Focus on Fraud: FTX Case Study PDF

Focus on Fraud! FTX! What Happened? Introduction • Why study fraud? • How many corporations have committed fraud? • How many companies have committed fraud? • How many not-for-profit organizations have committed fraud? Introduction • Entities do NOT commit fraud • People do • People can be studie...

Focus on Fraud! FTX! What Happened? Introduction • Why study fraud? • How many corporations have committed fraud? • How many companies have committed fraud? • How many not-for-profit organizations have committed fraud? Introduction • Entities do NOT commit fraud • People do • People can be studied • Most people behave in patterns • That is the basis for the science of psychology • By studying fraud cases, we can discover patterns that people will one day repeat Introduction • Definition of fraud • An intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception that results in a misstatement in financial statements that are the subject of an audit. Introduction • Responsibility for detecting fraud • Preparation • No • Compilation • No • Review • No • Audit • Must assess and respond to the risk of fraud Fraud Focus Case FTX! What Happened? The Company The Company • FTX was the world’s third largest cryptocurrency exchange • FTX was Bahamas-based but had a US affiliate, FTX US • US residents could only trade through FTX US • It offered derivatives, options, volatility products and leveraged tokens and spot markets in over 300 cryptocurrency trading pairs • Its own native token was FTT/USDT The Company • FTX had easy to use desktop and mobile trading apps with reasonable fees which attracted investors of all levels of expertise • Nine major currencies were supported including the dollar and the euro • Silicon Valley investors put $1.8 billion in FTX • Before collapse, FTX had been valued at $32 billion The Company • FTX ran extensive advertising to lure people to use the potential of crypto • Investors included celebrity athletes and musicians • They also had celebrity endorsements • 11 of them are now being sued for damages in the case • They are liable due to the promoting of “unregistered securities” • Taylor Swift was in talks for a $100 million sponsorship deal but backed out when she was told the securities were unregistered • Coming from a wealth management family, she knew better The Company • High profile investors included: • Sequoia Capital • Over $200 million • Dan Loeb’s Third Point LLC • Tiger Global Management • Ontario Teachers’ Pension Plan • SoftBank Group Corp • Temasek Holdings (Singapore investment company) • FTX executives and employees The Company • Founder • Sam Bankman-Fried (SBF) • MIT graduate • 30 years old at the time The Company • SBF also co-founded Alameda Research with Tara Mac Aulay • Alameda Research was his hedge fund • Alameda and FTX shared office space, employee, tech and communication channels • SBF owned 90% • Alameda fell into trouble early in 2022 when crypto prices dropped The Company • SBF and his team were some of the biggest donors in US politics • More than $70 million to election campaigns in less than 18 months • SBF personally gave $40 million • Mostly to Democrats and liberal groups • Executive Ryan Salame gave $23 million • Mostly to Republicans and conservative groups • The groups could be forced to return the money if they still have it • Campaign disclosures indicate the money has been spent • These donations gave FTX attention in Washington for investors The Fraud The Fraud • The key players • Sam Bankman-Fried • His parents were both Stanford law professors • 2014 MIT graduate with a bachelors in physics and a minor in math • After graduation he went to work for Jane Street Capital • In November 2017 he co-founded Alameda • In April 2019 he founded FTX The Fraud • The key players • Gary Wang • Met SBF at a high school math camp • College roommate with SBF at MIT • Co-founder of both FTX and Alameda • Wang was one of the few people with access to the root code on the exchange The Fraud • The key players • Caroline Ellison • CEO of Alameda • She and SBF met as traders at Jane Street Capital • They also became romantically involved The Fraud • From the the very beginning of the exchange, SBF moved FTX customer funds over to • Alameda Research • Venture investments • Real estate purchases • Political donations • The moves were concealed The Fraud • The central player in the fraud was “Alameda Research” • Alameda had a “secret exemption” from the FTX exchange’s process for liquidating bad trades • Thus they could incur more risk • Alameda was the ONLY customer to maintain a negative balance at FTX • SBF told the programmers to write code to allow that for Alameda • Internal systems at FTX did not track funds sent to Alameda as loans • Alameda did not disclose any money owed to FTX • All loans were poorly documented or not at all The Fraud • From 2019 to 2021 customers of FTX wired money to Alameda and its subsidiary North Dimension Inc. • North Dimension did not disclose its relationship with Alameda • Customer funds for FTX were not segregated and were commingled with other assets • SBF claims this was a hold over from when FTX didn’t have its own bank account The Fraud • Alameda’s collateral was mostly illiquid assets such as FTT, a token issued by FTX • FTX did not disclose the related party special treatment given Alameda on the FTX platform • FTX also did not disclose the financial risks created by the relationship The Fraud • Ellison manipulated the price of FTX issued digital asset FTT in order to inflate the value and use it as collateral for borrowings • SBF had Ellison buy FTT to offset downward selling • In interviews, SBF stated that FTX and Alameda were separate and there were no special privileges The Fraud • Alameda spent billions on startup operations • It often used FTX cryptocurrency as collateral for borrowing • While Caroline Ellison was CEO, evidence indicates that SBF actually ran it • He claims he stepped away from Alameda and had no idea what went wrong or how FTX money got there • He insinuated that she was the problem The Fraud • Alameda became SBF’s “piggy bank” • Between March 2020 and September 2022 he took $1.3 billion in loans • It also lent $225 million to Gary Wang but that was mostly used by SBF • Wang did withdraw $200,000 for himself The Nature of Fraud Nature of Fraud • The 3 characteristics of fraud • Incentive • Pressure inside or outside • Personal Nature of Fraud • The 3 characteristics of fraud • Opportunity • Lack of proper controls • Opportunity for override Nature of Fraud • The 3 characteristics of fraud • Rationalization • Lack of ethics • Attitude • Pressure The Collapse The Collapse • SBF made the decision that signaled the end • He lent billions of customer assets to Alameda to bail them out • On 11/2/22 CoinDesk published a report that questioned the health of both FTX and Alameda • People paid heed and the customers panicked • Money was taken out fast • FTX agreed to sell to Binance (largest crypto exchange), but they backed out and FTX was forced to file bankruptcy • FTX filed for Chapter 11 bankruptcy on 11/11/22 and SBF resigned The Collapse • The Bahamas connection • FTX was founded in Hong Kong, but moved to and was headquartered in the Bahamas due to favorable regulations • On 12/29/22, the Securities Commission of the Bahamas reported that they seized $3.5 billion in digital assets in mid-November 2022 • They said they did this after SBF told authorities there was a hacking attempt The Collapse • The Bahamas connection • They indicated that SBF and Mr. Wang facilitated the transfers • On 12/30/22, FTX’s US management indicated the worth to be only $296 million at the transfer date and $167 million at the current date • The question has been raised whether the SC acted properly Arrest Arrest • SBF was arrested on 12/12/22 in the Bahamas after the US filed criminal charges with 8 criminal counts • Wire fraud • Commodities-fraud conspiracy • Securities-fraud conspiracy • The SEC and the Commodity Futures Trading Commission sued SBF as well on 12/13/22 • The SEC lawsuit seeks • Civil fines • Surrender of any profits • Bar from serving as officer or director of a public company Arrest • Additional charges of bribery • SBF has also been indicted on conspiracy to bribe Chinese government officials • The intent was to regain $1 billion in frozen crypto • In 2021 bribed one or more officials with $40 million in crypto to regain access to the frozen funds • Chinese law enforcement had seized the assets as part of its investigation of a party that traded with Alameda • After months of failed attempts to regain control, SBF had Alameda employees pay the bribe Arrest • Additional charges of bribery • The funds were unfrozen after the initial bribe payment • He then made additional payments of tens of millions to complete the deal • Alameda used the funds to fund additional trades • The Chinese Embassy did not comment Arrest • SBF spent 10 days in the notorious Fox Hill detention facility in Nassau • SBF is quoted as saying after release “I thought it was going to be like “The Shawshank Redemption”” • In contrast, he was spared from the general population and kept with five other inmates at the infirmary • He showered under a cold-water hose and dried using a 3x5” towel Arrest • He slept on a bed made of cardboard and semi-soft plastic on top of stilts • He used his suit jacket (that he used in court) as a pillow • He was denied his vegan diet and ate peanut butter, Wonder bread and fresh fruit • He said the worst part was the lack of internet • He said it was 80% of the total cost of being in prison Arrest • SBF was released on bail of $250 million on 12/22/22 • He was ordered to remain at his parents’ house in Palo Alto CA • This is the highest bail ever set • His parents helped secure his bond with equity in their home valued at $4 million • He is prohibited from using his parents’ computers and other devices, can only visit preapproved websites and can only use a phone without internet access • All visitors are screened for electronic devices • He is required to wear a monitoring bracelet Arrest • His trial is set for 10/2/23 and he faces up to 115 years in jail Arrest • Caroline Ellison and Gary Wang have pleaded guilty to similar charges made against SBF • The SEC and CFTC have sued them as well • Ellison and Wang agreed to settle claims and accept liability • Ellison and Wang confessed they were aware of the misuse Arrest • Wang wrote the software giving Alameda access to FTX customer assets • SBF did direct him to do so • Wang owned 10% of Alameda • Ellison used customer money for trading and high-risk investments • Also at the direction of SBF Bankruptcy and Investigation Bankruptcy and Investigation • FTX filed for Chapter 11 bankruptcy on 11/11/22 • John J. Ray was appointed the new CEO of FTX charged with overseeing the bankruptcy • He has extensive experience in high profile bankruptcies including Enron • He said he has never seen anything as bad as FTX • “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” Bankruptcy and Investigation • Findings • Supervisors approved payments with emojis • Employee homes were bought with company funds • SBF used messaging programmed to auto delete after a short time and encouraged employees to also do • Bank accounts and financials were not tracked • Software was used to hide the misuse • Many employees had no idea Bankruptcy and Investigation • In his first interim report as part of the bankruptcy, John J. Ray stated the following: • “Hubris, incompetence and greed” set the stage for collapse • Management “expressed little interest in instituting appropriate oversight or a control framework” Bankruptcy and Investigation • In his first interim report as part of the bankruptcy, John J. Ray stated the following: (cont.) • Management was a small group who • “stifled dissent, • commingled and misused corporate and customer funds, • lied to third parties about their business and • joked internally about their tendency to lose track of millions of dollars in assets.” Bankruptcy and Investigation • In his first interim report as part of the bankruptcy, John J. Ray stated the following: • FTX lacked • Key executive roles • A cybersecurity department • Processes for detecting and handling security risks • These lack of policies exposed millions of dollars in crypto assets to a “grave risk of loss, misuse, and compromise” Bankruptcy and Investigation • What accounting software did FTX use? • SAP Business One Professional? • Sage 300? • Oracle NetSuite OneWorld? • AccountMate? • Open Systems Traverse • Answer: QuickBooks! Bankruptcy and Investigation • On 12/13/22 the SEC filed a suit against FTX and SBF • The SEC suit is based on the allegation that SBF hid business practices from investors • It does NOT claim FTX or SBF issued digital assets that violated investor-protection laws • The SEC claims SBF had an unlimited line of credit with FTX which was never disclosed to investors Bankruptcy and Investigation • Money was diverted from FTX to Alameda to support their lending relationships and inflows from other investors • SBF claims he has no idea where the money went • Prior to his arrest in a live stream from the Bahamas, SBF said he didn’t intend to commit fraud or use customer funds to cover Alameda Bankruptcy and Investigation • Investor identities • A group of international investors has requested their names not be released for privacy • They say disclosure would subject them to the risk of theft and other scams • FTX lawyers argue keeping the information private would help maintain whatever value is left • The Justice Department and the WSJ have asked that the names be released for full transparency • It is normal in bankruptcy proceedings • Government lawyers have argued that this could have a negative impact on future bankruptcies The Auditors The Auditors • Units of FTX were audited by two US accounting firms • Prager Metis CPAs, LLC • FTX Trading Ltd • Armanino LLP • FTX US • Red flag• Why were there two audit firms? The Auditors • Neither firm was in the Big 4 or second tier • Prager Metis indicates that its headquarters is in the Metaverse • Armanino claimed to be the “first accounting firm to formalize and complete a ‘Proof of Reserves’ for a digital asset exchange” • Noah Buxton, Digital Asset Practice Leader, Armanino LLP The Auditors • Both firms did perform limited SEC engagements and were thus under the PCAOB • Due to the small number, they were only subjected to PCAOB inspection every three years • Their PCAOB Inspection reports are public record and can be accessed easily online The Auditors • Prager Metis • 2020 PCAOB Inspection issued 5/13/22 • Of the 4 audits inspected, all 4 had deficiencies • 3 had multiple • 1 had a single • Issues • Revenue • Accounts Receivable • Goodwill and Intangible Assets • Inventory • Long-Lived Assets • Cash and Cash Equivalents • They also found noncompliance with PCAOB standards and rules The Auditors • Armanino • 2021 PCAOB Inspection issued 10/6/22 • Of the 2 audits inspected, both had deficiencies • Both were found to have a single • Issues • Revenue • Significant account • Information technology • They also found noncompliance with PCAOB standards and rules The Auditors • John J. Ray stated that the audited statements could not be relied upon • Both firms are being sued for their involvement • The SEC is looking closer at the work of audit firms for crypto companies • This has led to firms dropping crypto clients • However, many of the firms are offshore where they avoid oversight • FTX was based in the Bahamas Fallout Fallout • Some lawmakers have called for new regulation on crypto • Evidence appears to indicate that the collapse of FTX had nothing to do with crypto, but was classic fraud • SEC chair Gary Gensler says more is not needed • He believes crypto firms should be required to comply with existing rules • He has added more enforcement attorneys to focus on crypto • This has put more pressure on the CFTC Fallout • Many CPA firms are parting ways with crypto companies due to risk of lawsuits, increased oversight and damage to reputation • Many crypto companies share the common problem of lack of effective internal controls • Looking at 19 publicly traded crypto mining companies found that none were audited by the Big 4 • These firms have decided the risks are too high Conclusion Conclusion • This was NOT about crypto, NFTs, or other scary stuff no one understands • Fraud is always committed by people, not companies • It was simple theft using old fashioned tried and true methods • Money was simply shifted to a related party where it could be stolen • The issues should have been discovered if basic audit procedures had been followed Conclusion • Fraud has three basic elements • Incentive • Opportunity • Rationalization Conclusion • A look at the Fraud Triangle • Incentive • Greed? • The thrill of success? Conclusion • A look at the Fraud Triangle • Opportunity • Unknown territory for most • Control of the code • Investors were excited Conclusion • A look at the Fraud Triangle • Rationalization • Lack of a moral compass? • Entitlement? • It was all a game? Conclusion • In an audit we are required to consider fraud in determining if the financial statements are materially correct • We can never obtain complete assurance • We have no responsibility in other engagements • However, there is still an expectation Conclusion • Problems for the auditors • New company • Fast growth • Lack of understanding of the business environment • Lack of internal controls • Related parties • Emerging industry • Limited SEC experience • These are symptoms to which we should all pay attention Conclusion • Keys to success • Understanding that some people are capable of doing bad things • Knowing the kinds of fraud which people have committed over the years • Being aware of own bias which may prevent us from seeing things • Documenting our work • Staying independent Bibliography Bibliography • FTX Founder Sam Bankman-Fried Led Yearslong Fraud at Company, SEC Says • 12/13/22, WSJ, Dave Michaels • Caroline Ellison Was Alameda’s CEO, but Officials Say Sam BankmanFried Ran It • 12/14/22, WSJ Justin Baer • FTX Wants to Claw Back Sam Bankman-Fried’s Donations • 12/20/22, WSJ, Patricia Kowsmann • FTX and Sam Bankman-Fried: Your Guide to the Crypto Crash • 12/22/22, WSJ, Eric Wallerstein • FTX Collapse Puts Pressure on SEC’s Crypto Enforcement Strategy • 12/22/22, WSJ Paul Kierman • New FTX Charges Against Caroline Ellison, Gary Wang Show U.S. Is Going After Deputies Too • 12/22/22, WSJ, Vicky Ge Huang • Justice Department Has Sharp Eye on Crypto Sector, Top Official Says • 12/23/22, WSJ, Aruna Viswanatha Bibliography • FTX Customers Want Identities Redacted From Bankruptcy Filings • 12/29/22, WSJ, Andrew Scurria • Bahamas Regulator Says It Seized $3.5 Billion in FTX Crypto Assets • 12/30/22, WSJ, Jonathan Randles & Becky Yerak • Bahamas Regulator Says It Seized $3.5 Billion in FTX Crypto Assets • 3/28/23, WSJ, James Fanelli • FTX crypto founder Sam Bankman-Fried thought jail would be 'like The Shawshank Redemption': report • 1/28/23, Fox Business, Breck Dumas, Marta Dhanis and Reuters • FTX: An Overview of the Exchange and Its Collapse • 1/5/23, Investopedia, Timothy Smith Bibliography • Bankrupt crypto exchange Technology FTX has recovered $7.3 billion Future of Money in assets • 4/12/23, Reuters, Dietrich Knauth • Hubris, Incompetence, and Greed' Plagued Failed Cryptocurrency Exchange FTX • 4/10/23, Investopedia, Mack Wiloski • Exhibit(s) (Notice of Filing First Interim Report of John J. Ray III to the Independent Directors on Control Failures at the FTX Exchanges) Filed by FTX Trading Ltd.. (Attachments: # 1 Exhibit A) • 4/9/23 • Taylor Swift Avoided FTX Lawsuit by Asking One Simple Question • 4/19/23, Investopedia, Hiranmayi Srinivasan