FTX: When everyone ignores fiduciary responsibility.

At Airbase, our core competency is to de-risk financial operations. Our spend management platform is used by companies to get visibility and control over non-payroll spend, no matter where in the world that spending happens. Our customers — often hyper-growth companies, many venture funded — are serious about compliance and efficiency. So it’s surprising and fascinating to see FTX’s blatant and flagrant disregard for best practices around financial stewardship. Even more perplexing is why the admittedly few “grown-ups” — auditors, board members, investors — didn’t blow the whistle on any of the many dubious practices the FTX team was engaged in. 

I was curious how an expert might assess the FTX debacle, so I caught up with Jay Swaminathan, Founder, CEO, and Principal Consultant at AppWrap, a leading accounting automation consulting firm. His early career included a stint in audit at Ernst & Young. Here’s our conversation about what lessons this meltdown might hold.

The failure of accounting practices and auditors.

FTX had audited financials from March of 2022. Should anyone have taken comfort in those? If not, why not? What can investors rely on in audited financials?

Since it’s not a public company, only sophisticated investors would have relied on them — not public investors. But the risk that financial statements fail to reveal the whole picture still remains. If the company did go public, it could have swept up significant amounts of individual investors’ money. It’s possible, however, that the SEC may have identified the lax accounting in their S1 comment. In terms of relying on audited financials, they are the foundation of public market investing. It’s unthinkable that we would not be able to trust them. The reality is that accounting and governing laws are constantly working to catch up to advances in technology and new financial instruments — this is an example of that unfortunate lag.

Illiquid assets are often at the core of serious financial meltdowns. These can be the assets themselves or the structure of a transaction that makes it risky. With illiquid assets being used to secure questionable deal structures, there were both in this case. The SEC is looking at designating crypto as a regulated security. Would this designation have made at least some difference?

I think so. As I mentioned, accounting and compliance have not caught up with the technology, creating a serious disconnect between entrepreneurs and accountants. For example, what is the value of a property owned by the company in metaverse or the NFTs bought?

A failure to review internal controls.

Notably missing from the FTX audit was an internal controls review. What is typically revealed in this type of audit that could have raised awareness of irregularities?

There were so many gaping holes in internal control, including no proper approval for expense reimbursements, several transactions with a company related to the CEO, and significant margins given to employees. I think they also had severe internal control issues with their IT and IT security, given the news of a hack right after the meltdown. There were also internal controls around risk management that were squarely missing. For example, what was the goodwill carried in the books after the acquisition of Voyager for $1.3B and who were the valuation experts involved in this deal? We recently learned that FTX has 130 affiliated companies. This one fact alone should have been a matter of serious concern: What is their purpose? What kind of oversight existed for them, etc.?

Failure of the “external finance” model.

Most CFOs think of themselves as stewards of company capital, but FTX did not have a CFO or an internal finance or accounting department. Would the existence of a CFO or senior internal finance professional have made a difference? If so, how?

I think so. There is little news about the existing board of FTX U.S. and its governance. I think a CFO or somebody who is generally in a responsible accounting position would have tried to intervene in many of these practices, or possibly have become a whistleblower. For example, the simplest expense approval controls were missing. If you look into the COSO framework, none of the five components exist and any trained financial professional would have identified that easily. I suppose the auditors took a “maximum control risk” approach to this audit, but they should have been alarmed by the blatant non-existence of controls.

The COSO Cube

A failure of governance.

A Fortune article claims that investor Chamath Palihapitiya once advised Sam Bankman-Fried to form a board. FTX’s response? “Go f—k yourself.” Would a board of directors have made a difference?

The U.S. entity had a board, and I am curious to know what they did from the beginning of the year and what decisions of the board were ignored. Also, there is a discussion around the competency of the board, but from afar these look like really competent professionals — although maybe personal friends of the CEO. It could be that they had little to no visibility into the Bahamas organization and its relationship with Alameda. Or, maybe they were equally shunned with little or incorrect information. I am sure they are doing a lot of soul-searching as their personal brands are forever tainted by this experience.

But, yes, a fully functional board would have identified peculiar transactions, questioned these loose intercompany transactions, and at least slowed the fall.

A failure of capital markets.

Is FTX the result of a frothy market that has now corrected itself? If the investing environment had continued to offer ready cash in exchange for sky-high valuations, could Bankman-Fried have continued to keep his scheme going indefinitely? Do you think we will see a wholesale shift in attitudes amongst the investor community, or will this be treated as a one-off case?

Investor greed has created plenty of Ponzi schemes, some of them continuing undetected for years. Exchanges typically are low-margin businesses and the profit they seemingly generated is a good indication that something out of the ordinary was going on — of course, hindsight is 20-20. We have seen this from so many other players — Madoff, Theranos, etc. I am afraid that this is not going to be the last. I feel there are so many companies with crazy valuations, including public companies — especially ones that went public via SPACs. Companies whose value is based on questionable research are still out there — yet to be found. These false valuations are revealed from time to time, like when investors learned that the Nikola CEO made false statements about their technology. It’s probably safe to assume that many other companies are operating under false pretenses and new ones will be created. We’ve not seen the end of Ponzi schemes.

Ponzi schemes are possible when people believe in the person telling the story. Clearly, investors were enchanted by SBF’s story and brand. Do you think that the belief in the wunderkind model — i.e., this person is so much smarter and capable than anyone else — will continue, or do you expect to see increased cynicism from investors?

It’s a cycle. Of course, those of us from the Valley are super proud of our child prodigies and creative founders. But believing — and investing — in mavericks and their innovations doesn’t mean abandoning best practices when it comes to how a company operates. I’m curious about the fiduciary responsibility of the VC firms that attest to a company by investing in them. The customers, partners, and even employees derive comfort from their involvement and decide to engage with these companies based on the validation a top-named investor brings. The VCs and PEs spread their investments and can absorb a loss like this, but I think their reputation should also be impacted. How could they associate with a fraudulent company? An individual investor may not know the difference, but it is hard to say that a sophisticated venture capitalist would not have identified at least some irregularities. It raises the question: Were they waiting to deceive the public with the IPO and cash out? In that sense, were they also party to these Ponzi schemes?

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