By now, you may be generally familiar with the recent collapse of FTX, and some of the reasons for its failures are obvious. But by examining FTX side-by-side with perhaps the most infamous investment fraud ever perpetrated, we can discover some keys as to why lapses in due diligence may never be a thing of the past. These two epic failures bear little factual resemblance to one another at first glance, but this post will look more closely at the more transcendent lessons they hold.
FTX, according to Investopedia, was a leading centralized cryptocurrency exchange specializing in derivatives and leveraged products. It also provided spot markets in more than 300 cryptocurrency trading pairs, including FTT (its native token) vs. other cryptocurrencies. FTX filed for Chapter 11 bankruptcy protection on November 11, 2022, when the exchange collapsed as the result of "a complete failure of corporate control," according to FTX’s new CEO.
The exchange, along with Alameda Research, a “secretive crypto hedge fund,” was created by 30-year-old entrepreneur Sam Bankman-Fried. According to an anonymous source cited by the Wall Street Journal, in November 2022, Alameda Research owed $10 billion to FTX. The source said FTX had lent Alameda Research money from customer funds at FTX. Alameda Research’s CEO was Bankman-Fried’s 28-year-old former girlfriend, Caroline Ellison. FTX did not have a CFO, and its COO, Constance Wang, was also 28 years old. A cursory review of each of their bios reveals that they are educated but inexperienced relative to their professional roles surrounding an exchange with approximately one million customer accounts and $10 billion of daily transaction volume.
Red flags abound
Have you picked up on any due diligence “red flags” yet, such as what processes did FTX have in place to prevent the transfer of client funds to an affiliated but separate entity, what other conflicts of interest existed at the management level, why is executive management so inexperienced, why is there no CFO, does anyone fully understand the business model, and what is a native token anyway?
What if you further learned that FTX’s financial statements were not made public and were not audited by a “big four” audit firm, it had only 300 employees, its main operations were based in the Bahamas, and it was incorporated in Antigua and Bermuda? If you did not lose any money with FTX, you will say the red flags are obvious, “I would never have invested in something so opaque, even if (as actually happened) many large and reputable money managers have already invested.”
But lapses in due diligence come in all shapes and sizes.
What if, however, the fact pattern was vastly different? What if instead of inexperienced individuals bringing to market an investment opportunity in new, esoteric, cutting-edge, cyber currency trading strategies, an experienced individual with a background in running a reputable and highly regulated exchange offered a “collar strategy” investment, whereby underlying stocks are protected by the purchase of put options? Say, perhaps, rather than offering the allure of massively outsized returns, he offers a boring but predictable and reliable growth pattern. What if the offer were sweetened by adding that several big four audit firms have given a clean bill of health to multiple funds that have already invested, and the returns have been stellar throughout multiple business cycles?
Enter Bernard Lawrence Madoff
Over an 18-year period culminating in 2008, hedge funds gained an average of almost 12% a year, but the returns fluctuated sharply from year to year, while Bernie Madoff claimed an average annual return of better than 11% but with very little volatility. His firm purported to return a steady 1% per month and never to have suffered an annual loss. In 1983 Bernie Madoff was elected to the NASD (now known as FINRA) advisory council, where he sat on numerous committees and task forces, chairing several, and was a prominent member of the securities industry throughout his career. Madoff served as vice chairman of the NASD (while his Ponzi scheme was underway), a member of its board of governors, and chairman of its New York region. Madoff wasn’t merely a name associated with NASD, in some sense, Madoff was NASD. He was also a member of NASDAQ's board of governors and its executive committee and served as chairman of its trading committee.
Did you spot any red flags?
Bloomberg News reported that a research firm warned clients away from Madoff’s firm after discovering that its books were audited by a three-person accounting firm. At the time, Ernst & Young audited certain funds-of-funds which held Madoff’s investments but not Madoff’s direct holdings. Ernst & Young was later sued on the basis that it failed to perform adequate audit procedures to test the existence of assets held by the fund-of-funds and instead relied on assurances made by Madoff, to whom the fund-of-funds had outsourced everything from investment decisions to record keeping.
Why do lapses in due diligence come in all shapes and sizes?
FTX and Madoff appear to be at opposite ends of a vast due diligence failure spectrum, so what hope do we have in averting failures going forward? The first step is identifying what these “lessons learned” have in common. In each instance, investors believed in the genius of the investment schemes, that is to say, they believed they had discovered something others had not yet realized, ideas and individuals that were ahead of their time, so innovative they would revolutionize investing. Investors did not want to miss out on opportunities that were almost too good to be true. In the instance of FTX, they believed a genius had devised a plan that would one day revolutionize trading with cryptocurrency in ways others were only just now starting to realize, and in the instance of Madoff, they believed a genius had discovered a trading model that somehow banished volatility from the trading equation without sacrificing return. Perhaps the popularity of these beliefs is better explained by human nature than by deeper assumptions about investing behavior that underly economics and finance: We are more likely to believe in things we want to believe are true.
Human fallibility explains why we can easily overlook red flags, including conflicts of interest. As with Bankman-Fried, Madoff had conflicting business interests. Whispers on Wall Street, well in advance of his downfall, were that something was fishy about his investing success; perhaps he was “front-running” his separate market-making business with his investment business, and that explained why he was outperforming his competitors. The darker side of human nature may be that some people were willfully deaf to the whispers as long as they were in on it.
What can we do about It? Humans are human.
So if lapses in due diligence can come in all shapes and sizes because humans are... well... human, what can we do to avoid lapses? To answer the question, I think it’s best to begin with the quintessential guide to investing: Securities Analysis by Graham and Dodd, which was first published in 1934. According to the principles of investing, we should make it a rule never to invest outside of our competency. We should find business we understand, and we don’t need to invest in overcomplicated opportunities or in extremely complex business models to make money, and we should avoid acting on emotions. One of the concepts heavily discussed in investing today, and a concept used to explain the FTX run-up, is the “fear of missing out,” or FOMO. Does prudent investing require us to never feel FOMO or regret? Absolutely not, but we should only feel FOMO when, through a lack of due diligence or lack of effort, we fail to understand a great opportunity. Furthermore, the greater risk may be accepting investments we should have ruled out, as opposed to erroneously rejecting investments we could have “ruled in.”
What, then, are the key elements of a comprehensive system of due diligence?
Ok, so you have done your due diligence on an investment, you fully understand it, and believe in the structuring and economic environment necessary to support its success. The next step is to become comfortable with the individuals responsible for its success. Have they been trustworthy, and thus, what is the likelihood they will continue to act with integrity? A comprehensive due diligence review covers an analysis of the investment opportunity and the individuals responsible for its success through fact-based evidence.
No system of due diligence can foresee the future, but a comprehensive system can greatly minimize unfavorable outcomes. In the example of FTX, there were not only gaps in the control infrastructure, substantial conflicts of interest, and questionable affiliated transactions but a lack of experience with the individuals charged with executing control over the firm. With Bernie Madoff, there was a classic due diligence error, a deferral to authority vs. a factual verification. The fund-of-fund auditors deferred to the reputation of Mr. Madoff in accepting the word of his small, hand-picked auditors, as opposed to confirming the existence of his assets first-hand. Financial services regulators eventually concluded that in the 40 years of Madoff trading records they reviewed, there was no evidence Madoff ever traded a single share on behalf of his investment clients. While no amount of due diligence can prevent bad behavior, robust, comprehensive, fact-based (evidence-based) due diligence can oftentimes uncover when it has occurred or predict when it is likely to occur.