Whistle blown on Refco (October 24, 2005)

The trust customers and investors place in a business leader is so hard to quantify, yet so critical to a business venture’s success. And when that trust disappears, it can leave so fast it takes your breath away.

Such was the case in mid-October with Refco Inc., the large, New York City-based diversified brokerage house that specialized in the murky world of commodities, derivatives and futures markets.

In business for 36 years, and with 2,400 employees in 14 countries, Refco and its subsidiaries had been among the most active members of futures exchanges in Chicago, New York, London and Singapore.

In the metals sphere, Refco provided execution services for exchange-traded derivatives in gold, silver, platinum and palladium, and, as a leading ring-dealing member of the London Metal Exchange, transacted a significant percentage of the world’s non-ferrous metals volume.

On Oct. 10, less than two months after its US$583-million initial public offering, Refco stunned the market by announcing that its chairman and CEO Phillip R. Bennett had hid US$430 million owed to Refco by a company he controlled, with transactions dating back to 2004 and continuing up to October 2005.

On Oct. 12, Bennett, a 57-year-old Briton, was arrested in the U.S. and charged with securities fraud. He was later freed after posting a US$50-million bond, including US$5 million in cash, and agreeing to wear an electronic monitoring device around his ankle.

Refco said that the US$430 million, plus interest, had been immediately repaid in cash but warned that its financial statements for the past five years “should no longer be relied upon.”

As for long-time CEO Bennett, Refco dryly noted that he had “taken a leave of absence” at the board’s request.

The company says it is co-operating fully with the U.S. Securities and Exchange Commission, the Commodity Futures Trading Commission and the New York Stock Exchange.

After the news broke, Refco shareholders promptly headed for the exits, driving shares down 72% to US$7.90 on the NYSE by Oct. 13, when trading was finally halted. The NYSE will now delist the shares, having commented that the company’s stock was “no longer suitable for listing.”

At presstime, Refco shares were trading at US65 on the pink sheets. Pity those who bought them at US$22 apiece in the IPO only 10 weeks ago!

Refco’s 2012 notes, which bear a coupon of 9%, were similarly traded furiously, reaching yields of over 38% — even higher than auto-parts maker Delphi, which filed for bankruptcy protection in early October.

Many of Refco’s customers were also scrambling to get through the “Out” door, though a few remained loyal and kept their accounts.

Refco’s management quickly swung into damage control and decided to enforce customer “loyalty” by declaring, on Oct. 13, a 15-day moratorium on customer withdrawals from its subsidiary, Refco Capital Markets, owing to a lack of cash.

It also brought in as special advisors to the board Arthur Levitt (a former chairman of both the S.E.C. and the American Stock Exchange) and Eugene Ludwig (a former comptroller of the U.S. Currency and present-day CEO of Promontory Financial Group).

Refco then retained Goldman, Sachs & Co. as its financial advisor (Goldman Sachs, along with Credit Suisse First Boston and Bank of America, had sponsored Refco’s recent IPO). By Oct. 17, the company had reached a preliminary agreement with a group led by investment firm J.C. Flowers for the sale, for US$768 million, of Refco’s futures brokerage business, conducted through Refco LLC, Refco Overseas Ltd., Refco Singapore Pte., and certain other subsidiaries. (Mr. J. Christopher Flowers is the largest shareholder of Shinsei Bank and Nasdaq-listed Enstar Group, and was — by incredible coincidence — formerly a partner at Goldman Sachs.)

Mark Winkelman, another Goldman Sachs veteran, is taking over as chairman of Refco LLC, and Jacob Goldfield will serve as vice-chairman.

However, the Flowers deal isn’t a certainty, as the Dubai government has expressed an interest in buying all of Refco Inc. for upwards of US$1 billion.

Refco Inc. and some of its subsidiaries finished the day on Oct. 17 by filing for bankruptcy protection in the U.S. — the fourth-largest filing in U.S. history.

The company did emphasize that none of its regulated subsidiaries had filed for bankruptcy protection, including the futures brokerage business conducted through Refco LLC, Refco Overseas, Refco Singapore, and the registered broker dealer Refco Securities.

With Refco filing for bankruptcy protection, Goldman Sachs withdrew as advisor, to be replaced on a longer-term basis by Greenhill & Co.

We’ve watched, slack-jawed, as one of the world’s most prominent commodities and futures trading companies has been brought to its knees in just seven dizzying days.

Gold bugs have long complained about the “mountains of sewage” that unregulated, over-the-counter financial derivatives now represent in the global economic system, and have repeatedly warned of the danger they pose to economic order should they spiral out of control.

This week’s surprising, near-death experience of Refco — formerly the world’s largest independent derivatives dealer — only strengthens their argument.