Interim Report Explores FTX’s “Profound” Management Failures: Miller, Paschal Discuss Key Takeaways

On Apr. 9, 2023, FTX’s current CEO John R. Ray III filed an interim report in the United States Bankruptcy Court for the District of Delaware following the company’s Chapter 11 filing last November. Ray, whose nearly 40-page report details mismanagement by FTX founder Sam Bankman-Fried, security breakdowns, a lack of key personnel and policies, flaws in accounting controls, and more, draws a damning conclusion: “The FTX Group’s profound control failures placed its crypto assets and funds at risk from the outset.” Click here to read the full report.

On Feb. 22, 2023, Fishman Haygood and Stumphauzer Kolaya Nadler & Sloman filed the most comprehensive class action lawsuit to date on behalf of FTX customers. The lawsuit seeks to recover damages in the form of investment losses against the banks, venture capital firms, accounting firms, and law firm that allegedly aided and abetted Bankman-Fried and his company in a scheme to defraud customers out of billions of dollars and crypto assets.

While the collapse of FTX continues to unravel, Ray’s initial report seems to bolster these allegations. Attorneys Kerry Miller and Hogan Paschal, who represent the plaintiffs in the firm’s lawsuit, detail a few of the highlights here.

• First, the firm’s lawsuit alleges that several venture capital firms, including Sequoia, Paradigm, and Thoma Bravo, propped up FTX’s fraudulent scheme with billions in necessary capital, advisory board services, and glowing public endorsements, despite obtaining an awareness of FTX’s countless misrepresentations and omissions regarding the safety and security of the exchange, as well as Bankman-Fried’s looting of depositor funds. These misrepresentations include the gross mismanagement identified by Ray in his interim report.

For example, Ray’s report details how FTX stored crypto in “hot wallets,” which are inherently risky and contrary to industry practice of storing crypto in “cold wallets.” Wallets consist of a public key, used to identify the wallet/owner on blockchain, and a private key, required to access the crypto in the wallet. Hot wallets connect to the internet; cold wallets are offline. Because hot wallets are “internet-connected, [their keys are] vulnerable to hacking, malware, and other cybersecurity threats.” FTX also stored private keys on the cloud, without encryption or other safeguards. Moreover, Ray uncovered that FTX did not even have in place critical cybersecurity controls, such as an IT department or even a Chief Technology Officer.

These facts contradict Bankman-Fried’s public representations that FTX was safe and that, “FTX uses a best practice hot wallet and cold wallet standard solution for the custody of virtual assets. The firm aims to maintain sufficient virtual assets in the hot wallet to cover two days of trading activities, which means only a small proportion of assets held are exposed to the internet, the remaining assets are stored offline in air gapped encrypted laptops…”

• Next, the lawsuit alleges that certain banks, including Signature Bank and Silvergate Bank, aided and abetted Bankman-Fried and the fraud by helping launder customer funds. To do this, the lawsuit alleges that the banks transferred funds out of customer accounts and into accounts that Bankman-Fried separately owned or controlled, including Alameda Research, the main vehicle through which he operated the fraud.

As detailed in Ray’s report, Bankman-Fried wrote in internal communications that he believed Alameda was “unauditable” because it was only able to “ballpark” balances and lacked a comprehensive transaction history. In his correspondence, Bankman-Fried also notes, “We sometimes find $50m of assets lying around, that we lost track of; such is life.”

Under the Bank Secrecy Act and other regulations, banks must monitor for suspicious activity. The lawsuit alleges that these banks were not only aware of these fraudulent transfers (especially those to a purportedly “unauditable” entity), but also that the banks facilitated the transfers anyway because they stood to profit tremendously for as long as the fraud continued.

• Finally, the suit includes as defendants the professional accounting firms Armanino, LLP and Prager Metis CPAs, LLC. For their part, the suit alleges that the accounting firms ran sham audits on FTX’s behalf, signing off on financials for primary FTX entities that the accounting firms knew would entice customers to invest in FTX, because it was one of the only crypto exchanges with an outside auditor’s stamp of approval.

To perform accurate audits, it stands to reason that a company must maintain proper records. However, in his report Ray states, “Key accounting reports necessary to understand the FTX Group’s assets and liabilities, such as statements of cash flows, statements of equity, intercompany and related party transaction matrices, and schedules of customer entitlements, did not exist or were not prepared regularly… Copies of key documentation [such as loan agreements and intercompany agreements] were incomplete, inaccurate, contradictory, or missing entirely.”

Fishman Haygood represents both plaintiffs and defendants in class action and mass action litigation, both in Louisiana and across the nation. Read more about the firm’s FTX suit here.