Lessons learned from Madoff . . . but forgotten too soon!
As Mark Twain famously said, “History does not repeat itself, but it rhymes”. The rise and fall of Sam Bankman-Fried, and his crypto exchange FTX, share a lot of similarities to the Madoff scandal over a decade ago. In fact, many of the financial scandals, frauds, and collapses over the years had many red flags that sound due diligence should have detected.
In my book, Goals-Based Investing, I share the lessons learned from Madoff – several of which should have been red flags for investing or doing business with FTX. Before sharing the lessons, let me remind everyone how we got to this point in time.
Who is Sam Bankman-Fried and FTX?
Sam Bankman-Fried (aka “Mini-Madoff”) was born in Silicon Valley and educated at MIT. He launched his crypto trading firm Alameda Research in 2017, and in 2019 launched his crypto exchange platform FTX. In 2020, the two companies reported $1.35 billion in profits. At his peak, Bankman-Fried was worth $26 billion, and at 30 years old, he had celebrity endorsements from Tom Brady, Larry David, and Kevin O’Leary, among others. He had also secured the naming rights for the NBA’s Miami Heat arena.
In November, CoinDesk released a report questioning the cozy relationship between Alameda and FTX. The report found that even though Alameda Research and FTX are two separate companies, Alameda's assets were mostly tied up in FTT, a coin that FTX had invented.
A few days later, things got worse when CZ Zhao, the CEO of Binance — FTX's chief rival — decided to liquidate roughly $530 million worth of FTT. Customers also raced to pull out, and FTX saw an estimated $6 billion in withdrawals over the course of 72 hours.
Ultimately, FTX declared bankruptcy, and then a coordinated investigation discovered the misappropriation of client funds, political donations to curry favor, and insufficient internal controls. The SEC accused Sam Bankman-Fried of orchestrating a “massive, years-long fraud” in which he diverted billions of dollars of FTX customer funds for “his own personal benefit.” The civil complaint, filed in the Southern District of New York, said Bankman-Fried raised more than $1.8 billion from investors who bought an equity stake in the exchange, believing FTX had appropriate controls and risk management measures.
Similarities to Madoff Scandal
Bernie Madoff was charismatic and actively involved in the wealthy communities in New York and Florida. Madoff often claimed that he was closed to new investors but would make exceptions for wealthy families and institutions. The reality was he needed new investors to perpetrate his Ponzi-scheme. Madoff had a cozy relationship with regulators who failed to identify the fraud – even when they were provided a roadmap.
Not surprisingly, Madoff was very secretive about his strategy and was unwilling to allow many firms on-site to conduct due diligence. For those allowed on-site, he fabricated statements showing transactions generating the results and could point to an outside audit verifying the results. However, if you compared the transactions versus the tape, you would have realized they were false; and if you visited the accounting firm, you would have realized it was a one-man shop with one client – not one of the big accounting firms that you would expect for a firm of Madoff’s size.
What can we learn from the Madoff scandal?
If it sounds too good to be true – it probably is – do not invest unless you understand how the strategy works.
Compare results to those of similar strategies
Do not confuse marketing with due diligence
Beware the ‘exclusivity’ pitch
Numbers can be misleading – dig deeper
Evaluate compliance controls and independence
Accountants should be large reputable firms (hedge funds generally use the top firms)
Independent pricing services are an important check
Review independent custodians/brokerage statements
Make sure that firms are registered with the appropriate regulator
Over the last several years, there has been an ongoing debate about who should regulate cryptocurrencies and crypto trading. While the debate has gone on, the crypto industry has exploded, with new coins, exchanges, and adoption by investors of all sizes and sophistication.
It now seems inevitable that one or more regulatory authority (SEC, CFTC, etc.) will provide oversight. Unfortunately, it seems unlikely that investors will get back their money from FTX, since Sam Bankman-Fried and his colleagues spent most of the money on lavish gifts and a luxurious lifestyle in the Bahamas.
We shouldn’t confuse a bad actor and bad investment. FTX was a fraud perpetrated by Sam Bankman-Fried – this doesn’t mean that all cryptocurrencies are bad investments. While I am generally not a fan of increased regulation, I think regulating the industry would help to build investor trust and identify any other bad actors.
Conclusion
I don’t feel sorry for the paid endorsers or those who failed to conduct adequate due diligence. I feel sorry for the individual investors who fell for Mini-Madoff’s story. They believed the media hype and the paid endorsers. After all, they had likely seen Kevin O’Leary (“Mr. Wonderful”) challenge entrepreneurs on Shark Tank. Kevin is always focused on profitability and cash flow – and typically offers the Sharkiest deals. Surely, Mr. Wonderful did due diligence before becoming an endorser? Apparently not.
We will learn a lot more about Sam Bankman-Fried, and FTX, in the coming months. There will likely be books written and movies made about this colorful character. Unfortunately, this fraud will leave investors feeling like the markets aren’t fair and that there are bad people trying to take advantage of them. While there are bad people like Mini-Madoff, there are an abundance of honorable people who serve investors well. There are quality advisors and investment managers who help clients achieve their respective goals and objectives.
Let’s learn the lessons from the FTX Fraud. We should focus on investing with reputable firms with strong internal controls and investments that make sense. Understand the economic relationships between firms, especially affiliates, and insist on audits by well-known firms.
Remember, if it sounds too good to be true – it probably is!
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