“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.” Such was the lament of John Ray, the legendary restructuring executive tasked with the unenviable assignment of serving as the caretaker CEO of bankrupt FTX Trading Ltd. As the criminal and civil cases by the DOJ, SEC and CFTC against FTX founder and former CEO Sam Bankman-Fried play out in the courts, what does the “complete failure of corporate controls” at FTX teach us about corporate governance, unchecked founder control and the importance of proper oversight?
In 2017, Sam Bankman-Fried aka SBF co-founded Alameda Research LLC, a quantitative trading firm specializing in crypto assets. Two years later, he founded FTX Trading Ltd. to operate a global crypto asset trading platform. FTX then raised nearly $2 billion in four preferred stock funding rounds, during which it and SBF represented to prospective investors that FTX had appropriate controls and risk management mechanisms to protect customer assets, that those assets were safe and that Alameda was just another platform customer with no special privileges. It turns out that Alameda was exempt from whatever risk mitigation measures were put in place and was given significant special treatment on the FTX platform, including a virtually unlimited line of credit unwittingly funded by the platform’s customers. Also unbeknownst to FTX’s investors and trading customers was that SBF improperly diverted billions of dollars of customer assets to Alameda, and then used those funds to make risky venture investments, purchase Bahamian real estate for himself, his parents and other FTX executives, extend big loans to FTX executives (including SBF himself) and make large political campaign donations (he was the second largest donor to Democrat campaigns in 2022 behind only George Soros). None of this was disclosed to FTX investors or customers.
According to the SEC’s complaint, SBF’s “house of cards” began to crumble in May when crypto asset prices plummeted. Lenders demanded repayment of loans made to Alameda, and SBF directed Alameda to draw down billions of dollars from its “line of credit” from FTX to repay some of those loans. He also used those proceeds for additional venture investments and loans to himself and other FTX executives. In November, Binance, the world’s largest crypto exchange by volume, announced it will sell off its substantial holdings of FTX’s native token FTT (received in connection with the buyout of Binance’s 2021 investment in FTX), which caused the price of FTT to crater. FTX then entered into an LOI with Binance for Binance to acquire FTX, subject to due diligence. The next day, Binance announced it wasn’t going to proceed with the transaction because of issues it uncovered as part of its due diligence which were beyond its ability to help, as well news reports regarding mishandled customer funds and alleged Federal agency investigations. Faced with billions of dollars in customer withdrawal demands that FTX could not fulfill, FTX, Alameda and their affiliated entities filed for bankruptcy.
Related Party Transactions
From time to time, a company may have opportunities to do business with other entities that happen to be controlled by a director, officer or large stockholder of the company. Such related party transactions pose inherent risks to a company, namely that the related party will receive favored terms to the detriment of the company and its stockholders. Investors typically seek to guard against this risk in two general ways. First, by identifying at the outset during due diligence whether any related party transactions exist and whether adequate safeguards are in place to ensure that the terms of any such transactions are no less favorable to the company than could be secured in arms’ length transactions. Second, by negotiating for enhanced safeguards going forward to ensure that any such proposed transactions are properly vetted.
Two of the most effective mechanisms that investors negotiate for to mitigate against the risk of related party transactions are board representation and director vetos. As to the former, board representation proportionate to equity ownership is generally considered fair. For example, if a VC owns 25% of a company’s outstanding shares and the board consists of eight seats, it would be fairly typical for that VC to have the right to designate two directors on that eight person board. That board representation right would be set forth in the company’s amended and restated certificate of incorporation. Director vetos are typically set forth in an investors’ rights agreement between the investors and the company, which identifies a list of designated transactions that require the affirmative vote of the investor’s board designee(s). A typical director veto provision of this sort would look like this:
“Matters Requiring Investor Director Approval. So long as the holders of Series A Preferred Stock are entitled to elect a Series A Director, the Company hereby covenants and agrees with each of the Investors that it shall not, without approval of the Board of Directors, which approval must include the affirmative vote of the Series A Director,…enter into or be a party to any transaction with any director, officer, or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such Person.”
Looking the Other Way?
John Ray’s Declaration in the FTX bankruptcy case identifies “unprecedented” breakdowns in governance, oversight and controls. Among these were the absence of investor representation on the board, which in turn meant FTX was not required to obtain investor director approval for related party transactions. How did the VCs allow for this?
According to Bloomberg, the preferred stock investors in FTX included such VC luminaries as Sequoia Capital, Lightspeed Venture Partners, Iconiq Capital, Insight Partners, Thoma Bravo and SoftBank Group Corp., none of whom served as lead investor. With no lead investor, none of the VCs had the leverage to dictate terms. Also, all of the VCs made their investment in FTX when investor fervor for cryptocurrency startups hit an all-time high, giving those startups significant leverage.
It appears that FTX used its leverage to thwart any meaningful due diligence that could have identified the existing conflict with Alameda, as well as any effort to negotiate for board representation and director vetos. According to The Wall Street Journal, when Sequoia and other VCs “asked for a seat on the company’s board of directors, Mr. Bankman-Fried repeatedly pushed back, telling them their ownership in the company was too small to warrant it”. Maybe the VCs didn’t press the issue. Or maybe they did, but SBF was too busy playing League of Legends during the meeting at which the board representation proposal was made, just as he reportedly did while originally pitching Sequoia.
Or maybe the VCs were too smitten with SBF that they didn’t want to know. SBF had cultivated an image of a responsible, visionary leader of the crypto industry. He characterized FTX and himself as playing an important role in stabilizing the industry, and seemingly backed that up by providing credit to and taking over other failing crypto firms. During SBF’s pitch to Sequoia, a Sequoia partner reportedly typed “I LOVE THIS FOUNDER” to his colleagues. An inspiring founder can overwhelm otherwise cautious investors who end up abstaining from due diligence. Also, as I mention above, SBF was a top campaign contributor to Democrats. He also hired multiple former regulators to serve in senior positions at FTX, and his parents are both professors at Stanford Law School.
For its part, Sequoia insists that it performed adequate due diligence and that, in any event, its fund that invested in FTX had $7.5 billion worth of gains and that the FTX investment accounted for less than 3% of the committed capital for that fund. Fair enough. The damage may not be material to Sequoia and its limited partners. But the FTX debacle is devastating to tens of thousands of individuals who may have viewed Sequoia’s and the other VCs’ investment in FTX as a seal of approval.
In Noam Wasserman’s The Founder’s Dilemmas, he describes a key tradeoff that entrepreneurs face: they can be rich or they can be king. By that he meant that if an entrepreneur insists on maintaining complete control, his company is less likely to grow because he’ll have trouble raising capital, attracting key employees and achieving growth. If he raises capital to maximize growth potential, he’ll need to give up some control. Wasserman shows how all parties benefit from a proper growth-control tradeoff. Founders benefit from oversight because it makes the company more credible and thus more investable and ultimately more valuable. For the same reasons, oversight also helps investors and employees. As we see from the FTX fiasco, unchecked founder control runs the risk of value destruction.