Refco
Encyclopedia
Refco was a New York
New York
New York is a state in the Northeastern region of the United States. It is the nation's third most populous state. New York is bordered by New Jersey and Pennsylvania to the south, and by Connecticut, Massachusetts and Vermont to the east...

-based financial services company, primarily known as a broker of commodities and futures
Futures
-Finance:*Futures contract, a tradable financial contract*Futures exchange, a financial market where futures contracts are traded*Futures , an American finance magazine-Music:*Futures , a 2004 release by Jimmy Eat World...

 contracts. It was founded in 1969 as "Ray E. Friedman and Co." Prior to its collapse in October, 2005, the firm had over $4 billion in approximately 200,000 customer accounts, and it was the largest broker on the Chicago Mercantile Exchange
Chicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...

. The firm's balance sheet at the time of the collapse showed about $75 billion in assets and a roughly equal amount in liabilities. Though these filings have since been disowned by the company, they are probably roughly accurate in showing the firm's level of leverage.

Refco became a public company on August 11, 2005 with the sale of 26.5 million shares to the public at $22. It closed the day over 25% higher than that, valuing the entire company at about $3.5 billion. Investors had been attracted to Refco's history of profit growth—it had reported 33% average annual gains in earnings over the four years prior to its initial public offering
Initial public offering
An initial public offering or stock market launch, is the first sale of stock by a private company to the public. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises...

.

The Scandal

Refco, Inc. entered crisis on Monday, October 10, 2005, when it announced that its chief executive officer and chairman, Phillip R. Bennett
Phillip R. Bennett
Phillip Roger Bennett was the embattled CEO of Refco, Inc. He is a British citizen who was educated at Cambridge University.In the 1970s, he worked for Chase Manhattan Bank. He joined Refco in 1981 and became the firm's Chief Financial Officer in 1983...

 had hidden $430 million in bad debts from the company's auditors and investors, and had agreed to take a leave of absence
Leave of absence
Leave of absence is a term used to describe a period of time that one is to be away from his/her primary job, while maintaining the status of employee...

.

Refco said that through an internal review over the preceding weekend it discovered a receivable owed to the company by an unnamed entity that turned out to be controlled by Mr. Bennett, in the amount of approximately US$430 million. Apparently, Bennett had been buying bad debt
Bad debt
A bad debt is an amount that is written off by the business as a loss to the business and classified as an expense because the debt owed to the business is unable to be collected, and all reasonable efforts have been exhausted to collect the amount owed...

s from Refco in order to prevent the company from needing to write them off, and was paying for the bad loans with money borrowed by Refco itself. Between 2002 and 2005, he arranged at the end of every quarter for a Refco subsidiary to lend money to a hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...

 called Liberty Corner Capital Strategy, which then lent the money to Refco Group Holdings. Bennett's company then paid the money back to Refco, leaving Liberty as the apparent borrower when financial statements were prepared. It is not yet clear if Liberty knew it was hiding scam transactions; management of the fund has claimed that they believed it was borrowing from one Refco subsidiary and lending to another Refco sub, and not lending to an entity that Mr. Bennett secretly controlled. On October 20, they announced plans to sue Refco.

In April 2006, papers filed by creditors of Refco seemed to show that Bennett had run a similar scam going back at least to 2000, using Bawag P.S.K. Group in the place of Liberty Corner Capital Strategy.

The law requires that such financial connections between corporation and its own top officers be shown as what is known as a related party transaction in various financial statements. As a result, Refco said, "its financial statements, as of, and for the periods ended, Feb. 28, 2002, Feb. 28, 2003, Feb. 28, 2004, Feb. 28, 2005, and May 31, 2005, taken as a whole, for each of Refco Inc., Refco Group Ltd. LLC and Refco Finance Inc. should no longer be relied upon."

This announcement triggered a number of investigations, and on October 12 Bennett was arrested and charged with one count of securities fraud
Securities fraud
Securities fraud, also known as stock fraud and investment fraud, is a practice that induces investors to make purchase or sale decisions on the basis of false information, frequently resulting in losses, in violation of the securities laws....

 for using U.S. mail, interstate commerce, and securities exchanges to lie to investors. His lawyer said that Bennett planned to fight the charges. On October 19, trading of Refco's shares was halted on the New York Stock Exchange
New York Stock Exchange
The New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...

, which later delisted the company. Before the halt, Refco shares were trading for more than $28 per share, and as of October 19, they had dropped (on the pink sheets
Pink Sheets
OTC Markets Group, Inc., informally known as "Pink Sheets", is a private company that provides services to the U.S. over-the-counter securities market including electronic quotations, trading, messaging, and information platforms. According to the U.S. Securities and Exchange Commission, OTC...

) to $0.80 per share.

Refco, Inc. filed for chapter 11 for a number of its businesses, to seek protection from its creditors on Monday, October 17, 2005. At the time, it declared assets of around $49 billion, which would have made it the fourth largest bankruptcy filing in American history. However, the company subsequently submitted a revised document, claiming it had $16.5 billion in assets and $16.8 billion in liabilities. Refco also announced a tentative agreement to sell its regulated futures and commodities business, which is not covered by the bankruptcy filing, to a group led by J.C. Flowers & Co. for about $768 million. However, other bidders soon emerged, including Interactive Brokers
Interactive Brokers
Interactive Brokers Group, Inc. is an online discount brokerage firm in the United States. The company traces its origin to 1977 when Thomas Peterffy bought a seat on the American Stock Exchange as an individual market maker, and formed T.P. & Co. the following year...

 and Dubai Investments, the investment division of the emirate of Dubai
Dubai
Dubai is a city and emirate in the United Arab Emirates . The emirate is located south of the Persian Gulf on the Arabian Peninsula and has the largest population with the second-largest land territory by area of all the emirates, after Abu Dhabi...

. These offers were for a time rebuffed, as the Flowers-led group had a right to a break-up fee if Refco had sold this business to anyone else. Carlos Abadi, involved in the Dubai bid, said that the Dubai-led group offered $1 billion for all of Refco and was rejected. "However, the bankruptcy judge in charge of the case deemed the break-up fee unjustified, and the Flowers group withdrew its bid. The business was instead sold to Man Financial on November 10. Man Financial kept the majority of the Refco futures businesses after selling Refco Overseas Ltd (Refco's European operation) to Marathon Asset Management
Marathon Asset Management
Marathon Asset Management is an investment manager focused on opportunistic investing in credit and fixed income markets globally. Marathon manages a family of investment programs principally focused on credit strategies including hedge funds, managed accounts, single-client funds and...

 who then relaunched the business as Marex Financial Limited.

Though of much smaller size, the regulatory impact of the scandal will be larger than for probably any other corporate failure except for Enron
Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...

. Refco had sold shares to the public in a public offering only two months before revealing the apparent fraud. Their auditors, Grant Thornton
Grant Thornton
Grant Thornton LLP encompasses the U.S. operations of Grant Thornton International, the largest accounting organizations outside of the Big Four . The member firms of Grant Thornton International comprise a global network of 27,000 employees and 2,207 partners in more than 110 countries...

 (lead partner Mark Ramler), and the investment banks that handled the IPO, Credit Suisse First Boston
Credit Suisse First Boston
Credit Suisse First Boston was the former name of the banking firm Credit Suisse.-History:In 1978, Credit Suisse and First Boston Corporation formed a London-based 50-50 investment banking joint venture called the Financière Crédit Suisse-First Boston...

, Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...

, and Bank of America Corp., all supposedly completed due diligence
Due diligence
"Due diligence" is a term used for a number of concepts involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations...

 on the company, and all missed the CEO's hiding $430 million in bad debts. Their largest private investor was Thomas H. Lee Partners
Thomas H. Lee Partners
Thomas H. Lee Partners is a private equity firm based in Boston, Massachusetts specializing in leveraged buyouts, growth capital, special situations, industry consolidations, and recapitalizations....

, a highly regarded buyout fund, and the reputation of its managers has been similarly sullied.

On October 27, 2005, shareholders of Refco filed class action
Class action
In law, a class action, a class suit, or a representative action is a form of lawsuit in which a large group of people collectively bring a claim to court and/or in which a class of defendants is being sued...

 lawsuits against Refco, Thomas H. Lee Partners
Thomas H. Lee Partners
Thomas H. Lee Partners is a private equity firm based in Boston, Massachusetts specializing in leveraged buyouts, growth capital, special situations, industry consolidations, and recapitalizations....

, Grant Thornton, Credit Suisse First Boston, and Goldman Sachs. On March 2, 2006, a lawyer representing Refco's unsecured creditors began steps to sue the IPO underwriters for aiding and abetting the fraud, or for breach of fiduciary duty. In April 2006, creditors sued Bawag P.S.K. Group for more than $1.3 billion.

In April 2006, Christie's
Christie's
Christie's is an art business and a fine arts auction house.- History :The official company literature states that founder James Christie conducted the first sale in London, England, on 5 December 1766, and the earliest auction catalogue the company retains is from December 1766...

 auction house sold Refco's prized art collection, which included photographs by Charles Ray
Charles Ray (artist)
Charles Ray is a Los Angeles-based sculptor. He is known for his strange and enigmatic sculptures that draw the viewer’s perceptual judgments into question in jarring and unexpected ways...

 and Andy Warhol
Andy Warhol
Andrew Warhola , known as Andy Warhol, was an American painter, printmaker, and filmmaker who was a leading figure in the visual art movement known as pop art...

.

On February 15, 2008, Phillip R. Bennett
Phillip R. Bennett
Phillip Roger Bennett was the embattled CEO of Refco, Inc. He is a British citizen who was educated at Cambridge University.In the 1970s, he worked for Chase Manhattan Bank. He joined Refco in 1981 and became the firm's Chief Financial Officer in 1983...

 pleaded guilty to 20 charges of securities fraud and other criminal charges. On July 3, 2008, Bennett was sentenced to 16 years in federal prison.

The $430 million in bad debts

Though no detailed report on Bennett's transactions has yet been made public, anonymous sources cited by the Wall Street Journal and other publications have stated that the debt stemmed from losses in as many as 10 customer trading accounts, including that of Ross Capital, and the widely reported October 27, 1997, trading losses of hedge fund manager Victor Niederhoffer
Victor Niederhoffer
Victor Niederhoffer is a hedge fund manager, champion squash player, bestselling author and statistician.Victor Niderhoffer was born in Brooklyn to a Jewish family. His father, Arthur, graduated from Brooklyn Law School but went to work in the police. Victor’s mother, Elaine was a teacher....

. Niederhoffer said on his website in response to these news articles that Refco wanted to take over the assets in his accounts and assume all the liabilities in order to meet capital requirements, and that he and Refco signed a formal agreement to that effect on Oct. 29, 1997, in the presence of two major law firms and under the close scrutiny of regulators. "There were no debts, loans, or any other financial obligations left open between us," Niederhoffer said. "Refco received considerable assets from us as part of our agreement. I don't know how much money Refco received for these assets, or how it accounted for the transaction, or whether it ended up with a profit or loss. If Refco did suffer a loss, I am confident that it was quite minimal relative to the $460 million receivable said to have been a key link in the firm’s debacle, or to the actual sums that the principals and key players of the firm took out many years later." The story in the Journal implies that Refco settled Niederhoffer's debt for positions that were worth less than he owed them, or perhaps that they accrued trading losses unwinding those positions.

Ross Capital has also been named by the Wall Street Journal's anonymous sources as one of the firms with losses that somehow led to Bennett's $430 million debt. Ross Capital is run by Wolfgang Flottl, whose father used to run Bawag P.S.K. Group, an Austrian bank that lent Bennett the money to repay Refco. In 1999, Bawag purchased 10% of Refco in a private transaction, and had an outstanding loan of 75 million euros to Refco at the time the firm collapsed. On October 5, before news of the hidden loan was made public, Phillip Bennett applied for a 350 million euro loan, to be collateralized with his shares in Refco. The loan was granted on October 10, and Bennett used it to pay off the hidden $430 million. The Refco stock that collateralized the loan is now worthless, and on November 16, Bawag joined the line of people suing Refco, demanding 350 million euros plus punitive damages in compensation for the company's failure to disclose information that would have discouraged Bawag from lending the money to Bennett. The Austrian National Bank and Financial Market Authority were investigating Bawag's involvement with Refco.

The apparent fraud was caught by Peter James, Refco's newly hired controller
Comptroller
A comptroller is a management level position responsible for supervising the quality of accounting and financial reporting of an organization.In British government, the Comptroller General or Comptroller and Auditor General is in most countries the external auditor of the budget execution of the...

. Apparently, in the fiscal quarter before the story broke, Bennett failed to execute his temporary Liberty Strategies-hidden repayment of debt. This left the position on the books for James to find. It is unclear why the firm's Chief Financial Officer
Chief financial officer
The chief financial officer or Chief financial and operating officer is a corporate officer primarily responsible for managing the financial risks of the corporation. This officer is also responsible for financial planning and record-keeping, as well as financial reporting to higher management...

 had not spotted the loan, but the firm's previous CFO, Robert Trosten, left Refco in October, 2004 with a $45 million payout that was not disclosed in the firm's IPO prospectus. He was under investigation by regulators who suspected he may have known something about Bennett's malfeasance. Robert C.Trosten pleaded
guilty to five charges in 2008. Tone N. Grant, a Refco official, was convicted of 5 charges on April 17, 2008. He was sentenced to 10 years on August 8, 2008.

$525 million in Fake Bonds

On March 15, 2006, information leaked by the U.S. prosecutor's office revealed that Refco held offshore accounts holding as much as $525 million in fake bonds. The company held the "securities" for Bawag P.S.K., the Austrian bank with which Refco had a close relationship, discussed in part above, and for a non-U.S. hedge fund called Liquid Opportunity. Apparently, Bawag and Liquid Opportunity jointly owned six Anguilla
Anguilla
Anguilla is a British overseas territory and overseas territory of the European Union in the Caribbean. It is one of the most northerly of the Leeward Islands in the Lesser Antilles, lying east of Puerto Rico and the Virgin Islands and directly north of Saint Martin...

 companies, which in turn owned the fake bonds. Refco's attorneys have declined to comment.

Apparently, the six Anguilla companies initially responded to Refco's bankruptcy filing as a normal customer would have, filing as creditors with a combined claim of $543 million. However, they failed to follow up with any legal filings.

This is presumably good news for other Refco customers, in that $543 million in potential claims on the firm's assets have disappeared. The likelihood that the fake bonds represent some kind of ongoing criminal activity does not bode well for the principals of Refco, BAWAG
BAWAG
BAWAG is a bank in Austria. On October 1, 2005, it merged with the separate Österreichische Postsparkasse to form the "Bank für Arbeit und Wirtschaft und Österreichische Postsparkasse AG", shortened as BAWAG P.S.K..-History:BAWAG was founded in 1922 by the Austrian Chancellor Dr...

, or Liquid Opportunity.

Older Scandals

Refco has not enjoyed a clean reputation with regulators. The Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....

 and the National Futures Association
National Futures Association
The National Futures Association is an independent self-regulatory organization and watchdog of the commodities and futures industry in the United States. The NFA oversees and protects investors from fraudulent commodities and futures activities. The NFA also provides mediation and arbitration...

 took action against Refco and its units more than 100 times since the firm's founding. According to The Wall Street Journal, it was "among the most cited brokers in the business, according to data provided by the NFA."

The 1978 "cattle futures" trading scandal was played out in Refco accounts, the period during which the Hillary Rodham cattle futures controversy
Hillary Rodham cattle futures controversy
In 1978 and 1979, lawyer and First Lady of Arkansas Hillary Rodham engaged in a series of trades of cattle futures contracts. Her initial $1,000 investment had generated nearly $100,000 when she stopped trading after ten months...

 originated.

In 2001, the NFA ordered Refco to pay $43 million to 13 investors after their Refco broker used bogus order tickets to clear trades.

On May 16, 2005, the company disclosed that it had received a "Wells Notice
Wells notice
A Wells Notice is a letter that the U.S. Securities and Exchange Commission sends to people or firms when it is planning to bring an enforcement action against them...

," indicating it might face charges related to improper short selling at its Refco Securities unit and other matters. The company had been implicated in naked short
Naked short selling
Naked short selling, or naked shorting, is the practice of short-selling a financial instrument without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale. When the seller does not obtain the shares within the required time frame,...

 sales on the stock of a company called Sedona Corp., disclosed that it was negotiating with the SEC and hoped to reach a settlement that would likely include an injunction against future violations and "payment of a substantial civil penalty." Refco put $5 million in reserve in anticipation of the settlement. The company has also been sued by Sedona in connection with this trading.

Further reading

  • "Lure of Refco on Rocks," New York Times, October 18, 2005
  • "Creditors Look For Their Share Of Refco Assets" Wall Street Journal, October 20, 2005
  • "'Naked Shorting' Case Lurks in Refco's Past" Wall Street Journal, October 20, 2005
  • "Thomas Lee May Delay Fund After Refco, Person Says," Bloomberg News, October 20, 2005
  • "Bawag Says It Tried to Halt Refco Loans Hours After Transfer," Bloomberg News, October 20, 2005
  • "Bawag Scrutiny Mounts, Putting CEO to the Test," Wall Street Journal, October 21, 2005
  • "Refco's Debts Started With Several Clients," Wall Street Journal, October 21, 2005
  • "Bennett's Refco Scheme Exposed by Late-Night Hunch: 'It Hit Me'", Bloomberg News, October 27, 2005
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