If you haven’t already heard, FTX, the crypto exchange, has been all over the news for what people are calling “a scandal for the ages”. The exchange was founded in 2019 and had over one million users. It was also argued to be the third-largest cryptocurrency exchange by volume, globally.
The company has filed for bankruptcy and a lot of information about its management (or mismanagement) has come to the light since then. It might interest you to know that this very company had a valuation of about $32 billion just weeks ago.
Bankruptcy allows people or businesses who can no longer pay their debts to sell off their assets to offset liabilities or through a repayment plan usually in installments over the course of three to five years.
In a bankruptcy case, assets are measured and evaluated, and the assets may be used to repay their debt.
In this article, we explore some of the company’s missteps, and why they were sure to land on the rocks. This should help provide you with a mental model, to trigger your alarms if or when your business is guilty of any of the following practices.
- Misappropriation of funds: The Company used corporate funds to purchase homes and other items for employees and advisors with no documentation or mention of these transactions as loans.
A corporation is an independent entity, created by law in order to carry on business. As a result, the business is not liable for the burdens or personal responsibilities of its owners or employees.
- Current Ratio of 0.1:1: The current ratio is a liquidity test that measures a company’s ability to pay short-term liabilities or obligations within one year. The current ratio provides investors and analysts with insight on how the company can utilize its current assets (assets that can be converted into cash within one year) to offset its debt obligation and other liabilities.
Generally, the acceptable current ratio of a company is 2:1, which means that the business has two times more current assets to cover its short-term liabilities.
FTX was reported to have less than $1 Billion in liquid assets Versus $9 Billion in total liabilities which means that they could barely cover 10% of their liabilities in a liquidation scenario like this one.
- Corporate Governance Failure: Standard practice demands that board meetings are necessary for company governance. It requires shareholders to come together to discuss the company's progress and future plans. But the company found a way to skip this step and go straight to the decision-making process.
This means that shareholders were not involved in decision-making, which has become problematic, as there was no room for adequate checks and balances within the organization.
- Accounting Failure: The company had a history of not keeping accurate records, including its employee count. They failed to maintain proper records of whom they employed and what those employees did. This means their total employee count was probably higher than the number of people who actually worked for them. According to reports, attempts to find presumed employees have proven unsuccessful.
The company also lacked appropriate disbursement controls for business-related expenses. Expenses were arbitrarily approved through communication channels, evidence of which were automatically deleted within a short while.
The exchange failed to reconcile positions on the blockchain and kept the misuse of investors' funds a secret. Balances of customer crypto deposits were not disclosed in their financial statements.
It is important for a business to maintain accurate accounting records and books, as it provides information on the company’s financial performance which is a metric used by stakeholders to make business decisions. A lack of transparency in financial reporting makes for unreliable information and a case for fraud.
- Unfair dealings with Related-party Transactions: Alameda Research, a cryptocurrency trading firm, owned by the same CEO as FTX, Sam Bankman-Fried, traded on FTX with other institutional and individual traders.
Alameda was announced to be secretly exempted from Margin call protocols, which happens when leveraged positions are closed out of a trade due to significant changes in the price of an underlying asset. As a result, Alameda could have been running on losses, placing the company’s liquidity at risk.
Investors' funds are entrusted to a business with the sole purpose of making money, and not to meet the personal needs of business owners. Funds should be managed responsibly. A business should have two times more current assets to cover its short-term liabilities.
Regulatory and statutory rules, practices, and processes are to be upheld in business management. The importance of accuracy and transparency in financial reporting cannot be overemphasized. It is imperative to have a well-equipped and trained Accounting Team.
Business protocols and standards should be adequately practiced regardless of existing relationships.
This list is not exhaustive, but it covers a fair deal of red flags you should be aware of.