The Meaning of FTX, Part Deux

A couple of weeks ago, I blogged about how the most striking aspect of the FTX saga was the lack of due diligence by FTX’s equity backers – and how proud they were of that fact, before everything came crashing down.

This week, we got a little more color on that, in the form of the SEC’s complaint against Samuel Bankman-Fried (like everyone else, for ease of reference, I’ll call him “SBF”).  The least surprising thing about the case is that the SEC focused not on the fraud perpetuated on crypto asset traders, but on the fraud perpetuated by SBF on investors in FTX.  That’s because the SEC only has jurisdiction over fraud committed in connection with securities trading, and it’s not always clear whether a particular crypto asset is, or is not, a security.  To sue SBF over fraud perpetuated on FTX customers, the SEC would have to perform the Howey test on an asset-by-asset basis for everything the customers traded – not exactly a feasible undertaking.  So, the SEC took the low-hanging fruit and sued to vindicate the rights of the stockholders in FTX.

Just one teensy problem.  Here are examples of the fraud, taken from the SEC’s complaint:

For the entire span of the Relevant Period, while raising money from equity investors, Bankman-Fried, and those speaking at his direction and on his behalf, claimed in widely distributed public forums and directly to investors that: FTX was a safe crypto asset trading platform; FTX had a comparative advantage due to its automated risk mitigation procedures….

FTX’s Terms of Service, which were publicly available on FTX’s website and accessible to investors, assured FTX customers that their assets were secure…

Similarly, FTX posted on its website a document entitled, “FTX’s Key Principles for Ensuring Investor Protections on Digital-Asset Platforms,” in which FTX represented that it “segregates customer assets from its own assets across our platforms.”…

Throughout the Relevant Period, Bankman-Fried made public statements assuring that customer assets were safe at FTX. For example, he stated in a tweet on or about June 27,  2022: “Backstopping customer assets should always be primary. Everything else is secondary.”  He likewise tweeted on or about August 9, 2021: “As always, our users’ funds and safety comes first. We will always allow withdrawals (except in cases of suspected money laundering/theft/etc.).”

Bankman-Fried also told investors, and directed other FTX and Alameda employees to tell investors, that Alameda received no preferential treatment from FTX. For example, Bankman-Fried told the Wall Street Journal in or around July 2022: “There are no parties that have privileged access.” Likewise, in a Bloomberg article published in or about September 2022, Bankman-Fried claimed that “Alameda is a wholly separate entity” than FTX. In the same article, Ellison is quoted as stating about Alameda: “We’re at arm’s length and don’t get any different treatment from other market makers.” Bankman-Fried made similar statements directly to investors…..

FTX invested significant resources to develop and promote its brand as a trustworthy company. For example, in materials provided to one investor in or around June 2022, FTX cultivated and promoted its reputation:

                    FTX has an industry-leading brand, endorsed by some of the most trustworthy public figures, including Tom Brady, MLB, Gisele Bundchen, Steph Curry, and                     the Miami Heat, and backed by an industry-leading set of investors. FTX has the cleanest brand in crypto…

Bankman-Fried repeatedly touted FTX’s automated risk mitigation protocols—which he called FTX’s “risk engine”—to the public, and prospective investors, as a safe and reliable way for crypto asset trading platforms to manage risk. Bankman-Fried promoted the concept of “24/7” automated risk monitoring as an innovative benefit of cryptocurrency markets, including at a hearing on or about December 8, 2021, to the U.S. House of Representatives Committee on Financial Services….

In a submission to the Commodity Futures Trading Commission, FTX touted its automated system, claiming that it calculated a customer’s margin level every 30 seconds; and that if the collateral on deposit fell below the required margin level, FTX’s automated system would sell the customer’s portfolio assets until the collateral on deposit exceeded the required margin level….

Bankman-Fried thus misled FTX’s investors by representing that its risk engine would protect FTX customer funds and would limit FTX’s exposure to any single customer….

Get it?  The majority of what the SEC alleges are not statements to investors; they were statements to the general public, to FTX customers, to Congress.  There are a couple of stray allegations about direct communications with investors – among other things, SBF at one point handed investors a printout of what the FTX website said, and there were some audited financials (mentioned briefly in paragraph 51; the SEC’s reticence over them suggests it’s not comfortable resting its entire case on those) – but there’s really not much direct investor communication at all, at least not before the collapse and SBF began looking for bailouts. 

Compare, for example, to the SEC’s complaint against Elizabeth Holmes.  Investors got media releases, sure, but they also got binders about purported relationships with big pharma, they got lab tours, they got information on clinical trials.  But there’s nothing like that in the case against SBF.

Now, that may be because everyone’s operating on a condensed timeline.  Maybe these are the statements the SEC could get at quickly, and it intends to supplement its complaint later (in which case, this blog post will quickly become irrelevant).  But at least for now, the overwhelming suggestion is that the SEC based its case on false public statements because SBF didn’t actually make any false private ones – investors bought FTX stock without demanding so much as an offering memorandum.

From a legal perspective, that may not be a problem, exactly.  In the context of private plaintiffs and fraud on the market, it’s well established that a statement may be “in connection with” a securities transaction so long as market analysts relied on it, even if the communication was not specifically directed to investors.  See In re Carter- Wallace Sec. Litig., 150 F.3d 153 (2d Cir. 1998).  As a result, private class action plaintiffs frequently base claims on advertisements targeted to customers, mainstream news appearances, and so forth.  So, in this case, even if SBF were to argue that he wasn’t talking to investors, he was talking to other audiences, the obvious rejoinder is that the whole reason investors were willing to invest on a song was because of FTX’s public reputation, carefully cultivated by SBF.

That said, if you already had the impression that the VC/private investment space is based more on “vibes” than financial models, the SEC’s complaint only provides more evidence.