The MF Global You Don't Know but Probably Should

This is a story about Refco, a troubled but once high-flying futures brokerage firm that ultimately became part of MF Global. Special thanks to Forbes contributor Francine McKenna, who also keeps the excellent blog re: The Auditors. Not only has she done the smartest work we've seen on the connections between Refco and MF Global, but she also spent time giving us ideas for how to pursue this story, and in the process provided insights that proved crucial in our reporting.

Most accounts characterize him as an impressive CEO.

Well-educated with a track record for making fistfuls of money, he knew the risks created by the sometimes-outlandish behavior of traders and sought to moderate it at the futures and commodities brokering firm he led. Or so it seemed.

We recognized that this sort of egocentric trader personality was simply not going to survive. ... The firm had to change its image, its posture and its general approach to the market. We had to become professional.

You think that quote is from Jon Corzine, the former New Jersey governor and U.S. senator who's become the face of a multibillion-dollar failure at futures firm MF Global? Wrong. That's Phillip Bennett, a mysterious Englishman speaking about Refco in a 1987 interview with Forbes.

Eighteen years later -- and three years before the collapse of Lehman Brothers and Bear Stearns -- Refco revealed that Bennett had hidden $430 million in bad debts from, well, everyone. Creditors panicked, liquidity evaporated, and Refco, already leveraged at a rate of more than 350-to-1 as of May 2005, filed for bankruptcy that October, just two months after what had been a successful IPO.

Today, as regulators weigh whether to bring charges in the MF Global case, Bennett is serving out a 16-year term in prison for securities fraud.

Looking back, and seeing connections
But back in the late fall of 2005, as Refco was falling apart, an investor group led by J. Christopher Flowers, a Corzine friend and former colleague at Goldman Sachs (NYSE: GS), swept in to offer $768 million for the futures business. An initial agreement would be abandoned as other bidders emerged.

Flowers would re-enter the story in a similar fashion two and a half years later, but Refco would first have to be sold to Man Financial of the United Kingdom. The firm announced its bid on Nov. 13 and within two weeks terms of the $282 million deal were finalized.

Within two years, in July 2007, Man Financial would spin off its brokerage operations into what we now know as MF Global. Former Refco employees followed, including assistant general counsel Dennis Klejna and Steve Grady, who as of this June led MF Global's prime services business.

Yet trouble persisted. In February of 2009, a broker named Evan Dooley made what MF Global said were unauthorized trades in wheat futures resulting in $141.5 million in losses. The stock fell 28% the next day, destroying precious equity in the process. Futures firms tend to use equity and debt to raise capital when bets go bad.

The Dooley case left MF Global looking for more capital, and that left an opening for Flowers. His firm pledged up to $300 million in fresh capital in May 2008 in exchange for a board seat and convertible preferred shares yielding 10.725% in annual dividend payments.

If that sounds familiar, it should. Warren Buffett extracted similarly generous dividend payments on behalf of Berkshire Hathaway shareholders as conditions of big investments in Goldman Sachs and General Electric. The difference, of course, is that neither Goldman nor GE is staring down the long barrel of a bankruptcy filing.

Two failures, much like the other
There isn't now and may never be a verifiable direct connection between the failures of Refco and MF Global, but the head-shaking similarities between these two firms -- which are now conjoined because of the Man buyout -- are startling.

First and most obvious is missing money. Bennett hid Refco debts; MF Global is accused of comingling client funds in order to remain solvent. Roughly $600 million is still unaccounted for. We can't be sure criminal malfeasance is involved, but the Commodity Futures Trading Commission has launched a formal investigation.

Billions of dollars in trading capital has been frozen in the meantime. CME Group (NYSE: CME) has confirmed it has $2.5 billion in MF Global client funds on deposit. InterContinentalExchange (NYSE: ICE) is also limiting trades.

Rules? Who says we need rules?
Refco and MF Global also share a penchant for attracting the eyes of regulators. According to data provided by the National Futures Association, MF Global and Refco have paid millions more in fines than their most direct peers:

Source: National Futures Association data.

MF Global may have suffered just one CFTC citation in its brief history as a publicly traded futures operator, but the text of the complaint is particularly troubling given the events of the past two weeks.

"The CFTC order finds that, from 2003 to 2008, MF Global failed in four separate instances to ensure that its risk management, supervision and compliance programs comported with its obligations to supervise diligently its business as a CFTC registrant," the order states. The commission imposed a $10 million civil penalty as a result of the infractions.

It's a good bet the CFTC team now investigating MF Global will refer back to this case. Just don't expect it to influence the outcome. History would call such hope wishful thinking. After all, Refco went bust just shortly after coming public.

Months of due diligence conducted by auditors and bankers yielded no warning signs, and that's despite the extraordinary leverage ratio that was hiding in plain sight. (Refco had been leveraged at a Lehman-like 26-to-1 as far back as 2003, according to data supplied by S&P Capital IQ.) IPO underwriters at Goldman, Bank of America, and Credit Suisse (NYSE: CS), among others, simply cashed in and moved on.

Six years later, $600 million is missing at MF Global. Nothing's changed. And nothing will change until boards of directors, ratings agencies, investors, and regulators choose -- actively choose -- to demand more of the people running this industry.

Don't hold your breath waiting.

Have a different view of the MF Global bankruptcy? Please weigh in using the comments box below. You can also help us report the full version of this story by sending scoops to [email protected].