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Blog > FTX Collapse Spotlights Operational Risk and Compliance Challenges for Investment Firms

The Arootah Return Blog

FTX Collapse Spotlights Operational Risk and Compliance Challenges for Investment Firms

What’s evident is the need for due diligence on the part of investors into the corporate governance of any fund, entity, or business in which someone is placing their money
Picture of person holding a cell phone that shows FTT token down -79%.

By now, we’ve all heard the story of the epic collapse of FTX, one of the world’s largest centralized cryptocurrency exchanges. While Bahamian regulators froze accounts belonging to FTX in early November, shortly thereafter, and amid large-scale customer withdrawals, the Founder and CEO of FTX, Sam Bankman-Fried, announced that FTX.com, FTX.US, Alameda Research, and more than 100 of its corporate affiliates were filing for bankruptcy.

FTX began a decline in the days leading up to the bankruptcy announcement, as various industry players questioned its balance sheet as well as the relationship between FTX and Alameda Research, a crypto-focused investment fund also founded by Bankman-Fried. It was alleged, for example, that Alameda drew customer funds from FTX. The reports triggered an estimated $6 billion in withdrawal requests amid questions on whether FTX possessed liquid assets sufficient to fund the withdrawals.

While the full story surrounding FTX’s apparent insolvency is still developing and neither FTX nor its executives have been officially charged with any wrongdoing, the fallout has led to publicly reported criminal and regulatory investigations. Of the many dimensions of the FTX fiasco, the most shocking is the comprehensive failure of corporate governance, now becoming clear as the bankruptcy process unfolds. Sloppy and likely illegal management practices at FTX have raised doubts which extend beyond crypto as an asset class and highlight the importance of operational due diligence. The crypto industry is taking the brunt of it right now. Crypto assets are down 75% in the last year. It is a “run” as fierce as the banking crisis of the early 1930s. The incident also cast doubts on several other components of the larger financial system.

What’s clear in this case is the need for proper due diligence on the part of investors into the corporate governance of any fund, entity, or business in which someone is placing their money. Equally as important, is that firms establish these best practices upfront to be able to share with investors, prospects, and regulators to highlight their commitment to sound and ethical business practices. While many aspects of corporate governance should be considered, a basic checklist is necessary to ensure certain key controls and safety measures are in place.

  • Board of Directors: To be independent and functionally competent as the steward of shareholder interests
  • Conflicts of interest: To eliminate self-dealing by executives and other violations of the company’s fiduciary responsibilities to its investors and customers
  • Financial controls: Including an independent audit to produce and verify accurate and timely financial information and provide full disclosure to investors and regulatory authorities
  • Capital structure and ownership: To provide a clear, traceable line of authority and fiduciary duty for all parts of a corporate structure

Many of the underlying operational and governance failures of FTX were highlighted by the new CEO of the now-bankrupt company, John J. Ray III, a Chicago lawyer.

“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,” Ray said in court filings. “From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated, and potentially compromised individuals, this situation is unprecedented.”

That statement came from the same executive who presided over the restructuring of energy giant Enron, which provides us with another milestone example of what can go wrong when investors fail to conduct sufficient due diligence.

Ray added the FTX Group did not maintain centralized control of its cash, failed to have an accurate list of bank accounts and account signatories, and neglected to maintain appropriate books and records or security controls for its digital assets. In the end, although cryptocurrency was often a misunderstood asset class, the issue is the importance of operational due diligence and understanding of financial controls. Although no investment is ever guaranteed or a sure thing, there needs to be a demonstrated structure in place every investor must consider in trusting that the entity is fulfilling its fiduciary obligation as a steward of capital. It’s important to understand the weak points and holes of any financial decision you make. When you trust an exchange, website, app, or anyone to hold your assets on their platform, you are entrusting that they’ll act with your best interests in mind. But as we see more and more, humans are inherently greedy, and you can’t assume that everyone is playing by the same rules as you.

Steven Wilner is Arootah’s chief operating officer, overseeing the company’s daily business operations, leading key initiatives, and implementing company-wide strategies. Steven has more than 34 years of industry experience as a COO, CFO, and CCO in building, growing, and leading successful hedge fund, investment advisory, and asset management firms across a variety of strategies. His hands-on experience with all aspects of the business, financial, and operational needs of hedge funds, family offices, and investment management firms has enabled him to successfully consult and advise several start-ups and established firms on best practices, process improvement, business development, and organizational efficiencies that have resulted in significant and measurable growth and cost-saving measures. 

Disclaimer: This article is for general informational purposes only and is not intended to be and should not be taken as professional medical, psychological, legal, investment, financial, accounting, or tax advice. Arootah does not warrant or guarantee the accuracy, reliability, completeness, or suitability of its content for a particular purpose. Please do not act or refrain from acting based on anything you read in our newsletter, blog or anywhere else on our website.

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