On Nov. 2, CoinDesk’s Ian Allison lit the match that set the FTX empire built by quixotic founder Sam Bankman-Fried on fire.
Looking at financial reports dated June 30, Allison noted that FTX proprietary trading arm Alameda Research had $14.6 billion in assets on its balance sheet but that its single biggest asset was $3.66 billion of “unlocked FTT” and the third-largest “asset” was $2.16 billion more of “FTT collateral.”
Nearly 40% of Alameda’s assets consisted of FTT, a coin that Bankman-Fried himself more or less invented. It wasn’t an independently traded stablecoin or token with some volume and a market price or actual fiat in a reputable bank.
Francine McKenna is a lecturer in financial accounting at The Wharton School at the University of Pennsylvania. Her 15-plus years of journalism experience includes roles at MarketWatch/WSJ, Forbes and American Banker. She currently produces a newsletter, The Dig, about public and pre-IPO companies.
Allison wrote that the situation suggested that ties between FTX and Alameda were unusually close. The story led to a Twitter war between Bankman-Fried and his former mentor Changpeng Zhao, who leads Binance, a rival exchange, and then a call for help from Bankman-Fried to Zhao that ended in a failed bailout. FTX and its 160-plus business units all filed for bankruptcy in Delaware nine days after the CoinDesk story that started the conflagration.
CoinDesk obtained the audited financial statements of West Realm Shires, also known as FTX US, and FTX Trading Ltd., the combined offshore Bahamas-based entity that includes an exchange catering to non-U.S. customers and Alameda, the proprietary trading operation.
It’s not clear why FTX commissioned two different audit firms to audit its 2020 and 2021 financial statements. The reports by Armanino LLP, which signed the report for the U.S. operation, and by Prager Metis LLP, which signed the opinion for the offshore operations, were issued at the end of March 2022.
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Did some investors tighten their due diligence process after the Theranos debacle and insist on seeing information that had been vetted by CPAs? Or was FTX taking the first steps toward an initial public offering?
This month's blowup of Bankman-Fried's empire was like a meteor striking the crypto world, and the shock waves are still upending the industry. But if you knew where to look in the audited financial statements, there were signs that it was coming.
First red flag
The first red flag anyone receiving these reports should have seen is that there were two different audit firms producing them. Why hire two different firms rather than one to produce an opinion on consolidated results? With the benefit of hindsight, we can see it perhaps suggested that Bankman-Fried didn’t want any firm to see the whole picture.
The choice of firms itself is questionable. These are two small outfits, not even on the next tier to the Big Four global audit firms – Deloitte, Ernst &Young, KPMG and PricewaterhouseCoopers. Armanino and Prager Metis do audit a few public companies but none of the size or complexity of FTX. Because the firms are so small, the audit regulator, the Public Company Accounting Oversight Board (PCAOB), inspects them only once every three years.
Prager Metis has a poor recent track record with the PCAOB (first reported by the Financial Times but publicly available here) and Armanino does, too.
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In 2019, the PCAOB published its private comments about deficiencies in Armanino’s overall quality-control processes related to its 2018 inspection because the firm hadn't corrected the board within a year.
Armanino was also the auditor for Lottery.com and issued an opinion for 2021. The lottery-sales startup reported that it had overstated its available unrestricted cash balance by $30 million and improperly recognized revenue. There was substantial doubt about its ability to continue as a going concern. Armanino resigned from its audit role this past September, right before a class-action lawsuit was filed against Lottery.com's executives.
Big Four Involvement
Forbes had previously reported that two Big Four global audit firms were also advising FTX. What were Deloitte and PwC doing for FTX?
Deloitte has made a name for itself in the crypto-friendly public company world as the go-to firm for guidance on the accounting for crypto investments and transactions. Right before its IPO in April 2021, Coinbase switched to Deloitte, which audited six months of financial information and then joined the previous auditor Grant Thornton in presenting its opinion in Coinbase’s first draft registration statement.
CoinDesk also has evidence, based on PwC’s own internal systems, that PwC had taken steps to limit its services for FTX US to only those allowed for auditors of public companies. Its Washington, D.C., office posted restrictions for any PwC office seeking business with FTX, limiting the firm’s activities with FTX US in the way that is required for an auditor to be independent under the Sarbanes-Oxley Act.
Perhaps PwC was helping FTX keep its tax bill at zero given its myriad investments and complex global structure. PwC is one of two preeminent Big Four firms (the other is EY) that provides most of the tax lobbying and strategic tax advice to global firms.
Audit firms have interpreted Sarbanes-Oxley as giving them wide latitude to provide all kinds of tax services, even to audit clients. PwC and EY have continued to provide complex tax-structuring and tax-avoidance services that have been scrutinized by the Internal Revenue Service and global tax authorities, even when also signing the audit opinion.
The second red flag for any reader of the 2021 audit reports is that neither the Armanino nor the Prager Metis audit reports for 2021 provides an opinion on the FTX US or FTX Trading internal controls over accounting and financial reporting.
Thursday’s filing by FTX's new CEO, restructuring expert John J. Ray III, who was appointed after the FTX bankruptcy filing, confirms what reading the year-end 2021 financial statements should have screamed to any auditor or reader of the reports: There were no controls.
“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as I occurred here,” he wrote.
“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.”
(Ray was similarly appointed after the collapse of Enron in 2001.)
Because FTX is a private company, audits weren't required unless an investor or bank asked for them or if FTX was considering an IPO. That's not to mention that Dodd Frank and the subsequent Jobs Act have chipped away at the protections for investors created by the Sarbanes-Oxley to make internal controls opinions rarer even for companies that do go public.
Sarbanes-Oxley, which was passed after the Enron-era scandals, requires auditors to provide an opinion on the company’s internal controls over financial reporting and for management to provide an assessment of disclosure controls and internal controls over financial reporting.
FTX, however, was large enough based on its revenue – combined revenue for its U.S. and offshore entities for 2021 according to the audit was $1.08 billion – and its potential market capitalization, to not fall under a Jobs Act exemption that relieves companies from providing an auditor’s report on internal controls, even after they have had an IPO.
Both audit firms wrote that their role is to, “Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of [West Realm Shires lnc.'s and FTX Trading Ltd. and subsidiaries'] internal control.”
However, in both cases, “no such opinion [on internal controls over financial reporting] is expressed.”
Third flag: No taxes paid
The third red flag is, despite a combination of enormous siphoning off of firm assets by related parties and favorable tax planning, neither FTX Trading nor FTX US paid any federal income taxes, although they both appeared to be profitable. FTX Trading's GAAP (generally accepted accounting principles) net income was $386.5 million in 2021 and $16.7 million in 2020. FTX US reportedly lost $66.7 million on a GAAP basis in 2021, according to the Armanino audited financial statements. The U.S. firm’s activity in 2020 was negligible.
The biggest red flag
The biggest red flag for preparers and readers of the audited financial statements should have been the number of complex, roundtrip and utterly confounding related-party transactions documented in just these two years. The related-party transactions at FTX Trading are so numerous that it is difficult to know where to begin to analyze them.
The following are the red flags related to transactions between FTX Trading and a control person such as Bankman-Fried, who was acting outside of his role as owner/control person at FTX. The related-party transactions between FTX US and FTX Trading (Alameda and the offshore exchange) appear to be limited as of last Dec. 31.
Related-party music chairs
There are numerous related-party transactions documented for FTX Trading. The footnotes to the financial statements also notably say that the trading and exchange arms also have operations in the U.S. FTX Trading audit firm Prager Metis describes the scope of this set of financial statements and its audit of them as such:
FTX Trading Ltd. (together with its consolidated subsidiaries referred to herein as "the Company," "the Exchange," or "FTX") was incorporated in Antigua in 2019. The company operates globally, primarily in the Bahamas, which is the company's headquarters and Antigua, while also maintaining operations in the U.S., Switzerland, Turkey and Australia.
The first related-party activity relates to the role of individuals as liquidity providers, market makers and traders of the firm. Bankman-Fried and other insiders were trading on their own exchange for their own accounts.
Certain related-party entities were the initial liquidity providers and participated in a majority of the market-making transactions at the inception of the exchange. Over time, other liquidity providers joined the exchange, and the percentage of trades involving related parties has decreased as a percentage of total revenue. The related entities do trade for their own proprietary purposes on non-market making transactions.
Liquidity provider, market making and trading exchange transactions with a related party represented about 6% and 11 % of total exchange transaction volume for the years ended Dec. 31, 2021 and 2020, respectively. Because the related parties were primarily market makers, which therefore generated negative commissions, net revenues (negative) for the years end December 31, 2021 and 2020 were -$22 million and -$13.4 million, respectively, which represented about 2.2% and 14.9% of total exchange transaction revenue on an absolute basis.
Another related-party transaction that has already been reported elsewhere is the exchange software royalty FTX paid to Bankman-Fried.
The exchange software royalty was developed by entities and parties that are significant shareholders. The exchange software was licensed from a related entity for a fee of about 25% of net exchange transaction revenue, depending on the revenue mix. The company has licensed the rights to the software code and the rights to further develop the technology.
The audited financial statements say that software royalties paid to Bankman-Fried for the years ended Dec. 31, 2021 and 2020 were $250.4 million and $22.7 million, respectively. The royalties were calculated based on 33% of net FTX exchange trading revenue, 10% of net additions to the insurance fund and 5% of net fees earned from other uses of FTX platform.
Another highly unusual and perilous related party activity was the use of related parties to manage FTX currency and treasury activities on an “outsourced” basis.
Certain related parties have provided currency and treasury management activities to the company. Those services include that the related entities serve as conduits of fiat, or crypto transactions, maintaining an intercompany account for and on behalf of the company that is repayable on demand, and the provision of the same day conversion of revenue and expense transactions of crypto to U.S. dollars, all at the company's direction. A significant percentage of the company's bill-paying activities have been facilitated through these related-party service transactions.
The FTX Trading audit report says that these currency management transactions were made up of a significant portion of the customer fiat transactions and expense payments to vendors in both fiat and crypto transactions.
FTT for acquisitions
Another massive red flag, in line with Allison’s reporting about the dependence on the home-grown FTT token on Alameda’s balance sheet, is the use of the FTX FTT token as currency for acquisitions.
As notable crypto startups like BlockFi and Voyager Digital ran into financial troubles in the last year, Bankman-Fried often stepped in as a white knight. Bankman-Fried swept up Blockfolio, a trading app, reportedly for $150 million, in October 2021. Here is the FTX Trading/Prager Metis audit report language related to that last transaction:
The FTT receivable and liability are marked to market based on the quoted price for the FTT tokens at the reporting date. As of Dec. 31, 202 l and 2020, the receivable was $496.8 million and $44.6 million respectively, and is presented as "receivable, related party" in the shareholders' equity section on the consolidated balance sheets.
Related parties entered into an FTX equity-for-FTT crypto option agreement. On Oct. 15, 2020, FTX agreed to purchase 52% of Blockfolio's shares outstanding for $83.6 million, but $78.7 million of this price was to be paid using FTT tokens. It’s in this footnote that we learn that “FTT was created by a related party to tokenize the royalty payments for the trading exchange technology platform licensed to FTX.” Why is that important?
FTX entered into an option with “a related party,” presumably Bankman-Fried, with the right to issue 32.5 million of the company's common shares and $1 million in exchange for 20 million FTT tokens to be delivered to Blockfolio’s selling shareholders on behalf of FTX. FTX immediately exercised the option and expected Bankman-Fried to send the tokens to Blockfolio.
FTT tokens were created by Bankman-Fried to “tokenize” the royalty payments paid to him by FTX Trading for the exchange software he created. FTX offloaded its obligation to Bankman-Fried to pay off Blockfolio in FTT tokens – tokens he created to “tokenize” the royalty payments he received from FTX for the exchange software – and he got more FTX shares in return. What happens to this obligation now that FTT tokens are worthless?
In the next transaction, it seems someone may have had impeccable timing in taking a receivable off the FTX books and benefitting personally. It is difficult to describe how insane and beyond the pale this transaction is from a fraud-risk and conflicts-of-interest perspective.
Another questionable transaction
In 2019, FTX issued 96.5 million Series A preferred shares in exchange for 1 million cryptographic BNB tokens issued by FTX rival Binance. The BNB tokens were subsequently loaned to a related party and were presented as "BNB receivable, related party" in FTX Trading's balance sheets as of Dec. 31, 2020. In February 202l, a related party purchased the BNB receivable for about $130.1 million.
Binance’s BNB tokens would have been a good token to have on FTX's balance sheet now. At current prices, 1 million BNB tokens would be worth $270.5 million. The FTX Series A preferred shares were issued against BNB (Binance) tokens that traded at $13 to $14 at the end of 2020, but, again, a related party purchased the BNB receivable in February 2021 for about $130.1 million.
The price of BNB tokens jumped significantly between Jan. 29, 2021 and Feb. 19, 2021 to $257.50 from about $44. If the related party bought before the jump in price, it got a huge bargain on the tokens. At $257.50, the related party overpaid.
More muddy waters
There’s another transaction that seems to have muddied the waters between the personal interests and professional responsibilities of key executives. In October 2021, a related party sold 12.8 million of the company's common shares to external investors in a secondary sale transaction for $301.8 million. The proceeds of the secondary sale were retained by FTX on behalf of the related party for operational expediency, and $301.8 million was included in “related party payable” on the consolidated balance sheets as of Dec. 31, 2021.
This $301.8 million may be the next real fiat cash that company top executives grabbed in a hurry on Nov. 11 as it belonged to one of them, according to the audit report.
On the other hand, Ray, the new FTX CEO, now says, according to a Bloomberg report of Thursday’s filing with the court, that the FTX audited financial statements shouldn't be trusted. “Advisors are working to rebuild balance sheets for FTX entities from the bottom up," he said.
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