Could the government have stopped the massive crypto fraud?

Prosecutors have indicted Sam Bankman-Fried for allegedly diverting billions of dollars of customer funds placed in his crypto trading platform, FTX. Bankman-Fried, the purported mastermind of that massive fraud, has been arrested in the Bahamas.

The Securities and Exchange Commission (SEC), the federal agency mandated to protect investors, has also charged him with violations of securities laws. That agency alleges that Bankman-Fried lied to those who sent billions of dollars to FTX by telling them their assets were secure when in fact he was engaged in an enormous embezzlement scheme.

Bankman-Fried was allegedly surreptitiously sending his customers’ money to a hedge fund that he controlled and using it to make all kinds of undisclosed investments, lavish purchases and large political donations.

The SEC’s action is seeking to enjoin him from any further violations of the federal securities laws and secure disgorgement of his ill-gotten gains. But unfortunately, the government appears to be coming up short in ending this gigantic fraud. If the history of such crooked dealings is any guide, FTX’s investors and trading customers will find that their money has been frittered away and recover almost none of it.

Among the most prominent crypto assets are digital currencies that purport to be an alternative to traditional government-backed money. Using elaborate protocols and blockchain technology as ledgers, they function like mediums of exchanges and stores of wealth.

Several years ago, the SEC issued an opinion that when functioning solely in that way, they were not securities because their purchasers were buying a commodity that they could use or consume. But they would be securities under the well-established investment contract theory, where their purchasers expected profit such as appreciation of those digital assets from the managerial efforts of others.

In those cases, all the reasons for the securities laws that protect investors would kick in. The sale and trading of digital assets would thus come squarely within that regulatory framework. The SEC certainly knew that crypto currencies and their trading platforms, including FTX, could be within their jurisdiction. 

Should those federal officials have policed operations like FTX more carefully and brought legal action to stop any that violated the registration and anti-fraud provisions of the laws they are charged to enforce?  

When I worked at the SEC as a young lawyer, I saw that it is vastly out resourced by the wealthy Wall Street community it must police and has the ability to prosecute at most only 2 percent of securities law violations. Despite that, the agency, since its creation in New Deal legislation, has generally received high marks for its effectiveness. Also, to its credit, the SEC makes admirable efforts to get those who would commit their savings to enterprises like FTX to first investigate their representations promising them secure profits.

Yet that agency has stumbled badly at times, most infamously in the Bernie Madoff scandal in which the SEC failed to catch a decades-long Ponzi scheme that bilked investors out of tens of billions of dollars. It appears we again have an unfortunate example where the government is a day late and a dollar short in protecting investors. 

Suits by private attorneys may be able to find some redress for the investors by pursing participants in this fraud who have ample resources, like FTX’s celebrity promoters.  And the actions by the Department of Justice and the SEC against Bankman-Fried may have some deterrent effect on future swindlers.

Yet I’m afraid the FTX debacle will join the ranks of other massive frauds such as Madoff, Enron and WorldCom, where investors have lost their savings to unscrupulous fraudsters. 

Daniel J. Morrissey is a professor and former dean at Gonzaga University Law School.