It’s impossible to read about the demise of MF Global and not think about Refco, the futures brokerage that collapsed in scandal in 2005 and whose remains were later bought by MF Global. Like Marley’s ghost, the weaknesses that played a part in Refco’s downfall returned to haunt MF Global.
Refco’s problems came to light just a few months after it completed an initial public offering in August 2005 that valued the company at $3.5 billion. A short time later, the firm discovered that CEO Phillip Bennett had maintained control of a separate entity that wasn’t consolidated with Refco’s books and held $430 million in Refco debt. When Refco disclosed the debt in October 2005, just eight weeks after the IPO, Refco’s liquidity evaporated, customers rushed to withdraw funds and the firm filed for bankruptcy within a week.
That scenario sounds a lot like MF Global, where a big and poorly disclosed bet on European debt led to a credit downgrade and a spiral into bankruptcy.
Refco CEO Philip Bennett masterminded the fraud, personally directing a series of transactions to mask Refco’s true financial condition. But the scheme could not have succeeded without a weak risk-monitoring system. And it seems likely that these weaknesses remained when Refco’s business was bought in a bankruptcy-court auction by MAN Financial, the predecessor to MF Global.
The New York Times recently reported that MF Global CEO Jon Corzine scuttled plans to upgrade the firm’s risk systems. So it’s quite likely that MF Global did not have the means to properly segregate client funds, track margin balances and, importantly, monitor the use of customer collateral by MF Global to finance its positions, a practice that, however surprising, appears to be lawful. (Seeking Alpha has a lengthy description here.)
The facts aren’t yet known, but if MF Global was tapping customer collateral to finance its trading, the parallels to Refco become even more striking. For the main technique used by Bennett in the Refco fraud was a series of short-term loans with third parties. The report of the Court-appointed Examiner in the Refco bankruptcy case describes it below:
To hide the RGHI Receivable, as each reporting period came to a close, Bennett and others caused the consolidated reporting Refco companies to manipulate their books through a series of transactions commonly referred to as “Round Trip Loans.” The loans made it appear that the RGHI Receivable was due from unrelated third parties rather than from RGHI. This concealment of the true nature of the RGHI Receivable also provided comfort to outsiders that the receivable was collectible. The mechanics of the typical Round Trip Loans is described below:
The Round Trip Loans were two short term loans of several weeks duration that spanned the end of Refco’s fiscal year-end or quarterly financial reporting periods. The first loan was made by a Refco entity to a third party at a certain interest rate for a certain period of time. The second one was made by that same third party to RGHI for the same period of time, but at a higher interest rate. The repayment of the loan by RGHI to the third party was guaranteed by RGL and the third party was also indemnified by RGL against any loss or expense for entering into the Round Trip Loan.
The funds or credit advanced for the loan to the third party were deposited into the third party’s account with RCM. Those funds were then transferred at the third party’s request from the third party’s account at RCM to RGHI’s account at RCM. The effect of these transactions was to reduce RGHI’s receivable balance owed to RCM by the amount of the Round Trip Loan, and to substitute a receivable in that amount from the third party. In most cases, these were bookkeeping entries and no cash actually “moved.” After the end of the applicable reporting period, the process was reversed and unwound.
These Round Trip Loans were sham transactions with no economic substance which were entered into solely to “dress up” Refco’s consolidated financial statements. The loans involved no risk to the third party because they included secret guarantees by Refco that were not reflected on Refco’s books.
(Refco’s use of Round Trip Loans sounds a lot like the “Repo 105” transactions used by Lehman Brothers to dress up its financial statements at quarter-end.)
The full report of the Examiner is a worthwhile read, if long. It provided the factual basis for prosecutions of Refco’s former executives and advisers. Former Refco CEO Phillip Bennet is now serving a 16-year prison sentence. Joseph Collins, a former partner at law firm Mayer Brown who served as outside counsel to Refco was convicted of fraud and conspiracy and sentenced to seven years in prison.
The Examiner’s report also had harsh words for Refco’s auditors and tax advisers, among them Ernst & Young, for which the Examiner found sufficient evidence to support a claim against the firm for professional malpractice and aiding and abetting fraud. Indeed, the Refco estate later sued E&Y and other advisors for $2 billion.
You can be sure that part of the report is getting careful attention at PricewaterhouseCoopers, which audited MF Global. And to complete the irony, PwC also worked for Refco.