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FTX – Lessons Learned from a Lack of Due Diligence

What do a supermodel, Shark Tank star and sovereign wealth fund have in common? They all failed to ask questions before investing their money.

What do a supermodel, Shark Tank star and sovereign wealth fund have in common? They all failed to ask questions before investing their money. The investments were related to the cryptocurrency exchange FTX and its trading arm affiliate, Alameda Research. Here are 4 factors you should consider before you invest in any potential investment.

Conflicts of Interest Between Affiliated Entities

The adage “follow the money” can help you identify potential conflicts of interest between entities. Conflicts of interest may sometimes be unavoidable. They aren’t always a bad thing. However, related party transactions should be disclosed. You should also understand how such conflicts are mitigated.

Contrary to assurances that Alameda and FTX were separate entities, the two firms were intertwined. In fact, the collapse of FTX can be directly attributed to Alameda trading billions of dollars from FTX accounts and leveraging the exchange’s native token, FTT, as collateral. At the time, it would have been easy to press both companies for more information.

Weak Governance and Poor Financial Controls

A strong effective control environment reflects the values of an organization. A legitimate organization will have well-defined policies and procedures that govern its operations. Additionally, those controls will be overseen by an independent party. At FTX, there were no such controls. In fact, the lack of any cash controls allowed customer funds to be freely transferred to Alameda. It certainly would have been a red flag during any due diligence process.

Additionally, you should review an organization’s board of directors. An independent board serves as a fiduciary and is enlisted to protect shareholder interests. FTX did not have a board of directors. They refused to do so and were audited by two little known auditing firms—more red flags.

Inexperienced Executive Team

The most nominal due diligence process involves reviewing an organization’s executives. Executives who may be politically exposed, have prior criminal records, bankruptcies or have poor track records may indicate more red flags.

By now, it shouldn’t come as a surprise to learn that FTX did not have a CFO. FTX’s Chief Regulatory Officer, Dan Friedberg, was previously the General Counsel at Ultimate Bet, an online gambling site. A deeper dive would’ve revealed that, while at Ultimate Bet, Friedberg was embroiled in a poker cheating scandal where he was caught on tape allegedly aiding the perpetrators of the fraud.

Unregulated Assets in a Foreign Country

When considering whether to invest in an organization, it is very important to know where that entity is domiciled and the applicable laws and regulations which would help protect your investment in case of insolvency. The lack of regulation for crypto assets continues to be a significant risk for investors. While the securities market is governed by the SEC, and the commodities, futures and options markets are governed by the CFTC, there are no specific laws which directly govern FTX and/or any crypto businesses directly. In addition, FTX was located offshore in the Bahamas. That provided even less protection for investors in the event of insolvency.

Don’t Make Yourself a Victim

Before you invest in any venture, make sure you understand the investment strategy behind it. Learn as much as you can about the people who are running it, including their backgrounds. Make sure you understand the control environment of the firm’s operations. You should also know what protections you can rely on if something goes wrong. Most importantly, if you don’t receive sufficient answers to your questions, it’s time to move on to another opportunity. Never allow yourself to be consumed by FOMO (or fear of missing out). You and your family have worked much too hard for your money.

Azzad emphasizes ongoing due diligence as part of our investment manager research process. In fact, verification and due diligence is the third of the Seven Tenets of Halal Investing at Azzad. To learn more about our due diligence and Islamic investment process, please contact us.

Azzad Asset Management

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