Financial Regulatory Forum

Fast-moving MF Global case offers early lessons for compliance

By Guest Contributor
November 4, 2011

By Emmanuel Olaoye

NEW YORK (Thomson Reuters Accelus) – Charges that hundreds of millions of dollars are missing from the accounts of MF Global’s clients raise the question of whether powerful executives at the firm influenced the independence of internal auditors as the futures brokerage scrambled for survival.

MF Global, which collapsed over risky trades on European debt, faces a shortfall of $633 million in customer funds, the CME Group Inc. has estimated.

The CME Group said MF Global failed to protect customer accounts by keeping them separate from its own funds. The revelation suggested that the firm commingled client funds with its own funds, violating a central pillar of the segregation rules.

“Segregation of funds must be maintained at all times of every day down to the nanosecond,” said Commodity Futures Trading Commission Chairman Gary Gensler.

The CFTC and the Securities and Exchange Commission are looking into what happened, along with the CME.

The feared shortfall is less than the initial estimate of $950 million, but any shortage is unacceptable, Gensler told Thomson Reuters Thursday, “You don’t put your hand in the cash register. You don’t. It’s the customers money.

Speaking after testifying before the Senate Homeland Security and Governmental Affairs Committee permanent subcommittee on investigations, Gensler said that of all the problems CFTC investigators run into at regulated firms, segregated fund issues are rare.

But enforcement actions show they are not unknown even among reputedly well-run firms. For example, the CFTC in September 2009 fined JP Morgan Futures for failing to segregate customer funds properly and failing to report the under-segregation in a timely fashion, and the Financial Services Authority in May 2010 fined a UK unit of the firm for related violations.

IT CAN’T HAPPEN…EXCEPT WHEN IT DOES

Jerry Markham, Florida International University law professor and former CFTC enforcement division chief counsel, said the multiple authorities overseeing account-segregation rules in the United States– the Securities and Exchange Commission for broker-dealers and the CFTC for futures commission merchants – and abroad creates a thicket of obligations for a firm such as MF Global.

“There’s a lot of room for confusion. There’s a lot of room for error or problems that could arise in the segregation process. On the other hand, they could [also] steal the money,” Markham said.

The main way to prevent accidental commingling is through computer systems that can track multiple accounts for each customer and flag segregation problems, Markham said.

Sophisticated systems would also make it difficult for a rogue employee to carry out deliberate commingling, which would probably require complicity with someone in compliance operations because “there are all kinds of controls on these accounts,” Markham said.

Misusing customer accounts was also a factor in the 2005 bankruptcy of commodities and futures broker Refco, whose customers were deemed unsecured creditors because their accounts had not been segregated.

Several Refco executives went to federal prison for fraud, and the company was bought by an entity that later became MF Global.

Another similarity between the Refco case and the possible facts at MF Global is that the potential damage to the customer accounts was collateral damage to the underlying transactions, which in both cases were outside each firm’s traditional business.

Refco fraudulently hid a large debt in its initial public offering, which occurred just two months before its collapse, and MF Global was apparently swamped by chief executive Jon Corzine adding investment banking to the firm’s longstanding role as a futures commission merchant.

Enforcements for account misuse have not been common, Markham said. In the 1970s and 1980s there were several cases in which FCMs out of “expedience” would combine customer funds in a joint customer account, then draw on it when a customer could not make a margin call. But those practices have mostly fallen by the wayside, he said.

THE HUMAN ELEMENT

Howard Schilit, founder and chief executive of the Financial Shenanigans Detection Group LLC, said such practices could suggest that the firm’s internal auditors were overruled by senior executives in reporting the violation to the board.

“If you have a very powerful authoritarian senior executive, it could create enormous pressure on the people involved in the internal audit function. The fact that a senior executive would put pressure on the internal auditors to override the normal kinds of controls is not that unusual an event,” Schilit said.

Internal auditors are often in the unusual position of looking for wrongdoing but also having to work with the very people they could get into trouble, so they may face tremendous pressure to be team players even when they are reporting to mid-level managers, Schilit said.

“They are hired by management, they are paid by management but they are really internal spies that are looking for evidence of bad behavior. These people know that they are potentially going to turn up evidence of bad behavior and it could be a person they have worked with for the last 25 years,” Schilit said.

WINDOW DRESSING

Schilit said MF Global’s collapse was also interesting because of the CME’s statement that the transfer of funds from customer accounts appeared to occur after a CME audit of the funds last week. The development suggests that the firm may have deliberately transferred funds to avoid detection of wrongdoing, he drew parallels with Lehman’s collapse and its use of a controversial accounting device to hide leverage from regulators.

“When they know nobody is looking, they change their way of calculating [or] reporting on their books,” Schilit said.

 

(Additional reporting by Ted Knutson, Randall Mikkelsen and Stuart Gittleman. Writing by Stuart Gittleman)

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus.  Compliance Complete (http://accelus.thomsonreuters.com/solut ions/regulatory-intelligence/compliance- complete/) provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

 

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