Corporate Malfeasance: MF Global - Essay Example

? Corporate Malfeasance: MF Global April 4, Table of Contents Introduction…………………………………………………………………………………… 2 OpinionStatement………………………………………………………………………………2 MF Global’s Fall: Early Misdeeds…………………………………………………….3 Jon Corzine……………………………………………………………………………. 3 The management’s iniquity …………………………………………………………………….5 Regulators Role……………………………………………………………………….7 The End: MF Global’s Collapse………………………………………………………………..8 Last Minute’s Efforts…………………………………………………………………………….9 Legal Analysis…………………………………….…………………………………………….11 Endnotes…………………………………………………………..…………………………….12 1. Introduction MF Global, a future and options broker, filed for bankruptcy protection on 31 October 2011, marking an end to its frantic effort to stay afloat, and signaling the end of a giant company whose bankruptcy became the eighth-largest in the history of U.S.i The company sank under a trail of impropriety, illegality and shady dealings that were so oily, that the FBI, regulators and a myriad of other investigators were sucked into the investigation.ii Allegation of financial malfeasance followed immediately the bankruptcy was filed, with claims of missing client funds, with a cash shortfall as high as $700 million in the client account. The regulators are on record saying that the company had broken a cardinal rule that forbids companies from mixing client money with its own. 2. Opinion Statement 2.1. MF Global’s fall: Early misdeeds MF Global’s woes can be attributed to its leadership. The management, led by the CEO Jon Corzine made a series of investment that were highly risky, without undertaking measures to mitigate the risks. Therefore, the beginning of MF Global’s woes can traced to the day Jon Corzine was appointed its CEO. At the time of his appointment in March 23, 2010, the company was worth less than $ 1.5 billion, and therefore brought in somebody who would help it to rejuvenate. The company used to make money through the commission it received from its customers, and also by investing its customer’s deposits and pocketing the interest. Upon his appointment as the CEO, Corzine embarked aggressively on a European strategy whereby he invested heavily in sovereign debts of countries such as Portugal, Italy, Ireland and Spain, which were then thought to be super-safe.iii However, these debts were riddled with a lot of uncertainty, uncertainty that made their yields to exceed that of the U.S treasuries. 2.2. Jon Corzine. Perhaps the greatest mistake by MF Global was the appointment of Jon Corzine as its CEO. According to a postmortem report by the bankruptcy trustee, he deserved much of the blame for the firm’s demise, with the report mentioning his name adversely 284 times, with a conclusion that he had led the management into a negligent running of the business.iv He was an over ambitious man, former governor and senator of New Jersey. Corzine literally ran the company alone, making all the decisions on matters affecting the company contrary to the cooperate governance requirements. For instance, he assumed the role of the CEO and head trader, which was contrary to canons of risk management that requires that the two posts should be separated. He was not contented in remaining in the office and make executive decisions only, and most of the time he was on the trading floor directing things. He is said to even leave meetings in the middle to rush and see the prevailing prices in the market floor. To add, he was the greatest proponents of the European sovereign bonds and convinced everyone who cared to listen that they were super safe. He did not go down well with people who were not content with both the accounting treatment and the European sovereign debts. He had overruled the Chief risk officer on several occasions, and casted the image of an authoritarian figure.v As a result, risk management was left in the hands of an individual who was overly optimistic, leading to a serious lapse in the internal control system. He was over ambitious to turn MF global around, into a financial giant, and as a result he took excessive risks, while remaining over confident that the risk would not materialize. Pursuant to corporate governance requirements, somebody independent should have undertaken risk management. Corzine however did not condone independent people, who he viewed as obstacles and therefore, he replaced independent CROs with ‘yes people’. vi Some financial analysts argue that he had an ego too large for companies the type of MF Global. He had the mentality of a CEO of a giant financial firm. He therefore inculcated the culture of excessive risk taking into MF global. He easily manipulated the board, such that the board in most instances adopted his ideas, without taking into considerations the input of other stakeholders. He had once threatened to quit as result of being second guessed by the board. 3. The management’s iniquity Several misdeeds on the part of the company precipitated its eventual downfall. The first one was with regards to its treatment of Repo-to-maturity transactions.vii This occurred during the 2010 financial year, whereby MF Global started investing significant amounts in European sovereign debts, which were financed through an instrument they called the Repo-to-maturity (RTM). RTM approach was a clever invention by Corzine whereby the firm would finance the investment in the bonds by use of a lender that would charge interest to the firm. RTMs are supposed to be treated as and accounted for as borrowings, whereas the assets that is employed as collateral is supposed to be disclosed in the balance sheet. However, MF Global treated these RTMs as sales contrary to the U.S accounting rules, therefore letting the firms to remove the asset that it had pledges as collateral from the balance sheet, while at the same time maintaining the exposure to the creditworthiness of the bond issuers. They initially proved profitable to the company. The company placed its first European RTM trades in late 2010, investing about $ 1 Billion in bonds issued by Italy, Ireland, Portugal and Spain. The bet had a maturity period of an average of less than one year. As a result, MF Global reported around $783,000 in profits, the first after a 5 straight year losing streak. Intent to remain profitable, the company tripled the investment to $3.5 Billion and the trend went on and on, such that by the time of the Euro zone crisis, the company had invested over $6 billion. In essence, MF Global acted as a seller, who received the total return on the reference asset, of which it did not own, but rather was subject to price and default risk in an off balance sheet transaction, being synthetically long the assets and their attendant risks.viii Normally, in such a scenario, the underlying asset is required to be liquid, or easily tradable to raise cash. However, the European sovereign debts failed to satisfy this requirement.ix It subsequently became liable to default and liquidity crisis. Despite the fact that no European country had actually defaulted on the debts, the perception became a reality as the creditors to the firm feared for their own welfare. Consequently, in an effort to meet its commitments, MF Global utilized their customers’ funds that should have been actually segregated in customer account. Under Corzine stewardship, the company discovered means of twisting the accounting rules. This enabled him to find ways to legitimize the shady dealings that the company was engaged in. for instance, he made it possible to purchase a sovereign debt, using a loan that was secured by the asset. The company derived profits from the difference between the interest rates it was earning from the debt and the rate that it was paying its ‘creditors’. The company manipulated accounting rules such that they could book the prospective earning immediately, whereas their corresponding loans and the investment were not disclosed in the balance sheet. Secondly, another factor that led to the collapse of the company can be attributed to Corzine’s resolution to increase the bank’s leverage. At the time when he was appointed, the Bank had an asset base of over $40 billion in net worth, and equity of over $3 billion, which was a ratio of 13 to 1. By 2011, however, the same $40 billion was propped up by equity of only $ 1billion, which translated to a ratio of 40 to 1. xAs results, some customers left and those who stayed behind started demanding for more collateral from the bank. To satisfy this new demand, and maintain its clientele, MF Global employed all the credit lines open to it and as a result, its financial woes worsened, finally it opted to divert its own clients’ money, thereby breaking the rule against the use of the client’s funds. 3.1. Regulators Role MF Global shoddy dealings had not been detected even by a single regulator, despite the fact that it was dually registered with CFTC as a future commission merchant, and with SEC as a broker cum dealer.xi Subsequently, the regulators upon getting to know these factors ordered the company to institute remedial measures without delay. As a result of the regulators resolutions, MF Global reported a consequent loss of $ 192 Million for the 3 months ending 30th September 2011. This poor performance negatively impacted on the company’s stocks, with the stock price plummeting downwards by over 50%. This was closely followed by a downgrade by the credit rating agencies, which elicited negative publicity and eventually culminated in its liquidation. Consequently, the regulators lapse in discharging their mandate contributed to MF Global’s downfall. Nevertheless, the lapse in regulator’s oversight can be attributed to regulations that had been watered down over time. Originally, the Commodities Exchange Act of 1936 had strict requirements with regards to the treatment of the customer’s assets. It required that customers’ assets be segregated from the firms’ assets so that customers could always get their money, regardless of the financial position of a firm, and what happened to it.xii The firms were allowed to invest the customer’s assets only in safest investments such as the US treasuries. The rules were however amended, which paved way for fraud witnessed in firms like MF Global. For instance, in 2000 changes were made to allow the likes of MF Global to invest not just in US treasuries but also in sovereign debts, because the sovereign debts were then thought to be super safe. Subsequently in 2005, changes in the regulations made it possible for firms such as MF Global to lend themselves their customers’ cash, while securing the loan using an asset, for example the sovereign debts, all without the customers knowledge or consent. As a result therefore, these changes made it possible for MF Global to, by exploiting accounting rules, book the earnings that might not exist, while at the same time removing the risk from the balance sheet despite the fact that it was looming large. 4. The End: MF Global’s Collapse When MF Global finally disclosed the extent to which it had bet on European sovereign bonds, its investors and customers freaked out. As a result, they began to flee, worried alarmed by the firm’s massive bet on the sovereign debt. As result, there was massive withdrawal of the customers’ funds, which catapulted the company into a massive liquidity crisis that led to the eventual bankruptcy of the company. Apparently, the company management had failed in another critical area of risk mitigation, whereby if they had foreseen the impact of lack of investor confidence, they would have hedged the company against liquidity risks. After the regulator, FINRA, realized the status of MF Global in the spring of 2011, it concluded that the company ought to inject more capital in order to protect itself, as it had not set anything aside to protect itself against the risk posed by the sovereign bonds, treating them risk free like the US treasury bills. FINRA ordered MF Global to set aside an extra $255 million, and in addition to file a public notice of a regulatory capital deficiency, which MF Global did on august 25. In addition, the executives were also a worried lot, because of the prevailing circumstances in terms of profitability; it was clear that something needed to be done. With the firm about to announce its results, the management of MF Global was involved in a series of meetings with credit rating agencies in order to mitigate the results of their announcement of the looming negative results. Moody was however adamant and soon announced intentions to announce a downgrade, on October 20th, prompting MF Global executives into a desperate attempts to avoid a downgrade. They were involved in a series of meeting to arrest the impending doom. 5. Last Minute’s Efforts They resolved to sell assets in order to free up cash while retaining an investment banker to explore the possibility of the sale of either part or the entire firm. Subsequently, the firm was involved in desperate selling of all its assets in order to free up cash. As the time went on, the firm accelerated the sale, incurring losses in the process. However, selling the European bonds proved complex and complicated as it involved over 22 bonds in over 6 countries, acquired in over 86 separate transactions. According to the consulting arm, it would take at least 5 days to offload the bond, with a cost estimated to be as high as $280 Million. What followed was a week of desperation for MF Global, with huge figures flying around. Finally, 2 credit rating firms downgraded it to a junk status. As a results, the regulators descended to the firm, it an attempt to seek answers. Only a sale could save the firm. By the end of the week, out of all the prospective buyers, only one was remaining; Interactive Brokers. However, this deal fell through and the board had no otherwise but to file for bankruptcy protection.xiii The company sank with over $ 1.2Billion in customers assets. It affected not only institutional investors, but also individual investors such as farmers, ranchers and financial advisors, who had sought to diversify portfolios as well as hedge risks.xiv The worst affected group was however the shareholders who, after the payment of all the liabilities accruing, nothing would remain for the shareholders to take home and recover some of their losses. This was because the firm went under owing several creditors a huge sum of money, and under the bankruptcy laws, the creditors are ranked before the shareholders, who are literally the last group to share in whatever remains in the company. Consequently, there have been calls for the prosecution of Corzine and other top officials for the role they played in the fall of the company. The justice department has preferred several civil and criminal options against them, with some of its former customers demanding the appointment of a special prosecutor.xv MF Global’s misdeeds came to haunt it in its last minutes frantic effort to survive, and to salvage the firm. The management attempts to sell its customers’ accounts to another firm, Interactive brokers fell through.xvi The latter was to advance $800 Million to MF Global, to enable it to reorganize. Had this deal succeeded, customers would not have discovered that anything was amiss. Nevertheless, the deal, which was at an advanced stage, fell through when the unexplained shortfall in the customer’s funds was discovered, prompting Interactive Brokers to withdraw. 6. Legal Analysis MF global leadership failed to observe various rules and legal provisions, and regulatory rules that are have been set aside by various regulators, to wit, the requirements for disclosure, sanctity of customers’ funds, failure to observe accounting rules and standards. Nevertheless, the failure to segregate the customers funds were its main undoing, and the greatest of them all. In the business MF Global was engaged in, it was paramount that it would protect its customers’ funds, such that in times of bankruptcy like it underwent, the customer’s funds remained protected. This is normally a key rule, which is supreme. 7. ENDNOTES Read More