The Bottom Line: The FTX Trading Ltd. debacle, like previous implosions due to governance failures and fraud, should give ESG integration skeptics pause for thought.
Summary
According to published accounts, the rapid bankruptcy filing of FTX Trading Ltd., an exchange for trading cryptocurrencies founded in 2020 by Sam Bankman-Fried, and more than 100 related entities, including Alameda Research, could involve some one million individual creditors and estimated debts to its customers and investors, direct and indirect, of about $8 billion¹. There will be additional fallouts, likely involving other crypto entities, such as exchanges, lenders, and tokens, and beyond, especially on the regulatory front, and a final loss tally may not be known for some time. Governance failure and potentially fraud appear to be at the core of FTX’s collapse and both the Securities Exchange Commission and the Commodity Futures Trading Commission are investigating FTX. The losses are not only impacting retail but also sophisticated institutional investors. These include sovereign wealth funds, private equity firms, hedge funds, pension funds, endowments, and family offices, as well as other investment vehicles. Criminal fraud findings complicate the issue, but a high likelihood of exposure to loss could potentially have been red flagged if corporate governance due diligence had been methodically undertaken and the results factored into investment decision making. While challenging to evaluate, governance issues have played an important role in the evaluation of corporations, financial institutions, public finance organizations and other entities. The emphasis on governance is not a new development and the link between corporate governance and the performance of companies has been well established. This has preceded the introduction of ESG integration in investing practices with its principal emphasis on risk mitigation, but in more recent years the importance of governance has been reinforced by the adoption of ESG investing principles that have recently faced headwinds. The FTX debacle, like previous implosions due to governance failures, should give ESG skeptics pause for thought.
High likelihood of exposure to loss could potentially have been red flagged if methodical governance due diligence had been conducted
In recent years, corporate governance has attracted more and more attention among professionals, academics and officials involved in the economy. Concern for improving and strengthening mechanisms of corporate governance has grown worldwide. This has been especially so after high profile governance breakdowns impacted firms like Enron Corporation, WorldCom, Parmalat SpA and others or even more recently governance breakdowns at Bear Stearns Companies Inc., Lehman Brothers Holdings Inc. and others.
According to the CFA Institute², corporate governance is the system of internal controls and procedures by which individual companies are managed. It provides a framework that defines the rights, roles, and responsibilities of various groups—including management, the board, controlling shareowners, and minority or noncontrolling shareowners—within an organization.
At its core, corporate governance is the arrangement of checks, balances, and incentives a company needs to minimize and manage the conflicting interests between insiders and external shareowners and stakeholders. Its purpose is to prevent one group from expropriating the cash flows and assets of one or more other groups and to provide a structure that ensures the long-term viability of the organization.
In general, good corporate governance practices seek to ensure that:
-Board members act in the best interests of shareowners. In recent years, effective corporate governance practices have been extended to the interests of a broader stakeholder group (e.g., labor groups, society at large); over the long-term, the interests of shareowners and stakeholders converge;
-The company acts in a lawful and ethical manner in its dealings with all stakeholders and their representatives;
-All shareowners have a right to participate in the governance of the company and receive fair treatment from the board and management, and all rights of shareowners and other stakeholders are clearly delineated and communicated;
-The board and its committees are structured to act independently from management and other influential groups, and to act in the best interest of the corporation;
-Appropriate controls and procedures are in place to cover management’s activities in running the day-to-day operations of the company; and
-The company’s governance activities, as well as its operating and financial activities, are consistently reported to shareowners, market participants, and stakeholders in a fair, accurate, timely, reliable, relevant, complete, and verifiable manner.
FTX implosion seen as a complete failure of corporate controls and a complete absence of trustworthy financial information
At FTX, none of the above good governance practices were in evidence. John J. Ray III, now acting as the Chief Executive Officer on behalf of FTX debtors, made the following comment in the FTX Trading Limited Chapter 11 filing: “I have over 40 years of legal and restructuring experience. I have been the Chief Restructuring Officer or Chief Executive Officer in several of the largest corporate failures in history. I have supervised situations involving allegations of criminal activity and malfeasance (Enron). I have supervised situations involving novel financial structures (Enron and Residential Capital) and cross-border asset recovery and maximization (Nortel and Overseas Shipholding). Nearly every situation in which I have been involved has been characterized by defects of some sort in internal controls, regulatory compliance, human resources and systems integrity. 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. 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.”
FTX, reported to be the industry’s third-largest cryptocurrency exchange and valued recently at $32 billion, filed its petition for Chapter 11 bankruptcy in the United States Bankruptcy Court for the District of Delaware on November 17, 2022. Organized in various jurisdictions around the world with headquarters in the Bahamas, FTX faced a severe liquidity crisis that necessitated the bankruptcy filing.
Largely unregulated, FTX was organized along a complex array of businesses, including investments and property, that have been grouped into four silos. These included: (a) FTX US and related entities that operated an exchange for spot trading in digital assets and tokens with about 1 million users. In addition, through various owned entities, FTX also offered futures, options and swaps contracts on digital assets and other commodities, broker-dealer services, securities clearing, custodial services, video game development and a marketplace for trading non-fungible tokens. (b) Alameda Research LLC, owned entirely by co-founders Sam Bankman-Fried and Zixiao “Gary” Wang, operated quantitative trading funds specializing in crypto assets employing strategies that included arbitrage, market making, yield farming and trading volatility. Alameda apparently dipped into FTX’s customer deposits to meet cash needs, thus commingling funds between the two entities that should have been operating at arm-length that could lead to criminal fraud-charges. (c) Private venture investments management, and (d) Various entities, including FTX.com. Not available to US investors, FTX.com is a digital asset trading platform and exchange that also holds certain marketplace licenses and registrations in certain non-US jurisdictions. Also offered is an off-exchange portal that enabled users to connect and request quotes for spot digital assets and trade directly. The portal enabled users to lend their digital assets to other users for spot trading and matched users wanting to borrow with those willing to lend. In addition to ownership by co-founders, only the last two lines of business identified as c and d apparently have third party equity investors. These would include investment funds, endowments, sovereign wealth funds, families and other entities.
A final tally of realized losses, both direct and indirect, may not be known for some time
In addition to any losses that will be incurred by individual investors, institutional investors are also impacted and some realized losses have already been disclosed. These include both direct and indirect investments by sovereign wealth funds, private equity firms, hedge funds, pension funds, endowments, and family offices, as well as other investment vehicles. There may also be additional indirect fallouts involving other crypto entities, such as exchanges, lenders and tokens and a final tally may not be known for some time.
The following are just a few examples of the losses or exposures to potential losses that have been disclosed or identified to-date:
-The Singapore state-owned Temasek Holdings which has announced that it will write down its entire $275 million investment in FTX.
-SoftBank’s Vision Fund planned to write down its almost $100 million investment in FTX.
-Sequoia Capital, which reportedly owned FTX and FTX.com in its Global Growth Fund III, announced that nearly $214 million it invested in crypto exchange FTX Trading Ltd. is a total loss³. Indirect investors through Sequoia’s Global Growth Fund III included the Alaska Permanent Fund Corp. that in 2018 committed $200 million to Sequoia’s Global Growth Fund III and the Washington State Investment Board retirement system that approved an allocation of up to $350 million to the same fund⁴.
-Ontario Teachers invested a total of $75 million in FTX in October 2021, followed by another $20 million invested in January of 2022. The pension plan housed the FTX investment in its Teachers’ Venture Growth platform.
-Institutional Venture Partners Fund. Among investors in Institutional Venture Partners fund with exposure to FTX are Tennessee Consolidated Retirement System; City & County of San Francisco Employees’ Retirement System; Maryland State Retirement & Pension System; and Alaska Permanent Fund Corp.
-Lightspeed Venture Partners Illinois Municipal Retirement Fund was invested in Lightspeed Venture Partners, which also had exposure to FTX.
Conclusion
The high likelihood of exposure to losses on the part of sophisticated institutional investors, in particular, could have been red flagged if corporate governance due diligence had been methodically undertaken and the results factored into investment decision making. Governance is a key focal point of ESG integration and the consistent and systematic accounting of relevant and material governance factors in investment decision making has been an important consideration even before the advent of ESG integration investing. Incorporating governance has little if anything to do with socially responsible investing and everything to do with risk management considerations and taking advantage of investment opportunities after the completion of thorough investment analysis.
¹ FTX US founded in 2000. Assets and liabilities of FTX and related firms have not been verified and while some firms’ financial statements have been audited but on a more limited basis relative to publicly listed companies, there are substantial concerns regarding these. ² The Corporate Governance of Listed Companies, CFA Institute. ³Source: Pensions & Investments, Institutions weigh exposure to FTX crypto exchange, November 10, 2022. ⁴ Ibid.
