The Last Days of Refco

The last days of Refco

Laurence Davison
Originally published in the December 2005 issue

A scant few months ago, the future looked bright for newly-listed brokerage Refco. Following a successful August IPO and the Commodity Futures Trading Commission (CFTC) data ranking the firm as one of the only two independent futures commission merchants (FCMs) in the world's 10 largest, there seemed to be no barrier to further growth. Barely two months later, the firm was bankrupt and being auctioned off in segments.

The scandal broke out of a clear blue sky on 10 October. A short but puzzling statement issued by Refco hit the newswires, announcing that the firm's chairman and chief executive, Phil Bennett, had been requested to take a leave of absence by the board of directors after he had been found to be in control of an entity that owed Refco a sum of $430m. Bennett was destined never to return to the broker.

Initially, the statement confused readers. It did not explain the debt beyond saying that it was "the result of the assumption by an entity controlled by Mr Bennett of certain historical obligations owed by unrelated third parties to the company, which may have been uncollectible," and, even stranger, added that the money, plus all accrued interest, had already been repaid to the firm by Bennett.

Perhaps more worryingly than the actual destination of the money was that Refco admitted that its financial records stretching back several years could not now be considered trustworthy, and that this could "delay the filing of its quarterly report… for the quarterly period ending 31 August, due on 17 October." The firm added that it could not estimate when "the fiscal 2006 second quarter… filings will be made or when the audit committee investigation will be concluded."

Immediate reactions were varied, and it should be stressed that not everyone was a harbinger of doom in the early hours. One senior executive at a large international bank, for instance, told FO Week that he expected the money to relate to Refco's status before its stock market listing, when Bennett held a controlling interest in the private company, and that the situation would probably play out without calamity.

However, there were also plenty of voices to the contrary; the earliest insights generally related to the fact that even if the missing millions really had been repaid in full, the issue would from that stage on by one of confidence. Another senior trading executive homed in on this issue, saying "How could a company that has been prepping itself for an IPO with outside investors and outside advisors let something like that be overlooked, glossed over or whatever?"

Prophets of doom

Others predicted, at the very least, a difficult process in the months ahead for Refco. Another banking executive said, "You're going to get [Securities and Exchange Commission] in there and I'm already hearing about lawsuits regarding the IPO. They hid this from the underwriters so they will be suing them. And the underwriters are going to be sued, probably. They are going to be absolutely entangled in lawsuits."

Meanwhile, uncertainty spread from the top of Refco to the bottom. Joe Murphy, chief executive of Refco Global Futures and president of holding company Refco LLC, was given the task of taking over the running of the group in the wake of Bennett's departure. The scale of the task was indicated a few weeks later when Murphy quit his position as chairman of the Futures Industry Association in order to concentrate on the task at hand.

On the ground, Refco staff and representatives had largely gone to ground, with the firm's press office not returning calls and previously reliable sources within the firm also unreachable. The only connected individuals immediately contactable were day traders at Refco subsidiary Refco Trading Services – which had been purchased as Macfutures a couple of years previously – who said that while business was continuing, many had already asked to remove cash from Refco accounts and were only maintaining minimum levels on deposit. They said, however, that there had been no problem in accessing funds.

This was perhaps symptomatic of what eventually killed Refco off: while the firm remained solvent throughout, levels of customer and indeed employee confidence were shattered, with an exodus of both happening so quickly and on such a scale that it made the business's position untenable and collapse inevitable. By the time the majority of the firm was sold to Man Group in late November, insiders were estimating that over 60% of Refco's customer business had fled elsewhere.

Within days of the initial statement, rival brokers were privately admitting that they were gaining business from customers deserting Refco. "They have no choice," said one FCM executive. "These firms don't know what other skeletons are in the closet. And if you are a customer, an individual with a significant portion of your portfolio in futures or a hedge fund or CTA, you know this much: there was illegal activity going on at the firm where you trusted your funds.

"You may not know the depth of it, but do you want to continue to do business there? The answer, almost legally in many cases, is no. For many corporate accounts, you have a fiduciary responsibility to get the funds out of there."

Sharp practice

This exodus was certainly not helped by the reputation Refco had gained over its history. The firm had long been known for its sharp practice, with numerous stories circulating about its activities, and a fairly impressive regulatory rap sheet on the files. Ironically, the run up to the IPO had seen Refco attempt to clean up its public image. Executives like Murphy had been hired specifically to give a more corporate impression of the group following the purchase of a majority share in the firm, for $507m, by private equity group Thomas H Lee partners in 2004.

The investors had seen in Refco a chance to turn a profit by acquiring a player in the growing derivatives sector, tidying it up for the market and listing. Other IPOs in the business had seen stellar success, such asthat of the Chicago Mercantile Exchange, which floated in late 2003 valued at around $30 a share, then grew to hit a valuation of over $300 a share late in 2005. Thomas Lee wanted some of that action, with the difference that it took a stake in a brokerage rather than an exchange. The decision would prove costly.

Furthermore, the speed with which Refco was prepared for its listing has led some to question the role of the book runners and auditors, including Goldman Sachs, CSFB, Banc of America and Grant Thornton. The latter, for instance, commented on "significant deficiencies" in Refco's reporting practices in an S-1 filing regarding its listing made with the Securities and Exchange Commission.

In the document these deficiencies were described, according to the US's Public Company Accounting Oversight Board, as liable to result in "more than a remote likelihood that a misstatement of the financial statements that is more than inconsequential will not be prevented or detected". Specifically, Grant Thornton stated that Refco needed to increase existing finance department resources to be able to prepare financial statements that were fully compliant with all SEC reporting guidelines on a timely basis, and further that there was a lack of formalised procedures for closing books.

In the weeks following the initial revelations, a bevy of class action suits were filed against not just Refco and its various entities and executives – including Bennett – but also all those connected with the original listing, which was described as fraudulent and misleading.

The role of the banks and auditors became especially significant in the week following the first announcement, as Refco announced the closure of subsidiaries Refco Capital Markets – a foreign exchange, equity and fixed income trading operation – and Refco Securities – its US equity brokerage – on 13 and 14 October respectively.

Gone under

Finally, just eight days after the original statement threw Refco into turmoil, it filed for Chapter 11 bankruptcy in a Manhattan court. This, lawyers said, made it unlikely that suits brought against the firm itself would have much chance of ending in restitution. "Bankruptcy pretty much wipes out shareholder actions," said class action and litigation attorney Myron Cherry of Myron M Cherry and Associates. "In any bankruptcy, shareholders are last. So if there isn't enough money to pay creditors, then there is no money for shareholders."

Another agreed, backing the pursuit of the related companies. Speaking to FO Week, Melvin Weiss of Milberg Weiss said, "You have to go against the underwriters, the accountants, board members and people who signed the registration statement who were selling to shareholders on the offering." He added that firms such as Grant Thornton should have caught the shifting of receivables on and off the balance sheet quarterly, at the so-called cut-off period. "There is a substantial chance of getting a substantial recovery," Weiss said. "The fingerprints of failure are all over this. Cut-off period manipulations are very frequent, when you substitute one asset for another asset and unwind it at the end of the quarter. It's just too much of a red flag for them not to have dug deep enough to discover what was going on."

On 12 October, even before the bankruptcy was announced, prosecutors had pounced on Bennett, who was arrested for alleged securities fraud before being granted $50m cash bail and essentially placed under house arrest in New York. On 10 November, Bennett was indicted of eight charges by a US grand jury – charges which he denied, his lawyer, Gary Naftalis saying that he and his client "look forward to our day in court". The indictment only mentioned Bennett but added that others, "known or unknown to the grand jury" were believed to be involved in the fraud.

The charges alleged that the amount of money channeled out of Refco by Bennett had varied between around $400m and as high as $720m. They also requested that Bennett be forced to forfeit $700m that was alleged to be Bennett's "proceeds" from his illegal activities. Naftalis also insisted that the former Refco head had made no personal profit from activities relating to the missing millions.

Throughout the case to date, it has remained somewhat unclear what exactly Bennett was using the money for, although strong rumours have persisted that the intent was to conceal trading losses made by Bennett and other individuals at Refco stretching as far back as the Russian crisis in 1998.

What had been established by investigators was that in February Bennett allegedly led a number of transactions to disguise a $300m-plus debt owed to Refco by his firm Refco Group Holdings (RGHI) by "temporarily paying off the debt and transferring it from RGHI to another entity unrelated to Bennett," according to Heather Tucci, a US postal inspector who investigates securities fraud. The transaction was made so that the debt owed by RGHI would not appear on Refco's fiscal year-end balance sheet, which ended on 28 February. Investigators said in documents obtained by FO Week that similar transactions occurred for the quarters ending in May, November and August.

Shifting cash

The consensus view seemed to be that Bennett had been using external entities to show losses made at Refco as uncollectible debts owed to the firm, shuttling cash between them around financial reporting periods to avoid the scrutiny of internal and external auditors. The situation became public, it was claimed, when an internal audit spotted irregularities. However, strong rumours have continued to circulate ever since that audit was tipped off by a third party who had either been in league with Bennett and fallen out or simply become aware of the activities going on.

One firm to issue strong denials of involvement shortly after the scandal broke was hedge fund Liberty Corner Capital Strategies (LCCS), which was rumoured to be the third party involved in the alleged cover-up by Bennett in receiving transfers of his debt to the firm. The fund issued a statement saying that neither LCCS, "nor its principal William Pigott were the targets of the criminal investigation into Refco". It asserted that the transactions in question had been memorialised in loan documents, guaranteed by Refco's parent company. The firm had not, it said, at any time held uncollectible receivables owed to the brokerage and stressed that any alleged bad practice had occurred at the time of concealing the debt, not in subsequent payments made to cover it.

The statement said, "If there was fraud committed in connection with that bad debt, it was committed… when Bennett assumed the debt, not at the time of the LCCS loan transactions." It finished by saying that LCCS had been "actively cooperating" in Refco investigations being carried out by the CFTC and SEC.

The story concerning LCCS was that the New Jersey-based fund had received a series of $300m-plus loans from Refco Capital Markets, which it had then lent on to Bennett at a higher rate of interest. While the firm did not deny that loans had been made, its lawyer, Kevin Marino, said that the fund believed they had been legitimate.

He explained that LCCS, which had been a prime brokerage customer of Refco's, was first approached about entering into the transaction in 2002. In the criminal complaint filed against Bennett, prosecutors only focused on loans between Refco and LCCS since February of this year. However, Refco has said its financial statements became unreliable in 2002. What made the deal attractive to Liberty Corner was the ability to pocket a quick profit by turning around and re-lending the money it received from Refco Capital Markets at a higher interest rate, and market sources said that transactions of the type are not unusual.

Marinosaid LCCS had no idea that the company it was re-lending the money to, Refco Group Holdings, was a private entity that Bennett used to control his considerable equity stake in Refco Inc. The hedge fund, he said, thought it was dealing with two different Refco entities.

Bad loan

Another question that initially lingered was that if the scandal had been related to trading losses, how had it been possible for Bennett to repay the money so swiftly? Even if the situation was a more straightforward case of fraud, even a wealthy man like Bennett would surely struggle to raise over $400m in cash over what could legally only be the course of a weekend – since Refco was required by stock exchange rules to disclose the situation as soon as it knew about it.

Almost two weeks after the first revelations, the source of the cash became known: Austria's Bank für Arbeit und Wirtschaft und Österrecihische Postsparkasse Atkiengesellschaft – better known as Bawag. Bawag owned a 10% share of Refco for a number of years before selling its stake when Thomas Lee bought its majority share, and it seems that the bank's long-standing relationship with Bennett may have led it to make a spectacularly ill-judged loan decision. Unfortunately for Bawag, not only did it seem to have made a loan that had virtually no chance of ever being repaid, but it later emerged that the deal had been secured against Bennett's – at the time – most valuable asset: his stock in Refco.

As the firm was suspended and then delisted by the New York Stock Exchange in the days around its bankruptcy that stock had, within a week, become worthless. Bawag joined the list of investors, including hedge funds and Refco employees, who had suddenly seen their allocation evaporate. The Austrian bank later sued Refco and Bennett for recompense.

Another hedge fund figure to run into Refco-related difficulties was Jim Rogers, who had $362m in accounts at Refco Capital Markets through his funds the Rogers Raw Materials Fund and Rogers International Raw Materials LP. When Refco Capital Markets was shuttered shortly before the bankruptcy was announced all accounts were frozen, and in November Rogers sued for return of the money, which was a significant portion of the $840m that nine customers have demanded back.

The sale of Refco's surviving assets in November also had an effect on Rogers' situation, since the purchaser would undoubtedly wish to indemnify themselves from Refco's liabilities. If this were to happen, Rogers, Bawag and the others would be relegated to the status of unsecured creditors and could hold little hope of ever seeing the return of a significant portion of their funds. Rogers has objected to the terms under which Refco's sale was planned, which offered the buyer precisely that limited liability. Rogers' lawyers described as "unconscionable" the notion that creditors might be forced to seek restitution solely in the purchase price of Refco, which would not come close to meeting the demands of the queue of investors.

Bidding war

Several interesting factors emerged early in the bidding process for the remaining sections of the disgraced brokerage. Firstly, the initial prime mover appeared to be a private equity consortium headed by JC Flowers. In fact, the speed with which that firm entered the race – Refco announced a tentative agreement to sell its remaining businesses to Flowers for $768m on 18 October, the same day as it filed for bankruptcy – raised eyebrows throughout the markets. The common theme of Goldman Sachs was identified by many: the bank had led run Refco's IPO and was then appointed special adviser to the bankruptcy, while JC Flowers featured several ex-Goldman Sachs executives in senior positions.

However, the conspiracy theorists were soon scuppered, as Goldman Sachs pulled out of its advisory role, while Flowers failed to win the bidding process.

Meanwhile, another potential bidder was anxious to distance itselffrom the situation as Man Group issued a statement insisting that the hedge fund and brokerage firm "was not… in discussions with Refco or its advisors regarding a Refco acquisition". This assertion did not survive the next month.

Over the course of the weeks leading up to the auction process ending on 10 November, around a dozen potential buyers emerged, with some of the leading names including Chicago's Interactive Brokers and a consortium called Dubai Investment Group. While Interactive appeared to have the leading bid, a figure of $857.9m being quoted as their valuation, the process was changed in early November when it became known that Man had reconsidered its initial judgment and decided to enter the race.

As the witching hour approached, the contenders dropped out one by one, with Interactive being one of the last to fall, withdrawing its candidacy on the morning of the final decision. Another bid fell late in the day when Chicago-based broker Alaron's offer was excluded at the last minute from the auction, as managing partner Gary Weber confirmed. "We didn't make the final cut," he said. "A voicemail was left with one of our attorneys very, very late [on 9 November] and I was notified of it two minutes before a TV interview with Bloomberg News this morning."

Finally, the winning bidder was announced as none other than Man Group, which had previously insisted that it had not been looking at Refco. The price, $323m in cash and liabilities, was significantly lower than previous estimates because it did not include Refco's regulatory capital of over $700m. On 28 November, following the purchase, Refco firefighter Joe Murphy quit the firm to leave it to its new owners.

The breakup

In a press conference in late November, Man said that the businesses acquired in the purchase were, substantially, all of Refco's futures business in the US, UK and Asia. It did not contain the small continental European activities of the brokerage, however. At least two significant court cases were themselves pending against Refco in France, and market speculation suggested that Man did not wish to take the risk of future liabilities in return for a relatively insignificant business.

At the press conference, Man's deputy chief executive and finance director Peter Clarke acknowledged that Refco had lost the "bulk" of its institutional client base between the emergence of the scandal at the firm last month and Man's bid being accepted. However, he also said that Refco's private client business had "not lost a significant number of clients," and that since Man emerged as a buyer the exodus of clients across Refco's businesses had halted. In its results statement, Man said that it expected Refco to become earnings enhancing during the financial year to the end of March 2008.

Clarke also insisted that the terms of the deal meant that Man could not become liable for any Refco losses in future court cases. He said, "Any concerns about the past can be, as the US bankruptcy court says, 'car washed', so we do not take any historical or contingent liabilities."

At the start of December, it also emerged that Man was not even interested in owning all the businesses it had bought as the firm divested the entirety of Refco's former London operations to a management buyout backed by another investment firm, Marathon Asset Management. Indeed, sources close to the deal told FO Week that the Refco businesses had proved sufficiently hard to value that Man had divested them for a nominal fee, perhaps as low as a dollar.

In a statement, Man said it had decided on the sale because of the high degree of overlap between the Refco London activities and its own, while numerous market sources said that Man's biggest interest in the defunct brokerage was its subsidiaries in the Far East, where Man has long been looking to expand its penetration. It also seemed likely that the Marathon sale had largely been negotiated before Man's original purchase was finalised.

How successful either the Man or Marathon purchases will prove to be will only emerge over time, but some winners and losers had already become clear. Biggest losers of all, of course, were those who invested in Refco prior to, at and after its IPO. The scale of the bankruptcy made it the US's 14th largest of all time, and hundreds of millions of dollars of creditors' money will no doubt never be recovered.

Meanwhile, while Man has insisted that it has no immediate plans to shed former Refco staff, uncertainty remains. Traders on the ground at Refco Trading Services – amongst the minnows in the scandal – are unsure about who even owns their firm. And one has to feel sympathy for those who, believing that Refco was fundamentally secure, decided to buy stock in the FCM on 10 October.

The mistake they made was to judge the firm on its financial fundamentals, which never appeared, at the futures trading hub of the business at least, to be under threat – all major exchanges through which Refco traded have said that the firm's credit lines and standing remained good throughout. What the investors did not account for, though, was that the confidence that is so vital to maintaining a brokerage's customer base could evaporate so thoroughly and so rapidly that it could be bankrupt within seven days of the scandal breaking.