, until people stopped believing in magic.
Obviously, traditional lenders are going to be more reluctant to allow a borrower to use imaginary legumes as collateral. As a broader consequence, we are seeing a recalibration between traditional finance and investors – particularly on the institutional side – and the cryptocurrency markets.
Are accounting firms/auditors qualified to assess this type of financial shenanigans?
For the most part, I expect the majority of accounting firms are unqualified to assess these complex risks or conduct a meaningful audit of cryptocurrency assets. This is similar, in some ways, to the difficulties seen in the lead-up to the Great Recession in figuring out how to determine the value and relative risk of synthetic collateralized debt obligations and “CDO-squared” instruments. Any time there is financial innovation, and there is little time to prepare an accounting standard and framework for evaluating it, it is going to be dicey in terms of an audit and quantifying the value of those assets and the risks they pose.
Zhao of Binance is advocating so-called “proof of reserves” checks on crypto holding of exchanges, which allow users to confirm that their holdings are included in checks of blockchain data and that the exchange’s reserves match clients’ assets. How useful do you think this idea is?
This brings us back to a regulatory reform of the industry along the lines of the Dodd-Frank Act, which established minimum capital requirements for banks and systemically important nonbank financial entities. It also imposed enhanced supervisory, liquidity and risk-based standards and compliance requirements for large financial institutions.
One of the more interesting allegations against FTX is that its use of customer assets for other purposes was fraudulent and unlawful. That is a curious contention, if we compare it to operations of commercial banks, for example. If you make a cash deposit at your local bank branch, they don’t put your money in special lockbox and place it in the vault. Banks commonly use capital from customer deposits for commercial lending, mortgage loans and other services.
Many crypto exchanges (e.g., FTX, Binance, Huobi, OKX) operate offshore. Should this be a concern?
FTX was formed offshore, but it’s in Chapter 11 in Delaware.
SBF was arrested in the Bahamas and now awaits extradition to the U.S.
On the face of it, it doesn’t seem to make much difference.
From my perspective, though, there is cause for concern about the levels of compliance by offshore firms with warrants, subpoenas and seizure orders from law enforcement, financial regulators and courts in the U.S. The extent of cooperation is not equal across all exchanges.
What lessons can CFEs draw from this, and what roles can they play?
I think it’s important for fraud examiners in these settings to ask basic questions, and keep asking until the answers make sense in the plainest language possible.
Cryptocurrency can be complicated, particularly for newcomers, but that does not mean these companies and their financial books and operations should be regarded as a black box. There should never be an inverse relationship between the complexity of an organization and the strength of its internal controls.
Hudson Intelligence is a private investigation firm specializing in international asset tracing and investigations of complex frauds and financial crimes. The firm was founded in 2011 by John Powers, CFE, CTCE, and works with investors, law firms, corporations and government agencies. Its licensed investigators and forensic analysts have coordinated on financial fraud investigations with the Federal Bureau of Investigation (FBI), Department of Homeland Security (DHS), Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC) and other agencies in the U.S. and abroad.