By Steven Moore
I. Introduction
In December 2022, the House Financial Services Committee convened a hearing to investigate the collapse of the cryptocurrency exchange FTX, which occurred in early November 2022.[1] The testimony provided at this hearing, as well as subsequent reporting, exposed a shocking case of fraud and corporate malfeasance, rivaling the infamy of Bernie Madoff’s scheme. Just a few months prior to the collapse, FTX founder Sam Bankman-Fried had been celebrated as a rising star in the crypto industry, praised for his dedication to generosity and financial altruism. However, behind the scenes, Bankman-Fried and his close circle of associates were violating nearly every corporate control mechanism and running what amounts to a Ponzi scheme, through their various subsidiaries and hedge fund partners. Ultimately, FTX drained over a million customers’ personal accounts of $8 billion and left creditors with over $3 billion in liabilities.[2] This article will delve into the events preceding FTX’s downfall, the inadequate due diligence exercised by its investors, and the regulatory enforcement failures that allowed Bankman-Fried’s actions to go unchecked.
II. “A Complete Failure of Corporate Control”
In May 2019, Sam Bankman-Fried (SBF), alongside co-founders Gary Wang and Nishad Singh, launched FTX Trading Ltd. and West Realm Shires Services Inc. FTX US, collectively known as FTX.[3] The platform, designed as a centralized digital asset exchange catering to both the mass market and first-time users of cryptocurrencies, became the flagship product of the newly established entity.[4]
Starting in early 2019, FTX provided customers with the opportunity to open various types of accounts, including “yield-bearing accounts” (“YBAs”), enabling them to deposit a wide range of cryptocurrencies through the website or mobile app.[5] To attract customers, FTX promised appealing annual yields of up to 8%, with hourly compounded interest on their funds. Notably, FTX did not register the YBAs in accordance with any federal or state securities laws.[6] By using targeted advertising, FTX appealed to younger and inexperienced investors, offering higher returns for lower deposit amounts, and eliminating associated fees or minimum balances. This strategy allowed FTX to gain the interest of novice traders looking for an easy entry into the cryptocurrency market. Along with its subsidiaries, affiliates, and related entities, FTX quickly became an industry leader.
One distinguishing feature of FTX’s business model compared to traditional brokerage firms, is its custody of client assets. In simpler terms, FTX directly holds customer assets and maintains the unilateral authority to return them to their clients.[7] Given the inherent risk associated with such a relationship, FTX promised in its terms of service that “[a]ll cryptocurrency or dollars that are held in your account are held by FTX.US for your benefit;” that “[t]itle to cryptocurrency represented in your FTX.US Account shall at all times remain with you and shall not transfer to FTX.US.;” and that “FTX.US does not represent or treat assets in your FTX.US account as belonging to FTX.US.” Most importantly, FTX assured that no customer funds were “the property of, or shall be loaned to, FTX Trading.”[8]
Contrary to FTX’s terms of service and SBF’s statements made in interviews, social media posts, and even during sworn congressional testimony, FTX failed to take necessary measures to safeguard customer funds, implement margin risk controls, or establish adequate internal accounting procedures. Rather than engaging a reputable Big Four accounting firm like their multi-billion-dollar company peers, FTX chose to utilize QuickBooks, an accounting solution designed for cost-conscious individuals and small businesses.[9] What’s more, FTX willfully neglected to create an independent board of representatives to provide effective oversight.[10] As noted by John Ray, who oversaw Enron’s bankruptcy and is now acting CEO of FTX, “FTX Group’s collapse appears to stem from the absolute concentration of control in the hands of a very small group of grossly inexperienced and unsophisticated individuals who failed to implement virtually any of the systems or controls that are necessary for a company that is entrusted with other people’s money or assets.”[11]
FTX’s intricate network of companies expanded to encompass over 100 separate entities, with SBF at the helm, and his crypto hedge fund, Alameda, at the core.[12] Alameda, a quantitative trading firm specializing in crypto assets, focused on arbitrage trading strategies such as market making, yield farming, and volatility trading. Unbeknownst to the public and investors, the yield generated by the YBAs that FTX customers eagerly signed up for was being sourced from Alameda’s trading activities.[13] Even more concealed was the fact that SBF had been funneling FTX customer funds to Alameda. This was accomplished in two ways: (1) by directing customer deposits into bank accounts associated with Alameda, most notably its wholly owned subsidiary North Dimension, and (2) by granting Alameda access to an unrestricted line of credit from FTX, which was backed by customer assets.[14]
SBF had consistently “co-mingled” funds between FTX and Alameda since the fund’s inception. While co-mingling funds between two associated, yet separate entities can be sufficient to cross the line into corporate fraud, the story does not stop there. After transferring billions of dollars in FTX customer funds to Alameda, SBF utilized Alameda as his “personal piggy bank” to purchase luxury real estate, support political campaigns, and make private investments, none of which were disclosed to FTX’s customers or equity investors.[15] In Ray’s written congressional testimony, he outlined the extent of SBF and FTX’s fraudulent activities:
- The FTX Group went on a spending binge in late 2021 through 2022, during which approximately $5 billion was spent buying a myriad of businesses and investments, many of which may be worth only a fraction of what was paid for them.
- Loans and other payments were made to insiders in excess of $1 billion.
III. Unraveling the Timeline
The collapse of FTX began with the publication of a CoinDesk article on November 2nd, which raised concerns about FTX and Alameda Research. The article reported that Alameda Research’s main asset was the FTT token, used as collateral on the balance sheet. This revelation led to concerns about the capital of FTX and Alameda, given the token’s inherent risk and volatility. In response to the CoinDesk report, Binance, a rival exchange, announced on November 6th that it would sell around $530 million worth of FTT tokens. This decision caused a significant drop in FTT token prices, and investors rushed to withdraw their funds from FTX. The sudden withdrawal requests, estimated to be around $6 billion, created a liquidity crunch for FTX, leading the exchange to pause withdrawals.[16]
To address the liquidity crisis, Binance announced on November 8th that it had reached a non-binding agreement to purchase FTX. However, after conducting due diligence and uncovering news of mishandling customer funds and a potential U.S. agency investigation, Binance decided not to proceed with the acquisition. With no resolution in sight, FTX filed for bankruptcy with all of its subsidiaries on November 11th. The company’s sudden collapse left investors scrambling as withdrawals were paused and all customer assets were frozen.[17]
IV. Eyes Wide Shut: How Wall Street Enabled the Deception
Though SBF has been the primary target of the FTX scandal, the involvement of other key players should not be overlooked. The rise of FTX to a $32 billion valuation was fueled by significant backing from prestigious venture capital firms, banks, and private equity funds.[18] From 2019 to 2022, SBF cultivated strong ties with financial giants such as Signature Bank and Sequoia Capital, which now face potential liability.[19] This section will explore the allegations against these VC firms and banks, as well as the legal hurdles and possible consequences they face.
Currently, two civil cases are attempting to hold the associated banks and VC firms accountable for third-party damages. The first case, Rabbitte v. Sequoia Capital, targets venture capital firms Sequoia Capital, Paradigm, and Thoma Bravo.[20] While the more recent case, O’Keef v. Sequoia Capital, broadens its scope to include FTX’s primary banking servicers Silvergate Bank and Signature Bank.[21]
Rabbitte v. Sequoia Capital accuses the VC firms of leveraging their professional reputations and media outreach capabilities to portray FTX as a trustworthy and legitimate crypto exchange at the expense of FTX customers.[22] The case raises concerns about the liability of VC firms, who often see themselves primarily as promoters of their investments. The legal argument that the firms violated California’s False Advertising Law and California Corporations Code §25504 by making misleading statements and materially assisting FTX’s securities violations is not new. However, to establish liability under §25504, a plaintiff must demonstrate that the defendant (1) “materially assisted” in the violation with (2) a “clear intent” to deceive or defraud. [23] The complaint contends that the firms lent FTX an “air of legitimacy” through their actions, such as media coverage and social media promotion, but struggles to establish a clear intent to deceive or defraud.
Establishing liability is challenging because VC firms typically regard promoting their portfolio companies as part of their “value add.” While the FTX case is unique due to its allegations of fraud and securities violations, numerous VC firms have faced scrutiny for promoting companies that later failed or engaged in misconduct. It’s important to note that venture capital firms anticipate a high failure rate, as they invest in early-stage companies with uncertain outcomes. According to a study by Harvard Business School senior lecturer Shikhar Ghosh, about 75% of venture-backed startups fail to return their invested capital to investors.[24] Consequently, FTX’s failure is not alone sufficient to establish liability, the investors must have actually been aware of the fraud prior to promoting the company.
The Theranos scandal, which resulted in significant financial losses for investors like Rupert Murdoch and Betsy DeVos after the blood-testing startup was exposed as fraudulent, serves as a comparable example. While investors suffered public embarrassment and financial loss, successful liability actions were only brought against Theranos itself because knowledge of the fraud was known only to Theranos insiders.[25] In the FTX case, the plaintiffs may face challenges in proving that the firms acted with intent to deceive or defraud investors, rather than simply promoting an investment opportunity. However, the outcome of the case could have widespread ramifications for the venture industry. If the firms are found liable, it could set a damaging precedent for future VC investments and may ultimately limit the ability for startups to raise capital.[26]
With respect to the O’Keef v. Sequoia Capital case, Silvergate Bank and Signature Bank are facing allegations that they provided services to FTX, despite being aware of FTX’s fraudulent activities and misappropriation of customer funds.[27] The lawsuit claims that the banks provided FTX with services such as international wire transfers, ACH transactions, and Signet (Signature Bank’s custom crypto solution built for FTX), which allowed FTX to carry out its fraudulent activities. The lawsuit further alleges that the banks were required, under various anti-money laundering regulations, to conduct enhanced due diligence and ongoing monitoring on FTX but failed to do so adequately.[28]
The regulations that the banks are accused of violating include the Bank Secrecy Act (BSA), as amended by the USA PATRIOT Act, and implementing regulations issued by the Financial Crimes Enforcement Network (FinCEN) of the U.S. Department of the Treasury.[29] These regulations require banks to obtain and maintain certain records when opening accounts, monitor account activity for suspicious transactions, and take appropriate steps to understand the nature and purpose of customer relationships.[30] The lawsuit alleges that the banks knew that FTX was misappropriating customer funds by comingling them between FTX’s accounts and those held by Alameda, which is majority owned by SBF. Despite this knowledge, the banks continued to provide services to FTX and, in doing so, violated these regulatory requirements.
This case may have similarities to other cases in which banks have been accused of facilitating fraudulent activities by their clients. For example, in 2018, the US government fined Rabobank $369 million for violating anti-money laundering regulations and failing to prevent its clients from engaging in money laundering activities.[31] Specifically, in the Rabobank case, the bank was found to have ignored red flags indicating that its customers were involved in drug trafficking. The bank also failed to file suspicious activity reports with the U.S. Treasury Department, as required by law.[32]
However, holding the banks in the FTX case accountable in the same way as Rabobank may prove challenging for several reasons, particularly due to the unique nature of the cryptocurrency industry. The complaint relies on the assertion that Silvergate’s due diligence process must have revealed that FTX transfers to Alameda were originating from customer funds, and that Silvergate ignored its own findings “in service of its own profits.”[33]
While possible in theory, the complaint ignores that the complex and often opaque transactions within the cryptocurrency industry can make it difficult for banks to distinguish between legitimate and illegitimate transfers, especially when dealing with multiple accounts and entities. Unlike other industries with well-established regulations, the crypto industry is in a constant state of flux as lawmakers and regulators work to catch up with technological advancements and develop appropriate legal frameworks. This dynamic environment can make it difficult for banks to stay current on best practices and compliance requirements, leading to potential oversights or misinterpretations.
Moreover, it is essential to consider the scale and scope of the alleged fraudulent activities in the FTX case compared to the Rabobank case. In the Rabobank case, the bank was found to have ignored clear red flags related to drug trafficking, such as suspicious wire transfers and unusually large cash deposits. In contrast, the FTX case involves the misappropriation of customer funds within the context of a rapidly growing and complex industry, which may make it more difficult to pinpoint specific instances of misconduct and attribute them directly to the bank’s actions or lack thereof.
In light of these factors, predicting the outcome of the case against Signature and Silvergate is challenging. While the banks are accused of facilitating FTX’s fraudulent activities, the distinctive aspects of the cryptocurrency industry and the banks’ efforts to comply with existing regulations could introduce complexities to the case and potentially affect the final judgment.
V. Regulatory Challenges: The SEC and CFTC’s Struggle to Combat Fraud and Enforce Due Diligence in the Crypto Industry
The lawsuits against the VC firms and banks involved in the FTX scandal underscore the persistent issues of identifying fraud and deception in the crypto industry. Simultaneously, they reveal the limitations faced by regulatory agencies such as the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) in creating and enforcing crypto-specific regulations. SBF managed to circumvent existing SEC and CFTC regulations and spent years lobbying Congress and relevant agencies to delay the introduction of tailored legislation for the crypto industry.[34] Consequently, the lack of federal regulation leaves SEC and CFTC regulators ill-equipped for effective oversight in this sector.
1. SBF’s Political Influence Campaign
To safeguard FTX’s business operations from potentially restrictive regulations, SBF embarked on a strategic political influence campaign. He willingly testified before Congress on crypto market regulation while simultaneously pushing for a bill that would establish a regulatory scheme favoring FTX.[35] Gaining the support of policy professionals and political pundits, likely orchestrated through substantial campaign contributions made by FTX affiliates, SBF successfully contributed to the drafting of the Digital Commodities Consumer Protection Act. This bill aimed to grant the CFTC authority to regulate specific crypto products, displacing the SEC’s jurisdiction in this area.[36] As the CFTC is generally considered a more lenient financial regulator than the SEC, it is unsurprising that SBF met with the agency’s senior officials multiple times leading up to FTX’s collapse.[37] Although the bill never passed, the ongoing jurisdictional dispute between the SEC and the CFTC impeded the implementation of a robust regulatory framework.
2. Navigating Ambiguous Regulations
A key challenge lies in the fact that cryptocurrencies often defy classification within existing regulatory frameworks designed for traditional financial assets. The SEC primarily oversees securities, while the CFTC covers commodities and derivatives. The ongoing debate over categorizing cryptocurrencies as securities or commodities has resulted in uncertainty surrounding the agencies’ regulatory responsibilities.[38] Even when existing regulations apply to cryptocurrencies, enforcement can be problematic due to the decentralized and global nature of the crypto industry.[39] Regulators may struggle to identify and prosecute wrongdoers operating beyond their jurisdiction or grasp the complex, ever-evolving technology underpinning cryptocurrencies.[40] While the SEC and CFTC have initiated some enforcement actions against fraudulent crypto schemes, these efforts have been deemed reactive rather than proactive and often come after significant damage has been inflicted on investors.[41]
VI. A Collaborative Approach for the Future
Addressing the regulatory challenges posed by the rapidly evolving cryptocurrency industry requires a collaborative effort between both the SEC and CFTC. As cryptocurrencies and digital assets continue to proliferate into main street, a comprehensive regulatory framework is necessary to provide clarity and protect to investors. This may involve clarifying cryptocurrency classifications, amending existing regulations to explicitly address the unique risks associated with digital assets, and determining whether a digital asset should be considered a commodity (subject to the CFTC’s enforcement authority), a security (subject to the SEC’s jurisdiction), or something more novel.
In addition to establishing this framework, regulators should emphasize proactive measures to prevent fraud by providing clear guidance on due diligence requirements for banks and other financial institutions servicing the crypto industry. Furthermore, it is crucial to assess whether the SEC and CFTC collectively possess sufficient regulatory authority to effectively regulate crypto markets or if congressional action is required.
VII. Conclusion
The collapse of FTX and the subsequent revelations of fraud and corporate malfeasance have sent shockwaves through the cryptocurrency industry and the broader financial world. The case highlights the need for increased due diligence by investors and stronger regulatory enforcement to prevent such egregious actions by companies and their leaders. The downfall of Sam Bankman-Fried and FTX serves as a cautionary tale of the dangers of blindly trusting charismatic leaders and the importance of holding companies accountable for their actions. The fallout from this scandal will likely have far-reaching consequences for the cryptocurrency industry and will serve as a wake-up call for all investors to prioritize transparency, accountability, and ethical business practices.
[1] David Shepardson, U.S. House Committee to Hold Hearing on Collapse of FTX Reuters (2022), https://www.reuters.com/technology/us-house-committee-hold-hearing-collapse-ftx-2022-11-16/ (last visited Apr 16, 2023).
[2] Tracy Wang, Bankman-Fried’s Cabal of Roommates in the Bahamas Ran his Crypto Empire (2022), https://www.coindesk.com/business/2022/11/10/bankman-frieds-cabal-of-roommates-in-the-bahamas-ran-his-crypto-empire-and-dated-other-employees-have-lots-of-questions/ (last visited Apr 16, 2023).
[3] Samuel Bankman-Fried (release no. LR-25616; Jan. 19, 2023), Samuel Bankman-Fried (Release No. LR-25616; Jan. 19, 2023) (2023), https://www.sec.gov/litigation/litreleases/2023/lr25616.htm (last visited Apr 16, 2023).
[4] Id.
[5] FTX “Yield Bearing Accounts” (ybas) Lawsuit Lawyers, Parker Waichman LLP, https://www.yourlawyer.com/ftx-yield-bearing-accounts-ybas (last visited Apr 16, 2023).
[6] Connor O’Keefe v. Sequoia Capital Operations, LLC, et al., (S.D. Fla. 2023) No. 1:23-cv-20700.
[7] Id.
[8] Id.
[9] Lakshmi Varanasi, FTX CEO’s Bewilderment that Company Used QuickBooks for its Accounting Echoes a Scene in ‘Breaking Bad’, Business Insider, https://www.businessinsider.com/ftx-ceo-said-company-used-quickbooks-like-scene-breaking-bad-2022-12 (last visited Apr 16, 2023).
[10] Testimony of Mr. John J. Ray III CEO, FTX Debtors, December 13, 2022, House.gov (2022), https://democrats-financialservices.house.gov/uploadedfiles/hhrg-117-ba00-wstate-rayj-20221213.pdf (last visited Apr 17, 2023).
[11] Id.
[12] Samuel Bankman-Fried (release no. LR-25616; Jan. 19, 2023), Samuel Bankman-Fried (Release No. LR-25616; Jan. 19, 2023) (2023), https://www.sec.gov/litigation/litreleases/2023/lr25616.htm (last visited Apr 16, 2023).
[13] Id.
[14] Laurel Grass, 3 Wobbly Defenses from Bankman-Fried’s Substack Post, Law360 (2023), https://www.law360.com/articles/1571397/3-wobbly-defenses-from-bankman-fried-s-substack-post (last visited Apr 16, 2023).
[15] Testimony of Mr. John J. Ray III CEO, FTX Debtors, December 13, 2022, House.gov (2022), https://democrats-financialservices.house.gov/uploadedfiles/hhrg-117-ba00-wstate-rayj-20221213.pdf (last visited Apr 17, 2023).
[16] Q.ai, What Happened to Crypto Giant FTX? A Detailed Summary of What We Actually Know So Far, Forbes (2022), https://www.forbes.com/sites/qai/2022/12/13/what-happened-to-crypto-giant-ftx-a-detailed-summary-of-what-we-actually-know-here/?sh=6b79d65f60fa (last visited Apr 16, 2023).
[17] Id.
[18] Elijah Nouvelage, Silicon Valley Poured Money into FTX, With Few Strings Attached, The Wall Street Journal (2022), https://www.wsj.com/articles/silicon-valley-poured-money-into-ftx-with-few-strings-attached-11668103682 (last visited Apr 16, 2023).
[19] Id.
[20] Connie Loizos, If Sequoia, Paradigm and Thoma Bravo Settle a New Lawsuit, It Could Upend VC; Here’s Why, TechCrunch (2023), https://techcrunch.com/2023/02/15/settling-venture-capital/ (last visited Apr 16, 2023).
[21] Connor O’Keefe v. Sequoia Capital Operations, LLC, et al., (S.D. Fla. 2023) No. 1:23-cv-20700.
[22] Patrick J. Rabbitte v. Sequoia Capital Operations, LLC, Thoma Bravo, LP, and Paradigm Operations LP, (N.D. Cal. 2023) No. 3:23-cv-655.
[23] Id.
[24] Deborah Gage, The Venture Capital Secret: 3 Out of 4 Start-Ups Fail, The Wall Street Journal (2012), https://www.wsj.com/articles/SB10000872396390443720204578004980476429190 (last visited Apr 16, 2023).
[25] Attack of the Indirect Investor – Robert Colman V. Theranos, Morse Law (2023), https://www.morse.law/news/attack-of-the-indirect-investor/ (last visited Apr 16, 2023).
[26] Loizos, supra note 20.
[27] Supra note 21.
[28] Id.
[29] Id.
[30] Anti-Money Laundering, CFTC, https://www.cftc.gov/IndustryOversight/AntiMoneyLaundering/index.htm (last visited Apr 16, 2023).
[31] Karen Freifeld, Rabobank Agrees to Pay $368 Million Over Processing Illicit Funds, Reuters (2018), https://www.reuters.com/article/us-rabobank-fraud-usa/rabobank-agrees-to-pay-368-million-over-processing-illicit-funds-idUSKBN1FR2U4 (last visited Apr 16, 2023).
[32] Id.
[33] Supra note 21.
[34] Dave Michaels, FTX Collapse Draws Senate Scrutiny as Lawmakers Push for Crypto Oversight, The Wall Street Journal (2022), https://www.wsj.com/articles/ftx-collapse-draws-senate-hearing-scrutiny-as-crypto-oversight-in-focus-11669868740 (last visited Apr 16, 2023).
[35] Ankush Khardori, Gary Gensler on Meeting with SBF and His Crypto Crackdown, Intelligencer (2023), https://nymag.com/intelligencer/2023/02/gary-gensler-on-meeting-with-sbf-and-his-crypto-crackdown.html (last visited Apr 16, 2023).
[36] Id.
[37] Dave Michaels, FTX Collapse Draws Senate Scrutiny as Lawmakers Push for Crypto Oversight, The Wall Street Journal (2022), https://www.wsj.com/articles/ftx-collapse-draws-senate-hearing-scrutiny-as-crypto-oversight-in-focus-11669868740 (last visited Apr 16, 2023).
[38] Cheryl Isaac, CFTC and SEC Perspectives on Cryptocurrency and Digital Assets – Volume I: A Jurisdictional Overview K&, L Gates (2022), https://www.klgates.com/CFTC-and-SEC-Perspectives-on-Cryptocurrency-and-Digital-Assets-Volume-I-A-Jurisdictional-Overview-5-6-2022 (last visited Apr 16, 2023).
[39] Caroline Crenshaw, Statement on DeFi Risks, Regulations, and Opportunities, U.S. SECURITIES AND EXCHANGE COMMISSION (2021), https://www.sec.gov/news/statement/crenshaw-defi-20211109 (last visited Apr 16, 2023).
[40] Id.
[41] Cheryl Isaac, CFTC and SEC Perspectives on Cryptocurrency and Digital Assets – Volume I: A Jurisdictional Overview K&, L Gates (2022), https://www.klgates.com/CFTC-and-SEC-Perspectives-on-Cryptocurrency-and-Digital-Assets-Volume-I-A-Jurisdictional-Overview-5-6-2022 (last visited Apr 16, 2023).
