Failure Of Corporate Controls: Red Flags In FTX’s Audits

Bankman Fried’s empire collapsed like a meteor hitting the cryptocurrency world, and the aftershocks are still shaking things up. But if you looked at the audited financial statements carefully, there were indications of the FTX issue.

The first red flag

The fact that these reports were produced by two different audit companies, Armanino LLP and Prager Metis LLP, should have been the first warning sign for anyone receiving them. Why use these two firms to produce an opinion on consolidated findings? With hindsight, we can see that it might have indicated that Bankman-Fried didn’t want any firm to have the full picture.

The audit results of FTX last year were not made public. Image: REUTERS

The selection of companies is in itself debatable. These two little businesses do not even rank among the Big Four international audit firms: Deloitte, Ernst &Young, KPMG, and PricewaterhouseCoopers. Armanino and Prager Metis audit a few publicly traded firms, but none are as large or as complex as FTX. The audit regulator, the Public Company Accounting Oversight Board (PCAOB), only inspects the firms once every three years due to their modest size.

The second flag

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 provide an opinion on the internal accounting and financial reporting controls at FTX US or FTX Trading.

Thursday’s filing by FTX’s new CEO, restructuring expert John J. Ray III, who was appointed after FTX’s bankruptcy filing, confirms what any auditor or reader of the company’s year-end 2021 financial statements should have screamed. There was no oversight.

Audits were unnecessary because FTX is a private corporation unless an investor, bank, or FTX was planning an IPO. In addition, Dodd-Frank and the Jobs Act have weakened the investor protections introduced by Sarbanes-Oxley, making internal control opinions rarer for firms that go public.

The third flag: No taxes paid

The third red flag is that neither FTX Trading nor FTX US paid any federal income taxes, although both companies appeared profitable. This is due to massive asset diversion by related parties and good tax planning.

The GAAP (generally accepted accounting principles) net income of FTX Trading in 2021 was $386,5 million, compared to $17,7 million in 2020. According to the audited financial statements of Armanino, FTX US incurred a GAAP-based loss of $66.7 million in 2021. The activity of the American company in 2020 was negligible.

The biggest red flag

For preparers and viewers of the audited financial accounts, the number of complex, convoluted, and utterly perplexing related-party transactions disclosed in these two years should have been the largest warning signal.

The first related-party activity pertains to the roles of persons within the organisation as liquidity providers, market makers, and traders. Bankman-Fried and other insiders engaged in self-serving trading on their exchange. The associated entities engage in non-market-making transactions for their proprietary purposes.

The exchange software royalty FTX paid to Bankman-Fried is another transaction disclosed elsewhere. The audited financial statements reveal that Bankman-Fried was paid $250.4 million and $22.7 million in software royalties for December 31, 2021, and 2020, respectively.

The use of related parties to manage FTX currency and treasury activities on an outsourced basis was yet another highly unusual and risky related party activity. According to the FTX Trading audit report, these currency management activities comprised a substantial part of client fiat transactions and expenditure payments to vendors in both fiat and cryptocurrency.

Following Allison’s analysis of Alameda’s reliance on its FTT token, using the FTX FTT token as currency for acquisitions is an enormous red flag. FTX released Bankman-Fried from his obligation to pay Blockfolio in FTT tokens –tokens he created to tokenise the royalty payments he received from FTX for the exchange software –in exchange for additional FTX shares.

FTX offered 96.5 million Series A preferred shares in return for 1 million BNB tokens released by Binance in 2019. Between January 29 and February 19, 2021, the price of BNB tokens skyrocketed from approximately $44 to $257.50. If the associated party purchased the tokens before the price increase, it received a tremendous discount. The connected party overpaid by $257.50.