On Dec. 8, five weeks after MF Global filed for bankruptcy, former MF Global Chairman and CEO Jon Corzine came before the House Agriculture Committee to tell them he was "stunned" to discover on Oct. 30 that there was a shortfall in MF Global customer-segregated funds.
Corzine’s testimony broke a long silence — he resigned days after the filing — but didn’t offer many answers to the thousands of customers whose lives had been turned upside down five weeks prior. Not that many of the members of the committee knew what questions to ask. They did know one: Did you move customer money? Corzine said "[there was] no intention to ever authorize the transfer of customer funds."
Asked the question in numerous ways, his response was basically the same each time: There was never any "intentional comingling of funds," leaving the option that funds may have inadvertently been moved into a house account.
More revealing was testimony from CME Group Executive Chairman Terry Duffy who stated, "At about 2:00 a.m. Monday (Oct.31), MF Global informed the CFTC and CME that customer money had been transferred out of segregation to firm accounts."
While stories citing unnamed sources claimed MF Global comingled customer funds with the firm’s capital and a curt release by CME Group on Nov. 2 hinted at the firm’s wrongdoing, this was the first clear statement of it. It had for more than five weeks been an official mystery. And the mystery was growing as three weeks into the process, Nov. 21, the liquidation trustee, James W. Giddens, doubled what had been a firm estimate of the shortfall. After weeks of work and sporadic communication less was known, except that the shortfall could be $1.2 billion or more instead of $633 million.
Another revelation at the day’s testimony was acknowledgement by the trustee of the rights of customers. Trustee counsel James Kobak, citing bankruptcy law on customer-segregated funds said, "It is crystal clear. I don’t think it is just a priority; it really says customers have exclusive right to these funds."
Up to this point, trustee pronouncements of a claims process had frustrated customers and their representatives who believed customers’ interests were not being defended and the trustee did not understand the meaning of segregated customer funds.
This was a good day for MF Global customers and if not the end, the end of the beginning.
There was unease as several major futures industry players scrambled around early Wednesday, Oct. 26 in South Florida looking for news on MF Global instead of simply enjoying a nice round of golf at the CME Group’s Global Financial Leadership Conference in Naples. The day prior there was word that MF Global was in trouble. The firm announced (after moving it up) its fiscal 2012 second quarter earnings report after one ratings agency had already downgraded its debt. The news was not good — a loss of $191 million — but more disturbing were revelations the firm had built a huge proprietary trading position in European sovereign debt that was draining capital from firm assets.
The stock plummeted, MF received additional credit downgrades and industry insiders mulled who would come in to buy the firm. At this point, heading into the last weekend of October, there was a growing realization that a sale and or bankruptcy were imminent, but that was seen as a worst-case scenario. Today the industry can only dream of a simple bankruptcy.
A potential sale to Interactive Brokers Group was scrapped early on Oct. 31 as a shortfall in MF Global’s customer-segregated funds was revealed. What followed was a confusing series of events that punctured previously held assumptions of the safety and security of futures segregated accounts and left futures customers feeling abandoned.
On Oct. 31 the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) announced, "that a SIPC [Securites Investor Protection Corporation]-led bankruptcy proceeding would be the safest and most prudent course of action to protect customer accounts and assets. SIPC announced today that it is initiating the liquidation of MF Global under the Securities Investor Protection Act (SIPA)."
It certainly would not be the quickest.
This baffled futures industry participants who felt it would delay customers being made whole. SIPA calls for the bankruptcy of dually registered futures commission merchants (FCMs) and broker/dealers (BDs) to come under SIPC. But futures regulators in the past had gone to court to fight for jurisdiction when an asset freeze would be adverse to futures industry customers. In the Sentinel bankruptcy, the CFTC fought to have customer funds released immediately.
The week following the filing was a confusing one, with traders barred from the floor, accounts frozen and liquidation-only orders being followed sporadically. The SIPC trustee did work with CME Group and the CFTC to arrange a transfer of approximately 14,500 futures accounts with roughly 60% of the margin backing those positions.
When that initial distribution was complete the trustee announced plans for a claims process that eventually would return the remainder of customer funds as well as addressing other creditors.
We need a hero
The futures industry has prided itself — particularly following the credit crisis of 2008 — with having an efficient regulatory structure that protects customer funds even, or especially, in the face of a failure of a clearing broker. But nearing two weeks into the MF Global debacle, customers were not close to being made whole and all the so-called industry leaders strangely were silent.
Bankruptcy is bad but a violation of segregated funds is exponentially worse; no one was stepping up and former MF Global customers noticed this. Several insiders called on the CME to move to make customers whole and take over their claims in the liquidation. After all, it was CME users being harmed and its industry’s reputation at stake, even if it wasn’t the CME’s responsibility.
"If I could withhold my dues from the MFA (Managed Funds Association), NFA (National Futures Association), FIA (Futures Industry Association) and CME exchange fees I would do it," says Stanley Haar, founder of Haar Capital Management. "The CFTC and all these other organizations, none of them have proven why they should even exist, what functions they perform."
Haar’s assessment was not uncommon.
Enter James L. Koutoulas, CEO of Typhon Capital Management. On Nov. 8 he announced that he was informally representing about 200 clients and brokers affected by the MF Global bankruptcy on a pro bono basis in conjunction with the Northwestern Law Investor Protection Clinic. The stated goal was to get Koutoulas appointed to the MF Global Bankruptcy Creditors’ Committee to make sure individual clients and brokers were represented.
The group, later named the Commodity Customer Coalition (CCC), grew rapidly, gaining professional help across the futures spectrum. Koutoulas challenged the motives of the trustee as well as firms on the creditors’ committee, and called for all funds held by the trustee to be returned immediately. At the time, the shortfall was believed to be only 11.6% of what was owed customers and Koutoulas and co-founder John Roe, principal at BTR Trading, thought all of it should be returned to customers immediately. In fact, they thought the law allowed that any shortfall should be resolved immediately by dipping into the assets of the parent, MF Global Holdings.
The CCC grew to more than 7,000 members and was joined by others who were bypassing the trustee and communicating their anger directly with bankruptcy Judge Martin Glenn and members of Congress.
Its immediate dispute was a lien placed on the liquidation by JP Morgan. The giant firm was seeking to get ahead of customers; the CCC didn’t like it and raised conflicts issue of the trustee whose law firm did business with JP Morgan. The bankruptcy judge did not grant the motion to put Koutoulas on the
creditors’ committee, but did require the trustee to meet with the group.
And things changed. The trustee put out a proposal for an expedited claims process that could provide quicker interim distributions and clearly separated futures customers from securities customers and general creditors.
After that first bulk transfer was complete, the trustee announced that any remaining transfer would be handled by a claims process. This raised the ire of the CCC and many customers and customer groups. The National Introducing Brokers Association (NIBA) sent a petition that included 700 signatures collected online in 72 hours directly to the Bankruptcy Court, calling for the immediate distribution of segregated funds.
The CME on Nov. 11 announced it would provide a $250 million guarantee to backstop the trustee’s efforts in distributing funds. It also promised $50 million from CME Trust to market participants in case the shortfall is not recovered. Ten days later it would add an additional $300 million to its guarantee, bringing the amount up to $550 million to expedite a further distribution.
The gestures by the trustee were not judged to be good enough and the trustee followed with a promise to so-called "cash only" customers on Nov. 16. Because the one transfer was positions and some margin, those customers completely in cash got nothing.
This was progress, albeit slow. Representatives of the CCC now were active in the process and growing frustrated with the trustee’s lack of understanding of futures. While there was a promise to cash-only customers, this would not include those customers who liquidated in the days following the bankruptcy. Although they took advantage of the liquidate-only order, trustee attorneys said they could not trust any transactions after Oct. 31. The trustee mentioned something regarding valuation problems and a lack of a guarantee to Susan Osmanski, compliance consultant for CCS Capital Management, who was working with the CCC. Osmanski could not get the trustee to understand that there could not be valuation issues on a cleared trade. When she inquired whether there were out-trades in the suspected trades, she received a blank look.
Also left out in the cold were customers who had only minor positions and those who attempted to pull money out, only to have MF Global checks bounce. Jason Skole fully funded a $200,000 account with commodity trading advisor Global Ag. Because the CTA had only a few minor ag market positions on, Skole received $7,574.69 in the first transfer and had $185,211.86 frozen, but was not eligible for the second transfer. "For me, approximately 4.1% of my net account value transferred. Meanwhile [the trustee] is proposing that cash customers get 60% of account values right now," Skole says.
And there were many customers in the same position.
What about the bankruptcy?
Perhaps lost in the shock of the missing seg funds was a pretty substantial failure of an FCM. At first glance, and probably second and third, it is a simple case of too much leverage. Corzine claims that he actually reduced the amount of leverage at the firm since joining, but acknowledged that board members and the chief risk officer Michael Roseman, who was replaced in March 2011, raised questions about his strategy to hold sovereign debt of at-risk European nations. Corzine did it through what is called repurchase transactions to maturity, or RTMs. These involved the purchaser agreeing to buy back the underlying debt security on its maturity date. MF Global would earn a spread differential of the interest rate paid and the repurchase rate. Generally accepted accounting principles allow these transactions to be "off-balance-sheet."
The Chicago Board Options Exchange (CBOE) was the designated examining authority (DEA) on the securities side for MF Global. CBOE Chairman and CEO Bill Brodsky, in testimony before the Ag committee, noted that CBOE, along with the SEC and the Financial Regulatory Authority (Finra), agreed in August that MF Global should be required to take a net capital charge for the RTMs due to its market risk. After initially debating this, MF Global took the charge in late August. Because the regulators applied this charge retroactively, it caused MF Global to have a net capital deficiency for July. CFTC Commissioner Jill Sommers acknowledged this in testimony. MF Global shortly thereafter was able to increase its capital and move back into compliance and remained in compliance as late as Oct. 29.
But there were other red flags. Weeks before the bankruptcy, MF Global began cutting checks, sending them through the mail instead of executing a wire transfer for some customers. Many customers liquidating in the final days received checks that later bounced. This complicated matters as the troubled MF Global books showed this money going out and said customers were left out of the second distribution.
Better late than never
Constant pressure, numerous complaints and additional guarantees from CME Group, the only exchange to offer one, pushed the trustee to make a third bulk distribution, the details of which were finalized on Dec. 9, a day after the Congressional hearing.
In its response to objections to the third bulk transfer of customer money, the trustee backs up claims made by Koutoulas and the CCC from the beginning.
"The trustee clearly defines customer property and notes that if there is a shortfall in funds basically there is no parent company property until it is complete," says Roe. "If there are any assets in the estate of MF Global that belongs to the customers, it does not go to the creditors. It was a total reversal of what they had been saying to date."
It seems odd that it took the trustee more than five weeks to confirm the rules on customer funds in a bankruptcy, but it did in spades. "SIPA, the Bankruptcy Code Commodity Broker Liquidation Provisions and the CFTC Part 190 Regulations require that the claims of commodity customers and securities customers of MF Global must be satisfied in full before the claims of general creditors of the MF Global estate may be satisfied," stated the reply. It also shot down the Creditors Committee for MF Global Holdings’ attempt to halt the third distribution: "Against this background, it cannot credibly be argued — as the Holdings Creditors’ Committee attempts — that the trustee‘s proposed third bulk transfer and maintenance of $800 million of U.S. Segregated Customer Property should be halted in its tracks so that commodity customers suffer in order to protect the Chapter 11 Debtors’ non-customer creditors. If anything, claims may have to be made against the Chapter 11 Debtors to recover property that should rightfully be distributed to MF Global’s customers."
The response appears to back up the CCC’s claim that money should have been returned to customers immediately and any shortfall in customer funds could have been made up from the money at the parent before any claims made by the general creditors. The trustee rejected claims from the creditors’ committee but oddly once again delayed a decision on a JP Morgan motion that seems to have been rendered mute by this ruling.
What seems apparent is through the process the trustee has gone through a steep learning curve regarding futures operations. The trustee worked with CME on the first bulk transfer, which moved customer positions and 60% of margin to other brokers.
While this allowed customers to access their accounts, they quickly were forced to put up more money if they wanted to hold onto those positions, which were marked to the date of transfer so no open trade equity moved with it. That means any profits on those trades stayed with the MF Global estate.
While gratifying that some money was returned, there is no credible reason it took so long. "Why are we in bankruptcy? The customer should have been cut out of this the very first day," says Roe. "The clawback should have happened immediately. You get the accounts moved over to another broker and you deal with the entity in the bankruptcy; and you share that loss with the creditors of the holding company. [MF] screwed up, [it] committed an illegal act. I have no idea why the series of mistakes that ended up getting SIPC involved in this happened. If they knew right away there was a crime, I have no idea why the CFTC decided to abdicate its role to SIPC."
That is a question that should be asked before we delve into the inevitable process of examining recommended rule changes. "What people don’t understand is that it should never have gone to bankruptcy with the customers attached to it in the first place. That has been lost in the process," Roe says. "What we are left with is increasing evidence that we are going to see a 100% return, it is just a matter of time, and finally all the people involved in this are coming around to the argument that we laid out since Nov. 1."
It is hoped that is not overly optimistic, but as the industry develops plans and contingencies to address what happened, it should not leave out the simple, and ask why it took an ad hoc group of customers to defend basic principles of segregation. The rules and experience were in place to address this situation immediately but for some reason futures customers were abandoned and leaders shrunk from their responsibilities. The correct process is: Move the accounts, move the money on hand, demand the money from the responsible parties and then handle the failure of the firm.
Non-US money still in limbo By Steve Zwick
MF Global was centered in the United States, but it had roughly $1 billion in customer accounts abroad — some from U.S.-based customers trading on foreign exchanges, but mostly from local traders, prop shops and hedgers in cities as diverse as Sydney, Singapore and Dubai. As those customers wrestle with the prospect of financial ruin, others are re-thinking the way they select clearing brokers. More and more are looking to avoid companies that trade for their own account and to work instead with multiple clearers.
Unlike in America, however, there does not appear to be a shortfall in customer-segregated funds at MF Global UK Ltd, although the jury is still out on whether the so-called "special administration regime" (SAR) implemented after the Lehman debacle will facilitate a return of these assets within an acceptable time frame. In fact it is already too late depending on your definition of acceptable.
A spokesman for court-appointed administrator KPMG says that this is still the plan and that funds may start flowing to customers as early as January, but non-segregated customers tell Futures that they are disgruntled over the fact that Richard Fleming, Richard Heis and Mike Pink — the three KPMG partners who are acting as joint special administrators — are telling them that their funds fall into the same heap as other creditors. Neither of the three worked directly on the Lehman case, but a spokesman for KPMG says the team they’ve assembled has no shortage of experience on that front.
The case represents the first test of SAR, which was created in February and is supposed to protect customers of companies that come under the UK Financial Services Authority’s (FSA) jurisdiction by requiring administrators to publish a timeline for dispersing customer funds and bringing the FSA into the process in ways that weren’t the case in the past.
Several customers who met with the administrators have told Futures that they lack an understanding of how derivatives work — something that Hugo Jenkins, Managing Director of the Futures and Options Association (FOA), says he’s heard from his members as well.
"The feedback has been that the administrator has taken a while to get up to speed on how derivatives work," he says.
At the same time, he gives the administrators credit for dealing with a difficult situation, and says that many problems evident in the Lehman default haven’t surfaced this time.
"With Lehman Brothers International Europe, there was a lack of understanding on what powers clearinghouses in the UK have," he says. "But that is not an issue now because big accountancy firms have signed up to an industry protocol that clarifies the capacity that a clearinghouse has to act independently of the administrators."
KPMG began accepting official claims on Dec. 8, and will continue to do so until March 30, 2012, leaving roughly 10,000 customers in the fog.
"It’s going to get even more complicated before it gets better," says Says Fred Grede, chairman of Vega Financial Engineering Ltd and a trustee in Sentinel Management Group Inc.’s bankruptcy. "People have to understand that there’s no harmonized set of rules for dealing with bankruptcies, so every country is going to handle this differently."
And each administrator is going to look first at funds and claims in his jurisdiction before looking elsewhere.
"If you’re a U.S. customer trading on foreign exchanges, you’re going to have issues with repatriating your funds," he says. "You’re going to find that you’re in line with people in that regime, while people from, say, Hong Kong who have money with the U.S. entity will be in line with you. It’s going to be a mess."
As far as the FSA is concerned, Jenkins says, "the new powers granted to them are helpful, but such is the priority given to client money by the FSA, it would be equally helpful if they could give some public assurances as to how they are overseeing the process."
Christian Baum, managing director of Riverdale Associates Ltd., a London-based derivatives markets consultancy, points out that the FSA has other issues on its plate.
"The FSA is being phased out as we speak, so I am not really surprised that they haven’t been proactive in this issue," he says.
Beyond the bankruptcy mess, the case has focused attention on the European Market Infrastructure Regulation (EMIR), a massive package of mandatory reforms working their way through Brussels that include provisions that will require clearinghouses and their members to offer customers the option of having their assets and positions segregated from those of other customers. EMIR also pushes the bulk of OTC derivatives onto central clearing platforms, making security of collateral even more important.
On the exchange front, Eurex liquidated all customer positions, while Anglo-French clearinghouse LCH.Clearnet transferred positions to other clearing members – highlighting glaring differences in the way exchanges deal with bankruptcies and defaults across the European Union.
"A unified European law that cuts across national insolvency regimes and makes posted collateral bankruptcy remote seems essential, not only to protect customers but also to reduce systemic risk," says Baum. "Measures offered by individual market participants such as LCH or Eurex Clearing are not sufficient. Statutory regulation on at least a European Union level is necessary and may involve posting collateral on separate custody accounts that couldn’t be accessed by the clearing broker or bank unilaterally."
But Europe isn’t the only place where glaring differences are evident. In the Pacific Rim, the Australian Stock Exchange liquidated its positions, while the Singapore and Hong Kong exchanges transferred open positions to other brokers.
MF was the main provider for Taiwanese FCMs trading in offshore markets, leaving scores of traders out of the markets.
Local Australian customers of MF Global Australia face even more uncertainty, because the company’s Australian retail operation was a joint venture with the UK company. As a result, ASX says it can’t release funds belonging to local customers unless it gets the go-ahead from the UK administrator. What’s more, while KPMG was able to find a buyer for remnants of the London operation, the Australian administrators have had no such luck.
Then there’s the disruption caused by MF Global’s dominant position in Australia’s grain markets. The bankruptcy caused the market to close temporarily and has frozen a large chunk of the local liquidity providers out of the market, leaving grains trading choppily and raising questions about the wisdom of allowing any one firm to hold such massive positions.