By R. Tamara de Silva
December 19, 2011
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.  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) , 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. 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
December 19, 2011
R. Tamara de Silva is a securities lawyer and independent trader
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.