Lessons from the bankruptcy of FTX: What went wrong with the due diligence?

ftx crypto exchange

Lessons from the bankruptcy of FTX: What went wrong with the due diligence?

ftx crypto exchangeThe meltdown of the crypto empire, FTX, made headlines across the financial press and was added to the long list of major corporate disasters after Enron and Theranos. The 32 billion dollar crypto exchange platform filed for bankruptcy on November 11th due to a liquidity crisis and accusations of fraud.

This meltdown has immensely shaken investors’ confidence in crypto assets and left the entire crypto world with adverse domino effects. Some similarities between the FTX, Theranos, and Enron disasters include the involvement of very well-off investors whose due diligence failed to uncover glaring red flags.

This raises the question of what these big names missed during the due diligence process and the points of undergoing due diligence.

Poor oversight

To begin with, let’s take a look at the causes of the collapse. Various media have mentioned that a total lack of financial and corporate controls are major causes of the collapse.

Sam Bankman-Fried (a.k.a SBF), the firm’s principal shareholder and CEO, effectively controlled all decision-making with little to no documentation of the processes and acts conducted. The lack of an independent director in the corporate structure was one of the glaring red flags which resulted in a lack of oversight of the interests of investors and clients.

In addition, restructuring officer and interim CEO John J. Ray, who is most known for overseeing the liquidation of Enron Corp, claims that FTX lacks the kind of disbursement controls that are crucial for a business enterprise. Employees of the FTX Group, for instance, used an online “chat” platform to seek and submit payment, and a dispersed group of managers authorized payments by replying with personalized emojis.

Poor oversight also enables widespread misuse of investment funds. Further investigation found that employees and parents of SBF purchased luxury properties with corporate funds. The self-made crypto billionaire quietly transferred customer funds from his exchange FTX to its sister company, Alameda Research, in a way that flew under the radar of investors, employees, and auditors in the process.

Alameda Research is a small trading firm that SBF built in 2017. This small firm required money to run its trading business and it was the reason SBF created FTX. As crypto prices went down, the value of FTT (FTX Token) went down, making it hard for Alameda to pay its lenders. The relationship between FTX and Alameda is currently under the scrutiny of the authorities.

Another red flag is that FTX did not have an in-house accounting department, and its financial statements were largely unaudited. As for the audited report, it was carried out by a small auditing firm that operates virtually. The fact that an audit of the financial statements of a company as huge as this was carried out by a small firm, an institution outside the Big Four, should’ve been seen as a red flag by the investors.

Due diligence was performed, but…

The fall of FTX was a bolt from the blue for its investors, including big investors, one of which was Temasek. The Singapore state-owned company claims to have conducted extensive due diligence over eight months on FTX, including reviewing FTX’s audited financial statements, which showed a profit.

However, founder and editor of the FCPA blog, Richard L. Cassin, questions and criticizes investors who claim to have done their due diligence, but have missed such obvious red flags.

Due diligence is basically a mitigation tool, a thorough business investigation that is usually carried out by a company or individual before making a decision (purchase, merger, and investment).

In practice, due diligence can mitigate some, but not all risks, depending on the material being investigated. This means that in different businesses, different crucial aspects are to be investigated.

Crypto itself is such a new world that the due diligence that is carried out must be different from the due diligence that is carried out on conventional businesses.

Professor Mak Yuen Teen from the National University of Singapore’s business school told the media that discerned and fast-moving assets such as cryptocurrencies make due diligence more complicated to carry out. However, at least due diligence can focus on several fundamental and critical aspects, including the business model, company structure, related entities, where the company operates, whether the company is in a strictly regulated jurisdiction, whether there is an independent and competent board of directors, etc.

The investors may fail to perform due diligence on some of these aspects, leaving enormous risk loopholes. Red flags that should be clearly visible and responded to, which are ignored, can result in substantial losses.

In addition to being a mitigation tool, due diligence also serves as a compliance tool. Many nations like the United Kingdom and the United States, require companies to perform due diligence in order to reduce the risk of financial crime. If they do not perform due diligence, and wrong things happen after the decision, the companies are likely to face legal liability.

 


Putri
Photo by Jason Briscoe on Unsplash

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