Timely Objections Blog

Yesterday, Standard & Poor's relieved the Eurozone's bail-out fund, the European Financial Stability Facility ("EFSF") of its AAA credit rating, possibly hampering the fund's ability to contain the European debt crisis. This comes on the heel's of the S&P stripping both France and Austria of their triple-A rating in favor of a rating of AA+.[1] The effect of the S&P downgrade may be negative. Ratings agencies exist to level asymmetries in information and evaluate risk but one of their inherent oddities is that they seek to compare things whose differences in scale make them incomparable. Ratings agencies also have conflicts of interests, they often evaluate financial products (like collateralized debt obligations) that they do not understand, they seem to lack fixed ways to measure absolute risk, and they are at times, catastrophically wrong.

Elephants and aardvarks

Downgrades should not be considered in a vacuum. When the ratings agencies equate economies based upon ability to repay debt, they artificially equate countries disregarding factors such as size, geo-political risk and political infrastructure that make their comparisons odd.

S&P announced on August 5, 2011 that it would downgrade the credit rating of the United States. Interestingly it announced during the last day of this same month that while the world's only superpower and largest economy would now get only a AA+ rating, securities backed by sub-prime home loans, the same type of investments that led to the worst financial debacle since the Depression (and one from which we have not yet arguably recovered) would receive its once coveted triple AAA rating...unlike the United States.

There is no question that the United States will be able to repay its debts, we will continue to print more money-the larger issue is the continual erosion in the Dollar over time. Although a currency cannot be devalued ad infinitum without catastrophic results, at least for the time being, there is no credible replacement for the Dollar continuing to be the world's reserve currency. No other nation has the assets to back up being the world's reserve currency.

Looking at the S&P's downgrade of the United States in a vacuum, one would think that it is more prudent (according to all three ratings agencies), to prefer Austria, Denmark, Norway, France, Germany, Singapore, Luxemburg, the Swiss or even Finland. There is no consensus by all three agencies on countries like Hong Kong, Australia and the Isle of Mann. Yet other than ratings, the similarity ends there. Comparing the United States, the largest and most analyzed economy in the world with relatively petite nations like Luxemburg and Finland are like comparing the teeth of an otter and an elephant-one is so remarkably larger than the other that a comparison seems problematic. Admittedly both animals have teeth. Or like comparing the speed of an elephant and an aardvark.

To put the utility of comparison between the United States, which has a GDP of $14.657 trillion, in perspective, here are the GDPs of some of the remaining triple AAA rated countries in 2010 according to the IMF [2] :

• Luxemburg has a GDP of $52.43 billion,
• Germany's GDP is $3.314 trillion (largest in the EU)
• France $ 2.582 trillion,
• United Kingdom $2.172 trillion
• Lichtenstein $4.83 billion
• China $10 trillion (largest behind United States)

Comparing the largest most innovate, most scrutinized economy in the world to a nation like China is humorous because in terms of actual accounting standards, any meaningful transparency, the complete absence of a stable democracy or political freedoms-China is a peasant country. When the United States is downgraded, there is no other United States to compare it to, so to some extent, the rating downgrade may not be absolutely everything the media proclaims it to be.

Effect of downgrade on United States so far

When the markets opened on the first Monday after S&P's downgrade of the United States, the benchmark 10-year Treasury bond's yield dropped to 2.5%. Price, which is inverse to yield in bonds, has continued to increase even approaching all-time historic levels. This past August, the 10-year yield dropped almost 60 basis points, piercing below 2% (lower than their historic all-time low in 2008 when Lehman Brothers collapsed). The demand for United States' Treasuries has increased dramatically immediately following the S&P downgrade.

If the United States were deemed less credit worthy (less likely to pay its creditors), then investors and bond holders would demand higher returns for buying any U.S. debt/bonds. The very ability of the United States to borrow money by issuing bonds would be jeopardized. The market has ruled against this logic and to a large extent against S&P-justifiably so.

Remember a government bond is a debt instrument issued by a national government denominated in that government's currency. United States Treasury securities are valued in US dollars-their price is in United States Dollars.

A risk-free interest rate is the nominal rate of return for an investment with no risk (no credit risk) [3] of financial loss. The risk-free rate of return for almost all this century was the yield of United States Treasuries.

graph.pdf

Why would the market seemingly disregard the opinion of S&P? Perhaps because many people remembered that during the housing bubble, sketchy loans (once again I proffer this as a new legal term of art) were repackaged by investment banks into investment pools and other mortgage backed securities and received the gold standard of financial ratings, the coveted and in theory elusive, AAA rating by the largest credit ratings agencies, including S&P and Moody's. S&P's granting of triple AAA ratings to companies and investment vehicles that turned into junk ratings caused $2 trillion in losses to everyone that relied on them-basically, everyone. No one else seemed to find it ironic that this same agency told the United States by how much it thought its debt should be lowered.

Conflicts of interest and fraud

But back to the credit ratings agencies... Not that long ago, in August 2010 and again in July of 2010, the SEC threatened to charge all three ratings agencies with fraud. Some would say better late than never. During the housing bubble, sketchy loans (I use this as a new legal term of art) were repackaged by investment banks into investment pools and other mortgage backed securities and received the gold standard of financial ratings, the coveted and in theory elusive, AAA rating by the largest credit ratings agencies, including S&P and Moody's. The agencies' granting of triple AAA ratings to companies and investment vehicles that turned into junk ratings caused billions if not trillions of dollars in losses to everyone that relied on them-basically, everyone. The credit ratings agencies are paid by the issuers (their clients) of the securities they were supposed to evaluate, creating an inherent conflict of interest. They were the game's referee and one of its players at the same time.

The SEC report on Credit Ratings Agencies from June 2007 identified another problem other than having the referee in a match being paid by one of the sides, (not the investors or the public's side mind you), that prevented the agencies from giving accurate ratings. The agencies could not give accurate ratings of many of the instruments involved in the housing bubble and credit crisis because of the complexity of the transactions involved and the inability of agencies to understand what they were analyzing.

One could argue that the agencies were not engaging in a deliberate (alright not a horribly deliberate) fraud, that is having a public position of trust, being paid and knowing they cannot do what they are assigned to do but pretending to do it anyway. Mind you, if anyone else had engaged in this behavior, they would have likely been indicted for fraud and possibly RICO.

What may let the agencies off the hook is that they relied on the issuers' (the clients again, usually investment banks) audit committees. Audit committees cannot seem to be comprised of Chia Pets in human dimension. The fact that these committees represented having signed off on the financial instruments in question should mean something-if not, why have these corporate committees?!

Furthermore, one could argue that the credit ratings agencies must not be held responsible for their ratings because they did not and could not have understood the trading transactions taking place at the investment banks because they had to rely on the information they were given which was not itself transparent.

A possible longer term solution to the conflict of interest driven nature of the credit ratings agencies is to take away the compensation structure of the credit ratings agencies and deregulate them completely in-order to discourage inherent conflict of interest or use the Credit Spread Market-problem solved! Take away what is essentially a government-sponsored monopoly of credit ratings agencies and allow investor paid credit ratings agencies, which could open up the market and privatize the ratings industry. Without credit ratings agencies, the market will determine value more efficiently than the analysts at the agencies. A problem with this approach is that there might be variance between the ratings of twenty agencies as opposed to just three, causing the rating on any one agency to mean less and to make more work for risk managers.

No liability

S&P has somehow avoided to this very day, all criminal and civil liability for its part in the most recent financial crisis. If the agencies had some liability for their ratings, they may have a better incentive for assuring that they got them right. Neither the Justice Department nor the SEC (which has itself managed to miss all the major financial debacles of the past five years) has ever charged S&P with criminal conflict of interest (as they in practice do and would do to any number of much smaller economic participants with a much smaller fields of damage). Neither the Justice Department nor the SEC has gone after S&P for admitting before Congress in 2008 and 2009, that their being paid by the issuers (their clients) of the securities they were supposed to evaluate, created an inherent conflict of interest and did in fact wrongly influence their ratings.

Nobody has charged the S&P with criminal fraud or fraud on the marketplace for taking money from issuers in simple bad faith (playing the part of the referee and judge in a boxing match after being paid by one of the boxers) for rating securities, they admitted in sworn testimony they did not understand!

This sordid tale has no end. According to Bloomberg, S&P is giving its self-coveted triple AAA rating to junk,

and not the United States of America.

Relatively speaking

Size matters. Pension funds and many of the largest institutional investors have rules about what investments they may invest in and these rules are based on the ratings given to investments by the credit ratings agencies. Consider that Australia, Andorra, Bermuda, Canada, Cook Islands, Denmark, Estonia, Finland, Germany, Hong Kong, Liechtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, Switzerland, and the United Kingdom retain their triple-A ratings.[5] These countries represent less than 21% of the world's collective GDP...my math may be slightly off. If investment funds were limited to investing in triple-A products, it would be preposterous to think that less than 21% of the economy of the world would fund the remaining 79%.

Another weakness of the credit ratings agencies is that there is no set standard employed for measuring absolute risk. What I mean by absolute risk is the measure in gambling parlance, of the risk of ruin. Wall Street and regulators have, in the example of a bank lets say, no better way other than asking for capital ratios to ascertain a bank's risk or ruin. Other factors, like the value of assets and counterparty transactions lack still, even in 2012, transparency.

Because the credit ratings agencies share this problem of being unable to objectively ascertain absolute risk, they lag the markets' own detections of absolute and relative risk. For example, the agencies did not foresee the Latin American debt crises, the European debt crisis, AIG, the Credit Crisis, Enron, Worldcom, or even MF Global. In this sense, credit ratings agencies look backwards better than they can look ahead. Arguably, there are extremely few economists or market participants that can look ahead-this may be a wholly unfair criticism...except this is part of the reason for having the ratings agencies.

The most obvious problems with the existing regulatorily instituted regime of three credit ratings agencies is that they have no competition, no real accountability because they have to be utilized even when wrong, and no liability. This oligopoly ought to be dismantled and the private sector should be allowed to get into the ratings game in the same way that analysts exists in the financial markets for every other type of investment. Doing so would eliminate the existing conflicts of interests within the credit ratings agencies and allow investors to pay the private ratings agencies for their research. Competition will have to drive the caliber of research and ratings upward.

Sadly, nothing in the gargantuan 2,300 page Dodd-Frank Act or that has been discussed in the Senate Committee on Banking, Housing and Urban Affairs addresses the problems with the credit ratings agencies...the same ones that contributed to our recent financial crisis.@

R. Tamara de Silva

R. Tamara de Silva is an independent trader and securities lawyer

Footnotes:
1. The EFSF's ratings are derived from its backers and France and Austria were two of the largest guarantors behind Germany. S&P's downgrade of the EFSF will mean the fund has 440 billion less in Euros than before the downgrade.
2. These numbers are adjusted by PPP (purchasing power parity), basis-this takes into account, relative cost of living and inflation rates, rather than just exchange rates.
3. There are other risks like inflation risk (the principal returned on a debt instrument upon maturity would have less purchasing power) and currency risk (the Dollar could as it has, decline in value relative to other currencies).
4. http://www.bloomberg.com/news/2011-08-31/subprime-mortgage-bonds-getting-aaa-rating-s-p-denies-to-u-s-treasuries.html
5. http://www.standardandpoors.com/ratings/sovereigns/ratings-list/en/us?sectorName=null&subSectorCode=39&filter=E

"If someone who is very wealthy comes in and takes over your company and takes out all the cash and leaves behind the unemployment? I don't think any conservative wants to get caught defending that kind of model." This quotation, which could have been from David Axelrod or President Obama, was actually from Newt Gingrich. In other words, conservatives cannot defend capitalism if it means that people will lose jobs.

Some history is helpful. Job creation and job retention are not the primary motivations for innovation and industry in the United States, they have never been. Job creation gained traction in the public discourse when it used as a justification for the government spending TARP funds-the rationale being that the government's spending would create a soft landing for the economy, lessen the economic impact of the recession and Credit Crisis and create (albeit often temporary and expensive) jobs. Yet it is not job creation that has motivated this country's most celebrated capitalists but profit motive or sometimes the pursuit of excellence expressed as an idea. Henry Ford did not start building his own self-propelled vehicles that ran on gasoline in order to create jobs any more than Steve Jobs began building personal computers to create jobs.

Hard Edges

We may not be in an economic crisis but a period of economic change. Capitalism has hard edges, especially in periods of extremely rapid economic change. Failure and obsolescence are the sina qua non of capitalism. What Mr. Gingrich's statement is missing is the possibility that America and the rest of the developed world are in the midst of period of rapid flux.

Almost without exception, most neo-classical economic theory holds that crises do not persist indefinitely, because economic systems revert to some equilibrium or balance. Perhaps, America and Western Europe as seen by the possible collapse of the European monetary union, may by in as much a period of economic change as it is in crisis. The distinction is important because if we are in a period of rapid economic change, things may not get better exactly as we expect them to-they will change.[ 2 ]

We may be in the midst of another economic revolution akin to that of the Industrial Revolution. Alternatively, we may be seeing disruptive technologies change the world and create economic upheaval (the hard edges) in the form of extreme wealth and extreme poverty as we saw in the close aftermath of the steam engine, the internal combustion engine, the railway and the utilization of electricity.

The world has never been, not at any time since mastery of the seas meant dominance in trade-not even during the silk trade--as interconnected as it is now. Technologies like the Internet and information technology have been both disruptive and creative at once, and at a breathtaking pace. The face of manufacturing, as we have recognized it for most of the twentieth century has itself changed, so has its importance as a percentage and engine of economic growth. It has been replaced by other sectors including and perhaps infamously, the financial services sector described by the term financialization. Just as what happened one hundred years ago, politicians lobbied for groups that were nearing obsolescence, but were unable to stop change itself. We see changes in the countless examples of relatively lower skilled, high paying jobs that have been erased and may never return. In periods of rapid economic change, settled patterns of work are upended. Another factor is the creation of disparate wealth between wealthy superclasses (robber barons) and everyone else, including the newly displaced.

Bain Capital, Private Equity and Venture Capital

It is easiest to extol the virtues of free markets and capitalism when able to toss in Steve Jobs, Bill Gates, Thomas Edison or Henry Ford as stunning examples of its success- but to be fair, these people are eight sigma events. Most capitalists are hardly this glamorous, they never make magazine covers, and their stories and personages are decidedly more bland if not just boring-fitting very well into the fat middle of a normal bell curve. Mitt Romney has been roundly accused of being unpardonably bland but this is not an economic transgression. Attacks on his career at Bain Capital are misplaced because both the private and venture capital business models provide extremely important social and economic functions.

Romney and Bain Capital are charged with making too much money, having businesses fail and alternatively, causing some of the most sympathetic people in North America to lose their jobs. The fallacy of these arguments are legion.

Bain Capital is primarily a private equity firm that also has a venture capital arm. Private equity firms invest by buying ownership of companies where they see the potential for a return for themselves, a return they capture by later selling the company at a profit to another party or parties either in the private or public markets (they sometimes retain acquired companies). Private equity investors can be more sophisticated than other corporate governors and in theory be better managers- thereby using their unique vantage point and experience to create wealth for investors.

Venture capitalists take a lot of risk, often investing their own money in start-ups and the new companies of entrepreneurs in the hopes of finding the next Google, or Apple. Both private equity and venture capitalists are rewarded for being able to recognize the best entrepreneurs, the best ideas, and helping to bring them to market by financing them, so that the world profits from the next iPhone, the next life-saving technology or Google.

No one in either industry risks their own or their investors' money expecting to fail. They would not stay in business if they did.

Sometimes, as the bi-partisan critics point out, people in companies acquired by private equity lose their jobs. One of the reasons for this is that private equity turns companies around by making them more efficient. This is often accomplished by getting rid of excess layers of management, unnecessary employees and generally, "bloat." It is important to remember that what is considered "excessive" in layers of management or how "bloated" a company may look-is largely subjective. Profit motive is the engine of capitalism, not job retention.[3 ]

When we introduce terms like "looting" which is a loaded term it is important to keep in mind that this is also a subjective term. Romney's critics are looking at Bain in hindsight...with some not insubstantial measure of bias. Also consider, that the world may be changing at a rapid place and some degree of job displacement may be the norm.

Investing in companies and trying to turn them around is not as easy it is sounds. It also involves an appetite for risk that most people do not have. A majority of businesses fail within two years of sooner after their inception (even if they are not distressed to start before being acquired by a Bain Capital).

Taking risk is nonetheless commendable. Taking huge risks can lead to catastrophic failure or success. I read somewhere that Thomas Edison failed well over 1,000 times before successfully creating the lightbulb. But he made in well in excess of 1,000 attempts and had the stomach to endure that much defeat-this is not common. Facebook, and Google were not guaranteed to successes. There is only one Mark Zuckerberg and only one Steve Jobs. If a high failure rate did not come with taking significant risks, there would be a 100,000 Bill Gates as opposed to just one. Looking at Bain's record, I am reminded of the Pareto Principle or 80/20 rule--that 80 percent of the effects are the result of 20 percent of the causes.

Overall, venture capitalists do well and their importance to the economy cannot be disputed. Venture capital is responsible for 12.1 million private sector jobs or about 11% of total private sector jobs that collectively generate $2.9 trillion in revenue.[4 ] Private and venture capital firms are responsible for most jobs in the software, telecom and semiconductor industries.[ 5]

Slavery and Principles in Opposition

The Founders has a very odd notion for their time, the idea that people were born with natural rights-not granted by a monarch or a government but actually born with rights, rights inherent to all individuals. This was a radical idea!

While there is no pure form or capitalism, capitalism is more conducive to individual freedom and human rights than any other system.[6 ] It simply trumps all alternatives. Capitalism promotes the opposite of slavery and is conducive a core principle deeply held by the Founding Fathers - that human beings have human rights. Self-ownership, the opposite of slavery is one of them.

This also comes with the harsh reality that some people will not succeed and must fail in a capitalist system. Because in a larger sense, it really makes no difference whether capitalism works perfectly or not-it is the legally instituted economic system most opposite of slavery.

Candidates for the Presidency, including the incumbent, like all politicians crave power so much that they must feed populist tendencies which, are based on emotion regardless of whether they cannibalize this country's core principles. All of the arguments against Bain Capital are populist ones designed to enrage, and excite anger and envy. They seek to alter the capitalist system by selectively identifying what parts of a free market are acceptable at a moment in time and what are not--and to suggest improper conduct where there is no evidence of any illegality (other than profit) by imposing the same arbitrary values-envy not being a great value by the way.

Some principles have to be above populist tendencies or we will have no principles standing. Steve Jobs and Henry Ford are good examples against these populist arguments-their motivations were never job creation or job retention but their economic enrichment-in pursuing these narrow goals they changed the world. Insisting that job creation or retention trump the motive of wealth creation, is something entirely other than capitalism.

Adam Smith's first great work before The Wealth of Nations was The Theory of Moral Sentiments, which made the case for sympathy as a foundation for human relationships in a civil society. Politics plays a large role in human relationships especially when it is used as lever to ignite class warfare and to institutionalize envy. Populism must never be used as a political campaign, however convenient or effective, because it ultimately enrages and divides a nation at its core, and sometimes these divisions cannot be healed.

Instead of attacking Bain Capital, all the candidates from both parties ought to address what harms capitalism (other than themselves obviously). If it were just Adam Smith's animal spirits competing and the fiercest winning, we would not have government subsidies, tax breaks and bailouts--all selectively doled out for a few-not all. Not even a Fed giving free money to some (a preferred very few)-not all. Or maybe we would because many of those that succeeded the most would always use their resources to create cartels, monopolies and buy political influence. Bribery and policy for vote getting- have no place in a purely capitalist system and their presence has...at least this is my guess-given capitalism a bad name.@
R. Tamara de Silva
Chicago, Illinois
January 14, 2012

R. Tamara de Silva is an independent trader and securities lawyer

Footnotes:
1. Class War? What Americans Really Think About Economic Inequality, Lawrence Jacobs.
2. Of course economists that guess correctly and point out a plausible causal variable will appear brilliant but there again, only in hindsight. We cannot really know if we are in a crisis or in a period of dramatic change but it cannot hurt to be aware of the possibility of the latter.
3. The profit motive cannot be selectively excised from capitalism in favor of job retention, as many of Romney's critics suggest. It was not that long ago that the USSR boasted of full-employment but could never match the sheer volume of innovation produced by its arch rival.
4. http://uvc.org/why-private-capital-backed-companies/#jobGenerators
5. Id.
6. There is no purely capitalist system and may have never been-in the sense of a laissez-faire system because the State is always and in some manner involved.

Last Thursday December 15, 2011 was MF Global Holdings Ltd.'s and MF Global Inc.'s Chief Executive Jon Corzine's third time to testify before Congress. He may not have faired all that well in light of Chicago Mercantile Exchange Group Chairman Terrance Duffy's testimony on December 13, 2011, which seemed to contradict Corzine's previous testimony. Corzine adjusted his testimony on December 15, 2011 to account for the seeming contradiction. However, how well Corzine may have done to avoid perjury or any role in a possible fraud remains to be seen. A closer examination of Corzine's testimony and the events leading up to MF Global's bankruptcy on October 31, 2011 suggests problems. If there is any purpose to be achieved in having Corzine testify again, lawmakers should focus their questions towards the failed purchase of MF Global by Interactive Brokers and all customer agreements, including emails between MF Global and account holders leading up to the purported transfers of $175 million and $700 million in as yet missing customer segregated funds and the firm's use of a type of repurchase agreement.

Were the Transfers Legal?

In my first article on MF Global, I suggested that the $1.2 billion missing from customer segregated funds may have been incurred due to over-leveraged positions in European sovereign debt that coincidentally took a dramatic turn for the worse (as they did in fact as yield curves doubled rapidly in some issues) during the last weeks of October, and that funds were transferred to cover margin in customer funds held in European debt. In this scenario, as I suggested, nothing illegal would have occurred because CFTC Rule 1.25 had been amended to permit the investment of customer segregated funds in foreign sovereign debt.

Moreover, if the money was transferred legally and without any fraud, but simply lost in the market, there may not be any right to recover the money by MF Global's customers in bankruptcy proceedings. The use of customer segregated funds for margin payments on repo-to-maturity ("RTM") transactions are not illegal and hence unlikely, without anything else, to be recoverable in bankruptcy.

An alternate illegal scenario is that MF Global may have engaged in some late stage embezzlement of customer funds that were supposed to be segregated from MF Global's accounts and never commingled with any other funds. [1] One way this may have occurred is if the funds were transferred out of customer segregated funds for a legal purpose but without the customers' meaningful consent or, more likely, with an intent to deceive the customer.

MF Global was permitted to invest customer funds, and borrow customer funds so long as the dollar value of the funds taken from the customer segregated accounts remained the same-the accounts were kept intact. For example, if MF Global used customer funds by transferring a specific amount of money out of customer segregated accounts; it was required to simultaneously deposit something of equal value in these accounts to equal the dollar value of what had been taken out.

If MF Global transferred customer funds out of segregated accounts as a loan to MF Global to cover margin calls in existing positions in sovereign debt, (perfectly legal) [2], it may however, be fraud and intent to deceive on its part if MF Global knew it could not repay the money. This fraud may have occurred if MF Global knew (and it would be interesting to argue how it did not) that it sought to legally borrow from customer funds, knowing that it was de facto insolvent and could not replace the money.

In other words, an acceptable use of customer segregated funds for margin payments may not exist if at the time MF Global made the transfers, it was insolvent or in the midst of a crisis where insolvency was around the corner to be seen. Even if MF Global asked for and obtained the consent of its of customers, or consent was not required according to customer agreements, and it legally borrowed the money from customers by replacing it with other collateral (collateral such as commercial paper, as permitted by CFTC Rule 1.25), the transfers would still be illegal because MF Global would be deceiving its customers-knowing it was already insolvent. Even though the rules likely permitted the replacement of funds with other collateral (and the collateral was used) MF Global's actions are arguably illegal because they were deceiving their customers knowing they would not be able to make the customers whole. Meaningful deception like this would be fraud and embezzlement in which case, the funds could be clawed back in bankruptcy proceedings-Please note that I am speculating a bit in specific statements about bankruptcy proceedings and do not specialize in this area of law.

Changing testimony or selective recall?

On December 8, 2011, Corzine testified before the House Agriculture Committee that he had "no idea where the money is" and that "I know I had no intention to ever authorize the transfer of segregated moneys. I know what my intentions were."

On December 13, 2011, Corzine testified that, "I never directed anyone at MF Global to misuse customer funds. I never intended to. And, as far as I am concerned, I never gave instructions that anybody could misconstrue."

On December 13, 2011 Terrance Duffy testified before the Senate Agriculture Committee. In Mr. Duffy's testimony he said that the CME has been conducting their own ongoing investigation of MF Global and discovered on December 10, 2011, after questioning a former MF Global employee who knew about the transfer of $175 of customer funds towards MF Global's broker dealer operations, that Corzine knew all about the transfers and likely authorized them.

On Thursday November 15, 2011 Corzine repeated that he did not authorize any illegal transfers, pointing to his General Counsel and Treasurer as the people who would know about the transfers. However, he was able to recall the $175 million transfer enough to tell the Committee that Duffy likely meant a loan advance from customer segregated funds to MF Global's European operations. Remember that all his previous testimony was to the effect that he, "was totally stunned to learn customer money was missing...did not learn about it until October 30, 2011...etc"- in this context it seems a tad odd for him to suddenly develop a very specific recall about one event of October 28, 2011. Sadly, this was wholly lost on the Committee, which asked not one follow-up question.

In addition to Mr. Duffy's testimony that a MF Global back office employee said Corzine was aware of the transfers, the Committee alluded to evidence that the Chief Financial Officer of MF Global's North American operations (presumably Christine Serwinski) said that Corzine knew about the transfers. If so, there are at least two or more MF Global employees and officers who contradict Corzine's sworn Sgt. Shultz testimony.

Not being perfectly honest with FINRA

On December 8, 2011, Steve Luparello, the Vice Chairman of the Financial Industry Regulatory Authority ("FINRA") also testified before the House Committee on Agriculture about MF Global's collapse. According to Mr. Luparello, MF Global was not completely candid with the Chicago Board of Options Exchange ("CBOE") and FINRA. In late September 2010, MF Global assured both regulatory bodies that it did not have any positions in European sovereign debt.[3] MF Global did in fact have positions in European sovereign debt during this time but because according to GAAP accounting rules, positions held in RTMs are treated as sales and not liabilities, MF Global did not violate the law in hiding its credit and risk exposure to RTM, which are liabilities in the real, non-accounting world. Technically, MF Global was able to get away with it, at least for a time.

A little background may be helpful and a story of another failed firm, Lehman Brothers that generously indulged in a cousin of RTMs, the Repo 105. The Repo 105 was utilized by Lehman Brothers, among other firms that did not survive the last financial crisis including Washington Mutual, Northern Rock and some that did like Citigroup.

This is how it worked and how a liability (a loan) can be transformed into a revenue-generating event (a sale)...if you are an investment bank that is. Lehman entered into repo transactions with offshore banks. Lehman would sell (though actually a loan) a bundle of toxic assets such as sub-prime mortgages and dubiously collateralized debt obligations to the bank. This transaction is characterized on the books of Lehman as a sale. Lehman agrees to buy back or repurchase (hence the term 'repo') the toxic assets at a later date (maturity). In this way, Lehman moves loans and bad assets off its balance sheets towards the end of each financial quarter-removing liabilities dramatically improves a balance sheet- as if they do not exist. Then Lehman reports the sale as a revenue-generating event, in effect moving by way of example, $39 billion off its balance sheet in what is a liability, and reporting it as a sale of $39 billion. It is fraudulent twice over in that Lehman does not disclose on its financials that it has an obligation (a debt to buy back) to pay back the amount loan and it reports the loan as revenue.

In effect, this is what MF Global did with FINRA and CBOE. However, the regulators caught MF Global's exposure to European sovereign debt and told MF Global to keep substantially more money in reserves because of what FINRA identified in May 2011 as a $7.6 billion risk exposure. MF Global appealed to the SEC and because of the appeal process, it was only in August that FINRA and the CBOE were successful in getting MF Global to put up more money for its European debt exposure and utilization of RTMs.

An accounting error

Also on December 15, 2011, the oversight panel of the House Financial Services Committee released a CME Group document the CME had given to the government containing a detailed log of its dealings with MF Global between October 24, 2011 and October 31, 2011. According to this document, Christine Serwinski, the Chief Financial Officer for North America at MF Global, and its Assistant Treasurer, Edith O'Brien, told a Mike Procajlo, an exchange auditor at 1:00 a.m. on Oct. 31, 2011 that the customer money was transferred on Oct. 27 and Oct. 28 and possibly Oct. 26, 2011. "About $700 million was moved to the broker-dealer side of the business to meet liquidity issues in a series of transactions on Thursday, Friday and possibly Wednesday," Serwinski told Procajlo about eight hours before the firm filed for the eighth-largest bankruptcy in United States history.

Barely three days prior, on October 28, 2011, MF Global had submitted a statement to the CME showing that it had $200,178,912 in excess cash in its customer segregated funds as of the close of October 27, 2011.

On October 30, 2011, an official from the CFTC informed Procajlo that a draft statement of the value of MF Global's customer segregated funds, showed a deficit in customer segregated funds for the day ending October 28, 2011. MF Global's Assistant Controller, Mike Bolan and its General Counsel, Laurie Ferber said they believe the customer-funds deficit is "an accounting error." Ms. Ferber had told the CME on October 25, 2011 that rumors about problems stemming from MG Global's European debt trading were not accurate.

On December 15, 2011 Mr. Duffy told the House Committee that this so called accounting error was "a telling sign that regulators were being kept in the dark" about MF Global's customer accounts. What was Corzine doing during all of this?

Acquisition by Interactive Brokers

While the exchange was trying to get to the bottom of the accounting error, whose magnitude would not be revealed until the evening of October 30, 2011 as being $900 million, Corzine and other MF Global officials were trying to close a deal to sell MF Global to Interactive Brokers Group, Inc. On that same day, October 30, 2011, MF Global issued a press release at 6:00 p.m. announcing that it had reached a deal with Interactive Brokers.

Corzine as CEO of MF Global negotiated the potential sale of his firm to Interactive Brokers. The first question involved in any sale of a going concern involves the determination of an acquisition price. Corzine would have had to know what the assets and liabilities of MF Global were (the balance sheets) to even begin to negotiate a price. The deal was happening at the exact same time of the transfers.

It is beyond the bounds of credibility to argue that MF Global did not have regular if not daily accounting of cash balance sheets and that Corzine did not see them. If Corzine knew what the company was worth, during the very days in which at least $900 million in customer segregated funds was lost, he must have at a minimum known about the company's impending insolvency. How then could he not have known of the transfers?

In addition, as a matter of course in the futures industry, MF Global likely had to report the total daily amounts carried in segregated funds to the CME-it certainly had to do so from October 24, 2011 onwards. This computation is performed as a matter of course every single day at every futures broker.

Corzine's testimony before Congress would have us believe that hundreds of millions of dollars were moved around without the knowledge or approval of the MF Global's CEO and CFO all while the balance sheets were being scrutinized for an acquisition by Interactive Brokers, which Corzine spear-headed.

Corzine has sworn under oath that he did not know anything about the missing money until October 30, 2011. This is simply not possible.

Suggestions for House and Senate Committees

Further education about the industry is in order. Both the House and Senate soft-peddled the issues, and perhaps unintentionally avoided important questions and asked almost no meaningful follow-up questions, allowing Corzine to stretch the bounds of credibility in evasiveness. Further questioning should focus, among other things, on the representations made by MF Global to Interactive Brokers on October 24, 2011-October 30, 2011.@
R. Tamara de Silva
Chicago, Illinois
December 19, 2011

R. Tamara de Silva is a securities lawyer and independent trader

Footnotes:
1. http://www.timelyobjections.com/john-corzine/
2. Remember CFTC Rule 1.25 which had been amended to allow the investment of customer segregated funds in foreign sovereign debt, was amended back after the fall of MF Global to disallow the investment of customer segregated funds in foreign sovereign debt.
3. http://www.finra.org/Newsroom/Speeches/Luparello/P125233

Testimony before Congress today revealed that MF Global had illegally transferred $175 million out of customer segregated funds towards its European broker-dealer operations before it went into bankruptcy proceedings and very much under Jon Corzine's stewardship. On December 8, 2011 and again today before Congress, Corzine testified under oath that he was not aware of any illegal transfer. Today's testimony of Chicago Mercantile Exchange Group Chairman, Terrance A. Duffy suggests that Corzine did know about the transfer.

My last article on MF Global stated that $1.2 billion in losses may have been incurred due to over-leveraged positions in European sovereign debt that coincidentally took a dramatic turn for the worse (they did in fact) during the last weeks of October, or alternatively, that MF Global had engaged in some late stage embezzlement of customer funds that are supposed to be segregated from MF Global's accounts and never commingled with any other funds.[1]

It now appears that Jon Corzine may be the best example of the why it makes sense to invoke the Fifth Amendment if you are not inclined to be anything other than completely honest because you simply will not get away with anything other than complete honesty under oath. Corzine testified before the House Agriculture Committee December 8, 2011 and today before the Senate Agriculture Committee. Today, according to the testimony of Chicago Mercantile Exchange Group ("CME"), Chairman Terrance A. Duffy, Corzine may have lied.

In Corzine's December 8th testimony, he essentially hems and haws and states that he cannot recall much of anything, things were chaotic during the last days of MF Global, he was completely lacking in mens rea, would not have authorized any transfer of customer money out of segregated funds, does not have all the records after he resigned and certainly did not intentionally do anything wrong. Nothing other than attempting to mislead Congress and lying.

On December 13, 2011, Corzine testifies that, "I never directed anyone at MF Global to misuse customer funds. I never intended to. And, as far as I am concerned, I never gave instructions that anybody could misconstrue."

Also on December 13, 2011 Terrance Duffy, Jill Sommers, Commissioner of the CFTC and James Giddens, MF Global's bankruptcy trustee also testified before the Senate Agriculture Committee.

In Mr. Duffy's testimony he says that the CME has been conducting their own ongoing investigation of MF Global and discovered on December 10, 2011, after questioning a former MF Global employee who knew about the transfer of $175 of customer funds towards MF Global's broker dealer operations (I am speculating that this was likely done to meet margin requirements on European debt bets that the firm thought would bounce back in time before anyone was the wiser) that Corzine knew all about the transfers. If Corzine knew about the transfer of $175 million, his testimony to the House Committee of December 8, 2011 wherein he stated that he knew nothing about it was untruthful. Corzine may well have already perjured himself.

Remember that on October 26, 2011, the CME had performed a spot audit on MF Global. On October 24, 2011, the CME initiated a heightened scrutiny of the segregated customer fund reporting of MF Global as a result of MF Global's market risk. Beginning on October 24, 2011, the CME's daily audits verified that customer funds were on deposit at the bank(s) where MF Global represented that they were and in the amount that they were supposed to be.

On October 26, 2011, the CFTC also went into MF Global to make sure that what MF Global reported to be holding in customer segregated funds matched bank balances. The CFTC's spot audit showed that no money was missing.

On October 25, 2011 MF Global reported a substantial quarterly loss due to having leverage of 40:1 on its exposure to European sovereign debt. Predictably, MF Global's stock collapsed and it its bonds began to trade at distressed levels. Corzine utilized all MF Global's credit lines and tried to secure a sale of the firm to Interactive Brokers. On October 26 or October 27, 2011 MF Global provided reports to the CME and CFTC that it had a $200 million surplus in customer accounts. In reality on October 27, 2011, it was covering up a $200 million deficit in customer funds.

Five days later on October 31, 2011, MF Global filed for bankruptcy. But MF Global had already lied to both the CME and CFTC and violated CFTC rules and committed fraud and embezzlement.

On the morning of November 2, 2011, the CME announced that MF Global may have transferred money "
in a manner that may have been designed to avoid detection insofar as MF Global
 did not disclose or report such transfers to the CFTC or CME until early morning on Monday, October 31, 2011." [2]

The first hint of missing customer funds came out in press report on October 31, 2011 when Interactive Brokers announced they are walking away from a purchase of MF Global due to accounting discrepancies. At first MF Global denied anything of the sort, only to admit on November 1, 2011 that there were shortfalls in customer accounts. [3]

There are in excess of $158 billion in customer-segregated funds in the United States. The futures markets unlike the securities markets have existed without any meaningful problem or shortfall in domestic customer segregated funds and without needing the existence of any protection like SIPC until October 31, 2011. It is inarguable that the futures markets have been the most crisis-free well functioning markets in the world and remain so. It is unfortunate that because of Jon Corzine these markets may now be portrayed as somehow unsafe for the investment of public funds.

The answer to Corzine is not more regulation but as I have written before, a simple amendment of CFTC Rule 1.25 to prohibit the investment of customer segregated funds in foreign sovereign debt-this amendment has already occurred. It was Corzine himself who lobbied for the change in Rule 1.25 to allow for customer-segregated funds to be held in foreign debt instruments.

Regulation can never rule out the rogue actor or sociopath and must not try because there really are not that many around-Corzine being a case in point. What is least needed is a reactionary and wholesale change in the regulation of the futures markets.@

R. Tamara de Silva
Chicago, Illinois
December 13, 2011

R. Tamara de Silva is a securities lawyer and independent trader

Footnotes:
1. http://www.timelyobjections.com/john-corzine/
2. http://cmegroup.mediaroom.com/index.php?s=43&item=3202&pagetemplate=article
3. http://online.wsj.com/article/SB10001424052970204394804577012061970129588.html?mod=googlenews_wsj

Former Illinois Governor, Rod Blagojevich was sentenced to 14 years today for trying to sell President Obama's vacant Senate seat or as the indictment stated, "efforts to illegally obtain campaign contributions in exchange for official action." Is it wrong to try to sell a Senate seat for personal gain? Of course it is. What the jury considered Blagojevich to have done was essentially commit attempted graft, or the act of attempting to profit or profiting from a political office for personal gain. However, getting excited about Blagojevich's conviction is a bit naïve. Despite all the time, publicity and millions of dollars spent on this single prosecution, in Illinois today there is still no conflict of interest rule regime in place, to prevent the trading of government office and services for personal gain-not even now. Blagojevich's conviction is bread and circuses that will for a time appease the gullible masses and unquestioning press. Bloodletting occurred and an unpopular and loudmouth politician with unforgivable hair succumbed to the lions as the crowds cheered.

What was punished today will be repeated tomorrow and all tomorrows thereafter, but without fanfare and long after the Blagojevich jokes have subsided because Illinois law, insofar that it does not meaningfully outlaw conflicts of interest by those in elected office to prevent self-dealing and graft, seems to condone it. Graft is the currency of Illinois politics and government, especially in Cook County. It occurs every day and on every floor of Chicago's City Hall. In Illinois, the act of differentiating between graft and what passes for legal local government operation in so many local government agencies is the pass on a razor's edge or an exercise in sophistry.

Graft, Horse-Trading, Earmarks and Lobbyists

Ideally, Blagojevich's case should be used to reexamine the role of graft and quid pro quo in politics-that is if the very premise of my suggestion is not itself horridly naïve in that horse trading, is a close cousin of graft and arises out of a shared principle-quid pro quo. Is graft very much different from efforts to legally obtain campaign contributions in exchange for official action? The rationale for what is legal and what is illegal in quid pro quo deals in politics ought to have no bearing on who the party is that is doing the asking and getting.

Arguably, the hundreds of billions of dollars spent on earmarks for pet projects by legislators for their projects back home are manifestations of quid pro quo thinly disguised under the veil of constituent democracy in action. When Congress or the White House does it, it cannot be called, "democracy," "lobbying" or "free speech," and criminal extortion or bribery if done by someone else...or can it?

Legislation creates industry, first by lobbyists and then many cottage industries to explain the legislation and its impact and meaning. The other effect of legislation other than the growth of government itself is earmarks--earmarks are simply quid pro quo.

In the case of congressional earmarks and sweetheart Washington deals, or just garden variety official action for campaign contributions, it seems at times that the line between illegal pay for play in politics and official quid pro quo is paper-thin.

For example, by the admission of the White House on May 28, 2010, White House Chief of Staff and current Chicago Mayor, Rahm Emanuel apparently asked former President Bill Clinton to ask Rep. Joe Sestak to drop a Democratic Pennsylvania Senate bid against Sen. Arlen Specter, in return offering unpaid advisory positions. What if the offer was simply phrased as, "I'll trade you Secretary of the Navy for you not to run against Spectre?" Can this be legal, however it was phrased? Or is this not quintessentially quid pro quo?

The dismissal of all charges against former Sen. Ted Stevens (R-Alaska) demonstrates how thorny public corruption cases can be probably because we are entering the grayest of modern areas in present day politics. What is politics without an examination of the almost direct relationship between earmarks and campaign contributions-think about this-because politics cannot exist without both, at every level? Legislation creates industry, first by lobbyists and then many cottage industries to explain the legislation and its impact and meaning. The other effect of legislation other than the growth of government itself is earmarks--earmarks are quid pro quo.

It is in this gray area that congressional earmarking thrives. Like in the markets increased transparency might have an impact on some of the most corruptive elements of the practice, but it is still a gamble and members of Congress must think that there is a better than even chance that it will pay off for years; they might escape detection and prosecution.

Arguably the only good earmark is a dead earmark. But by this logic, many laws would never get passed and politics would grind to a halt at the state and federal level. Using earmarks to buy campaign contributions, as pay offs to political cronies, to employ your relatives or your former staff members (all practices which are commonly found in earmarking) constitutes quid pro quo.

Ear-marks, which are legally given often times for campaign contributions are considered to be the legal part of quid pro quo in our political system. What is politics without an examination of the almost direct relationship between earmarks and campaign contributions? Think about this-because politics cannot exist without both, at every level. Lobbyists give campaign contributions for earmarks in legislation. Harry Reid received almost $1,000,000 in 2010 election cycle out of $4,447,000 spent by the Vegas casinos to keep online gambling illegal. Harry Reid lobbies to keep online gambling illegal and is the casinos' staunchest advocate on the issue. If this is not quid pro quo, what is it?

Pay to Play, the Illinois Way

Getting back to graft in Illinois, there are about a handful of politicians that divide the assets of the state and local governments like a Christmas pie and they do so by institutionalizing graft. Governor Blagojevich, though accused of being insufferably tacky at times, was in reality and despite his attraction to the spot light and its fascination of him, somewhat of a bit player. Someone once wrote that Illinois is different from every other state in that it was the one absolutely corrupt state in the Union. No one with anything but a cursory understanding of Illinois politics (a certain prominent columnist comes to mind) would dispute this.

To those that are inclined to think that Blagojevich's conviction will send a lesson to other Illinois politicians, you need read no further. To those more critically inclined, consider a few anecdotes that follow (there are so many others but their inclusion would be outside the scope of a blog) in light of mathematical set theory and you will see that while Blagojevich intersected with the lords of Cook County, he never really controlled the throne-not even close.

The largest real estate tax firms that practice at the Cook County Board of Review, the agency that adjudicates property tax appeals in Cook County contribute to their Commissioners. Law firms and lawyers are paid a percentage of the tax savings they achieve for their clients in front of this tax appeal board-they achieve savings of hundreds of millions of dollars every year. The heads of many of these law firms are also among the most powerful politicians and legislators in Illinois. Of course, these lawyers and law firms (coincidentally) have contributed millions of dollars to the campaign war-chests of the Commissioners and their staff at the tax appeal boards.

It would be entirely cynical and not for me to suggest that anything approximating graft were to occur at these agencies, though in the spirit of disclosure I do represent Cook County residents in three separate Federal lawsuits that allege that an institutionalization of pay to play (graft) occurs.

Or consider that almost half of the over 400 current sitting state judges in Cook County were slated and ultimately elected due to backing by the Judicial Slating Committee of the Cook County Democratic Party. The slating process is opaque and political-mired in the political traditions and conflicts of interest of old time Chicago politics. While I could be mistaken, I do not believe there are any Republican judges at the circuit level, in effect one person is judge-maker or de facto head of the Judicial Branch. The requirement of no conflicts of interests on the part of the slate maker does not exist.

After Governor Blagojevich was caught trying to peddle President Obama's open Senate seat, the President came into town on October 2010 to raise campaign funds for Governor Pat Quinn and Alexi Giannoulias, who was running for Obama's open Senate seat.

Coincidentally and because it is a small world as it were, Alexi Giannoulais's father had contributed $10,000 to Blagojevich. In 2003, Blagojevich's then fundraiser Tony Rezko (who has since been convicted of fraud and bribery) sponsored Demetris Giannoulias (Alexi's brother) for an appointment with the Illinois Finance Authority. Governor Blagojevich went on to appoint Demetris Giannoulias to the Illinois Finance Authority. On June 29, 2005, Alexis Giannoulias contributes $10,000 to Friends of Blagojevich. Coincidentally, on September 1, 2005, Rod Blagojevich reappointed Demetris Giannoulias to the Illinois Finance Authority Board.

From 2006-2008, Giannoulias, had worked for President Obama's campaign and contributed to it. Giannoulias is a fixture at the East Bank Club where he played basketball regularly with then Senator Obama. President Obama endorsed Giannoulias for State Treasurer in 2006. When Giannoulias ran for State Treasurer, he promised to revitalize the State's 529 college savings plan called Bright Start. Under his watch the college savings plan lost nearly $150 million before $77 million was recouped by a settlement.

By way of some background, Giannoulias was also the senior loan officer at his family's Broadway Bank. During his tenor there the Bank loaned a convicted mobster and pimp, Michael "Jaws" Durango $15.4 million. Broadway Bank also loaned Tony Rezko $23 million.

In August 2011, Governor Pat Quinn appointed Alexi Giannoulias to serve as chairman of the Illinois Community College Board.

Blagojevich intersected with many of the most powerful politicians in Illinois but somehow lacked their finesse because they remain in office while he is to begin serving his prison sentence on February 6, 2012.

If United States District Judge James Zagel is correct in remarking during sentencing that Blagojevich deserves his 14 year sentence because, "When it is the governor who goes bad, the fabric of Illinois is torn and disfigured and not easily repaired...The harm is the erosion of public trust in government," then the public must demand this trust be restored by taking the trouble to notice what actually happens in Illinois government every single day. If a message is intended to be sent to other politicians, it will not be delivered unless meaningful conflict of interest laws are instituted in Illinois. Otherwise, Blagojevich will like the three governors before him, be considered a one-off event.@
R Tamara de Silva

December 7, 2011

*By way of disclosure, I used to work with Sam E. Adam and Sam F. Adam, the same lawyers that represented Governor Blagojevich during his first trial when he was only convicted of one charge, obstruction of justice and walked on 23 remaining counts as a result of a hung jury. While I did not work on the Blagojevich case, Sam F. Adam is my mentor in the criminal law and I consider to him the best living criminal defense lawyer.

November 29, 2011

This is the legal version of an NFL upset alert. On November 28, 2011, United States District Judge Jed S. Rakoff rejected what would have been the sixth civil settlement agreement between Citigroup Global Markets Inc. ("Citigroup") and the Securities and Exchange Commission ("SEC") since 2003. The SEC filed a complaint against Citigroup in October because Citigroup had peddled $1 billion in mortgage-bonds through a vehicle called Class V Funding III, without disclosing it was betting against $500 million of those assets-in essence offering something to its customers and not disclosing that it would be betting against them.

Contrary to press reports of the decision, Judge Rakoff is not being an activist judge or legislating from the bench when by refusing to uphold the $285 million settlement agreement. This Judge was upholding (and not without an insignificant amount of courage), the law. Perhaps even more importantly, his decision is a victory for the separation of powers doctrine.

Standard of Review

Civil settlements between the SEC and other parties, or what are alternatively called, consent decrees, are essentially permanent injunctions in that they forbid the party that is accused of violating some part of the securities laws from ever doing so again-often even attaching various conditions and stipulations meant to be honored for all time. The SEC in its filings prior to its last filing (a memorandum in support of a consent order), addressed the legal standard of review required for a court to grant a consent order, except this time when they asked the Court to finally grant the order, they did not fully address the standard of review.

By way of some background, usually, it is the function of the Legislature to make laws that proscribe conduct-not the Judiciary. It is an extraordinary thing to ask a court of law to permanently rule that someone is forever barred from doing something-injunctive relief is an extraordinary remedy because it throws the full weight of the court into what is the de facto making of a law-a judicial order. Breach of a Federal injunction can have criminal consequences-a Federal injunction is no common thing.[1]

The United States Supreme Court established in numerous decisions that there is a four part test courts must use in granting injunctions. Before granting an injunction, a court must determine that the granting of the injunction is at once: 1) fair; 2) reasonable; 3) adequate, and 4) in the public interest (emphasis added). Ebay Inc. v. MercExchange, 547 U.S. 388, 391

The SEC remarkably pled that they need not address the "public's interest," part of the standard of review and that even if they did, they alone could decide that something is in the "public interest." The SEC's argument if followed would abrogate a power given to the court and yet ask the court to stamp its imprimatur and issue an order-thereby making the SEC the judge, jury and executioner.

The Justice Department is part of the Executive Branch and were the Judiciary merely to rubber stamp all settlements entered into between the departments of the Executive Branch and private parties, turning them into judicial orders on the say so of the Executive Branch or other government agencies and departments, the separation of powers would very meaningfully cease to exist. The courts would become in every sense the handmaidens of the Executive and other government agencies, or as in this case, the SEC.

Purely private parties can settle a case without ever agreeing on the facts, for all that is required is that a Plaintiff dismiss his complaint. But when a public agency asks a court to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt, the court, and the public, need some knowledge of what the underlying facts are: for otherwise, the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importanc

What Judge Rakoff did in denying the SEC's request for a consent order was have the courage to point out to the SEC that it cannot alone, ignoring case law, determine the standard of review for the judicial approval of the civil settlement between itself and anyone else.

Settlement agreements between the Justice Department and SEC and private citizens are not like settlement agreements between two private parties in a civil matter or easement dispute. More often than not, the SEC presents an individual or concern with a choice between settling a complaint (not a conviction-we are at the stage of a mere accusation) for a fine or facing criminal prosecution against the full force of the United States Department of Justice and every means at its disposable (unlimited). This is Hobson's choice itself. Somewhat analogous to my accosting a stranger and offering the following choice, "I will beat you to a pulp and it will cost every penny you have to recover medically and years of care or, you may pay me $100,000 and we will pretend this never happened." Of course if it were proven that I did this, I would be unceremoniously tossed in a room not of my choosing for some duration and accused of extortion...but I am not the government. Neither are private civil settlements comparable to civil settlements with the SEC or Justice Department.

Judge Rakoff's Ruling

Judge Rakoff also went on to say in his memorandum and opinion that he would no longer approve of SEC settlement agreements that involved the defendants not providing any admissions of wrong-doing, "because the court has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment".

In other words, the courts cannot determine what is fair or adequate about a consent agreement between a government agency and private party without some evidentiary basis or knowledge of the facts.

An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous. The injunctive power of the judiciary is not a free- roving remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated. If its deployment does not rest on facts-cold, hard solid facts, established either by admission or by trials-it serves no lawful or moral purpose and is simply an engine of oppression.

Finally, in any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth. In much of the world, propaganda reigns, and the truth is confined to secretive, fearful whispers. Even in our nation, apologists for suppressing or obscuring the truth may always be found. But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency's contrivances

Citigroup is as the Court points out, a bit of a recidivist. Citigroup has signed many settlement agreements with the SEC without admitting any wrongdoing. It is almost a get out of jail for free card for a fee. Surely there is a purpose to these agreements than merely generating revenue for the SEC by making Citigroup part with pin money? Are these settlement agreements, as the Court and Bloomberg's Jonathan Weil have asked, merely considered the "cost of doing business" or some part of a transaction tax on offending financial titans?[2]

If it were in the public's interest to prevent fraud upon the market, then fines should be significant enough to actually deter illegal conduct. If not, prosecutions should be endured and convictions gotten. The historic role of punishment in the criminal justice system has not been just punishment, but deterrence. In the case of the settlement agreement at hand, the actual fine was $95 million with the suggestion that Citigroup pay up to $285 million-this is pin money to a bank with revenue in the billions of dollars-the "cost of doing business" will not deter anyone, nor is its pursuit an enormously wise use of taxpayer funds-certainly not according to a cost benefit analysis. @

R. Tamara de Silva
Chicago, Illinois
November 29, 2011

R. Tamara de Silva is a securities lawyer and independent trader

Any questions about this article should be directed to tamara@desilvalawoffices.com
Footnotes:
1. The power of the Federal court to protect and enforce its judgments is unquestioned. United States v. New York Telephone Co., 434 U.S. 159, 172-73(1977).
2. http://www.bloomberg.com/news/2011-11-02/citigroup-finds-obeying-the-law-is-too-darn-hard-jonathan-weil.html

Abstract: The collapse of MF Global is an unfortunate and watershed event for the futures industry. The regulated futures markets, long a stepchild of the larger financial markets, have been the most liquid, transparent and crisis free markets in the world. They have been remarkably free from any systemic financial crisis. . .with the exception of a certain salad oil scandal (almost 50 years ago) and until now with MF Global. With former Goldman Sach's CEO Jon Corzine's takeover and bankruptcy of what had been one of the largest and oldest commodity trading firms in the world, the crisis-free reputation of the futures industry is sullied. At the crux of MF Global's fall is CFTC Rule 1.25 which requires that, futures commission merchants ("FCMs"), like MF Global, are allowed to invest and collect interest on customer funds, in excess of customer funds, used as margin for customer trades. Rule 1.25 was amended in 2004 to allow FCMs to invest in sovereign debt (among five other investment vehicles) so long as these vehicles maintained the highest credit ratings by the three credit ratings agencies. If MF Global went into customer segregated funds, which are supposed to separated away from the firm's assets, to meet the FCM's own margin calls, then Corzine and as yet unknown agents will face criminal charges. If however, customer funds were invested in foreign sovereign debt, as firms are allowed to do under CFTC Rule 1.25 and these investments lost over $1.2 billion in value, then there is no criminal liability, only perhaps civil liability. The accounting firm PricewaterhouseCoopers, may face civil liability. A cursory look at all other similar crises from Refco and Griffin Trading (in the futures industry) to Lehman Brothers and rogue trading at UBS, demonstrates that MF Global is unique-this may be the first time in history that customer segregated funds were not properly segregated by an FCM. In any event, $1.2 billion in customer funds would not have been lost had CFTC Rule 1.25 not have been amended in 2004.[1] MF Global's demise has broader implications, other than legal culpability for accounting firms, the effectiveness of self-regulatory organizations and prospective regulation of the futures industry. Lastly, in order to ensure that the futures markets do not have another MF Global, CFTC Rule 1.25 must be amended back to reverse its amendment in 2000 and 2005.

Background

James Man started a sugar trading business in 1783, that became Man Financial and ultimately, the publicly traded MF Global, some 230 years later. In March 2010, a former Goldman Sachs CEO, Jon Corzine became CEO of MF Global joking with not some insignificant degree of obviously unjustified hubris that "I hadn't heard of this company a week ago." Would that he had remained in ignorance.

It was Corzine's stated goal to transform MF Global from a commodity broker into an investment bank with a large proprietary trading operation similar to the one Corzine ran at Goldman in the 1990s. The luster of Corzine's Goldman pedigree was not lost on the Financial Industry Regulatory Authority (FINRA) as they granted Corzine a waiver, from having to have a license to run MF Global. By way of some background, every person in the futures industry has a license, especially everyone interacting with clients.

On October 26, 2011, the Chicago Mercantile Exchange ("CME") performed a spot audit on MF Global. This audit merely verified that customer funds were on deposit at the bank(s) where MF Global represented that they were and in the amount that they were supposed to be. The CME had performed a full audit in January 2011. On October 25, 2011 MF Global reported a substantial quarterly loss due to having leverage of 40:1 on its exposure to European sovereign debt. Predictably, MF Global's stock collapsed and it its bonds began to trade at distressed levels.[2] Corzine utilized all MF Global's credit lines and tried to secure a sale of the firm to Interactive Brokers. Five days later on October 31, 2011, MF Global filed for bankruptcy. There is yet no reason to think that any customer funds, which are supposed to be safeguarded from a futures brokerage going bankrupt by virtue of their being completely segregated, would be in jeopardy.

However, on November 2, 2011, the CME announced that MF Global may have transferred money "
in a manner that may have been designed to avoid detection insofar as MF Global
 did not disclose or report such transfers to the CFTC or CME until early morning on Monday, October 31, 2011." [3]

The first hint of missing customer funds was released on October 31, 2011 when Interactive Brokers announced they are walking away from a purchase of MF Global due to accounting discrepancies. At first MF Global denied anything of the sort, only to admit on November 1, 2011 that there were shortfalls in customer accounts.[4]

Almost one month later, no one can account for where the money has gone. The CME verified that customer money was accounted for on October 26, 2011. It looks as if the money was moved out of customer segregated accounts in the amount of what is now considered to be well over a $1.2 billion shortfall, or the money was lost in trading losses and positions in...you guessed it, sovereign debt. It is possible that legally segregated customer funds could have been lost, in a titanic liquidity squeeze. If this is the case, then no violation of the law that requires customer funds to be segregated occurred.

The illegal scenario is if customer segregated funds were commingled with MF Global's funds. If MF Global went into what are supposed to legally segregated customer funds, that must be completely separated and never used by MF Global either for its own purposes or that of other customers, then fraud and embezzlement would have occurred. Almost one month afterwards, no one outside of MF Global knows which scenario occurred.

Applicable Rules

The key difference between FCMs and securities brokerages is that FCMs, unlike securities brokers, are required by law to keep their customer funds segregated from the FCM's own funds. It is in this way that FCMs have been able, with comparatively few exceptions, to ensure that customer deposits are completely protected from all losses an FCM may incur due to its own proprietary trading. Before MF Global, the requirement that FCMs segregate customer funds completely from their own funds largely prevented FCM customers from losing money due to an FCM bankruptcy.[5]

Having customer segregated funds completely separated and safe from an FCM's own funds and operations meant that protections like SIPC were not needed in the futures world as they are in securities. SIPC on the other hand restores funds to customers with assets in securities brokerage firms.[6] The National Futures Association (NFA) and the CFTC require FCMs to report the amount they carry in customer segregated funds to the clearing house of the FCM's designated self-regulatory organization (DSRO)-in MF Global's case, the CME.

In the case of MF Global, five principal rules applied. CFTC Rule 1.20, 1.23, 1.25, 1.32, 30.7 and Section 4d(a)(2) of the Commodity Exchange Act ("CEA").

CFTC Rule 1.20 holds that customer funds are to be segregated and separately accounted for.

(a) All customer funds shall be separately accounted for and segregated as belonging to commodity or option customers. Such customer funds when deposited with any bank, trust company, clearing organization or another futures commission merchant shall be deposited under an account name which clearly identifies them as such and shows that they are segregated as required by the Act and this part. Each registrant shall obtain and retain in its files for the period provided in §1.31 a written acknowledgment from such bank, trust company, clearing organization, or futures commission merchant, that it was informed that the customer funds deposited therein are those of commodity or option customers and are being held in accordance with the provisions of the Act and this part: Provided, however, that an acknowledgment need not be obtained from a clearing organization that has adopted and submitted to the Commission rules that provide for the segregation as customer funds, in accordance with all relevant provisions of the Act and the rules and orders promulgated thereunder, of all funds held on behalf of customers. Under no circumstances shall any portion of customer funds be obligated to a clearing organization, any member of a contract market, a futures commission merchant, or any depository except to purchase, margin, guarantee, secure, transfer, adjust or settle trades, contracts or commodity option transactions of commodity or option customers. No person, including any clearing organization or any depository, that has received customer funds for deposit in a segregated account, as provided in this section, may hold, dispose of, or use any such funds as belonging to any person other than the option or commodity customers of the futures commission merchant which deposited such funds.
(b) All customer funds received by a clearing organization from a member of the clearing organization to purchase, margin, guarantee, secure or settle the trades, contracts or commodity options of the clearing member's commodity or option customers and all money accruing to such commodity or option customers as the result of trades, contracts or commodity options so carried shall be separately accounted for and segregated as belonging to such commodity or option customers, and a clearing organization shall not hold, use or dispose of such customer funds except as belonging to such commodity or option customers. Such customer funds when deposited in a bank or trust company shall be deposited under an account name which clearly shows that they are the customer funds of the commodity or option customers of clearing members, segregated as required by the Act and these regulations. The clearing organization shall obtain and retain in its files for the period provided by §1.31 an acknowledgment from such bank or trust company that it was informed that the customer funds deposited therein are those of commodity or option customers of its clearing members and are being held in accordance with the provisions of the Act and these regulations.
(c) Each futures commission merchant shall treat and deal with the customer funds of a commodity customer or of an option customer as belonging to such commodity or option customer. All customer funds shall be separately accounted for, and shall not be commingled with the money, securities or property of a futures commission merchant or of any other person, or be used to secure or guarantee the trades, contracts or commodity options, or to secure or extend the credit, of any person other than the one for whom the same are held: Provided, however, That customer funds treated as belonging to the commodity or option customers of a futures commission merchant may for convenience be commingled and deposited in the same account or accounts with any bank or trust company, with another person registered as a futures commission merchant, or with a clearing organization, and that such share thereof as in the normal course of business is necessary to purchase, margin, guarantee, secure, transfer, adjust, or settle the trades, contracts or commodity options of such commodity or option customers or resulting market positions, with the clearing organization or with any other person registered as a futures commission merchant, may be withdrawn and applied to such purposes, including the payment of premiums to option grantors, commissions, brokerage, interest, taxes, storage and other fees and charges, lawfully accruing in connection with such trades, contracts or commodity options: Provided, further, That customer funds may be invested in instruments described in §1.25. [7]

Section 4d(a)(2) of the Commodity Exchange Act also states that customer funds must not be commingled with funds of the FCM nor ever be used by an FCM for any purpose such as margining other customer accounts or that of the FCM itself.

Section 4d(a)(2) of the CEA and related Commission regulations require that, among other things, all funds deposited with an FCM to purchase, margin, guarantee, or secure futures or commodity options transactions and all accruals thereon, be accounted for separately by the FCM and deposited under an account name that clearly identifies
them as such, not be commingled with the FCM's own funds, and be held for the benefit of customers.\4\ The segregation requirements are intended to prevent an FCM from using customer property to margin the trades of other customers or of the FCM itself. Further, the Division has interpreted the segregation requirements to preclude any
impediments or restrictions on the FCM's ability to obtain the immediate access to customer funds. The immediate and unfettered access requirement avoids potential delay or interruption in securing required margin payments that, in times of significant market disruption or otherwise, could magnify the impact of such market disruption and impair the liquidity of other FCMs and clearinghouses. [8]

The stage was set for MF Global on February 3, 2005, when the CFTC published proposed amendments to its Rule 1.25, which governed what types of investments an FCM may make of customer segregated funds. Before 2000, FCMs and designated clearing organizations ("DCOs") were only permitted to invest in United States debt (including municipal and state debt).

CFTC Rule 1.23 allows FCMs and DCOs to collect interest in the customer-segregated funds they hold.[9]

The provision in section 4d(a)(2) of the Act and the provision in §1.20(c), which prohibit the commingling of customer funds with the funds of a futures commission merchant, shall not be construed to prevent a futures commission merchant from having a residual financial interest in the customer funds, segregated as required by the Act and the rules in this part and set apart for the benefit of commodity or option customers; nor shall such provisions be construed to prevent a futures commission merchant from adding to such segregated customer funds such amount or amounts of money, from its own funds or unencumbered securities from its own inventory, of the type set forth in §1.25, as it may deem necessary to ensure any and all commodity or option customers' accounts from becoming undersegregated at any time. The books and records of a futures commission merchant shall at all times accurately reflect its interest in the segregated funds. A futures commission merchant may draw upon such segregated funds to its own order, to the extent of its actual interest therein, including the withdrawal of securities held in segregated safekeeping accounts held by a bank, trust company, contract market clearing organization or other futures commission merchant. Such withdrawal shall not result in the funds of one commodity and/or option customer being used to purchase, margin or carry the trades, contracts or commodity options, or extend the credit of any other commodity customer, option customer or other person. [10]

On May 17, 2005, the CFTC published final rules that further amended Rule 1.25 to allow for the practice of FCMs using repurchase agreements called "repos" with customer funds. A repo is simple the sale of a security (typically a government debt) tied to an agreement to buy the securities back later. A reverse-repo is the purchase of a security tied to an agreement to sell back later. Repos are essentially loans secured against a security. The interest rate received is called the repo rate. The party that sells a security agreeing to buy it back in the future at a higher price later is engaging in a repurchase agreement. The party that agrees to buy the security and sell it back in the future is engaging in a reverse repo.

The use of repos by MF Global would have permitted the firm to leverage customer deposits, although it is unknown that they did. However, leverage of 30:1 or greater, through the use of repos would have resulted in larger losses if the repos were in sovereign European debt.

CFTC Rule 1.25 governs the investment of customer funds by an FCM.

(a) Permitted investments. (1) Subject to the terms and conditions set forth in this section, a futures commission merchant or a derivatives clearing organization may invest customer money in the following instruments (permitted investments):
(i) Obligations of the United States and obligations fully guaranteed as to principal and interest by the United States (U.S. government securities);
(ii) General obligations of any State or of any political subdivision thereof (municipal securities);
(iii) General obligations issued by any enterprise sponsored by the United States (government sponsored enterprise securities);
(iv) Certificates of deposit issued by a bank (certificates of deposit) as defined in section 3(a)(6) of the Securities Exchange Act of 1934, or a domestic branch of a foreign bank that carries deposits insured by the Federal Deposit Insurance Corporation;
(v) Commercial paper;
(vi) Corporate notes or bonds;
(vii) General obligations of a sovereign nation [emphasis added]; and
(viii) Interests in money market mutual funds.
[11]

CFTC Rule 1.32 specifies how FCMs are required to compute the value of customer segregated accounts on a daily basis.

(a) Each futures commission merchant must compute as of the close of each business day, on a currency-by-currency basis:
(1) The total amount of customer funds on deposit in segregated accounts on behalf of commodity and option customers;
(2) the amount of such customer funds required by the Act and these regulations to be on deposit in segregated accounts on behalf of such commodity and option customers; and
(3) the amount of the futures commission merchant's residual interest in such customer funds.
(b) In computing the amount of funds required to be in segregated accounts, a futures commission merchant may offset any net deficit in a particular customer's account against the current market value of readily marketable securities, less applicable percentage deductions ( i.e., "securities haircuts") as set forth in Rule 15c3-1(c)(2)(vi) of the Securities and Exchange Commission (17 CFR 241.15c3-1(c)(2)(vi)), held for the same customer's account. The futures commission merchant must maintain a security interest in the securities, including a written authorization to liquidate the securities at the futures commission merchant's discretion, and must segregate the securities in a safekeeping account with a bank, trust company, clearing organization of a contract market, or another futures commission merchant. For purposes of this section, a security will be considered readily marketable if it is traded on a "ready market" as defined in Rule 15c3-1(c)(11)(i) of the Securities and Exchange Commission (17 CFR 240.15c3-1(c)(11)(i)).
(c) The daily computations required by this section must be completed by the futures commission merchant prior to noon on the next business day and must be kept, together with all supporting data, in accordance with the requirements of §1.31. [12]

CFTC Rule 30.7 covers the treatment of foreign futures or foreign options and the investment of customer funds in foreign instruments.

(a) Except as provided in this section, a futures commission merchant must maintain in a separate account or accounts money, securities and property in an amount at least sufficient to cover or satisfy all of its current obligations to foreign futures or foreign options customers denominated as the foreign futures or foreign options secured amount. Such money, securities and property may not be commingled with the money, securities or property of such futures commission merchant, with any proprietary account of such futures commission merchant, or used to secure or guarantee the obligations of, or extend credit to, such futures commission merchant or any proprietary account of such futures commission merchant.
(b) A futures commission merchant may deposit together with the secured amount required to be on deposit in the separate account or accounts referred to in paragraph (a) of this section money, securities or property held for or on behalf of other customers of the futures commission merchant for the purpose of entering into foreign futures or foreign options transactions. In such a case, the amount that must be deposited in such separate account or accounts must be no less than the greater of (1) the foreign futures and foreign options secured amount plus the amount that would be required to be on deposit if all such customers were foreign futures or foreign options customers under this part 30, or (2) the foreign futures or foreign options secured amount plus the amount required to be held in a separate account or accounts for or on behalf of customers pursuant to any law, or rule, regulation or order thereunder, or any rule of any self-regulatory organization authorized thereunder, in the jurisdiction in which the depository or the customer, as appropriate, is located.
(c) (1) The separate account or accounts referred to in paragraph (a) of this section must be maintained under an account name that clearly identifies them as such, with any of the following depositories:
(i) A bank or trust company located in the United States;
(ii) A bank or trust company located outside the United States:
(A) That has in excess of $1 billion of regulatory capital; or
(B) Whose commercial paper or long-term debt instrument or, if a part of a holding company system, its holding company's commercial paper or long-term debt instrument, is rated in one of the two highest rating categories by at least one nationally recognized statistical rating organization; or
(C) As designated;
(iii) A futures commission merchant registered as such with the Commission;
(iv) A derivatives clearing organization;
(v) A member of any foreign board of trade; or
(vi) Such member or clearing organization's designated depositories.
(2) Each futures commission merchant must obtain and retain in its files for the period provided in §1.31 of this chapter an acknowledgment from such depository that it was informed that such money, securities or property are held for or on behalf of foreign futures and foreign options customers and are being held in accordance with the provisions of these regulations.
(d) In no event may money, securities or property representing the foreign futures or foreign options secured amount be held or commingled and deposited with customer funds in the same account or accounts required to be separately accounted for and segregated pursuant to section 4d of the Act and the regulations thereunder.
(e) Each futures commission merchant which invests money, securities or property on behalf of foreign futures or foreign options customers shall keep a record showing the following:
(1) The date on which such investments were made;
(2) The name of the person through whom such investments were made;
(3) The amount of money so invested;
(4) A description of the obligations in which such investments were made;
(5) The identity of the depositories or other places where such obligations are maintained;
(6) The date on which such investments were liquidated or otherwise disposed of and the amount of money received of such disposition, if any; and
(7) The name of the person to or through whom such investments were disposed of.
(f) Each futures commission merchant must compute as of the close of each business day:
(1) The total amount of money, securities and property on deposit in separate account(s) in accordance with this section;
(2) The total amount of money, securities and property required to be on deposit in separate account(s) in accordance with this section; and
(3) The amount of the futures commission merchant's residual interest in money, securities and property on deposit in separate account(s) in accordance with this section. Such computations must be completed prior to noon on the next business day and must be kept, together with all supporting data, in accordance with the requirements of §1.31.[13]

Rule 1.25 was amended in 2005 in part because of lobbying by the FCMs, including ironically support from MF Global's current General Counsel.

The principal changes to Rule 1.25 that would have likely affected, or one should say enabled the fall of MF Global involved reverse repos, transactions within FCM that are also broker-dealers ("BDs") and possibly the elimination that investment in money market funds carry the highest credit rating.

Before 2005, CFTC Rule 1.25(b)(4)(iii) imposed concentration limits as to both the issuer and the counterparty in reverse repos, which limits are different from the concentration limits on direct investments. After 2005, the concentration limits would apply to all investments in securities, whether obtained pursuant to direct investment or pursuant to reverse repos.

After 2005, FCMs that are also broker-dealers were allowed to engage in-house transactions involving the simultaneous exchange of customer cash or customer-deposited securities for securities held by the FCM also in its capacity as a broker dealer. What this means is that an FCM can seemingly do both a repo and reverse repo at once-taking both sides. FCMs acting also as BDs would enable the exchanging of securities for a customer so that what is not acceptable as margin at a specific clearing firm would be exchanged by the FCM for another security that would be acceptable.

Another revision of CFTC Rule 1.25(b)(2)(i)(E) eliminated the requirement that FCMs and DCOs that invested customer funds in Money Market Mutual Funds ("MMMFs") invest only in MMMFs that carried the highest ratings by the credit ratings agencies.

Criminal or Civil Liability Contingent on Fraud

The criminal or civil liability, if any, of Corzine and his agents at MF Global, will likely rest on whether customer funds were properly segregated and not commingled with FCM funds, or whether they were converted for use of MF Global. The later situation would involve not just fraud, but also embezzlement-it would constitute a criminal violation of CFTC and SEC rules, et. al. The difference between civil liability and criminal wrong-doing is illustrated by looking at the tale of three FCMs, Refco, Griffin Trading Company and Lee B. Stern & Co.

Refco was once the largest futures brokerage at the CME but will be remembered as possibly the shortest IPO in history. Refco raised and lost over $1billion in investor capital before it went public in August 2005 and bankrupt in October of 2005.

Refco was co-founded by Tom Dittmer and Ray Friedman in 1969. Amid some regulatory scuffles, Dittmer resigned and was replaced by a new CEO, Phillip Bennett.
An internal audit of Refco revealed that Bennett had taken $430 million from Refco's and manipulated Refco's financials to disguise his taking. Refco's accounting firm, Grant Thornton after a complete audit, and all the investment banks that handled the IPO, including Goldman Sachs, and Bank of America Corp., after their due diligence, missed the $430 shortfall. Federal authorities were alerted of the missing funds by Refco's own internal audit. Bennett repaid all of the money but the public had lost faith in the company. Investors sold billions of shares worth of Refco and the resulting liquidity run forced the firm into bankruptcy.

The Justice Department filed criminal charges against Refco principals Phillip R. Bennett, Tone N. Grant, Santo C. Maggio and Robert C. Trosten for fraudulently hiding trading losses of both Refco's and of its customers, and fraudulently manipulating financial statements to secure a leverage buyout of the firm and subsequent IPO.[15] In addition to obtaining guilty pleas and convictions against all of them, the government recovered obtained over $33,000,000 in forfeiture actions against five other Refco officers, including Tom Dittmer. There were also civil suits and a class action.

By contrast, no criminal charges were filed against any of the principles of Griffin Trading Company, a futures commission merchant, that collapsed overnight on December 23, 1998 as a result of the trading losses of one of their customers in London, John Ho Park, lost nearly $10.3 million on December 21 and 22, 1998. Griffin Trading Company was founded by Farrel J. "Tex" Griffin, a former assistant U.S. attorney, and Roger S. Griffin (the two are not related). Some customer funds in segregated accounts were lost in London, but there was no question of criminal liability because customer funds in the United States were segregated and never commingled. Unlike in Refco's case, no one at Griffin committed any fraud.

In the case of Griffin Trading, all customers with money held in the United States did not suffer because their funds were held in segregated customer accounts. Customers of Griffin that had funds in London lost their money because at the time the Securities and Futures Authority's Client Money Rules ("SFA Rules") did not prohibit the use of one customer's money to cover another customer's losses. Although SFA Client Money Rule 4-55 did require that customer accounts be segregated from the firm's account, there was no prohibition on their being commingled with other customer accounts in one pool. This arrangement is typically called having one omnibus account (segregated but pooled account) as opposed to separate sub-accounts for each customer, as required by law in the United States. As a result, customers sued Griffin Trading in bankruptcy proceedings for money lost in the U.K.[16]

On October 22, 1992, two rogue bond traders at the Chicago Board of Trade ("CBOT") made unauthorized trades (they exceeded their trading limits) and forced the clearing firm Lee B. Stern & Co. to default on a $8.5 margin call to the CBOT's Clearing Corporation. The two rogue traders caused a loss to the FCM that exceeded its net worth by $2 million. Lee Stern made up for the shortfall personally, saved the firm and ensured that no customers lost any money-although his firm did lose its clearing status and was never again a member of the Chicago Board of Trade Clearing Corporation.

In the history of financial futures and FCM, customers have seldom if ever lost money even because of rogue trading by FCM employees or other customers because the FCMs, historically at the immediate behest of the exchange clearing house, have made sure that customers were made whole.

Were this not the historic practice within the futures industry and in theory an FCM's entire customer segregated account pool (segregated and not commingled as it may be) would be jeopardized and placed at risk by the trading of one customer making trades they cannot cover and are too large for the capital reserves of the FCM to cover. To put this in perspective, the futures industry has, other than for the very few examples above, had good risk practices.

What happens with MF Global depends on what happened to the missing money and whether it was segregated also not commingled after the CME's spot audit of October 26, 2011.

Liability of PricewaterhouseCoopers

Some ironies are worse than others. The CFTC has subpoenaed Pricewaterhouse Coopers ("PwC") presumably for any information is may have about Mf Global's missing customer funds. PwC advertises what lessons auditors should have learned from the collapse of Lehman Brothers on their website.[17] PwC gave MF Global an unqualified (clean) audit opinion on May 20, 2011. MF Global's bankruptcy is now considered to be the eighth largest in United States history.

One cannot help but wonder at times what use are auditing firms in terms of catching or preventing large financial crisis...ever? Grant Thornton issued an unqualified audit of Refco before its IPO. Lehman, AIG and a host of other financial titans received unqualified audit opinions preceding their failures and bankruptcies.

Are accounting firms like credit ratings agencies in that it is not in their interest to issue qualified opinions because they would in so doing drive themselves out of business? Or are they like the credit ratings agencies (MF Global was downgraded to junk after it filed for bankruptcy-so the ratings agencies were all over this after the fact), and incapable of understanding the securities and market risks of the firms they are paid to pass judgment over?

In their defense, PwC might have been dealing with a rogue trading situation-perhaps Corzine himself, some late stage commingling and embezzlement of customer funds or perhaps just over-leveraged positions in European sovereign debt that coincidentally took a dramatic turn for the worse (they did in fact) during the last weeks of October.

Future Regulation Must Rescind Changes to Rule 1.25

The risk free rate of return is the yield on 30 day United States T-bills. Had MF Global been prohibited from investing customer funds in sovereign European debt or using internal repos (assuming they have done either or both), then their customers' money would be inarguably safer at all times. Customer segregated funds held in T-bills or other United States debt instruments are safer than they would be invested in anything else. The CFTC must amend all the changes to Rule 1.25 that went into affect on 2004 and 2005, including the permission to invest in foreign sovereign debt that became law in 2000.

Regulating What Cannot Be So

The CME is MF Global's "primary regulator." Many argue that it is the exchange's role to have better policed MF Global. However, to impose this burden on the CME is not necessary because it is the CFTC that proposed and finalized all the rules to allow for an FCM's investment of customer funds by the use of repos and in a foreign sovereign debt.

No one has a greater interest in avoiding events like Corzine's MF Global than the CME. To be fair, the exchanges have historically maintained a stellar track record as self-regulatory organizations that police their member firms, whether clearing members or non-clearing member firms. The case of MF Global is of monumental significance to the entire futures industry because it may tragically portray the investment of public funds in the futures markets as somehow unsafe and unprotected.

Regulation can never rule out the rogue actor or sociopath. Whatever costs Corzine was determined to incur upon the world in his quest to self-glorification by making a 230 year firm, a proprietary trading desk, the world must take solace in one simple fact-there are not that many Corzines.

A wholesale revision of the futures regulatory regime would be unfortunate and ineffective because no regulatory regime or social science model can account for the irrational or mad actor-nor must it ever try.@
R. Tamara de Silva
Chicago, Illinois

R. Tamara de Silva is a securities lawyer and independent trader

Any questions about this article should be directed to tamara@desilvalawoffices.com
Footnotes:
1. Unless Corzine or his agents deliberately stole this money out of customer accounts, which no one not even the CME has either confirmed or denied.
2. The fact that European sovereign debt was reaching crisis levels began to be apparent to most of the world in 2009 and MF Global's 40:1 leverage and exposure to it should have signaled a red alert to its auditor PwC...but strangely did not seem in any way troublesome to PwC-certainly not worthy of actually pointing out or giving a qualified opinion!
3. http://cmegroup.mediaroom.com/index.php?s=43&item=3202&pagetemplate=article
4. http://online.wsj.com/article/SB10001424052970204394804577012061970129588.html?mod=googlenews_wsj

5. Please see discussion of Griffin Trading Company and Refco cases
6. It is important to remember that SIPC protection does not apply in cases involving fraud or rogue trading like with Barring Bank's Nick Leesen. Were SIPC in play with MF Global, it would not cover losses causes by any fraud or malfeasance on the part of MF Global-were any found to have occurred.
7. http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=de913862c8633d27e5dbb751f541f29e&rgn=div8&view=text&node=17:1.0.1.1.1.0.4.15&idno=17
8. http://www.cftc.gov/foia/fedreg05/foi050202a.htm
9. It is important to keep in mind that the yield received by the FCMs and DCOs investment of customer segregated funds has historically been a large profit center for them.
10. http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=1e218e6499b67aee6c250eae86e59bf9&rgn=div8&view=text&node=17:1.0.1.1.1.0.4.18&idno=17
11. http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=de913862c8633d27e5dbb751f541f29e&rgn=div8&view=text&node=17:1.0.1.1.1.0.4.20&idno=17
12. http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=1a1599ee01c68b489e7394311a832812&rgn=div8&view=text&node=17:1.0.1.1.1.0.5.27&idno=17
13. http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=541c9995ee3b4f389cf3273d6aec19f4&rgn=div8&view=text&node=17:1.0.1.1.21.0.7.7&idno=17
14. http://mobile.bloomberg.com/news/2011-11-16/tiny-rule-change-was-at-the-heart-of-mf-global-s-failure-william-d-cohan
15. United States v. Bennett, 485 F.Supp.2d 508 (2007)
16. In re Griffin Trading Co., 245 BR 291 (2000)
17. http://www.pwc.com/jg/en/events/Lessons-learned-for-the-survivors.pdf

Insider Trading Charges Against Goldman's Rajat Gupta
By R Tamara de Silva
October 26, 2011

Yesterday Rajat K. Gupta, a Senior Partner Emeritus and Managing Director of McKinsey & Co. and Board Member of Goldman Sachs Group, Inc., was indicted on criminal charges of insider trading.[ 1] Mr. Gupta is alleged to have provided Raj Rajaratnam, the founder of one of the largest hedge funds in history, Galleon Group inside information from which Rajaratnam profited[2 ]. Mr. Gupta will likely be prosecuted by the same U.S. Attorney, Preet Bharara, who obtained a conviction and eleven year sentence (the longest sentence ever dealt on the charge of insider trading) against Raj Rajaratnam.

Mr. Gupta's arrest comes on the heels of what has been an over four year investigation of alleged insider trading on Wall Street. The principal focus of the government's investigation has been on whether information was passed along by analysts and consultants of companies that provide "expert network" analysis to hedge funds and mutual funds. Expert network companies arranged for meetings and calls with executives from hundreds of companies and then shared this information with traders at hedge funds and mutual funds.

The activities of expert network firms came to be discovered by the Securities and Exchange Commission ("SEC") by analysis of the performance results of hedge funds and mutual funds. Funds that performed much better than other funds were scrutinized and essentially targeted for wiretap and surveillance. Historically the SEC has found inside trades by looking at the ticker tape (in addition to volume and unusual options activity) before and after the release of inside information.[ 3]

Even a superficial definition of terms is necessary. Insider trading is a legal term that encompasses both legal and illegal conduct. Legal insider trading occurs when corporate insiders, defined as officers, directors, and employees, buy and sell stock in their own companies. There are times when corporate insiders are prohibited from buying or selling stocks or making options plays in their own companies. Illegal insider trading generally encompasses "the buying or selling of a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security."[ 4 ]

Illegal insider trading also encompasses the "tipping" of information obtained by virtue of a tipper's fiduciary duty, employment of relationship of trust and confidence to any third party "tippee," who trades in the markets using or influenced by this information.

There is a significant amount of ambiguity and fluidity in the definition of who is an "insider," who may become a "constructive insider," what trading "on the basis of" information means, and what information, classified as property is truly "inside information." Some of the terms used in the SEC's Rule 10b-5[ 5], which governs insider trading, are determined in their breach as much as in their observance. Many terms in Rule 10b-5 are subject to the roving interpretations of the judiciary based upon the unique fact patterns of the cases for insider trading that reach trial. The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. Efforts to more precisely describe what is and what is not insider trading have been opposed by the SEC for fear that proscribing the precise conduct of Rule 10b-5 too precisely would narrow the powers of the SEC.

Congress and the SEC have extended the prohibition against trading on unequal and inside information to include of certain types of "outside" information-information about takeovers pursued by third parties-wherein there is no insider or fiduciary relationship [6 ].

In the case of Gupta, if the alleged conduct is proven to be true and the prosecution has actual proof of the information alleged exchanged in Mr. Gupta's indictment, then it fits within the unambiguous gambit of Rule 10b-5. This would be the archetypical case of insider trading. The indictment (11 CR 907), alleges among other charges, two clear examples of insider trading:

1) In September 2008, the indictment alleges that 16-20 seconds after leaving a board meeting at Goldman wherein it was discussed that Warren Buffet would buy $5 billion of preferred shares in Goldman (at the time an extremely valuable infusion to Goldman especially given its exposure to AIG), Mr. Gupta called Rajaratnam. Rajaratnam and Galleon Tech Funds began purchasing Goldman stock immediately, which it turned around and sold after the announcement became public for a profit of $840,000 and avoided a loss of several millions of dollars;
2) On January 29, 2009, the day before Proctor and Gamble was to report its quarterly earnings, Mr. Gupta exited a board meeting at P&G wherein the earnings were revealed to be coming out below the guidance P&G had given to analysts, and conveyed this inarguably inside information to Rajaratnam. Rajaratnam immediately began shorting approximately 180,000 shares of P&G.

As in the case of Mr. Gupta, what is described in his indictment is the disclosure by an insider (board member) of unambiguous inside information. However, if the evidence of Mr. Gupta's were not based upon actual wiretap recordings (if the prosecution had no recordings of Mr. Gupta actually conveying this information) but merely on the alleged hearsay conversations between a convicted Rajaratnam, while trying to get a reduced sentence, then the case itself becomes extremely tenuous and the evidence ambiguous.

In other cases, the problem becomes defining what is inside information and what is excellent hard won research-a problem exacerbated by the ambiguities in the definitions of the building block terms that go into what constitutes Rule 10b-5's definition of "inside information." Being privy to a board meeting to discuss earnings before they are released to the public or learning about a merger through a confidential email or conversation easily constitutes inside information. An insider's disclosure of clearly inside information would violate the fiduciary duties that corporate board member and managers, as agents, owe to their principals-the ultimate principal being the shareholders.

However, hiring researchers to park next to a Federal Express shipping station and daily tally the number of shipments loaded on the trucks over time to forecast seasonal shipping performance, is by way of an example, gumshoe research that may be proprietary and hard won, but is it ever inside information? What if a hedge fund routinely employed these tactics and achieved results far superior to other funds. Assuming there are 8,000 hedge funds in the United States each trying to out guess the performance of public companies and taking a bet on whisper numbers, no one in theory has an edge aside from inside information. Unless, certain funds simply had superior information through the most aggressive research. A fund that outperformed its competitors enough would likely draw attention from the SEC, but would this fund's use of research be inside information? To some degree the work of expert networks illustrates the problems with a roving and malleable definition of insider trading. Mr. Gupta's indictment, taking the alleged facts as true, does not.@

R. Tamara de Silva
October 26, 2011
Chicago, Illinois
Footnotes:
1. The topic of insider is large and discussed thoroughly and much more substantively in my upcoming book on the United States Criminal Justice System.
2. Copy of the indictment can be retrieved here: http://www.securitiesdocket.com/wp-content/uploads/2011/10/Gupta-Rajat-Indictment-Signed-and-Stamped.pdf
3. The exchanges are called self-regulatory organizations (SROs) and have historically been the best regulators and watchdogs of unusual and potentially illegal market activity.
4. http://www.sec.gov/answers/insider.htm
5. 17 C.F.R. § 240.10b-5, promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934.
6. United States v. O'Hagan, 521 U.S. 642 (1997)