James Park, a Professor at UCLA School of Law in Los Angeles, CA discusses the recent FTX bankruptcy and private company valuations…
Why was the cryptocurrency exchange FTX valued at $32 billion before it filed for bankruptcy? Many of the world’s most sophisticated investors believed it was worth that much and invested billions based on that valuation. They failed to detect the company’s massive misconduct and their investments were completely wiped out over the course of a few days. FTX illustrates the dangers of investing in private companies that are not subject to regulation by the Securities and Exchange Commission (SEC).
While many of the details of alleged wrongdoings at FTX are still emerging, there are reports that the exchange diverted customer funds to an affiliated hedge fund to make risky bets on other private cryptocurrency companies. As the value of crypto assets declined and the Federal Reserve raised interest rates, these investments lost almost all of their value. The misappropriated customer funds had been squandered, leaving FTX with a multi-billion dollar shortfall in assets, making it insolvent.
FTX likely defrauded its customers who had no idea that funds in their accounts would be used for speculation. The diversion was also potentially a fraud against the investors who purchased billions of dollars in securities to fund FTX. This sale was in a private placement, which permits a company to sell securities to sophisticated investors without the oversight of SEC disclosure mandates. However, even private security sales are governed by federal statutes and administrative rules that prohibit fraud. If FTX and its managers made misrepresentations to its investors relating to the company’s shenanigans, they could be liable for securities fraud.
If FTX had sold securities to the public in a traditional initial public offering, its finances would have been closely scrutinized from the inside by an underwriter, which assists companies selling securities to the public. The underwriter has its reputation on the line in vouching for the company. The underwriter is also potentially subject to harsh legal sanctions under federal securities law if it misses any fraud. FTX would have been required to file a detailed disclosure document with the SEC with audited financial statements. The exchange’s poor management and misconduct would likely have been revealed and its market value would not have been anywhere close to $32 billion. Indeed, a few years ago, the co-working office space company WeWork, which had an even higher private valuation than FTX, failed the scrutiny of its underwriters and had to cancel its sale of securities to the public.
Over the last few years, there has been a problematic movement to permit companies to go public with less scrutiny. Companies are now permitted to list their stock directly on public exchanges without the safeguard of an underwriter. The belief is that because private companies have been valued by sophisticated investors who know what they’re doing, these valuations can be trusted and the stock can just begin trading on an exchange without further scrutiny. If FTX had sold its shares directly on an exchange based on its $32 billion private valuation, ordinary investors would have lost billions of dollars when its fraud was revealed.
For a time, there was a brief but intense proliferation of Special Purpose Acquisition Companies (SPACs), which allow the general public to purchase stock in a company that is looking for a private company to acquire. The problem with SPACs is that they do not have an incentive to carefully scrutinize the valuation of the companies they acquire. Their managers are only paid when they successfully complete an acquisition and so their primary concern is to close a deal rather than ensure that their shareholders are paying a reasonable price. Because they often take inflated private stock valuations at face value, SPACs have generally lost money for their investors. For example, after its IPO failed, WeWork went public through a SPAC transaction. Its stock has fallen by about 70 percent since the transaction.
The collapse of FTX illustrates the value of laws like the Sarbanes-Oxley Act of 2002, which recently celebrated its twentieth anniversary. That law implemented a number of reforms such as requiring every public company to scrutinize and assess its internal controls on a yearly basis with the assistance of an outside auditor. Such controls were completely missing at FTX, which had terrible recordkeeping, allowing company funds to be routinely diverted for personal purposes. While the costs of these internal control assessments have been criticized, it is notable that accounting misstatements by public companies have generally fallen since the passage of this law.
FTX also shows the danger of permitting public investors to purchase stock that has not been registered with the SEC. Even sophisticated investors have a hard time detecting fraud. Private companies are inherently riskier and have uncertain prospects for success. For every company that is a success there are dozens if not hundreds of private companies that become completely worthless. There is good reason to draw a firm line between public markets that all investors can access and private markets that are restricted.
FTX was especially risky because it invested in unregulated crypto markets. Because the founders of crypto projects have refused to comply with SEC disclosure requirements, their value is completely uncertain. The prices of crypto assets fluctuate based on uncertain speculation and it is likely that their prices do not reflect real economic value. The collapse of FTX has validated the policy of the SEC to discourage investment in digital currencies that do not comply with disclosure requirements.
In the securities fraud cases that will inevitably be filed against FTX and its founders by private plaintiffs and the government, wealthy and sophisticated investors will be named as victims of the exchange’s fraud. It seems odd to protect wealthy venture capital markets from fraud, but doing so prevents unjust enrichment by fraudsters. Fortunately, public stock investors were not directly harmed by the company’s deception. The careful separation of public and private markets by the SEC has helped limit the impact of the FTX debacle.
James Park is a Professor of Law at UCLA School of Law. He is the author of a book on the history of securities fraud regulation, The Valuation Treadmill: How Securities Fraud Threatens the Integrity of Public Companies.
Suggested citation: James Park, FTX and the Illusion of Private Company Valuations, JURIST – Academic Commentary, December 6, 2022, https://www.jurist.org/commentary/2022/12/James-Park-FTX-SEC-business/.
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