FTX and Due Diligence

There’s been a lot of discussion about FTX and SBF in the investigations business since things fell apart over there. Many of my colleagues have made the worthy point that any business with exposure to crypto should view the whole thing as a cautionary tale and make sure to do their due diligence going forward. I agree with this – it’s absolutely true.

But it’s worth considering the possibility that FTX, Alameda, and SBF were already subjected to significant scrutiny by their counter-parties, and that ultimately this failed. This is merely a suspicion. It’s possible nobody really checked any of them out. I just don’t think it’s very likely.

Along these lines, I have another guess. Background checks on FTX, Alameda, and SBF either reflected mainstream opinion – and thus were useless considering what ended up happening – or were ignored by the customer. If this is true, FTX isn’t a cautionary tale about not doing your due diligence – it’s about how you do it, and how you use it.

A specifically pre-transaction due diligence investigation fails in a couple of circumstances: if a relevant background problem is missed or minimized by an investigator, or if it’s ignored by the end user of the information he finds. This reflects a shared responsibility between the investigator and the end user to make the process a success.

A client can mostly avoid the first problem by hiring competent investigators, leaving enough time to conduct a thorough investigation, and setting an appropriate budget for the work. An investigator avoids it by maintaining distance, perspective, and healthy skepticism towards the subject. And by not being overtaken by prevailing narratives and self-promotion in the case of very wealthy, famous, and – until recently – beloved people like SBF.

The second problem is harder to avoid. Certain circumstances make it nearly impossible:

1) When an enormous amount of money is about to be spent. Large sums create a momentum of their own that tend to skew all types of due diligence – legal, financial, reputational/risk/compliance, etc – in favor of spending the money. I don’t know why this is, but it’s an observable trend if you read a lot of court filings.

2) When investigative due diligence is the last stage in the evaluation of a deal. Again, momentum is against us at this point.

3) When a powerful stakeholder within a company has a vested interest in completing a transaction. Self-explanatory – investigators are contractors, serving at the pleasure of our clients. I think we’re more independent than in-house staff, but only so much.

4) When an investor is willing to accept a small amount of fraud or misconduct on the part of a founder-led enterprise, expecting that they will rectify this post-transaction.

When it comes to large, newsworthy deals, one or all of these circumstances usually obtains.

This may have something to do with what a firm thinks the purpose of investigative research is. Do the results of a due diligence investigation inform the thinking of a deal team about the transaction itself, or is the entire exercise an unavoidable expense arising from a legal requirement?

If the latter is the norm, it’s partially because due diligence investigators have done a poor job of communicating the purpose of their work, and (in certain circumstances) standing up for themselves when they present significant negative findings. These are age old communication and culture issues that have a lot to do with a relationship of trust between investigator and client. They’re hard problems to solve, but they can be very costly on both sides.

If anyone with due diligence responsibility is going through a process of self-examination in the wake of the FTX disaster, then it’s probably worth looking at the attitude towards the process in addition to the formal steps.