WSJ.com - Behind Big Wall Street Failure: An Unregulated Bermuda Unit

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• Read letters discussing the Bawag transactions: one⁶ | two⁷.

• Refco Creditors Get Clearance to Expand Probe⁸
06/20/06

• Bawag Deal Was Forged With Talks, Bluffs⁹
06/05/06

• Bawag Close to Settlement Over Refco¹⁰
06/03/06

• Refco Probe Leads to Bermuda¹¹
03/30/06

Offshore Disturbance
Behind Big Wall Street Failure:
An Unregulated Bermuda Unit

At 7:32 in the morning on Oct. 13, Paul Van Dillen tapped out an urgent email to Refco Inc. "Please return $9.9 mm," he instructed the New York-based brokerage firm.

Refco had a reputation for stellar service, but Mr. Van Dillen, an analyst for AQR Capital Management, got the runaround that morning. He traded six more phone calls and emails with Refco over the next four hours in an effort to recoup the millions held in Refco brokerage accounts by the $25 billion hedge-fund manager. Eventually, in a late-morning phone conversation with Refco employees, he got alarming news: Refco had just frozen $4 billion worth of accounts at the Bermuda unit that held his firm's money. (Read the email string¹).

Refco filed for bankruptcy protection four days later, one of the largest and swiftest failures in recent Wall Street history. Refco, one of the world's largest commodities brokerages, was a global trading hub for corporations, government agencies, individual clients and hedge funds. And yet its spectacular collapse came out of nowhere. AQR, based in Greenwich, Conn., is now one of thousands of big and small investors trying to recover about $1.8 billion of assets missing from client accounts.

In recent months, the inside story of Refco's collapse is emerging in federal bankruptcy-court proceedings in lower Manhattan and in related civil and criminal actions. At its center is Refco Capital Markets Ltd. of Hamilton, Bermuda. Court proceedings have uncovered a host of unusual practices by the Bermuda unit that appear to have contributed both to Refco's rapid growth and to its catastrophic fall.

In the U.S., brokerage firms must maintain separate accounts for clients. But at Refco's unregulated Bermuda unit, client and company money was all tossed into a single unsegregated pool, the court proceedings have revealed. Refco routinely used this money for corporate purposes, and the commingled funds flowed freely between the Bermuda entity and New York units and throughout Refco, according to court testimony by employees and clients. Refco Capital Markets also made big loans to customers to finance high-risk investments. When these clients were unable to cover trading losses, the unit helped hide the bad loans, the civil and criminal actions allege.

'THE NATURE OF THE FRAUD'

WSJ reporter Carrick Mollenkamp speaks with Sean Coffey², a lawyer representing Refco investors in a suit against Refco executives, bankers who handled its IPO and auditor Grant Thornton, about the case and what the plaintiffs say happened.

Refco Capital Markets was incorporated in Bermuda as an "exempt" company, which meant it could do business anywhere except Bermuda. In fact, it employed no one at all at its headquarters address in Bermuda. New York-based employees ran the unit. In effect, it was unregulated: Neither Bermudan nor American regulators had any duty to watch over it.

A spokeswoman for the Bermuda Monetary Authority, the nation's financial regulator, says its main role is to protect "retail and unsophisticated" investors. Firms such as Refco Capital Markets, which cater to sophisticated investors, are entitled to exemptions from Bermuda regulation, she says.

On Oct. 10, Refco disclosed that it had made a series of transactions that could have been used to hide bad debts. That sparked a run on the bank led by its clients. Six weeks after a $583 million initial public offering of stock, Refco sought Chapter 11 bankruptcy protection. Refco Capital Markets had only $1.9 billion in client-account assets, although they were supposed to total at least $3.7 billion. Phillip R. Bennett, then chief executive officer, was arrested on Oct. 11 at his home in Gladstone, N.J., on federal fraud charges.

Refco was founded in 1969 as Ray E. Friedman & Co. Mr. Friedman was a Chicago commodities trader who served a 23-month prison stint in the 1950s for selling substandard chickens to the Army during the Korean War. He was later pardoned by President Lyndon B. Johnson and died in 2004.

Initially, Refco was mainly a middleman between farmers and food buyers. Much of its commodities operation involved futures contracts -- agreements to buy or sell a specified amount of goods at a set price on a specific date, which allow buyers and sellers to hedge against price swings and speculators to bet on price moves.

In the 1970s, futures became a huge business. They were used to bet on prices of everything from currencies to U.S. Treasury bonds to precious metals. Under the leadership of Mr. Friedman's stepson, Thomas H. Dittmer, Refco became a big futures broker with a reputation as a tough competitor.

The firm frequently ran afoul of regulators. The Commodity Futures Trading Commission filed nine regulatory actions against Refco, while the Chicago Mercantile Exchange, the Chicago Board of Trade and other futures markets filed 131, according to the National Futures Association, an industry regulatory group.

Leo Melamed, former chairman of the Chicago Mercantile Exchange, says he once encountered Mr. Dittmer at an exchange event shortly after his organization fined Refco. "He told me: 'I made a few million, and you took a few thousand back -- so what?' " Mr. Melamed recalls. "Refco came into the industry as a renegade, and it stayed that way until the day it folded." Mr. Dittmer couldn't be reached for comment.

Mr. Bennett joined the company in 1981 from what was then Chase Manhattan Bank. He became chief financial officer in 1983 and chief executive in 1998. Under his leadership, Refco's operations grew significantly, eventually encompassing about two dozen subsidiaries. Mr. Bennett's lawyer, David Frankel, declined on behalf of his client to comment on Refco or the charges against Mr. Bennett.

In Bermuda, Refco set up a foreign-currency brokerage called Refco FX Associates. That later became part of another new Bermuda entity, Refco Capital Markets, which offered trading in exotic securities such as bonds issued by developing countries in Latin America and Asia as well as Russian stocks and silver futures.

Employees of Refco Securities LLC, a regulated subsidiary based in New York, ran the unregulated Bermuda unit. Customers of Refco Capital Markets ranged from overseas hedge funds run by highly regarded money managers to a baked-goods company in Georgia to a college professor in Iowa. It offered attentive service to all comers.

"You could call one person, and whether you had to buy an equity in the United States or in Korea or in Brazil, that one person could handle the transaction," said Richard Deitz, founder of a Moscow-based hedge-fund firm, VR Capital, during a bankruptcy-court hearing. Mr. Deitz said he and the Refco trader dedicated to his account communicated about trades and markets at least five times a day.

The service "was beautiful," says Peter Catranis of Aliso Viejo, Calif., who oversaw accounts for small investors.

The interest paid to clients on cash in their accounts was often 1.75 percentage points higher than Wall Street brokerages offered, one Refco executive testified in bankruptcy court.

Refco Capital Markets eventually counted more than 3,000 customers world-wide. By 2005, it produced more than half of Refco's pretax profit, according to bankruptcy-court testimony.

Big investors often borrow money from brokerages to invest, pledging securities in their portfolios as collateral. Most brokerages set limits on the emerging-market bonds and stocks they accept as collateral because of the risks associated with them. Refco Capital Markets often didn't set such limits. Thomas Yorke, who ran the Refco Capital Markets financing desk, said in bankruptcy-court testimony that Refco Capital Markets "didn't have any of the U.S. regulatory requirements to adhere to."

Vera Kraker, who ran the desk with him, said in a sworn statement: "We would look at pretty much any security a client would bring into Refco for financing."

Bahamas-based Capital Management Select Fund was able to borrow 50% of the value of its shares of Russian oil giant OAO Lukoil, its manager said in a court statement. Another brokerage, Bear Stearns Cos., wouldn't let it borrow more than 15% of the shares' value, the manager said.

As an "exempt" Bermuda company, Refco Capital Markets wasn't required to keep customers' money distinct from Refco's. Client and company money circulated among various Refco entities. Every day, the Bermuda unit sent money to an affiliated Refco entity, which used the cash to run Refco's varied businesses -- to pay bills, make loans and finance acquisitions, according to bankruptcy-court documents and testimony. And other Refco units ultimately sent funds to Bermuda for Refco Capital Markets to invest. Investigators have traced thousands of money transfers since 2000, with about $20 billion going from Bermuda to other Refco entities and about $18 billion going back.

Refco Capital Markets "had full use of all of the cash invested" with it, "and I am not aware of any restrictions that apply to the use of that cash," said former Refco treasurer Matthew Hreben in a sworn statement filed in bankruptcy court.

Many customers testified they had no idea the firm was using their assets this way. "That is not a business model of which I am familiar with," Mr. Deitz, the Moscow-based hedge-fund manager, said at a bankruptcy-court hearing. "It's something that I think is more in common with three-card monte."

In testimony, Refco executives said documents sent to customers to confirm trades disclosed that Refco had a free hand with client assets. They also said clients should have known that dealing with an unregulated Bermuda firm involved risk. "These are all big boys," Mr. Yorke said in court of the clients. "These aren't widows and orphans."

Much client money was transferred to other Refco entities, testified Todd Brents of AlixPartners LLC, a firm helping unravel Refco's books. Sometimes "there will be a notation in the accounting records that will say transfer $10 million for X," he said. "Other times," he added, "there will be no explanation." He testified he suspected a large transfer last August was used to acquire the brokerage operations of Cargill Investor Services, because it was made on the same day Refco paid $208 million for the rival trading firm. Days earlier, a similar amount had flowed into Refco Capital Markets.

Clients "didn't know that what they thought was a broker was actually acting as a bank for Refco," says New York lawyer Howard Seife, who represents two dozen Refco Capital Markets customers.

The practices that brought Refco down appear to have arisen because some brokerage customers suffered investment losses and were unable to repay loans made by Refco. Some of these bad debts dated to the late 1990s.

In February 2000, Mr. Bennett made an unusual proposal to Bawag P.S.K. Group, an Austrian bank that bought 10% of Refco in 1999. In emails between Mr. Bennett and Bawag executives, the project was referred to as "Cleanup," say people familiar with the matter.

The project was a complex effort to hide hundreds of millions of dollars of bad debts, including loans customers couldn't repay due to trading losses. A private company controlled by Mr. Bennett assumed those bad debts to make Refco's books look better, according to federal prosecutors and Refco creditors.

In order for Refco to mask the transaction from auditors, Mr. Bennett's company engaged in a circular series of money transfers, which took place just before Refco closed its books each financial period. His company borrowed money from Bawag and Bawag borrowed money from Refco Capital Markets, prosecutors and creditors allege. Then, Mr. Bennett paid the money to Refco.

Thus, the bad debt on Refco's books was converted into a standard, collectable loan to Bawag. None of the transactions were visible to investors. Days after the financial period ended, the transactions would be reversed, creditors say, saddling Refco once again with the bad debt. (Read letters discussing the Bawag transactions: one³ | two⁴)

Eventually, these transactions were conducted quarterly and involved both the Austrian bank and a New Jersey hedge fund, Liberty Corner Capital Strategies LLC, Refco creditors allege. Investors in Refco stock and bonds make similar allegations in lawsuits against Refco executives and the company's auditor and underwriters. (Bawag agreed last month to settle criminal and civil claims that it helped carry out the alleged fraud. Liberty Corner has denied knowingly participating in the alleged wrongdoing.)

In early 2004, Thomas H. Lee Partners, a buyout firm, was preparing to acquire a stake in Refco with an eye toward transforming it into a publicly traded company. As part of the deal, Refco was planning a large bond offering, which meant that investors would be scouring its books. Creditors allege that at that time, Refco hid $970 million in debts, including bad debts. Although the Lee buyout firm spent $10 million investigating Refco, it didn't uncover the problem, and the deal went through.

On Aug. 11, 2005, Refco went public. To celebrate, Mr. Bennett rang the opening bell at the New York Stock Exchange. Two weeks after the IPO came another series of debt-hiding transactions with Liberty Corner valued at $420 million, according to the civil complaint by investors.

As Refco closed its books for the period ending August 2005, company bookkeepers noticed an irregularity, a move that forced Mr. Bennett to disclose his role at an Oct. 6 meeting with Refco's audit committee, according to bankruptcy-court testimony and court filings. Four days later, Refco disclosed the transactions relating to the bad debt. Over the next few days, "we had literally hundreds and hundreds of millions go out the door," Mr. Yorke testified.

Among those demanding money was Christopher Sugrue, a former Refco executive who ran a money-management firm called PlusFunds Group Inc. On Oct. 11, he burst into the office of Mr. Hreben, Refco's treasurer, in the company's lower Manhattan headquarters, according to sworn testimony from Mr. Hreben. Mr. Sugrue demanded that $300 million of PlusFunds money be transferred from unregulated Bermuda accounts to regulated U.S. ones in order to protect the funds, according to the sworn statement. "He appeared to be very upset and was shouting," Mr. Hreben said in his statement. Mr. Hreben ordered him out. (Read Mr. Hreben's account.⁵)

The next day, Mr. Sugrue returned to see Ms. Kraker, who helped run the Refco Capital Markets financing desk. "He stood behind me at my station on the trading floor asking repeatedly if the money had been transferred as he had demanded," she said in a sworn statement.

Refco transferred the money, and Mr. Sugrue withdrew it. Others also withdrew their funds, depleting the coffers of Refco Capital Markets. Refco froze the unit's customer accounts and declared bankruptcy. A bankruptcy court later froze the money withdrawn by PlusFunds because under bankruptcy law, all Refco Capital Markets clients have to be treated equally. In an interview earlier this year, Mr. Sugrue said he had every right to recover the money.

Customers of Refco Capital Markets continue to try to recoup their money through bankruptcy court. Refco has sold its regulated futures-brokerage business to a unit of London-based Man Group PLC. Its remaining assets, including some expensive art work, are being sold off piece by piece. Mr. Bennett remains under house arrest. No date has been set for his trial.



	July 3, 2006