Ethical Failure Led to the FTX Scandal

In November 2023, after a monthlong trial in New York City, Sam Bankman-Fried (SBF), a 31-year-old former billionaire known as the “King of Crypto,” who earned his fortune running one of the biggest cryptocurrency exchanges in the world, was found guilty of fraud and money laundering. The jury found him guilty of lying to investors and lenders and stealing billions of dollars from the company he had founded, FTX, which was once valued at $32 billion. Customer withdrawals precipitated a run that exposed an $8 billion hole in the cryptocurrency exchange’s accounts and led to its collapse into bankruptcy in 2022.

Bankman-Fried’s sentencing is set for March 28, 2024; he’s expected to spend decades in prison. His case illustrates ethical issues that are applicable far beyond the world of cryptocurrencies and blockchain.

Ethical Breaches

Scandals of this sort often stem from—or are enabled by—defects in internal controls, regulatory compliance, human resources, and system integrity. Sam Taylor, head of corporate intelligence, Americas, at global cybersecurity consultancy S-RM, suggests that these factors apply to the case of FTX. Bankman-Fried consistently told FTX investors that multiple controls were in place, which was the crux of the U.S. Securities & Exchange Commission (SEC) civil complaint against the company. Many FTX funds were domiciled in offshore jurisdictions and allegedly handled by inexperienced people, Taylor says.

“SBF’s texts…suggest the decision to domicile the company in the Bahamas was an attempt to avoid future regulation,” he says. “Due to SBF’s leadership style, during FTX’s rapid growth period, it seemingly leapfrogged over the essential [step of putting in place a corporate governance] structure, and controls were never established.”

Sam Taylor, head of corporate intelligence, Americas, S-RM

Red Flags

Some of the failures at FTX include unreliable financial statements, mishandling of confidential data, diversion of corporate funds to purchase homes for employees, poor recordkeeping, and a lack of centralized control of company cash. These appear to be a result of a laissez-faire attitude to regulations and laws, as well as ethical breaches.

FTX allegedly had no recordkeeping, due in part to Bankman-Fried’s use of applications such as Snapchat that auto-delete after a short period of time for communication. Cryptocurrency isn’t regulated in the same way as securities are yet. However, if FTX were overseen by an independent regulatory body such as the Financial Industry Regulatory Authority or the SEC, the use of auto-deleting communications would be a direct violation of current requirements on brokerage firms and exchange markets to maintain records of communication and that they be available in a format where they can be reviewed for compliance purposes. The SEC has fined multiple banks and broker-dealers for failures to regulate off-book WhatsApp or text messages.

“The failure of FTX to log communications wasn’t a direct violation of federal securities laws, since it wasn’t regulated, but it is a standard that any other major financial institution would have to follow, and future regulation may require this standard for the cryptocurrency industry,” Taylor says. “From an ethical standpoint, and something that may have been inferred by the jury, it suggests SBF wanted the freedom to say what he wanted without it ever coming back to him.”

Another warning sign comes from a lack of trustworthy audits performed on FTX’s financial statements. One audit was conducted by an entity describing itself as “the first-ever CPA firm to officially open its metaverse headquarters in the metaverse platform Decentraland.” Further, many companies in the FTX Group allegedly didn’t have appropriate corporate governance, hold board meetings, or maintain an accurate list of bank accounts and account signatories. FTX lacked a CFO and internal audit team, and many of its subsidiaries—including cryptocurrency trading firm Alameda Research—didn’t have a CFO, chief risk officer, or controller.

“If the default of the firm is to seek out a Decentraland-based CPA, it would be hard if not impossible for the controller, CFO, or compliance officer to impose generally accepted corporate governance standards,” Taylor says. “Anyone in that role suggesting stronger controls would’ve likely met stiff resistance; they would want independent directors, independent auditors with experience auditing global or public companies, and the establishment of multiple layers of review and approval of financial statements and board decisions.

“What we know now is that FTX didn’t have a board of directors, which allowed SBF to maintain total control,” he says. “Independent oversight and respect for those in independent roles are keys to prevent the fraud that occurred here.”

Lessons Learned

The FTX scandal illustrates that several elements are necessary to prevent fraud and promote ethics, according to Taylor:

• Independent board oversight,
• Independent auditors,
• A strong general counsel with experience at a regulated financial institution,
• An internal compliance department reviewing the activities of all personnel with trading responsibilities, and
• A strong financial crimes or compliance controls group looking for conflicts of interest, sanctions issues, political exposure or influence, anti-money laundering, know-your-customers, risk management, etc.

“These functions aren’t cheap and take time to get up and running, but compared to a bankruptcy, the costs are de minimis,” he says.

While strong internal controls can prevent the types of unusually close relationships, poor corporate culture, and compromised systems that exposed FTX shareholders to elevated risks, they aren’t a panacea. It’s important for organizational leaders to instill an ethical culture as well.

“It’s true that internal controls can prevent this [kind of ethical breach] generally,” Taylor says. “However, a poor corporate culture and compromised systems can [enable bad actors to] find a way to circumvent any controls if they stem from the top, in this case: SBF.”

The fraud at FTX was a basic violation of the wall between the trading platforms—FTX and Alameda—as the founder allegedly comingled or borrowed against its customers’ funds. While cryptocurrency and blockchain are relatively new technologies, that type of scandal has happened several times in history.

“[Bernie] Madoff took in new customer funds to pay out old customers as part of a Ponzi scheme; however, this case is slightly different as it hews more closely to a failure to disclose an inherent conflict of interest between Alameda and FTX,” Taylor says. “This dynamic comes closer to a series of cases in the early 2000s brought by then-New York Attorney General Elliott Spitzer against investment banks for failing to disclose conflicts of interest between the stocks their analysts were recommending and the deals those same banks were running.

“The core legal and ethical issue here is disclosure,” he says. “If you’re telling one client one thing while not disclosing you have a conflict of interest, you’re not on solid ethical ground.”