Rogue Traders, Rogue Firms: The CME, PwC, MF Global and the Legacy of Refco

You may have noticed that I’ve given the CME Group the benefit of the doubt in my coverage of the MF Global mess. Many others have criticized the exchange group, public company, and quasi regulator for their actions, or rather alleged inaction, leading up to and during the failure of MF Global.

MF Global’s fall puts spotlight on CME Group, The Financial Times, November 2, 2011

The case of the missing customer funds at MF Global is putting a spotlight on the failed broker’s de facto supervisor, CME Group.

CME, the largest US futures exchange operator, is also the designated self-regulatory organisation for more than 50 futures brokers, including MF Global. As such, CME had direct responsibility for making sure MF Global’s books were square…

CME’s dual role puts it in a delicate position. MF Global, according to its website, was the top broker by volume at CME’s metals and energy exchanges in New York and in the top three at its Chicago exchanges. CME’s main source of revenue is clearing and transaction fees.

Brokers themselves have questioned letting exchan-ges be overseers. “Given their strong market knowledge and proximity to the trading markets, they provide the best forum for addressing many of the futures markets’ oversight functions,” the Futures Industry Association said in a 2004 letter to the CFTC. “However . . . we are concerned about potential conflicts of interest.”

There is an inherent conflict at every publicly-listed equities, futures, and commodity exchange. When the NYSE went public in early 2006 through a reverse merger with publicly-held Archipelago, there was some discussion of the conflict in roles that public ownership of the exchange presented.

Exchanges have traditionally been self-regulatory organizations (SROs) that have regulatory responsibilities for their members. Such SROs set listing standards for companies that list and trade on the exchange, set the trading rules and conduct surveillance of market operations and periodically inspect member firm operations. Typically all of these functions are subject to the oversight of the securities commission of the country. In some countries exchanges also have the authority to license and discipline member firms and their employees. This tension between the exchange’s role as a SRO and a for-profit making entity has been a cause for concern among regulators and market participants.

As discussed by Fleckner (2006), a demutualized exchange wears two different hats, that of the player and referee. He argues that the concern is not that exchanges will systematically under- or over-regulate because in the long-run exchanges are concerned about their integrity and reputation. Instead, as discussed in several papers, the concern is that for-profit publicly traded exchanges will be lenient in regulating themselves and use its regulatory powers to gain an unfair advantage over competitors. U.S. Securities Regulation In A World Of Global Exchanges, Reena Aggarwal, Allen Ferrell and Jonathan Katz at Harvard Law School, December 2006.

I have been in favor of the CME clearing house approach in the past. It worked in the case of the $141 million MF Global wheat trader error. That problem was found and addressed in less than 24 hours versus the SocGen case or the recent UBS case. Here’s what I wrote at the time.

The clearing firm is the first line of defense for a brokerage firm against unauthorized trading or exposures outside of risk limits. What’s comical is that the Department of Justice, via its letter to the Treasury regarding “vertical clearing house models” wants the US to implement a model for clearing firms like Europe’s, or the one that did not have enough weight or skin in the game to stop Kerviel and SocGen from racking up such big losses. The DOJ is saying that the Chicago Mercantile Exchange’s clearing operation and its relationships and tight straight-through processing model are a problem even though that model was able to put the brakes on the problem at MF Global in less than twelve hours.

I think the Department of Justice is wrong.

I have disclosed in various forms, but probably not often enough, that I give the CME Group the benefit of the doubt because I grew up in Chicago, the home of CME Group and the Chicago Board of Trade. I live here. The futures markets are in our blood. That being said, I will write the story as I see it. (I do not personally own any CME Group stock.)

I will call a spade a spade.

From the perspective of the individual trader and smaller brokerage firm member, the CME has not been the same since it went public. Higher fees, constantly changing margin requirements, and apparent favoritism towards large institutions grate on individual traders and bread-and-butter brokers. It’s a big public company now that focuses primarily on outside shareholders, not its “members”. And like any other public company, decisions may be made at times based on the self-interest of those who run it.

Any CME member who cleared MF Global is as angry as anyone else at the CME Group for the disruption, the confusion, and the lack of stewardship that allowed the failure of MF Global to occur. But the CME Group is owned, in large part, by its clearing firms and members who hold a large percentage of the open interest. Each clearing firm owns at least 6000 shares, multiplied by 80 clearing firm members of CME Group. That’s a lot of interested parties.

The recent announcement by CME Group of a $300 million backstop for the MF Global Trustee is something.

Though CME Clearing does not guarantee FCM-held assets, CME Group is willing to provide a $250 million financial guarantee to the Trustee to give the Trustee greater latitude to make an interim distribution of cash to customers now, given the monumental task he faces to sort through considerable data and claims in order to complete the MF Global liquidation and make distributions to creditors.  Additionally, CME Trust will provide $50 million to CME Group market participants in the event there is a shortfall at the conclusion of the Trustee’s distribution process…

This unprecedented guarantee offered by CME Group would be used by the Trustee in the event that a final accounting determines that the Trustee distributed more property than was permitted by the Bankruptcy Code and CFTC regulations.  In addition, if there is a shortfall at the conclusion of the distribution and the $50 million Trust has not been exhausted, the remainder of those funds will be used to restore the other CME Group customer accounts that suffered a shortfall in customer-segregated funds held at MF Global.  The Trust was designed to be used in cases such as this if customers lose money due to the failure of a clearing member.

But it may not be as great as it seems. An industry veteran explained it to me:

Is it really $300 million? It’s $50 million with a potential backstop of an additional $250 million. They may be trying to imply that they are coming up with half of the customer segregated funds shortfall. But what they are really guaranteeing is to make sure everyone is pari passu as an inducement to the trustee to free up money he is currently holding.  I’m not sure that the public (i.e., especially but not limited to MF customers) understands the distinction.

But until someone tells me otherwise – or I see otherwise – I am going with the fact that CME Group was in on the 24th of October and found the segregated funds they are responsible for to be accounted for. But there are ten clearing houses that were used by MF Global.  The CME is the largest, but not the only one, and their audit did not cover all the segregated funds. I’m going to dig into what and how their review was done. I’m going to make sure that we can say that everything that went wrong at MF Global probably went wrong after they left.

It’s especially important because the CFTC recently published the FCM information as of September 30 and MF Global’s numbers were conspicuously absent.  Is their excuse that the books are a mess? For MF Global’s auditor, PwC, that’s a terrible thing to say. It may just be a move by regulators to buy more time. Or it may be true.  Then what is PwC doing signing off on the 10Q as of September 30th or the annual report as recently as May?

What’s more troubling to me than any CME potential conflict as both a public company and a self-regulating organization (SRO) is the fact that former Refco executives who were fined for the Refco fraud were working in key positions at MF Global. They also hold, or have held, key positions in the Futures Industry Association, the CFTC, and a brokerage firm that will now benefit from MF Global’s demise.

When the U.S. Attorney for the Southern District of New York, Preet Bharara,announced the Refco enforcement actions in May of 2010 he spoke earnestly:  “More than just prosecuting criminals who engage in fraud, this Office strives to return as much as possible to their victims.  Justice has been rightly served for the victims of the Refco fraud.”

By that time, what was left of Refco post-fraud and post-bankruptcy had joined with Man Financial to become MF Global via a new IPO.

Bennett, Grant, Maggio, and Trosten faced criminal charges and all four are serving, or will serve, jail terms. Other Refco insiders, including Stephen Grady, Dennis Klejna, and Joseph Murphy, were not criminally charged but signed consent orders, or settlements, with the Department of Justice. Grady, Klenja, and Murphy paid $1 million, $1.25 million, and $5 million respectively – and then went back to work for the firm that became MF Global.

Not only did those three executives get to come back, they took on roles that gave them a bird’s-eye view of MF Global’s implosion – and, perhaps, of the transactions that were made, legitimately or not, in an ultimately futile attempt to keep the firm alive as it sought a buyer in the last days.

Dennis Klejna was the head of compliance at Refco when it exploded. Refco had recruited him from the CFTC, the regulator now in charge of investigating the MF Global collapse, where he was Chief of Enforcement. Klejna is now MF Global’s head of compliance and senior vice president for legal matters. Operating under bankruptcy protection must be keeping him especially busy these days.

Stephen Grady moved from Refco to Man Financial after Refco’s bankruptcy and is CEO of MF Global Chicago.

Joseph Murphy joined R.J. O’Brien in November of 2008 after six years at Refco, where he served as President of Refco Futures. R.J. O’Brien is one of the brokerage firms that received some MF Global customer accounts from regulators after the bankruptcy.

I bet these guys, or other legacy Refco accounting and since professionals still working in MF Global, can give investigators some clues on what happened to the missing $600 million.

And let’s not forget PricewaterhouseCoopers, MF Global’s auditors.

When it comes to hands-on access to private information, the auditor has more than any other regulator mentioned. And they are supposed to be experts in that client’s business and in the accounting and auditing standards for that industry. PwC also audits JP Morgan, Bank of America Merrill Lynch, and Goldman Sachs. They are all large players in the futures brokerage industry and mixed up in the MF Global mess.

Last year JP Morgan Chase’s futures and options desk neglected to segregate billions of dollars of client money, largely belonging to hedge funds. PwC, the auditor of JPMorgan Chase, and the bank – which is also MF Global’s main banker – admitted to U.K. regulators that for at least seven years, about $23 billion dollars of clients’ assets had not been properly segregated. JPMorgan Chase was fined 33.3 million pounds and PwC is subject to sanctions.

The auditor is part of the regulatory structure for public companies. They serve that role for the benefit of shareholders and the markets and earn oligopolistic profits as a result of the lack of competition and the government’s mandate that all listed companies have an audit.

The audit does not happen only once a year. The auditor also provides “negative assurance” on the 10Qs. MF Global’s most recent quarter end was September 30. Unfortunately, they will not be filing that 10Q on time. PwC also authorized inclusion of the audited financial statements from the year end, March 31, 2011, in MF Global’s August bond issue prospectus. MF Global was not only complex but a relatively new client. They got a lot of service and constant attention. They have been public only since mid-2007 but PwC also audits MF Global’s predecessor firm, Man Group.

The auditor has complete access, at any time, including to financial systems and reports. They are responsible for issuing an independent opinion on internal controls over financial reporting and for issuing additional reports to the regulators – which they are dependent on – regarding controls over segregated assets per the Commodity Exchange Act.

So… When you think about frequency, access, independence, and the fact they get paid well for their services by the shareholders the auditor is in line as the first-responder.

Back in 2008, when the wheat trader took MF Global for $141 million, the firm was brand spankin’ new with a lot of old pros and even older systems running it.  I said this then about PwC:

MF Global is a spin-off from Man Group plcMF Global IPO’d in July 2007 and inherited PricewaterhouseCoopers as their auditor, also.

MF Global has not been independent and publicly listed for very long, has not issued an audited annual report yet, and does not yet have an obligation to comply with Sarbanes-Oxley. They have issued quarterly financial reports to the SEC, carved out of the Man Group plc reports, but that are unaudited so far. Their CEO and CFO, however have made Sec. 302 certifications to the SEC regarding the firm’s internal controls.

From MF Global’s July 2007 prospectus:

We will be required by Section 404 of the Sarbanes-Oxley Act to evaluate the effectiveness of our internal controls by the end of fiscal 2009 and we cannot predict the outcome of that effort. As a U.S.-listed public company, we will be required to comply with Section 404 of the Sarbanes-Oxley Act by March 31, 2009. Section 404 will require that we evaluate our internal control over financial reporting to enable management to report on, and our independent auditors to audit, the effectiveness of those controls. While we have begun the lengthy process of evaluating our internal controls, we are in the early phases of our review and will not complete our review until well after this offering is completed.

Can’t wait to see how that works out…

I think we know now.

Here’s another good summary of the players and their games.  (It’s all good except the last shot at speculators.  The words “trader”, “speculator”, “hedge” and “derivative” are not pejoratives.)

9 replies
  1. WhiskeyJim
    WhiskeyJim says:

    It’s especially important because the CFTC recently published the FCM information as of September 30 and MF Global’s numbers were conspicuously absent. Is their excuse that the books are a mess?

    In another reality, PWC should be up in arms about that accusation, since it represents potentially crippling fines for the firm along with access to auditing team personal liability. In that world, fiduciary duty for others’ hard earned money would be very high.

  2. George Smithgolf
    George Smithgolf says:

    It is far too easy for critics and the public to blame PwC (or any of the Big Four auditing firms) for failing to detect improprieties. They do have substantial access to the company but one cannot legislate ETHICS. There are very clear limitations on the scope of an audit or a quarterly review. Given all of the requirements mandated by GAAS, SOX and the PCAOB, the firms scramble to get the accounting principles right and the technical compliance documented properly.
    I emphasize that management, the Board of Directors/audit committee, company employees including internal audit have a far greater chance of “fixing” intentional or unintentional flaws in the accounting that lead to bad outcomes.
    I also emphasize that business failures more so than audit failures are the culprits in major company losses.

Trackbacks & Pingbacks

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  3. […] That’s what another Chicago futures commission merchant and broker-dealer, MF Global, did, after a trading error cost it $140 million back in 2008, resulting in its bailout by investor J.C. Flowers. Flowers quickly installed a new CEO, Jon […]

  4. […] Group, the firm that bought a brokerage business from the fraud- ridden, failed firm called Refco in 2005, beefed it up and rebranded it, then spun it out as an IPO called MF Global in 2007. […]

  5. […] look at the Refco bankruptcy, infamous predecessor firm of MF Global that also went down in flames from fraud and declared bankruptcy. Bankruptcy examiner Joshua […]

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