The Collapse of Refco - All Within 7 Days

There was no economic reason for the transactions and – absent economic reason – alarm bells should have been going off. They did. They weren’t listened to.

In terms of corporate collapses, Refco must be in line for an award for most expeditious meltdown.

On the morning of Monday 10th October Refco (http://www.refco.com/) was one of the world’s biggest futures and commodities brokers, with 2,400 employees operating in 14 countries and a market value of $US3.6bn following a highly successful initial public offering in August 2005.

A week later, Refco had virtually collapsed and has filed for bankruptcy protection. Trading in its shares has been suspended indefinitely, its bonds are trading at a quarter of their face value and large parts of its operations are suspended or being wound down.

US federal prosecutors have charged Refco’s CEO and Chairman of the Board of Directors – Philip Bennett – with defrauding investors by hiding hundreds of millions of dollars in loans to another company that he controls. If convicted of the charge, Bennett faces up to 20 years in prison.

Of interest is that there appears nothing fundamentally wrong with Refco business model – all that has changed is that the company has found out that a debt which it thought was owed to it by a hedge fund was actually owed by the chief executive.

Because its accounts had not recorded that the debt was owed by the chief executive – as a “related party transaction” – the company warned that its figures going back at least four years could not be relied upon.

What Happened

After an internal review, the company found a receivable owed to Refco by a firm controlled by Bennett.

The receivable was for the amount of $US 430m and the company had – until the review – assumed that the debt was owed to it by a hedge fund.

This was not the case and the receivable largely consisted, the company believes, of “uncontrollable historical obligations owned by unrelated third parties” to Refco. These obligations were periodically transferred to Bennett’s personal company. Refco’s accounts then reflected a receivable from that entity.

The fact that the receivable was from a firm controlled by Bennet was “hidden at the end of … reporting periods” says Refco, in transfers to a (probably unconnected) customer account.

Since late last year, Bennett had “actively participated” in a scheme to hide the obligation – with the money repaid just before routine audits.

(The 10th October announcement from the company can be found here: http://www.refco.com/nr/nr.news.asp?Id=1397 )

Alarm Bells

With out boring you with the details – the transactions involved should have appeared odd to a knowledgeable reviewer of the accounts.

In essence there was no economic reason for the transactions and – absent economic reason – alarm bells should have been going off.

They did.

They weren’t listened to.