FTX was everything SBF told investors and regulators it was not

Case Number: 1:22-cv-10794

Plaintiffs: Securities and Exchange Commission (the “Commission”)

Defendants: Caroline Ellison (“Ellison”) and Zixiao “Gary” Wang (“Wang”)

Filing Date: Dec 21, 2022

Location: US District Court, Southern District of New York

Filer: Jorge G. Tenreiro, David L. Hirsch (not admitted in SDNY), Ladan F. Stewart, Amy Harman Burkart, David J. D'Addio - Attorneys for the Plaintiff

FACTS

C. Defendants Knew that FTX Had Poor Controls and Deeply Inadequate Risk Management Procedures, in Stark Contrast to Bankman-Fried’s Claims that It Was a Mature, Conservative Company.

59. From its inception, FTX had poor controls and fundamentally deficient risk management procedures. Assets and liabilities of all forms were generally treated as interchangeable, and there were insufficient distinctions between the assignment of debts and credits to Alameda, FTX, and executives, including Bankman-Fried, Wang, and Singh. This reality was a sharp contrast to the image of FTX that Bankman-Fried consistently portrayed to the public and to investors—a mature company that managed funds and risk in a conservative, rigorous manner.

60. FTX invested significant resources to develop and promote its brand as a trustworthy company. For example, in materials provided to one investor in or around June 2022, FTX cultivated and promoted its reputation:

“FTX has an industry-leading brand, endorsed by some of the most trustworthy public figures, including Tom Brady, MLB, Gisele Bundchen, Steph Curry, and the Miami Heat, and backed by an industry-leading set of investors. FTX has the cleanest brand in crypto.”

61. FTX also promoted itself as a company that was willing to work collaboratively with regulators and lawmakers. In the same materials, FTX claimed:

“FTX is also the only major digital asset venue to maintain positive, constructive relationships with regulators and lawmakers.”

62. Defendants knew or were reckless in not knowing that the reality was far different than what Bankman-Fried presented to FTX’s investors and customers.

i. The FTX Automated Risk Engine

63. Bankman-Fried repeatedly touted FTX’s automated risk mitigation protocols— which he called FTX’s “risk engine”—to the public, and prospective investors, as a safe and reliable way for crypto asset trading platforms to manage risk. FTX engineers, led by Wang, developed the software code that created the “risk engine.” In essence, the software code implemented a series of rules that were designed to reduce risk in any individual client’s account by automatically triggering certain actions (e.g., to sell collateral in an account when an account was overly extended).

64. Bankman-Fried promoted the concept of “24/7” automated risk monitoring as an innovative benefit of crypto asset markets, including at a hearing on or about December 8, 2021, to the U.S. House of Representatives Committee on Financial Services, where Bankman-Fried concluded his remarks by stating:

And the last thing I will say is if you look at what precipitated some of the 2008 financial crisis, you will see a number of bilateral, bespoke, non-reported transactions happening between financial counterparties, which then got repackaged and releveraged again and again and again, such that no one knew how much risk was in that system until it all fell apart. If you compare that to what happened on FTX or other major cryptocurrencies in use today, there is complete transparency about the full open interest. There is complete transparency about the positions that are held. There is a robust, consistent risk framework applied.

65. In addition to generally promoting the benefits of automated risk engines, Bankman-Fried repeatedly claimed that FTX’s own risk engine was especially sophisticated and carefully calibrated. In a submission to the Commodity Futures Trading Commission, FTX touted its automated system, claiming that it calculated a customer’s margin level every 30 seconds; and that if the collateral on deposit fell below the required margin level, FTX’s automated system would sell the customer’s portfolio assets until the collateral on deposit exceeded the required margin level.

66. These statements were materially false and misleading because of a critical omission: Bankman-Fried did not reveal that the automatic risk engine did not apply to the accounts of its most important customer—Alameda. As discussed above, Wang and other FTX engineers—as part of Defendants’ and Bankman-Fried’s fraudulent scheme—had created a special feature in the software code to exempt Alameda from the rules of the “risk engine.” This was a critical special benefit that Bankman-Fried afforded Alameda: Alameda’s collateral on deposit was allowed to fall below FTX’s required margin level without FTX liquidating any part of Alameda’s portfolio. Ellison was aware of, and took advantage of, this special undisclosed benefit.

67. Defendants knew, or were reckless in not knowing, that Bankman-Fried’s statements regarding FTX’s risk engine misled FTX’s investors by representing that its risk engine would protect FTX customer funds and would limit FTX’s exposure to any single customer, while failing to disclose that Bankman-Fried had directed Wang to ensure that the engine not apply to one of its largest customers.

68. As Bankman-Fried acknowledged in a network television interview on or about December 1, 2022: “I wasn’t even trying, like, I wasn’t spending any time or effort trying to manage risk on FTX.” Bankman-Fried continued: “What happened, happened—and, if I had been spending an hour a day thinking about risk management on FTX, I don’t think that would have happened.”

ii. The Valuation of Alameda’s Collateral

69. The collateral that Alameda had on deposit, consisting largely of enormous positions in illiquid crypto assets issued by FTX and Bankman-Fried (including the “FTT” token, the “exchange token” for FTX, as described below), compounded the undisclosed risk to FTX’s investors.

a. Alameda Overvalued Its Collateral by Ignoring Significant Liquidity Issues.

70. Defendants and Bankman-Fried valued the FTX-affiliated tokens at trading prices, but the collateral deposited by Alameda was not worth the value assigned to it. Alameda and FTX collectively owned the majority of these tokens, and only a small portion of the FTX- affiliated tokens were in circulation. As such, the tokens were illiquid, and, as Defendants and Bankman-Fried knew or were reckless in not knowing, if Alameda or FTX tried to sell Alameda’s holdings, market prices for the tokens would fall, thereby driving down the value of Alameda’s deposited collateral at FTX. As a result, even if FTX had liquidated Alameda’s portfolio, the sales of those thinly traded tokens would not have generated sufficient funds to cover the amount Alameda borrowed from FTX.

71. Defendants and Bankman-Fried were well aware of the impact of Alameda’s positions on FTX’s risk profile. On or about October 12, 2022, for example, Bankman-Fried, in a series of tweets, analyzed the manipulation of a digital asset on an unrelated crypto platform. In explaining what occurred, Bankman-Fried distinguished between an asset’s “current price” and its “fair price,” and recognized that “large positions – especially in illiquid tokens – can have a lot of impact.” Bankman-Fried asserted that FTX’s risk engine required customers to “fully collateralize a position” when the customer’s position is “large and illiquid enough.” But Bankman-Fried knew, or was reckless in not knowing, that by not mitigating for the impact of large and illiquid tokens posted as collateral by Alameda, FTX was engaging in precisely the same conduct, and creating the same risk, that he was warning against. Defendants too knew that Alameda was drawing down on a virtually unlimited line of credit from FTX, collateralized by what they knew or were reckless in not knowing was a large illiquid position.

72. The reality of FTX’s exposure to the risk created by the valuation of Alameda’s positions stood in stark contrast to Bankman-Fried’s assertions about risk management at FTX in his October 2022 Twitter analysis, in which he described FTX’s approach and claimed that constructing the rules for FTX’s risk engine in a manner that is “conservative, and handles apparent large moves gracefully” is “probably the most important thing we do at FTX.” Bankman-Fried further claimed, contrasting FTX to the failed endeavor: “There are a bunch of other risk engine protection and sanity checks, too, which would have caught something like this.”

73. Not only did Bankman-Fried fail to tell investors that he had exempted Alameda from FTX’s risk engine, he also falsely told certain investors that FTX had no exposure to FTT at all. In late summer 2021, for example, Bankman-Fried told a potential U.S. investor in FTX’s series B fundraising round that FTX did not hold FTT and, consequently, the investor would not have any exposure to FTT. The investor ultimately invested $30 million. For the reasons described above, Defendants and Bankman-Fried knew or were reckless in not knowing that at the time that Bankman-Fried made those representations, they were false and misleading. Specifically, Defendants and Bankman-Fried knew or were reckless in not knowing that any investment in FTX carried significant exposure to FTT, as the token was, among other things, posted as collateral for billions of dollars that FTX had loaned to Alameda to engage in speculative investments.

b. Alameda Manipulated the Market Price of FTT and, as a Result, Further Inflated the Value of Its Collateral.

74. Ellison, at Bankman-Fried’s direction, caused Alameda to manipulate the price of FTT by purchasing large quantities of FTT on the open market to prop up its price. This manipulative activity was in furtherance of Defendants’ scheme because it allowed Ellison and Alameda to engage in further borrowing, while concealing Alameda’s true risk exposure.

1. FTT Was Offered and Sold as an Investment Contract and, Therefore, as a Security.

75. On or about July 29, 2019, FTX launched a crypto asset known as “FTT.”(5) FTX launched FTT as an “exchange token” for the FTX platform (i.e., the crypto asset or token associated with a crypto trading platform).

76. Before launching the FTX platform in or around May 2019, FTX had minted 350 million FTT tokens in or around April 2019. Of the 350 million tokens minted, 175 million were allocated to FTX as “company tokens,” and 175 million were designated as non-company tokens. The company tokens were set to “unlock” (or become available for trading) over a three- year period after a so-called initial exchange offering (“IEO”) of the token.

77. From the time of its offering, FTT was offered and sold as an investment contract and therefore a security.

78. Of the 175 million non-company tokens, FTX offered and sold approximately 73 million FTT in so-called “pre-sales” to investors, at prices ranging from $0.10 to $0.80. FTX raised approximately $10 million from these sales of FTT prior to the IEO. The pre-sale tokens were programmed to unlock between one to three months after the IEO. FTX did not manage separate, segregated accounts for investors, but instead pooled all proceeds from the pre-sale and the IEO of FTT and treated them interchangeably.

79. FTX used the pooled proceeds from FTT sales to fund the development, marketing, business operations, and growth of FTX, depending on the success of FTX and its management team in developing, operating, and marketing the trading platform. If demand for trading on the FTX platform increased, demand for the FTT token could increase, such that any price increase in FTT would benefit holders of FTT equally and in direct proportion to their FTT holdings. The large allocation of tokens to FTX incentivized the FTX management team to take steps to attract more users onto the trading platform and, therefore, increase demand for, and increase the trading price of, the FTT token.

80. As a result of FTX and its management team’s large holdings of FTT, the interests of the company and its management team were aligned with those of investors in FTT.

81. FTX’s FTT marketing materials—consisting of an FTT “whitepaper” and information posted on FTX’s website—described FTT as “the token powering the FTX ecosystem.” The publicly available information led FTT holders to reasonably expect to share in FTX’s growth and future earnings, and from appreciation in the value of FTT.

82. The FTT whitepaper specifically highlighted the profit potential of the token. For example, the whitepaper included the following statements: “We launched FTX in April and already have among the world’s most liquid orderbooks” and “[o]ur goal is to become as profitable as Bitmex and OkEx within a year.” On the FTX website, FTT purchasers were offered a 5% bonus of tokens during the first three days of the IEO if they pre-funded their FTX wallets to purchase FTT, providing a potential immediate profit to investors. FTX also represented that FTT would be listed at $1.00 on July 29, 2019, and the “pre-sales” were at prices ranging from $0.10 to $0.80, which provided purchasers an immediate profit potential based on the announced listing price.

83. The FTX whitepaper further explained: “We have carefully designed incentive schemes to increase network effects and demand for FTT, and to decrease its circulating supply.” The FTT materials stated that the token provided investors with fee rebates and discounts on FTX, and the ability to use the token as collateral for futures positions as well as for “margin trading” that FTX promised to launch “in the future.” The FTT materials referred to potential gains from FTX’s future repurchase and burning of FTT (the “buy and burn” program), to be funded by FTX’s revenues.(6)

84. The FTX whitepaper also explained that “[c]ustomers who hold a certain amount of FTT for a period of time will receive lower FTX futures fees” and that this “will further increase demand for FTT.”

85. FTT was marketed as an investment that would appreciate in value as it grew and expanded in other ways. FTX represented that it “carefully designed incentive schemes to increase network effects and demand for FTT, and to decrease its circulating supply.” These incentives included that FTT would be listed on FTX and thus could be traded, and FTX’s “buy and burn” program would purchase FTT, thus boosting demand, and then burn those purchased tokens in order to decrease the supply of FTT and increase its price.

86. FTX marketed FTT by encouraging purchasers to believe that its platform would succeed and provide a return based on that success. The FTT whitepaper emphasized “Why Invest? -- All-Star Team,” and highlighted the importance of the management team’s experience and success in developing crypto asset trading systems. For example, the whitepaper stated that FTX’s “greatest strength lies in the team behind it” and touted FTX’s “Track Record of Proven Success” based on the background and experience of its management team. The FTT materials made clear that FTX’s core management team’s efforts would drive the growth and ultimate success of FTX. The whitepaper also advertised that certain features gave FTX an advantage over competing platforms, including industry-leading risk management systems and its liquidation engine model.

87. FTX also marketed FTT as an asset that could be used in an “earn program” or in “staking programs” (i.e., a program promising interest payments on deposited assets), as additional ways in which investors could earn returns from FTT.

88. FTX’s whitepaper tied the prospects of FTT’s investors to the growth of the FTX platform, and noted that FTX would undertake various “Strategies to Acquire Users and Grow Volume,” including the employment of influential spokespeople.

89. FTX’s whitepaper also stated that “[t]here are many ways FTT will be used as we add more products and features to FTX. For instance, when we launch a spot exchange in the future, FTT will be used for initial exchange offerings.”

90. As a result of the above representations and the economic reality at that time, FTT investors had a reasonable expectation of profiting from FTX’s efforts to deploy investor fundsto create a use for FTT and bring demand and value to their common enterprise.

2. Alameda and Ellison, at Bankman-Fried’s Direction, Manipulated the Market Price of FTT.

91. In July 2019, when FTX launched FTT, Alameda received a substantial portion of the 350 million FTT tokens that were minted, including all of the “company tokens” that were allocated to FTX. Alameda did not pay for these tokens

92. Alameda programmed its automated trading tools (or “bots”) to conduct trades and execute transactions to purchase FTT at specific prices. On more than one occasion, Alameda and Ellison, at Bankman-Fried’s direction, actively engaged in the trading of FTT with the goal of supporting the price of the token. On these occasions, Alameda adjusted the trading parameters of its trading bots in order to support the price of FTT.

93. For example, in 2019, there was downward pressure on the price of FTT as the token was being unlocked for early-stage investors. Bankman-Fried became concerned about, among other things, the psychological effect of the price of FTT dropping below a specific threshold, and instructed Ellison to have Alameda purchase FTT to support the price and avoid that outcome. In another instance in 2021, the price of FTT was again facing downward pressure from external events, this time related to substantial sales of FTT by a third party. Bankman- Fried again instructed Ellison to have Alameda purchase FTT on trading platforms to support the price. In addition, as described further below in paragraph 106, in November 2022, Ellison engaged in further deceptive conduct to support the price of FTT.

94. By manipulating the price of FTT, Ellison and Bankman-Fried caused the valuation of Alameda’s FTT holdings to be even more inflated. As described above, Alameda’s FTT holdings were a substantial part of the collateral Alameda used to borrow funds from external lenders. By overstating the value of the collateral on Alameda’s balance sheet, Ellison and Bankman-Fried concealed Alameda’s true risk exposure from those lenders, and misled investors about FTX’s risk exposure—all in furtherance of the fraudulent scheme.

iii. Loans to FTX Executives and Real Estate Purchases

95. The FTX funds transferred to Alameda were used not only for Alameda’s proprietary trading, but also to fund loans to FTX executives, including Bankman-Fried himself, and to fund personal real estate purchases. Between March 2020 and September 2022, Bankman-Fried executed promissory notes for loans from Alameda totaling more than $1.338 billion, including two instances in which Bankman-Fried was both the borrower in his individual capacity and the lender in his capacity as CEO of Alameda. Ellison knew, or was reckless in not knowing, about these “loans.”

96. Bankman-Fried also used commingled funds from Alameda to make large political donations and to purchase tens of millions of dollars in Bahamian real estate for himself, his parents, and other FTX executives. Specifically, in 2020 and 2021, Wang executed promissory notes with Alameda totaling approximately $224.7 million. The funds borrowed under the promissory notes in Wang’s name were not intended for Wang’s personal use but were instead used by Bankman-Fried for other purposes, including additional venture investments. However, Wang did withdraw approximately $200,000 in funds for his own purposes.

97. The loans to Bankman-Fried, Wang, and other individuals were poorly documented, and at times not documented at all. Similarly, the record keeping regarding the purchase and ownership of real estate was poorly organized and documented. Defendants knew, or were reckless in not knowing, that neither the fact of the loans and purchases, nor the poor documentation of significant company liabilities and expenditures, was disclosed to investors.

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