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The collapse of FTX – the epitome of corporate failure

Selected ArticleThe collapse of FTX – the epitome of corporate failure

The collapse of FTX exchange continues to shake global confidence in cryptocurrencies. The 30 year-old CEO of FTX, Sam Bankman-Fried has pleaded not guilty to criminal charges in New York, including wire fraud, money laundering and conspiracy to commit fraud. It’s been reported that billions were transferred out of the company, which filed for bankruptcy in November 2022. US Federal prosecutors have now reportedly seized some US$600 million of Mr Bankman-Fried’s assets.

The FTX collapse and its ongoing aftermath casts the arcane world of cryptoassets in a less than favourable light. The collapse shook the world’s already volatile cryptocurrency markets, and prompted renewed calls for greater regulation of the crypto sector. However, many of the existing corporate regulations do already apply to crypto companies.

With some US$1 billion in customer’s funds reportedly missing, the focus is increasingly on the corporate controls, or lack thereof, at FTX. John Ray III, the insolvency professional appointed to run the FTX bankruptcy, said that the collapse of FTX is the worst case of corporate failure he has seen in over 40 years.

Some say that the writing is on the wall for the private cryptocurrency sector, with major powers including the US and the EU actively taking steps to create a digital dollar and a digital euro. These will possess many of the benefits of cryptocurrencies, but they will be linked to the existing euro and dollar. Some believe that the rollout of these central bank-backed digital currencies will undermine the market for privately launched cryptocurrencies, which are inevitably volatile.

The FTX collapse has refocused minds on the question of the fundamental viability of the cryptocurrency sector. Some see cryptocurrencies as lacking any inherent value, amounting to little more than a Ponzi scheme. The well-known investor John Paulson has made a striking prediction that cryptocurrencies “will eventually prove to be worthless.” Some believe that a wave of stringent regulation is going to crash upon the sector, which may cause already faltering cryptoassets to collapse completely. That collapse would also imply the collapse of the ecosystem of businesses which service the sector, such as the cryptocurrency exchanges like FTX.

The global cryptocurrency market is now estimated to be worth some US$1.5 trillion annually. Governments are taking coordinated steps towards regulating cryptoasset markets. For example, the 2021 G7’s final communique committed the group to work “to urgently address the escalating shared threat” of ransomware attacks. Many such attacks used cryptocurrencies as the ransom payment method. Many have also been linked to Russia and, in the wake of the Ukraine invasion, regulating cryptocurrencies is increasingly seen as a geopolitical imperative.

The push against cryptoassets is global. Russia has also been accused of involvement in cyberattacks against the US, such as the 2020 Solar Winds attack. Russia is believed to have carried out major cyber-attacks against Ukraine in 2017.

Cryptocurrencies have also been implicated in money laundering and fraud. For example, the PlusToken Ponzi scheme caused losses of some $2.9 billion. One simple way for governments to tackle the misuse of cryptocurrencies is to increase their corporate regulatory enforcement of cryptoasset businesses, including the major cryptocurrency exchanges.

The global crypto sector is still largely unregulated, volatile and has too many unfortunate associations with money laundering, cybercrime and organised crime. In January 2021, ECB President Christine Lagarde called for the regulation of cryptocurrencies on a globally co-ordinated basis. Prior to her appointment as US Secretary of the Treasury, Janet Yellen said cryptocurrencies are now used transactionally “mainly for illicit financing”, saying they must be curtailed.

The Financial Conduct Authority was appointed the UK’s major regulator of the cryptocurrency sector in early 2021. Cryptocurrency firms must now register with the FCA before operating in the UK, although a temporary registration regime was created. The FCA has been active in regulating the cryptocurrency market, even banning Binance from conducting regulated activities in the UK in June 2021.

Despite many of the world’s major powers pushing against cryptocurrencies, some remain remarkably bullish about the crypto sector. FTX spokesman Kevin O’Leary recently told a US Senate Banking Committee hearing that the FTX collapse could be a positive for the industry, saying that “the recent collapse of crypto companies has a silver lining.”

Mr O’Leary went on to say, “This nascent industry is culling its herd. Going or gone are the inexperienced or incompetent managers, weak business models and rogue unregulated operators. Hopefully, these highly publicized events will put renewed focus on implementing domestic regulation that has been stalled for years.”

Although effective regulation of the crypto sector per se may still be lacking, the fact is that adherence to existing corporate governance regulations could have prevented the FTX catastrophe.

The reported corporate governance failures at FTX seem truly extraordinary. The failures alleged include not keeping proper books, records, or controls for digital assets, using software to conceal the misuse of customer funds and even approving payments via the use of personalised emojis.

Corporate control of FTX was in the hands of a small group of relatively inexperienced and potentially compromised individuals. The FTX collapse provides a timely reminder of the importance of corporate controls, and how they act as a system of checks and balances. This is vital, no matter what industry or sector a company is operating in. Whether a company is a tech start-up or a centuries old institution, the rules are the same.

The crypto sector is, of course, a notoriously volatile sector. A stream of new cryptocurrencies emerge almost daily, alongside markets in new types of cryptoassets such as NFTs. Values rise and fall with stunning rapidity. Regulators are clearly struggling to keep pace with developments.

Within the tech sector, some feel that as there are new ways of living and doing business, the old rules don’t apply. Such forward thinking can be a positive thing, and it has certainly helped develop creative new ways of living and doing business. However, this perception that the old ways are old hat, is factually untrue. The rules do apply and good corporate controls were developed over many decades for good reason.

In the UK, the broadly acknowledged essential features of good corporate governance include a separate chairman and CEO, independent audit functions, annual evaluation of a board’s performance and transparency in appointments and pay. Another important component is shareholders rights, and strong shareholder engagement, to drive accountability.

After all, shareholders are naturally highly motivated to see the company grow and thrive, and to reduce waste. All these features help to disperse power and improve decision making. This corporate governance system is based on a complex web of common law fiduciary duties, caselaw, legislation, codes of practice and regulatory guidance.

Government guidance and regulation is regularly revised and amended in the UK. Although, this is often in response to new collapses or crises, at least there is a determination to learn from mistakes made. The UK government’s response to a series of corporate collapses, where poor auditing was implicated – including the Carillion collapse  – was to significantly improve the regulation of corporate audits. Effective, independent audits underpin transparency and governance. Without these, shareholders, investors, employees are all flying blind.

In the United States, a key response of major audit firms to the FTX collapse has been to designate cryptoasset companies as “high risk”. This designation means a more lengthy, robust and thorough audit process is required. This will increase costs and the timelines around audits, but it may help to restore some confidence in the sector.

Tighter future regulation of cryptoassets now seems inevitable in many regulatory  spheres. Regulatory hostility to crypto is also evident from the HMRC’s guidance on their taxation. Cryptoassets invariably involve some form of Distributed Ledger Technology (DLT). The HMRC’s definition of cryptoassets covers exchange tokens, utility tokens, security tokens and it does not treat cryptoassets as currency or money. Instead, trading in cryptoassets is usually subject to Capital Gains Tax (CGT) for individuals. Exemptions for foreign currency bank accounts are not applied to cryptoassets.

VAT may also be payable where goods and services are paid for in cryptoassets. The HMRC guidance says that “VAT is due in the normal way on any goods or services sold in exchange for cryptoasset exchange tokens”.

This means that there are major tax disadvantages to the use of cryptoassets, which do not apply to normal currencies, and which also will not apply to the central bank backed digital currencies when they come on stream.

The crypto sector is viewed as risky by financial regulators. The FCA’s advice is that “cryptoassets are considered very high risk, speculative purchases. If you buy cryptoassets, you should be prepared to lose all your money.” It has banned selling cryptocurrency derivatives to consumers.

Improved corporate control and audit across the cryptocurrency sector, combined with a well-balanced regulatory regime, could enhance the sector’s reputation, and help it achieve a sustainable place in digital finance over time. However, for now, the only certainty for the cryptocurrency sector is ongoing uncertainty and volatility.

Anca Thomson is a partner and specialist corporate and commercial lawyer at Excello Law

 www.excellolaw.co.uk

 

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