Investors Should Have Seen FTX Coming

Text size About the author: R. Jeffrey Smith is managing director at RosettiStarr, a corporate security and investigations firm. He is a former investigative correspondent, foreign bureau chief, and national investigative editor at the Washington Post. He won the Pulitzer for investigative reporting with colleagues in 2006, and a National Magazine Award for public interest in 1986. Everything looked ideal, until it didn't. A supposed whiz kid with MIT branding who had made a small fortune in currency-price arbitrage invited investors to make much larger fortunes, using a special trading sauce whipped up for a hot new financial arena. He set up a workplace offshore -- but wasn't everyone working remotely anyway? He had a cherub's face, an earnest demeanor, and an impressive family pedigree. Sam Bankman-Fried even looked the tech-guru part, dressing in classic sweats and cultivating a reputation for long office hours and ascetic living. He claimed, moreover, to be earning huge sums of money mostly to help others and make the world a better place. He spoke inspirationally about how his trading company would soon become accepted as a repository of savings and a venue for low-cost transactions. Its revenues were reported to have jumped from $90 million in 2020 to more than a billion dollars in 2021. Bankman-Fried's firms -- FTX and Alameda Research -- imploded spectacularly after a nine-day downward spiral in November that wiped out billions of investors' dollars, led to his arrest, and forced him to surrender control. The courts will determine Bankman-Fried's legal culpability. He has pleaded not guilty. But as far as investors are concerned, the FTX saga is hardly the first time investment assets have evaporated on this scale amid plentiful signals that mischief was afoot, a lesson that hasn't fully sunk in and could easily be missed again. Bernie Madoff's Ponzi scheme defrauded thousands of investors out of tens of billions until he was arrested in 2008. Bankman-Fried's operation echoes one set up 17 years earlier by a Texan named Allen Stanford, who set up trading operations on an island, hired his former college roommate as an executive, arranged off-books loans from his firm, and went on to fleece thousands of investors out of roughly $7 billion, some of which he spent on real estate and other lavish perks. Stanford was convicted in 2012 of defrauding customers and sentenced to 110 years in prison. Watching another big scandal unfold -- followed by congressional investigations amid hand-wringing about regulatory distraction -- prompts fresh wonder about whether the financial system is so rickety and reliable corporate data so spare that ambitious investors are simply doomed to periodically lose their shirts. Investors looking at recent crypto losses have reason to ask whether the FTX fiasco could have been foreseen, and whether the problems that are now dogging Bankman-Fried are lurking elsewhere. A third of the members of Congress -- who recent tallies indicate took in roughly $93 million in political donations from FTX employees over the past two election cycles, funds they were asked to return by the end of February -- clearly did not ask those tough questions. But a close look at FTX's history makes clear there were red flags that could have sowed alarm for potential investors, regulators, and politicians, if only they'd conducted a serious research effort and paid attention to the results. To start with the basics, Bankman-Fried was candid long before his indictment about his weak preparation for creating Alameda at the age of 25. His undergraduate degree was in physics. He wrote on Twitter in August 2020 that he'd had trouble in school and "spent most of my life learning to be ok-but-not-very-good" at online gaming. At FTX, he was well-known, in fact, for gaming during business meetings, including during a digital February 2022 appearance at the Economic Club of New York. His habit abetted his reputation as an oddball savant but should have been seen instead as a signpost of inattentiveness to fundamentals -- an impactful shortcoming for someone forging a new path in an unregulated economic sector. Bankman-Fried admitted in the same 2020 Twitter thread that a year after founding Alameda the company was beset by internal conflicts, producing "some really shitty times. A management dispute I didn't know how to resolve boiled over and a bunch of employees left in early 2018." One of those who left was Tara Mac Aulay, an Alameda co-founder who said in a November Tweet that the resignations were "in part due to concerns over risk management and business ethics." In all, at least sixty-six FTX employees left the company before September 2022 and posted resumes on LinkedIn, creating a reservoir of information about the firm that potential investors could have exploited. The staff that remained at FTX and Alameda after these departures was noticeably young and inexperienced. In 2021, the first year that FTX pulled in more than $1 billion in revenue, FTX and Alameda co-founder Caroline Ellison, 28, tweeted that there is "nothing like regular amphetamine use to make you appreciate how dumb a lot of normal, non-medicated human experience is." Alameda, which she ran, persistently lost money during its brief existence, accounting for its eventually fatal dependence on FTX bailouts. None of this should have been a surprise. "We tend not to have things like stop losses," she said in a podcast last May. Stop losses are tools to manage trading risk. The ambience was more like that of a college fraternity than a multi-billion dollar business. FTX's head of engineering, Nishad Singh, was a high school friend of Bankman-Fried's younger brother, and Singh's girlfriend was the FTX human resources chief; Singh took out a $543 million loan from Alameda, according to court filings. Singh has pleaded guilty to multiple criminal charges. FTX's sales efforts sometimes followed a notorious boiler-room model, a circumstance that escaped wide notice because no one appears to have talked to its customers. After the implosion, the New York Times revealed that when Bankman-Fried circulated specific investment opportunities to regular clients, he attached 24-hour deadlines to qualify for the best prices. As one investor told the newspaper, the terms of the offers seemed like "code for saying 'no diligence.'" No prescandal review appears to have rigorously compared Bankman-Fried's public claims of personal privation and devotion to philanthropy with his actions. He told a reporter he planned to keep just 1% of his earnings. But the $190 million in total donations made by FTX's charitable foundation through the end of 2022 were essentially a rounding error (seven tenths of one percent) for someone with a personal fortune -- premeltdown -- estimated at $26 billion to $32 billion. The gap was another sign that beneath Bankman-Fried's claim to huge business acumen was a genuine talent for exaggerated self-promotion, a goal he has acknowledged in several postbankruptcy media interviews. A Feb. 8 court document filed in the Bahamas makes clear that FTX spent more on fancy properties and vehicles used by his employees -- $257.4 million to be precise -- than the FTX foundation funded by Bankman-Fried and his executives spent on philanthropy. Data of this kind is routinely recorded in retrievable public records. Some of Bankman-Fried's and FTX's expenditures were not public, or reported, because his company, like Allen Stanford's, chose to operate under much lighter disclosure rules than those governing firms in the United States or other industrialized countries. By itself, the offshoring of his work -- first in Hong Kong and then in the Bahamas with retained Hong Kong connections -- was a waving red flag, signaling that neither regulatory authorities nor the threat of public shame from adverse financial statements imposed real burdens on FTX for most of its existence. The absence of information, as any Sherlock Holmes devotee knows, can be significant. And at the FTX Group, there were, as the company's bankruptcy trustee John J. Ray III has testified, virtually no "audited or reliable financial statements." Not everything alarming about the company was hidden; it was instead largely ignored. FTX's U.S. branch had transparently bumpy relations with financial regulators, for example, including a clearcut conflict with the government about the company's trust and credibility. Last August, the Federal Deposit Insurance Corporation publicly ordered FTX U.S. to cease claiming that its products or accounts were federally insured. The company's U.S. president -- whose statements were specifically cited by the FDIC -- said "we really didn't mean to mislead anyone." But the exaggerated claims could have been read as signposts of an unscrupulous corporate culture and a harbinger of shortfalls in its revenues and profits. The FDIC's letter went to FTX's president and its chief regulatory officer, Dan Friedberg, who had a readily discoverable, blemished employment record. Friedberg had been a counsel to the online poker site UltimateBet in the mid-2000s as it attempted to cap payouts to customers cheated by the firm's software. To recap, then, those bewitched by Bankman-Fried ignored or simply failed to search for evidence of his low qualifications, his team's inexperience, the alarming qualities of its work habits, the large gaps between his promises and actions, the absence of any leavening executive influences or meaningful independent oversight, and a history of major clashes between Bankman-Fried and staff or regulators. All of this was discoverable before the bankruptcy. Was FTX's downfall predictable? You bet it was. And there's plenty of reason to believe the next big downfall will have been predictable, too. Guest commentaries like this one are written by authors outside the Barron's and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to ideas@barrons.com.