A broker battered

Oct 14th 2005
From The Economist Global Agenda

The boss of Refco, one of America’s leading futures brokers, has been arrested on fraud charges a couple of months after the firm’s successful flotation. The scandal may damage the reputation of an industry that has lately begun to forge an image of respectability

IN AUGUST, investors happily stumped up $583m for shares in Refco, one of America’s largest futures brokers (and its biggest retail commodities broker). After the initial public offering (IPO), those investors watched cheerfully as the firm’s shares rose above the offer price—as you might expect of a company that reported healthy profits last year and appeared poised to offer more of the same. But the future of that investment looked far less bright after Phillip Bennett, the firm’s chief executive, was arrested on Tuesday October 11th. Federal prosecutors have charged Mr Bennett with defrauding investors by hiding hundreds of millions of dollars in loans to another company that he controls. If he is convicted of the charge, Mr Bennett faces up to 20 years in prison, as well as hefty fines.

Refco’s troubles triggered pandemonium in the financial markets, sending the firm’s share price into free fall (see chart). On Thursday, as the New York Stock Exchange suspended trading in Refco’s shares indefinitely, the firm shut down Refco Capital Markets, a unit that provides half its profits, citing a lack of liquidity. Customers will be unable to withdraw funds from accounts for 15 days to prevent the subsidiary’s collapse. And on Friday, as the price of bonds issued by Refco fell to levels associated with bankruptcy, another key subsidiary, Refco Securities, informed the Depositary Trust Company that it was starting to wind down its business. In an effort to reassure investors that Refco is still in reasonable shape, the firm has appointed several high-profile outside advisers including Arthur Levitt, a former head of the Securities and Exchange Commission, Eugene Ludwig, a one-time comptroller of the currency, and Goldman Sachs, one of the investment banks that underwrote the firm’s IPO.

Banks, hedge funds and the myriad institutions that used Refco as a counterparty in trades are among those potentially affected by the fallout. There have been reports of customers moving their positions and capital out of the firm. On Tuesday, Refco was hit by a class-action lawsuit on behalf of shareholders who purchased the company's stock between August 11th, the date of the flotation, and the end of last week.

Federal prosecutors had become aware of the possible scheme that triggered Mr Bennett’s arrest and the firm’s travails on Monday, when Refco announced the findings of an internal review. This showed that Mr Bennett had borrowed $430m through a third company. The money was repaid on the day of the announcement, and Mr Bennett was placed on leave. An investigation began immediately and prosecutors worked round the clock to prepare a case. They say that since late last year Mr Bennett had “actively participated” in a scheme to hide as much as $545m, with the money cleverly repaid just before routine audits.

The initial internal review found a receivable owed to Refco by a firm controlled by Mr Bennett. This largely consisted, the firm believes, of “uncollectible historical obligations owed by unrelated third parties” to Refco. These obligations were transferred periodically to Mr Bennett's firm; Refco's accounts then reflected a receivable from that entity. The fact that the receivable was from a firm controlled by Mr Bennett was “hidden at the end of…reporting periods”, says Refco, in transfers to a (probably unconnected) customer account. Refco has said that financial statements as far back as 2002 cannot be relied on and that questionable transactions may date back as far as 1998.

Some observers also wonder how some of America’s smartest financial firms missed the sums that are alleged to have been taken out of Refco. These include Thomas H. Lee Partners, a big private-equity firm which holds a big stake in Refco, as well as the investment banks that underwrote the company’s IPO: Credit Suisse First Boston and Bank of America joined Goldman Sachs in taking the lead.

More broadly, the scandal is an unwelcome blow to the futures industry, which has tried for years to shed its reputation as a hotbed of slick operators. The phenomenal growth in the trading volume of futures—essentially risk-management instruments in commodities and financial instruments—has far outpaced that in equities in recent years, and brokerage firms have ridden the wave.

So far, damage to the reputation of the futures-trading industry appears limited. An IPO of shares in the Chicago Board of Trade (CBOT), an exchange that specialises in trading grain and Treasury-bond futures, is still set to go ahead next week despite the ills afflicting Refco, one of its biggest customers. (The CBOT raised the price range of its flotation steeply after noting the success of Refco’s IPO.) But shares in the Chicago Mercantile Exchange, which floated in 2002, fell sharply when the Refco scandal came to light. It later made assurances that Refco, also one of its main customers, was meeting all the financial requirements demanded of it, and the exchange’s share price rallied.

Ironically, Refco’s public image has not conformed to the racy stereotype of its industry. Mr Bennett, say some in the futures business, kept a low profile. The public face of the firm in America has been Joseph Murphy, the company's president and the chief executive of Refco Global Futures, a subsidiary. Mr Murphy currently serves as chairman of the Futures Industry Association, the leading trade organisation and a driving force in efforts to burnish the image of the futures business. He has not been implicated in the scandal.

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