November 2011 Archives

Judge Rakoff Rejects SEC Settlement Agreement with Citigroup

November 29, 2011
Judge Rakoff Rejects SEC Settlement Agreement with Citigroup

By R. Tamara de Silva

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
e. pp. 8-9


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

.pp 14-15.


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

MF Global's Missing Customer Funds and Its Implications on the Futures Industry

November 28, 2011
MF Global's Missing Customer Funds and Its Implications on the Futures Industry

By R. Tamara de Silva

November 28, 2011


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