Why due diligence by investors can still fail to uncover red flags, corporate governance issues

SINGAPORE: Up until the moment that FTX started collapsing, the consensus view was that everything was generally fine with the crypto exchange, with former CEO Sam Bankman-Fried a star of the corporate world.

That all changed earlier this month, with a chain of events which culminated on Nov 11 when FTX started bankruptcy proceedings in the United States, owing its 50 biggest creditors nearly US$3.1 billion (S$4.28 billion).

"Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here," said new FTX CEO John Ray, hired to oversee the firm's bankruptcy after Mr Bankman-Fried's resignation.

"From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented."

Among the issues that have emerged since the firm collapsed are supervisors using emojis to approve payments, executive decisions communicated on messaging apps set to auto-delete after a short time, and company funds were used to buy homes in the Bahamas for employees and advisers.

Founded in 2019, FTX was valued at US$32 billion in January and backed by prominent investors including Singapore's state investment firm Temasek, venture capital firm Sequoia Capital and the world's largest asset manager BlackRock.

Temasek, which wrote down its US$275 million investment, said it conducted "extensive due diligence" on FTX over eight months, including reviewing FTX's audited financial statement that "showed it to be profitable".

The state holding firm said it looked at regulatory risks, particularly in compliance and cybersecurity, and interviewed people familiar with FTX including employees, industry participants and other investors.

"It is apparent from this investment that perhaps our belief in the actions, judgment and leadership of Sam Bankman-Fried, formed from our interactions with him and views expressed in our discussions with others, would appear to have been misplaced," said Temasek.

After FTX's bankruptcy filing, Sequoia – which also wrote down its US$214 million investment – apologised to fund investors, telling them it had been misled by FTX and would improve its due diligence processes, the Wall Street Journal reported.

FINANCIAL STATEMENTS "AT FACE VALUE"

Investors, however, are actually not legally obligated to conduct any diligence before an investment, said Mr Chris Holland, partner at compliance consultancy Holland & Marie.

To perform due diligence checks, institutional investors often request a list of documents from a potential investee company – but exactly what material is provided is ultimately a matter of negotiation, he added.

In the case of assets such as crypto, due diligence is "obviously trickier" than traditional investments and company audits would also be more challenging, another expert told CNA.

"The assets are intangibles and they move quickly," said corporate governance specialist Professor Mak Yuen Teen of the National University of Singapore's business school.

Due diligence should focus on understanding business models, corporate structures and related entities, he said. Investors should find out where companies are incorporated and ask: "Is it a well-regulated jurisdiction with strict rules?"

They should also find out where companies' operations and key management are based. "Is there strong enforcement in that jurisdiction and are they jurisdictions with no extradition treaties with major countries?" Prof Mak asked.

Investors should additionally look into the background of key management "with respect to integrity and experience, whether there is a proper board of directors with people who understand the business, and whether there are reputable auditors with experience and capabilities", he added.

In a November bankruptcy court filing, Mr Ray, FTX's new CEO, said he had "substantial concerns" about the company's audited financial statements and did not think it appropriate to rely on them for information.

Even after obtaining financial statements, investors should not just take them at face value, said Prof Mak, adding that changes in auditors and the use of auditors that "no one has heard of" would be other red flags.

As for institutional investors investing large amounts of money, they should be able to get access to extensive information. "If they don't, they should be prepared to walk away," he said.

Through such checks, investors should have a "good chance" of picking up related party loans and lack of proper internal controls, said Prof Mak.

INVESTORS' "HERD MENTALITY"

On the face of it, FTX appeared to exhibit the traits of a fast-growing business, at least from reported figures, The Smart Investor co-founder David Kuo told CNA.

He pointed to FTX's revenue, which reportedly rose 1,000 per cent from US$89 million to US$1.02 billion in 2021. Net income reportedly grew from US$17 million to US$388 million in 2021, while user numbers and trading volume also increased.

"If we had to pick a red flag it would probably be the valuation. How can a company with net income of US$388 million be valued in the tens of billions?" said Dr Kuo.

He added that if any company wanted to "deliberately disguise" its activities, it could take a while before any misconduct surfaced.

"Generally, it is only when an operation runs out of money that brings any shortcoming in corporate governance to light," he said, adding that in his view, this was why FTX collapsed.

"The mismanagement at FTX could have been prolonged indefinitely if cryptocurrencies had not lost their allure. But they did."

Prof Mak, meanwhile, said he saw "many red flags" in FTX, relating to its countries of incorporation and operation – Antigua and Barbuda, and the Bahamas respectively – as well as its "lack of a proper board, inexperienced management team, and questionable external auditors".

"The reason why so many institutional investors jumped in is ultimately because of "FOMO" or the fear of missing out, he said.

He pointed to healthcare technology firm Theranos – whose founder Elizabeth Holmes was sentenced to more than 11 years in prison for fraud – and office-sharing company WeWork, which had its valuation cut and initial public offering (IPO) plans delayed after scrutiny of its finances and leadership.

"We also see supposedly smart investors jumping in after those companies have brought in some big-name investors. There is a certain herd mentality among institutional investors," said Prof Mak.

This is a structural issue in fund management because "all fund managers are basically benchmarked against their peers", said economist Walter Theseira, an associate professor at the Singapore University of Social Sciences.

"So when peers start to invest in a particular new industry or field, you have to go in as well, to ensure that your returns don't lose pace in the event the industry turns out to be very successful."

While due diligence can attempt to reduce some risk, Assoc Prof Theseira said that investment decisions are often "really driven by narratives and conventional wisdom".

"We might think that the people investing our money are geniuses who have command of a vast array of data and figures, and are able to select the best investments from the nearly infinite array of potential investments out there, but they are human just like the rest of us.

"They rely on mental shortcuts, personal networks, the news media, even gossip, to figure out what to target for investing," he said, adding that this was especially so for early-stage investing where "very little" hard data is available.

BALANCING GOVERNANCE AND GROWTH

Singapore Institute of Directors governing council member Howie Lau and vice-chairman Adrian Chan also advised investors to look at monthly or quarterly financial statements and audited annual statements, on top of considering whether the investee company has a "qualified, diversified and independent" board.

Investors should also look at key client and partnership agreements including considerations on termination, liability, liquidated damages and intellectual property; and employment or service contracts for the founders and key employees.

These should include share schemes and non-competition restrictions.

Mr Lau and Mr Chan further highlighted the importance of understanding the company's fundraising processes and terms for investments, which could include considerations on exit clauses, preference shares, convertible notes and future financing rounds, as well as board responsibilities, delegation and approval limits.

The pressure for a business to scale up rapidly can present governance challenges, they said, adding that start-ups are "naturally oriented" towards growth, but not towards controls and processes.

"The board should build core values in the enterprise early. Values become actions, and actions become habits. A strong culture and set of company values will be key foundations of any business," said Mr Lau and Mr Chan.

Company founders and investors should aim for a level of governance that is appropriate to the maturity and development of the company, and see governance as complementary to sustained growth rather than a source of friction, they said.

Dr Kuo said the lesson for retail investors is that they should only ever invest with money they can afford to lose.

Retail investors should never rely on the fact that well-known venture capital and institutional investors have invested in a company, to decide that it would also be a good investment for themselves, said Prof Mak.

"Their interests and investment strategies are not necessarily the same," he noted.

"Ultimately, retail investors should never put all their eggs in one basket, and they should be very careful about investing in non-traditional assets like crypto."