Sam Sivarajan holds a doctorate in behavioural finance and has led wealth management teams at several of Canada’s largest financial institutions. He is the author of Making Your Money Work: The Secrets to Financial Health and Uphill: How to Apply Ancient Wisdom and Modern Science to Life’s Choices and Challenges.
It was one of the most spectacular, and brutally short, company implosions in history. FTX Ltd., one of the largest cryptocurrency exchanges, declared bankruptcy on Nov. 11, 2022. Only a month earlier, the company was valued at as much as US$32-billion and its founder, Sam Bankman-Fried (or SBF, as he is known), saw his net worth collapse from around US$15-billion to zero over the same time frame. Students of investment history know that FTX was not the first and will not be the last such sorry story. So, what lessons can investors draw to avoid the next FTX?
1. Beware the celebrity CEO
Having vision, charisma and the energy to drive a company forward are all valuable traits in any company CEO or founder. But recent examples have demonstrated just how dangerous an over reliance on the celebrity CEO can be to an investor’s portfolio. Take Elizabeth Holmes, the founder and CEO of Theranos, the biotech darling. She was honoured regularly on magazine covers such as Forbes, Fortune and Time – in November, 2022, she was sentenced to 11 years in prison for fraud. Adam Neumann, the founder and former CEO of WeWork, was feted on magazine covers as well. Once valued at as much as US$47-billion, WeWork’s value plummeted after a failed IPO in 2019 with Mr. Neumann’s eventual exit. Sam Bankman-Fried was also on the covers of Fortune and Forbes. These CEOs were darlings of the press and the investment community – but investors should note that, in the end, these CEOs were like the emperor who had no clothes.
2. Do your own due diligence
The Bernie Madoff Ponzi scheme unravelled in 2008, having defrauded investors of more than US$65-billion over decades. One reason the fraud could be continued for so long is the concept of social proof – new investors relied on the fact that friends and celebrities had invested with Mr. Madoff without doing their own due diligence. For Theranos, famous investors included Rupert Murdoch, former U.S. secretary of state Henry Kissinger, former U.S. secretary of defence Jim Mattis, the Walton family (Walmart). Each relied on the other’s investment as validation. FTX investors included Sequoia Capital, Softbank, Ontario Teachers’ Pension Plan, model Gisele Bundchen and sports celebrities Tom Brady and Steph Curry. Sequoia Capital went from gushing about the vision of SBF to apologizing to its investors for its total loss on the investment. Lawsuits are now threatened against Ms. Bundchen, Mr. Brady and Mr. Curry. The lesson for investors: don’t blindly follow celebrities or large investors.
3. Lack of transparency or self-dealing should be a warning
Plenty of warning signs existed for the investor who was paying attention. At WeWork, Mr. Neumann bought properties personally and leased them back to WeWork at a hefty markup. He also planned to charge the company almost US$6-million to use his trademark of the word “We” after pushing the company to rebrand as the “We Company.” And Mr. Neumann was granted up to 20 votes per share, giving him almost unfettered control over the company, even as new sophisticated investors ponied up cash. Similarly, FTX, headquartered in Bahamas, a less regulated market than the U.S., had more than 130 subsidiaries. SBF owned the majority of shares in both FTX and its trading subsidiary, Alameda Research. There was little transparency, oversight or corporate governance. The veteran restructuring lawyer now overseeing the bankruptcy proceedings of FTX, who also handled the Enron bankruptcy, called this situation unprecedented and was appalled by the control given to a small group of inexperienced and conflicted individuals. That this happened with the tacit approval of sophisticated venture capital investors is even more puzzling.
4. Evolution is usually better than revolution
There is another common feature to these sorry tales – the founders were all touted as revolutionizing their industries. People forget that revolutions usually come with a lot of turmoil. That is exactly what happened in these cases. It should be no surprise that, in the wake of the recent crypto failures, there are now calls for more regulatory oversight. But what is ironic is the fact that these calls come from investors who rushed into these investments precisely because they were unregulated. Investors should remember that the market and industry evolved over decades to their current forms, even if we might have forgotten the original rationale and even if improvements can still be made. Securities regulators only came into force in the 1930s and 1940s after many retail investors were wiped out by unscrupulous promoters in the Roaring Twenties. Investors should be skeptical of anyone promising to revolutionize their industry – there may be a lot of downside before the upside kicks in.
The philosopher George Santayana famously said, “Those who cannot remember the past are condemned to repeat it.” While said in the context of political history, it equally applies to investors.