Rapid Decline: Refco Starts to Unwind A Major Business

Refco, Its Ex-CEO Charged, Could Still Be Rescued As Regulators Push for Aid - No Broad Market Risk So Far



October 15, 2005;   The Wall Street Journal  - Page A1


The crisis surrounding the big commodities brokerage firm Refco Inc. swiftly intensified yesterday, with banks and securities firms scrambling to see if the firm could avert failing outright.


Refco began unwinding customer positions at one of its securities units. The action came shortly after Refco froze activity for 15 days at another of its business units. Meanwhile, credit-rating firm Standard & Poor's Corp. said the company was "highly likely" to default on its rated debt.


The apparent unraveling, at extraordinary speed, was coming less than a week after the disclosure that Refco's chief executive officer owed the firm hundreds of millions dollars that had been thought owed by others. The events were a lesson in how fast, in today's electronic and globalized financial markets, a securities firm that depends upon client confidence and borrowed money to operate can face crisis. Nowadays, says Peter Solomon, a veteran investment banker who runs his own banking boutique, "You don't have time to work things out. People just hit the panic button." That's especially true, he adds, in "industries requiring trust."



Early yesterday, about 30 big investors and bankers held an unusual two-hour conference call to figure out what to do about Refco, which besides commodities also handles exchange-listed stocks, currencies and private trades of the complex financial instruments known as derivatives. Its customers are chiefly financial institutions as well as some sophisticated individual investors.


Lenders discussed whether to issue a formal letter alerting the firm that the developments represented a default on its loans -- meaning the loans would be due and payable. No decision was made, and the lenders are expected to talk again next week.



So far, Refco's troubles haven't posed a broader threat to the world's financial markets -- a sign of how far-flung global investors today can absorb even a big shock. Refco's financial obligations are spread across a wide range of companies and individuals, and the firm is in a number of ways dissimilar from a player such as Long Term Capital Management, whose troubles shook the system in 1998 and prompted the Federal Reserve to push other firms to bail it out. LTCM, a hedge fund, or private pool of capital, had more debt and operated in markets that weren't as liquid. The Federal Reserve Bank of New York is watching the Refco situation, but so far has not seen anything nearing systemic risk, said a person familiar with the matter.


The toll is heavy on shareholders who bought in the weeks since the firm went public in August. The last, after-hours trade of its stock was for $7.90 a share, down 72% in a week. Its notes due in 2012 have fallen so far they trade for 34 cents on the dollar.


Just Monday, Refco assured customers, lenders and investors it was in great financial shape. Its statement came after what the company said was a $430 million cash repayment of debt held by its then-chief executive, Phillip Bennett -- who is alleged to have accumulated that debt in secret.


On Tuesday, Mr. Bennett was arrested on charges of securities fraud, starting a cascade of concerns that slammed Refco's stock and bonds and crushed its ability to borrow money to continue trading. On Thursday, the New York Stock Exchange halted trading in Refco shares. Mr. Bennett, confined by an electronic monitor at his New York apartment, couldn't be reached for comment, and his lawyer declined to comment.


While two of Refco's business units are frozen, the company's futures-trading unit, its flagship business, remains afloat. Exchanges in New York and Chicago have said Refco remains able to honor its trades, but they are monitoring the firm more closely and, in some cases, have restricted its ability to withdraw money.


Late yesterday, possible buyers of parts or all of Refco's business emerged. Man Group, a London hedge fund, expressed interest, said someone familiar with the situation. Also, regulators asked Goldman Sachs Group Inc. and other firms to buy or assume financial responsibility for its massive futures-trading operation, said people familiar with the matter. A person familiar with Goldman's thinking said it wasn't interested.


Executives at J.P. Morgan Chase & Co. on Friday discussed whether the big bank should step in to help shore up Refco, but decided against such a move because the bank is a trading partner and could potentially wind up as a creditor, said someone familiar with the matter.


The approaches, made by regulators at the Chicago Mercantile Exchange and Commodity Futures Trading Commission, may help calm fears among investors, lenders and trading partners. Any buyer would likely be expected to guarantee deposits of the unit and allow traders to unwind their positions. But barring a takeover, the firm could face the prospect of filing for protection under the federal bankruptcy code.


Refco was formed in 1969 as Ray E. Friedman & Co., named after its founder, a Chicago dealer in meat and grain. Soon, Refco and other firms introduced contracts linked to financial products such as stock indexes, currencies and U.S. Treasurys, rather than traditional products like wheat or hogs.


For more than a century, futures contracts, which convey the right to buy or sell an underlying item on a fixed expiration date, had been used to guard against the financial risk of sudden price swings in natural resources. But with these new products, traders had a new universe of opportunities to place sophisticated bets on the economy, interest rates and other broad financial trends.


Refco seized that market under Mr. Friedman's stepson, Thomas Dittmer, who took the helm in the 1970s. The firm gained a reputation as a rough-and-tumble competitor for new customers, fees and trading.


Mr. Bennett was hired in 1981 from Chase Manhattan Bank and immediately set up a finance and treasury subsidiary, Refco Capital Corp. In 1983, Mr. Bennett was named chief financial officer of the overall firm.


Refco has had a long history with regulators. In 1983, the federal CFTC levied a then-record $525,000 fine against Mr. Dittmer and Refco for excessive speculation in cotton, soybeans, corn and wheat. The firm also gained notoriety for handling Hillary Clinton's livestock futures trades in the late 1970s, when she turned a $1,000 investment into a $98,000 profit in less than a year. It wasn't accused of wrongdoing in that episode.


In 1999, Refco agreed to pay $8 million in regulatory penalties to settle charges that it helped manipulate customer accounts in a case involving celebrated California money manager Jay Goldinger. Also in 1999, the CFTC ordered Refco to pay $7 million for allegedly failing to comply with rules regarding order-taking and recordkeeping of customer orders. In both cases Refco neither admitted nor denied wrongdoing.


Mr. Bennett became chief executive in September 1998, about a year and a half before the bursting of the dot-com bubble roiled markets and caused heavy losses for some of Refco's clients. He built a reputation for tirelessness, often arriving before 6 a.m. at his glass-walled office overlooking Refco's trading floor in lower Manhattan. He led a string of acquisitions of smaller firms. In regulatory filings, the firm said it handled more than $1.2 trillion in foreign-currency trades and $13.7 trillion in U.S. Treasurys volume in its most recent fiscal year.


It also held $4.1 billion in funds for its core futures-trading clients, making it one of the largest independent brokerage firms in the world. That figure is massive in the world of futures trading, which is highly leveraged, or financed using borrowed money, allowing users access to vast amounts of funding using relatively little cash up front.


In 1998, Refco launched a joint venture with an Austrian bank to provide clearing services for futures and options traded at European exchanges. The bank, Bank fur Arbeit & Wirtschaft AG, in 1999 bought 10% of Refco. It was the source of a loan this week to Mr. Bennett to repay the $430 million debt to Refco, according to someone close to Refco. Officials of the Austrian bank didn't return calls for comment.


Mr. Bennett led the firm heavily into technology, forming joint ventures that would allow trades to move off the people-intense exchange floors. In 2004 Refco agreed to sell a major stake to Thomas H. Lee Partners, an investment firm in Boston. By then, Mr. Bennett said, Refco was growing 30% annually.


The biggest deal was taking Refco public. In August, Refco raised about $580 million through an initial offering led by Credit Suisse First Boston, Goldman Sachs and Bank of America. Mr. Bennett maintained a 34% stake and the Lee firm a 38% share. As the banks vetted the offering, say people close to the deal, they noticed several hundred million dollars in debt, but auditors assured them a hedge fund would pay it back.


On Sept. 15, Refco threw a party for its largest customers at the Sheraton Hilton and Towers in Chicago to celebrate the IPO. As the crowd of several hundred ate their steak, Mr. Bennett made a jubilant speech about the firm's prospects. "He talked about how much things had grown and how great the company's future would be," says Josh Levy, managing director of  Tactical Asset Management,  a money manager that traded foreign-exchange contracts through Refco.


But a newcomer in the controller's office at Refco questioned the debt owed to Refco, according to people familiar with the matter. That led to the discovery of an alleged convoluted scheme involving Mr. Bennett's firm and a hedge fund called Liberty Corner Capital Strategy LLC., which is based in Summit, N.J.. The firms moved the debt back and forth, according to a federal complaint filed against Mr. Bennett this week. A lawyer for Liberty Corner said it believed it was borrowing from one Refco unit and lending to another.


Refco's board on Friday confronted Mr. Bennett. On Monday the company said he repaid Refco $430 million. His lawyer, Gary Naftalis, said in court that Mr. Bennett pledged stock as collateral for a loan. His Refco stock was valued at about $1.6 billion ahead of the debt disclosure.


Mr. Bennett was put on indefinite leave, along with another executive. The next night, he was arrested and charged with fraud. By the end of the week, his stake in the firm was of uncertain value.


Confidence in Refco quickly eroded, particularly after investor suits were filed. "I worried that these lawsuits would ultimately cost the company billions of dollars," says Mr. Levy. But he figured he would have months to unwind his positions. After all, big trading firms don't vanish over night.


But on Thursday morning, he says, he got a call at 6 a.m. from portfolio managers at his firm with rumors that Refco might file for bankruptcy. Mr. Levy ducked in and out of Yom Kippur services near his Brooklyn home, checking in on news, and calling Refco executives to move millions of dollars out of his account into a Refco competitor. He moved all the money out, he said, by Friday.


"It was incredible -- shocking -- how fast this came apart," he says. "And it happened while half of Wall Street was off at Yom Kippur services, praying for atonement."


--Robin Sidel, Peter A. McKay and Kara Scannell contributed to this article.