Today in history: October 14, 2005 – REFCO goes bust after CEO hides $430 million in bad debts

The electronic trading business in the United States was a very different environment in the years immediately before the Dodd-Frank Act’s comprehensive rewriting of not only the rule book, but also of the infrastructure which is used to process, clear and report trades.

America has always been home to the industry’s giants, reaching from large retail FX businesses to the proprietary trading floors of New York and Chicago, all of which produce tremendous volume, using some of the world’s most advanced trading systems and for a great many years, have upheld customer requirements as a major matter of importance.

The pioneers in the industry in terms of clearing, prime brokerage and trade processing have all been American, and date back at four decades in many cases, and at least two decades on the retail side.

In the early years of this Millennium, the US retail market was dominated by not only today’s evergreen stalwarts such as FXCM, GAIN Capital and OANDA Corporation, but name that no longer exist were part of the foreground in the domestic US market, including MF Global, REFCO, and Peregrine Financial Group (PFGBest).

It was largely the sudden demises of MF Global, PFGBest and REFCO that led the US government to embark on a ‘Wall Street Reform’ Act and rally the regulators to change the entire structure of the FX and OTC derivatives sector, and on this day in 2005, we waved a permanent goodbye to REFCO as it disappeared from the market in a very high profile and scandal-ridden fashion.

REFCO was one of America’s – and the world’s – oldest electronic trading companies, having been founded in 1969 as Ray E Friedman & Co, which is what REFCO is an acronym of, its original business activity being futures contracts and commodities.

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. 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, proving that not only OTC firms can hit the buffers, but those who trade via exchanges can too.

One of the most memorable aspects relating to REFCO’s demise is that it occurred so quickly after becoming a public company.

In August 2005, REFCO became listed on the New York Stock Exchange which resulted in a sale of 26.5 million shares to the public at $22 per share, valuing the company at the time at approximately $3.5 billion.

There was a rush to buy shares on the open market because the firm had reported a massive 33% average increase in earnings consistently over the four years prior to its initial public offering.

Just two months after becoming a public company, however, REFCO was no more

The first evidence that the end was night for REFCO came to light on Monday, October 10, 2005, when the company announced that its CEO and chairman, Phillip R. Bennett had hidden $430 million in bad debts from the company’s auditors and investors, and had agreed to take a leave of absence.

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.

This constituted accounting fraud, and following an investigation internally it emerged that Mr. Bennett had been buying bad debts 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 – effectively a house of cards.

Between 2002 and 2005, Mr. Bennet had arranged at the end of every quarter for a REFCO subsidiary to lend money to a hedge fund called Liberty Corner Capital Strategy, which then lent the money to REFCO Group Holdings, an independent offshore company secretly owned by Phillip Bennett with no legal or official connection to REFCO.

Mr. Bennett’s company then paid the money back to REFCO, leaving Liberty as the apparent borrower when financial statements were prepared. At the time, it was not clear if Liberty Corner Capital Strategy 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 subsidiary, and not lending to an entity that Mr. Bennett secretly controlled.

Thus on October 14, 2005, REFCO sunk, declaring 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 and Dubai Investments, the investment division of the emirate of Dubai.

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.

On October 20, Liberty Corner Capital Strategy announced plans to sue REFCO, and a few months later in April 2006, papers filed by creditors of REFCO seemed to show that Mr 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.

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 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.

REFCO may have made the headlines for all the wrong reasons on this day 11 years ago, however it has been the development ground for a large number of extremely high quality industry professionals who are now in senior executive positions for firms from New York, to London, to Singapore and Hong Kong, all of whom are highly polished and very experienced, thus REFCO, although no longer with us, has a legacy of very high quality in many offices around the world that is still alive today.