For those of you who have been living under a rock, Sam Bankman-Fried, is the former billionaire head of FTX Exchange, a Bahamian crypto-currency exchange that collapsed and filed for bankruptcy last month (November 2022). Prior to FTX’s collapse, Bankman-Fried was a billionaire whose net worth peaked at $26.5 billion last year. On December 12, 2022, Bankman-Fried was arrested by Royal Bahamian Police at his home in the Bahamas on an eight count, fourteen-page Indictment returned in the U.S. District Court for the Southern District of New York.
There are a lot of interesting aspects to the case. Bankman-Fried is 30 years old, eerily reminiscent of Elizabeth Holmes, the former billionaire CEO of Theranos which collapsed when she was 31 years old. Ms. Holmes has now been sentenced to an eleven-year prison sentence. The alleged improprieties are also reminiscent of the “Fyre Festival” another financial fraud that occurred under the watchful eyes of Bahamian authorities. The amount of loss in the Fyre Festival case, however, separates it from the allegations in Bankman-Fried’s case. Billy McFarland, the CEO of Fyre Media, defrauded his victims of only $26 million and received a mere six years in prison. Reliable accountings of financial losses for FTX’s investors have not yet been tabulated, but media reports suggest that the losses could greatly exceed those of either Fyre Media or Theranos.
In fact, the United States, with far more experienced and better resourced regulators than the Bahamas has repeatedly missed far larger frauds. In the infamous Bernie Madoff case, the U.S. Department of Justice (DOJ) recovered and distributed over $4 billion.
To me, the most interesting part of the case is the fact that the conduct charged involves primarily Wire Fraud. As the author of the hoped-to-be best-seller Understanding Mail Fraud and Wire Fraud: A Non-Attorney’s Guide, available from Amazon or Barnes & Noble, the case represents yet another case study in the law of Wire Fraud. The very powerful statute is meant to ensnare fraudsters, but it is often used as a “catch-all” to go after behavior the government finds objectionable, but which is often not illegal. There is too often a populist element in the prosecution’s motivation. Something bad happened; therefore, something must be done. However, bad things frequently happen, and they are just bad things. No one is to blame.
Of course, we do not know at this point whether Bankman-Fried is a criminal or an innocent victim of circumstance. Time and further investigation will tell, but as I sit here writing this article, either conclusion is possible. As the last sentence of DOJ’s Press Release states: “The allegations in the Indictment are merely accusations, and the defendant is presumed innocent unless and until proven guilty”. If only they believed that.
A Failed Business versus a Fraud
Most businesses that are formed fail. They fail without the involvement of fraud. They fail for a variety of reasons. Sometimes they fail because the product or service to be provided is ill-conceived. Sometimes they fail because they are mismanaged. Sometimes they fail because tastes or market conditions change. When businesses fail, those who invest in the business lose everything. In fact, business failure was so common at the beginning of the country that the Constitution empowered Congress to pass uniform laws concerning bankruptcy.
U.S. Constitution, Art. I, Clause 8.
In fact, the largest bankruptcy in history was the Lehman Brothers bankruptcy in 2008. At the time of its dissolution, Lehman Brothers had over $600 billion in assets and liabilities. There were many reasons for the bankruptcy, including mismanagement and miscalculation, but fraud was not a reason for the bankruptcy.
On the other hand, there are businesses that are vehicles for fraud. The most common example is the Ponzi Scheme. A Ponzi Scheme is usually based on some type of investment opportunity. Frequently, an investment advisor will recommend a particular investment promising higher than market rates of return. The advisor, however, doesn’t use investment funds to buy new investments but instead uses new investments to pay off older investors. As long as new investors can be lured into the scheme, it will continue. An essential element of a Ponzi Scheme is that an “intent to defraud” exists at the inception of the business and the investment advisor never intended to make money from investments (or, at a minimum, generating the advertised return through investments was never the goal).
So, what about Mr. Bankman-Fried? Was FTX a failed business based upon a misunderstanding of crypto-currency, or was it fraud from the inception? To be clear, a business can start as a legitimate business and later become a fraud, but if this is a case, there must be some point in time when the intent to defraud becomes obvious.
Based upon its press release, the DOJ alleges the misuse of FTX assets—specifically the misappropriation of “billions of dollars” in customers’ funds. These funds were then used, allegedly, for Bankman-Fried’s personal use, for campaign contributions, and to repay loans owed by another company, Alameda Research. Furthermore, the government alleges Bankman-Fried concealed his misuse of funds in customer financial information.
Although the amount involved in the case is large, the facts alleged are typical of alleged fraud we typically see. The question is: did Bankman-Fried have an intent to defraud, and, if so, when did that intent arise. Many companies, for example, make political contributions to individuals, parties, or political action committees, that they believe will enhance their operations or benefit their industry. Viewed in this way, political campaign contributions are frequently a valid business expense. Likewise, the purchase of information from Alameda Research—whether it be in the form of direct payments or the repayment of Alameda’s loans—could very well be a legitimate expense. Before jumping to conclusions, it is necessary to understand exactly what happened and to establish a clear timeline to work from.
The Cause of the Loss
In order to know if a crime has been committed, it is also important to understand the cause of FTX’s losses. Were FTX’s losses the result of changes in the cryptocurrency market, or were they caused by Bankman-Fried’s lavish lifestyle? The lifestyles of billionaires are indeed envious—private jets, private islands, lavish spending—and beyond the realm of most people to comprehend, but they may very well be irrelevant to FTX’s failure. According to media reports, Bankman-Fried was worth $26.5 billion in 2021. If he was indeed worth that much, then the “luxury” spending detailed in the Indictment was well within his legitimate means.
Often, prosecutors will introduce this evidence as a means of fanning the flames of envy and tainting the potential jury pool. It is often easier to destroy one’s reputation through press releases rather than through admissible evidence in court.
What do we know of the failure of FTX? FTX is a cryptocurrency exchange that trades FTX tokens (FTT). The entire cryptocurrency sphere is complex and subject to speculation and wild price changes. Even the oldest and most stable cryptocurrency, bitcoin, started at a value of around $320 per bitcoin before rising to a value of over $64,000 per token before crashing to $17,000 as of the publication of this article. Although there are true believers in blockchain technology, there are others who believe it to be untested and potentially subject to manipulation. In the case of FTT, a token was worth as much as $35 last year but has collapsed and is only worth $1.36 per token at this time.
In addition to operating FTX, Bankman-Fried had also previously operated Alameda Research, a hedge fund. According to a November 2, 2022, CoinDesk Report, Alameda held an unusually large amount of its assets in FTT or FTT related instruments. This arrangement, while not illegal, demonstrated the very close ties between the two entities, meaning that issues in one company could quickly spread to another. On November 6, a competitor of FTX, Binance, another entity with substantial FTT holdings, announced the sale of its FTT because of the November 2 Report. Thereafter, other investors began unloading their FTT resulting in a sudden and dramatic collapse of the value of FTT. The loss of liquidity doomed the company.
A lot of time and effort needs to go into determining the exact cause of the loss, and any type of substantial analysis is beyond the scope of this article, but the role of Binance CEO Changpeng Zhao and Binance would be an interesting area to explore. Binance was a competitor of FTX who caused its liquidity crisis by dumping FTT then entered into a deal to purchase FTX before pulling out of the deal ensuring FTX’s demise. On the surface, there is nothing illegal or untoward about Binance’s activities, but then again, there was nothing illegal about Alameda holding a significant amount of FTT.
To be sure, there are other issues that must be examined. Media reports indicate that certain expenses were hidden in FTX’s financial statements and manipulating the financials can signal financial fraud. There is a lot of work to be done by forensic accountants, certified fraud examiners, and lawyers.
An often-overlooked defense in these types of cases is the principle of “convergence”. Convergence can be a complicated issue, and we have a White Paper on Convergence in Wire Fraud Cases on our website. However, convergence in its simplest form means that all of the elements of a fraud must meet (or converge) at the same time. For example, suppose an investment advisor makes a bad investment and loses all of a client’s funds and then falsely reports to the client that his funds are secure. Has the investment advisor committed wire fraud? The short answer, based upon this hypothetical is “no”. This is because the loss occurred before any false statements were made, and there is therefore no convergence.
Although the investment advisor has not committed wire fraud, he may still be liable to his client for a variety of investment related misconduct. In addition to representing individuals charged with criminal wire fraud, we also represent investors who have lost money through investor misconduct, including in arbitrations before the Financial Industry Regulatory Authority (FINRA).
In the case hypothetical, if the investment advisor continues to accept funds for investment from the same client after he made the false statement, then the answer would most likely change to “yes”. At that point, the false statement results in the investment advisor receiving additional funds, and the elements have “converged”. Even then, however, the timing of the loss could be significant to calculating the amount of the loss attributable to criminal conduct. Since the amount of the loss is a significant factor in determining a sentencing range under the United States Sentencing Guidelines, showing that the majority of the loss was not attributable to criminal conduct can greatly reduce a sentence.
The arrest and prosecution of Sam Bankman-Fried garners a lot of media coverage for a number of dramatic factors, but the factual scenario underlying the Indictment is not unusual. For his attorneys, the defense is only beginning, and there are hundreds, perhaps thousands of hours that will need to go into the investigation of the case. Only time will tell whether he is guilty or not guilty. What is most important to all parties involved is a fair and just resolution of the case. A focus upon irrelevant details, however, can corrupt this pursuit.