FTX Collapse - an oversight by financial professionals?
With the collapse of FTX, it has come to light that many seemingly experienced financial professionals were caught off guard. Some have been found to have benefited financially from FTX as "influencers” representing the platform for their followers and clients.
Background
Newly appointed FTX CEO John J. Ray filed a declaration with the United States Bankruptcy Court for Delaware earlier on Thursday, November 17th. For those who may not be familiar with Ray, he held previous roles in bankruptcy turnarounds including his role in assisting Enron Corp. Enron was the massive energy derivatives and trading entity that collapsed overnight in December of 2001 and would be one of the largest scandals to hurt the financial markets in the United States. John Ray therefore has a level of understanding beyond most people when it comes to sifting through a garbage bin fires. In a recent CNBC report, John Ray was quite blunt about the status of FTX and the actions of the former management team, calling it one of the worst instances of corporate controls he had ever seen.
Sam Bankman-Fried, the former CEO of Alameda Research and FTX, was singled out by Ray in a public statement he made for the inability of management to recognize and resolve a startling multibillion-dollar hole in the company's balance sheets. Ray is quoted as saying, “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.” Ray has indicated that significant forensic accounting will need to be done to figure out where the financials truly are, as the current state of the audited financial statements is not reliable.
“Forensic accounting utilizes accounting, auditing, and investigative skills to examine the finances of business. Typically, forensic accountants are CPAs that look for evidence of crimes and commonly work for insurance companies, financial institutions, and law enforcement agencies.”
Some reports are also starting to surface that describe the opulent benefits that FTX employees allegedly received in the Bahamas. According to Ray's court declaration, company monies were occasionally utilized to buy residences for advisers and workers under their names. Loans from FTX to these individuals were not documented, and instead, people received free and clear deeds to these homes in their own names. As reported by Semafor, The Albany resort was a secluded community and is a gated property that included a marina for mega-yachts and had numerous equestrian trails for those who love horses. Residences start at $5 million while most recently, SBF’s five-bedroom penthouse was listed for $40 million.
When it came to internal expense controls, Ray noted that “FTX did not have the type of disbursement controls that I believe are appropriate for a business enterprise. For example, employees of the FTX Group submitted payment requests through an online chat platform where a group of supervisors approved disbursements by responding with personalized emojis.” In summary, the situation that is being uncovered is that FTX essentially had no accounting department or financial oversight. It was basically a free-for-all for the executives and employees to do however they saw fit to spend the billions of dollars in client funds.
External audits
What’s interesting about this entire situation is that there were 3rd party auditors and companies that verified the financials of FTX. As reported by the Wall Street Journal, when FTX faced a liquidity crunch, the auditor of its U.S. unit seized the moment to promote its services for other crypto companies that were in the spotlight. Armanino LLP, the FTX US auditor tweeted, its a “great time to remember” Armanino LLP’s specialized crypto assurance”... referring to a product that verifies customer assets held by crypto firms. Armanino audited FTX last year, amongst other crypto firms, who some have also collapsed. Interestingly enough, Binance, the biggest crypto exchange, said it is working on a “proof of reserves” report, a type of third-party verification that isn’t quite a full audit of the company’s books, but they hope would give customers a level of assurance that reserves were intacted.
FTX Trading, the international trading arm of FTX, was audited by the mid-sized firm Prager Metis CPAs LLC. According to its website, Prager Metis's has 24 global locations, and is the first accounting company to open a location in the metaverse. According to the financial accounts, the firm's Hackensack, New Jersey branch awarded FTX Trading a clear audit opinion for the previous year.
Ontario Teachers Pension Plan - the big puzzle
For those unfamiliar with the Ontario Teacher’s Pension Plan (OTPP), it is a massive organization in Canada. They are one of the largest pension plans in the world, that manages the investment of teachers across the province of Ontario. Currently, the OTPP manages investments for 183,000 educators and it pays pensions to some 148,000 retirees in Ontario. Assets under management currently sit at just over $220 billion Canadian dollars. The OTPP is a successful pension plan manager that often averages 20%+ annual returns, allowing it to maintain funding for a large number of retired teachers. OTPP is no amateur when it comes to investing, and they are no slouch in the private equity world, so it’s quite puzzling when you look at their $75 million investment in FTX.
To be very clear, OTPP’s investment into FTX international is a drop in the bucket in comparison to their entire portfolio. It equates to only 0.033% of their entire portfolio, which is very little risk to their overall investment portfolio. The investment was also made through their Teachers Venture Growth fund, which was established in 2019 to invest specifically in emerging technology companies raising late-stage venture and growth capital. The question still remains, how did the significant layers of due diligence at OTPP miss the red flags at FTX?
In a recent press release, OTPP stated that “in FTX’s case, our underwriting process included working closely with third-party advisors and FTX to explore commercial, regulatory, tax, financial, technical and other matters. Recognizing that no due diligence process can uncover all risks especially in the context of an emerging technology business, the investment in FTX was sized moderately in relation to TVG and the overall portfolio of the Plan.”
Final takeaway
What’s interesting is that even various accounting regulatory bodies have recognized the need for more controls when it comes to cryptocurrency audits. The Institute of Chartered Accountants in England states that “Cryptocurrencies are still a bit of an unknown entity when it comes to audit and assurance.” In relation to what considerations auditors need to take when looking at cryptocurrencies, they say that “although it has existed for more than a decade, cryptocurrency is still somewhat of a novelty. Any official guidance is almost nonexistent. As a result, it can be extremely difficult to audit.”
What might be the most disappointing is that FTX was a rare example of a crypto company that did have a full audit under generally accepted accounting principles. SBF at one time hailed this as a milestone as private companies aren’t required to audit or publish their financial statements like public companies. Although cryptocurrencies will eventually reach a greater scale globally, the greed that continues to plague these initiatives will continue to hamper user and investor confidence in the decentralization of global currencies. As well, just like all traditional professional services industries, most are slow (and even the last) to adapt to new technologies. Third-party audits are still lagging behind the necessary checks and balances of having a reliable system in ensuring the public is protected or at least given the best information before they invest in new opportunities.
