Jon S. Corzine may have led futures brokerage MF Global (OTC: MFGLQ) into bankruptcy on Oct. 31, but anyone looking would have seen signs of trouble three and a half years earlier.
On Feb. 27, 2008, a registered trader named Evan Dooley made a bad bet on wheat futures, forcing the firm to cover $141.5 million in losses. News of the scandal would break the next morning, leading investors to sell in a panic.
As shares of MF Global fell 27%, Fitch Ratings put the firm on negative watch, citing fear of cracks in its risk management system. Two and a half weeks later, on March 17, rumors of a liquidity crisis hammered the stock to what was then an all-time low of $3.64 a share. MF Global closed the day's trading off 65%.
For a firm dependent on investor confidence in order to raise capital, MF Global had seen half its equity wiped out in a few short hours.
In May, with its stock price still lagging, a debt-burdened MF Global agreed to what might be best described as a bailout investment from the private equity firm J.C. Flowers & Co. In exchange for pledging up to $300 million in capital, JCF would get the right to place up to two board members and would also receive discounted convertible shares yielding 10.725%. A JPMorgan Chase analyst called the terms "onerous," yet the deal paid off: Flowers' investment had restored confidence in MF Global.
Piecing together a powerhouse
That a rescue of this sort would ever be needed seemed unthinkable just months before. On July 18, 2007, MF Global raised $2.9 billion in a public offering. It was less than parent Man Group of the U.K. had hoped for, but still the second-largest New York Stock Exchange debut of 2007.
Kevin Davis, then CEO, had reason to crow. So did Chief Financial Officer Amy Butte. The pair appeared on CNBC the day of the offering to celebrate the firm's prospects minutes before making the honorary first trade of the day. For Butte, in particular, it was a special moment: She'd helped NYSE Euronext (NYSE: NYX ) go public two years earlier via the exchange's acquisition of publicly traded Archipelago Holdings. MF Global's IPO hailed her return.
Davis, meanwhile, played the role of conquering hero. A British import with a $1 million annual salary, he'd started in interest rate futures at what was then ED&F Man in 1991, rising to CEO of Man Group's brokerage unit eight years later. Over the next several years he'd expand Man's interests in futures, options, and derivatives brokering, including overseeing the two largest acquisitions in Man Financial's history: GNI in 2002 and Refco in 2005. The resulting patchwork came public as MF Global.
Volume soared as a result of Davis' empire-building. MF Global brokered 1.5 billion exchange-traded futures and options contracts in the 2007 fiscal year ending that March, up 49% from the year prior and more than double 2004 levels.
Futures contracts specify a price and terms for buying or selling currency, stocks, or raw materials. For example, commodities futures allow farmers to lock in prices for corn, cattle, pork bellies, soybeans, and the like to be delivered to a buyer at a later date. Those who remember the 1983 comedy Trading Places starring Eddie Murphy and Dan Akroyd might recall the pair betting on frozen concentrated orange juice futures, which really have traded on New York exchanges since 1967.
At MF Global, higher contract volume meant more revenue and profit. The company's pre-tax earnings had more than tripled in the year leading up to its public offering. Operating margins expanded from 3.9% to 8.1% over the same period, good for the industry in which MF Global operated but far below what Corzine -- then governor of New Jersey -- was used to as a former investment banker.
It didn't matter at the time. Treasuries were still yielding well, supplying MF Global with ample interest income. What's more, a newfound interest in and access to electronic exchanges -- including Butte's target at the NYSE, Archipelago -- had Davis convinced that industrywide volume would continue rising more than 20% annually.
"I think we're going to see a lot of new retail [futures] products, spread products, binary products ... different ways to trade the same markets, but in a more exciting way," Davis told CNBC at the time.
A wintry reception for a summer IPO
Yet few believed. As Butte and Davis rushed from the floor to participate in NYSE pomp and circumstance, investors were busy selling shares. MF Global closed off 10% on its first day of trading.
Most accounts express little surprise at the market's reaction. Man Financial had hoped to spin off its futures brokerage at $36 to $39 a share, only to be forced to cut its target to $30 a share as markets reacted to a worsening credit crisis that only a month earlier had forced Bear Stearns to stop redemptions of hedge funds invested in troubled subprime mortgage debt.
Blackstone Group (NYSE: BX ) could have also played a role. The hedge fund manager debuted at $31 a share in a $4.1 billion offering in late June only to see its stock fall more than 30% by the time of MF Global's IPO. Davis' uber-brokerage was entering a chilly market that was slowly freezing.
But if timing was a factor, the structure of the spinoff may have been even more important. Months before coming public, MF Global took out a 364-day $1.4 billion bridge loan, in part to repay debts owed to the parent company it hadn't yet separated from.
According to the prospectus, Davis and his team planned to refinance the debt but found little traction with investors. So, as the calendar turned to 2008, management instead agreed to pay higher interest rates on $1 billion of existing debt while pushing back the deadline for repayment. MF Global had become a deadbeat.
Investors and analysts had good reasons to be nervous. Regardless, the sell-off in MF Global shares convinced our own Motley Fool Global Gains service to recommend the stock in September 2007, at $26.17 a share.
That December, Refco, which Man Financial acquired in a bankruptcy auction coming just two months after its summer 2005 IPO -- beating out, among others, J.C. Flowers & Co. -- was back in the headlines. Former Executive Vice President Santo Maggio had pleaded guilty to one count of conspiracy to commit securities fraud, two counts of securities fraud, and one count of wire fraud.
The plea implicated former Refco Chief Executive Philip Bennett and would set in motion additional pleas and convictions in the months and years following. Today, at least three former Refco executives and associates are either already in or on their way to prison. Bennett is serving a 16-year term for his involvement in a scheme to hide $430 million in bad debt.
In 2008, investors either didn't know or didn't care that Refco had become a part of MF Global. Yet they should have. Assets attributed to the deal accounted for 11.3% of fiscal 2007 revenue. Hundreds of employees had come over in the deal, including senior executives Steve Grady and Dennis Klejna.
Both were named in a May 2010 federal consent order relating to the Refco fraud. Grady forfeited $1 million and Klejna $1.25 million in proceeds authorities allege were fraudulently obtained through a 2004 leveraged buyout of Refco by Thomas H. Lee Partners.
Grady and Klejna stayed on as Refco transformed into MF Global. Each enjoyed positions of power. Grady, in particular, had led MF Global's Chicago operations until June 2011 when he was promoted help run the Prime Services business. Refco's influence was alive and well until the very end.
The connection between these two firms extends beyond assets and employees. Refco under Bennett and MF Global under Davis shared a penchant for regulatory and exchange violations that far exceeded the history of peers such as Morgan Stanley and UBS.
Under Davis, MF Global was cited three times by the governing Commodity Futures Trading Commission and 77 times by various New York and Chicago exchanges with which it did business. Refco, by contrast, was cited nine times by the CFTC and a whopping 136 times by exchanges.
All told, the CFTC fined MF Global more than $12.1 million during the Davis era, with $10 million of that primarily related to failures associated with the Dooley debacle. Yet two other citations are equally (or even more) troubling.
In 2007, around the same time as the Maggio plea, the CFTC settled for $2 million in penalties and $75 million in restitution relating to charges that MF Global had unwittingly aided a fraud committed by hedge fund manager Paul Eustace of Philadelphia Alternative Asset Management. Regulators cited poor bookkeeping and insufficient supervision in allowing Eustace to execute the scheme.
Earlier that same year, in February, the CFTC settled for $120,000 in penalties relating to charges that MF Global failed to supervise broker Steven Camp. The agency accused Camp of fraud for misrepresenting poorly performing trading systems as profitable when soliciting customers from 2002 to 2005. The firm agreed to $196,900 in restitution as part of the settlement.
These and other regulatory actions lend credence to assertions made in an early 2008 class action suit that was at first dismissed, but then settled for $90 million in damages following appeal, according to filings supplied by the legal search site Justia.
A revised complaint from that case cites anonymous witnesses who describe MF Global's culture as one where brokers were encouraged to take trades others wouldn't in order to boost volume. Years later, Corzine would be accused of similar recklessness.
The complaint also alleges that Davis and others knowingly authorized removal of controls in order to increase the speed with which trades could be executed, improving "competitive viability." The descriptions are notable in that they jibe with reporting conducted by auditor and accounting watchdog Francine McKenna in the wake of the wheat trading scandal.
MF Global has since paid its out-of-pocket share ($2.5 million) of the $90 million due while denying the allegations or any wrongdoing. Nevertheless, the fines and Davis' departure in October 2008 (replaced by former Chicago Board of Trade CEO Bernard Dan) speak to the concerns investors and regulators had about the way MF Global handled risk during Davis' reign as chief executive.
The trade that changed everything
But of all the mistakes made during the Davis era, none were nearly so devastating as allowing Dooley to trade beyond his means. According to a grand jury indictment handed down in April 2010, Dooley, who prosecutors accused of fraud, skirted in-house guidelines by deliberately shifting risks to MF Global for trades made in his personal account.
Dooley declined to comment for the story, citing ongoing litigation, though some reports doubt that he was acting maliciously. Either way, the money is gone, marking the first but not last high-profile failure of a risk management system that MF Global actually touted as a competitive advantage in its IPO prospectus:
We also believe that our focus on brokerage services and standardized products, and the fact that our trading markets tend to be relatively liquid with readily available pricing information, enable us to effectively evaluate and manage the risks posed by our clients' positions. In each of our last four fiscal years, our losses due to trading errors and client defaults have represented less than 2% of our revenues, net of interest and transaction-based expenses, with losses due solely to client defaults representing less than 0.5%. [Emphasis added.]
Infamous last words. Failing to live up to the standard expressed in its IPO document cost Davis his job and MF Global $141.5 million in trading losses, creating fear, uncertainty, and doubt about the firm's future. MF Global needed a savior. It would get one in Chris Flowers.
In the next chapter, we detail Wall Street whiz J. Christopher Flowers' role in crowning Jon Corzine. Click here to read all about it.
Editor's note: An earlier version of this article stated that former Refco executive Joe Murphy stayed on with Man Financial and MF Global after the buyout. He did not. The Fool regrets the error.