Will venture capitalists be held accountable for investing in FTX?

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As impossible as it sounds, it’s true that multi-million-dollar venture capital funds did not conduct proper due diligence on mismanaged and disgraced exchange FTX

While the signs are clear with hindsight, the ongoing fallout underlines how many corporate funds and VCs are just as susceptible to scams as the next person. While regulatory scrutiny may find that more nefarious activities were at play the inherent risk of early-stage investing probably means that regulatory change is unlikely despite the fallout.

The US Securities and Exchange Commission (SEC) has filed charges against three FTX executives, including Sam Bankman-Fried. But this is only the beginning of the SEC’s probe. Earlier in January, Reuters reported the SEC is also looking for information about finance firms that made big investments in FTX in regards to the due diligence processes used prior to investing.

You’d be forgiven for thinking there’s nothing to look for, and that’s certainly the general impression these days.

While this area of investigation isn’t an obvious indication of wrongdoing, the abundance of venture capital funds associated with FTX raises eyebrows. Specifically, the SEC is looking at details about what policies and due-diligence processes venture firms had in place when they concluded that investing in FTX was a wonderful idea.

The FTX bandwagon (despite red flags)

The list of FTX investors who poured a combined $2 billion into the fraudulent exchange spans a lengthy “who’s who” list of well-known investment firms. These include NEA, Third Point Ventures, IVP, Insight Partners, Tiger Global, Sequoia Capital, Lightspeed Venture Partners, Temasek Holdings, SoftBank and BlackRock.

Notably, the list also includes the Ontario Teachers’ pension fund, one of Canada’s largest pensions with about $250 billion in assets under management. The fund will write down all of its $95 million investment in FTX.

That’s an insurmountable amount of capital flowing into an organisation which had its accounting firm based in the ‘metaverse’, no board of directors, a non-existent funds accounts structure, a questionable corporate domicile, and a highly levered sister company which had full access to user funds. And this is just the start of ‘red flags’ among a laundry list of issues.

So how did these multi-billion-dollar institutions with infinite resources miss the signs?

Every VC fund that invested in FTX said it conducted proper due diligence. This includes Temasek Holdings, which said it had an eight month due diligence process that didn’t identify a single issue.

While there are certain errors of judgment at play, it’s also undeniable that serious questions about foul or nonchalant play are being raised by the SEC and others. Were the funds acting responsibly on behalf of their clients when they dumped cash into FTX as part of their fiduciary responsibilities? Who did the funds and VCs represent? How is it even conceivable that not a single one of FTX’s investors didn’t find anything amiss? And is VC groupthink really what led to the biggest fraud since Bernie Madoff?

While these questions deserve solid answers, the ultimate issue is about oversight or lack thereof. Did these investors exercise any oversight on how they deployed funds or were they interchangeable with your average shitcoin trader with a hundred-thousand dollars on Uniswap? In the latter case, why even bother with following VC fund flows if they’re just as degenerate as meme traders on the internet?

When it comes to FTX and others like Terraform Labs, Celsius, 3AC and Genesis, the buck stops with those who have a fiduciary responsibility to their clients. Certainly, there is an expectation for regulators to protect investors from fraud and mismanagement of investments, but investors rely on investment managers to conduct proper due diligence and to make risk-adjusted decisions in keeping with their fiduciary duties too. This delicate balance of oversight, trust and accountability forms a delicate trifecta – if one part falls, the rest soon follow.

Venture capitalist groupthink

As the inquiries proceed, it’s worth considering all aspects – given that the most likely explanation is more complex and nuanced than catch-all blanket allegations of fraud. Indeed, this isn’t the first time VCs and private equity flowed into the latest shiny object, throwing caution to the wind and betting the house (and everyone else’s) on black.

The dot-com bubble was equally ridiculous. While Sam’s rap sheet of fraud amasses casualties, his greatest bait and switch heist was luring in the headless chicken VC market into his ponzi game. The “Crypto Kid” gave VCs a reason to swoon, and many of them fell for it without questioning a thing.

So now that we can reasonably assume that VCs are interchangeable with monkey-market traders, the question is: what’s next for VC investing?

According to Politico, avoiding groupthink could require a rule adjustment that would preclude private funds from seeking indemnification for simple negligence, effectively making it easier for limited partners (LP) in such funds to sue. Presumably, this would drive accountability, and would hopefully result in better oversight on the part of fund managers.

That said, the VC wake-up call for fund managers that blindly followed Sequoia Capital are unlikely to face much regulatory scrutiny; the reason being that investors are rarely promised specific due diligence processes or other requirements when investing. Also, if investors and partners are dissatisfied, they tend to vote with their wallet during follow-up fundraising.

Besides that, expanding liability to simple negligence would enable LPs to sue each time a deal goes South, which would add pressure on VC businesses, which would in turn be passed onto investors and portfolio companies. Additionally, LPs won’t take advantage of these rights because gaining a reputation as someone keen on litigation will preclude them from participating in future deals.

Nobody wants to work with a rat in any industry, after all.

In other words, the VC market is unlikely to change all too much. However, that doesn’t mean throwing the baby out with the bath water. Instead of opening the litigation floodgates, it’s correct to hold fraudsters accountable, while allowing responsible funds big and small to pursue innovation, wherever it rears its head.

Everything has a cost, it’s just a matter of when and how. Perhaps VCs should take a page out Tim Draper’s book and stack sats next time around.

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