MF Global: The blame game

Segregation/commingling

17 CFR 1.20 - Customer funds to be segregated and separately accounted for…

c) Each futures commission merchant shall treat and deal with the customer funds of a commodity customer or of an option customer as belonging to such commodity or option customer. All customer funds shall be separately accounted for, and shall not be commingled with the money, securities or property of a futures commission merchant or of any other person, or be used to secure or guarantee the trades, contracts or commodity options, or to secure or extend the credit, of any person other than the one for whom the same are held.

Although the regulations specifically outlaw the commingling of customer property with that of the futures commission merchant, the reality is somewhat different. It is industry practice to comingle FCM property with customer segregated funds. The FCM's proprietary funds that are included in the customer segregated account are known as “excess segregated funds” and the process of adding them to the customer segregated account is known as “topping off.” In theory, customer segregated funds should never be permitted to be in deficit and the proprietary excess segregated funds added by the FCM are intended to prevent a deficit from ever occurring

When a transferee, be it a bank or a broker, receives funds from a customer segregated account, he has no way of telling whether or not these funds represent excess segregated funds belonging to the FCM, or customer segregated funds belonging to the customers. This issue arose in the MF Global situation, where JP Morgan apparently received a wire transfer from an MF Global customer segregated account and asked for confirmation that the funds involved were not customer segregated funds. JP Morgan was apparently concerned that customer segregated funds were being applied to a proprietary MF Global debt.

Possible solution

The Commodity Customer Coalition (CCC), founded by James Koutoulas and John Roe, intervened in the MF Global bankruptcy on behalf of the 8,000 customers who have joined the CCC. A legal theory proposed by the CCC is that customer segregated funds retain their special character in the hands of any transferee such as JP Morgan.

“The CCC is asking the court to order what the law requires: That the segregation protection of commodity customer funds travels with those funds as the FCM moves them throughout its organization. The Trustee has an obligation to trace customer funds wherever they travelled and claw them back to the estate of MF Global, or sue the entity who accepted them to recover them, so he may distribute those funds to customers.”

If this is not the current state of the law, it should be, and the Commodity Exchange Act and the Bankruptcy laws should be amended to make this an absolute protection for customer segregated funds. Anyone accepting customer segregated funds should be on notice that there is an obligation attached to these funds. I would take the matter one step further and require that any transfer of proprietary “excess segregated funds” must be made to a proprietary account first before any subsequent transfer. Proprietary funds should only be transferred to a third party proprietary account from a proprietary account. That way, if customer funds were ever wrongfully depleted, it would be easy to trace them. Further, any transferee of customer segregated funds would be on notice of the special character accorded segregated funds and act appropriately.

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