MF Global’s original sin

Experienced players know that the outcome of a game of chess often is determined in the opening moves, just as it is with many military battles or legal contests for assets, control and influence. It’s the way the world works. 

So, were MF Global customers up against a stacked deck from the beginning? When MF Global Holdings attorney Kenneth Ziman went to court the day after the firm declared Chapter 11 bankruptcy, he appeared in front of Judge Martin Glenn, whom he had worked with previously at a law firm. The judge asked his former colleague: “I’ve read a number of stories that deal with alleged shortfalls in customer property. Is that only in the registered broker-dealer?” Ziman answered, “All funds are accounted for, and I’m talking about the broker-dealer.” With that, Judge Glenn said, “Okay.” 

No one, including regulators in attendence, disputed this misstatement or outright lie, and from then on, MF Global Inc. brokerage customers were on their own.

Sunday in the office with Jon

On Sunday, Oct. 30, 2011, the filing for the eighth largest bankruptcy in U.S. history, MF Global Holdings, Ltd., had to be finalized. Attorneys for the firm worked through the night against the clock in consultation with major creditors and regulators, including the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). 

Earlier that week, MF Global Chairman and CEO Jon Corzine had tried desperately to find a buyer for its brokerage unit, MF Global Inc., while attempting to raise cash for the holding company. Selling the dually registered futures commission merchant (FCM) and broker dealer (with its 318 securities accounts) might save the company and enable it to re-organize. The brokerage unit was by far MF Global’s largest and most viable asset, and the cash from the deal would help stop the hemorrhaging.

There had been a number of possible white knights in the days leading up to the bankruptcy. Corzine contacted his old firm Goldman Sachs, which outright rejected the deal. JPMorgan (the largest creditor to MF Global Holdings) reviewed a purchase and decided against it, stating it did not fit their business. But Interactive Brokers (IB) was very interested, and the only one to make a bona fide offer. It had missed an earlier opportunity when Man Financial (which became MF Global) bought the bankrupt Refco in 2005.  

With the Sunday night marathon of conference calls among executives, attorneys and regulators buzzing in the background, all were expecting a sale of MF Global Inc. IB’s accountants and lawyers pored through drawers, filing cabinets and computers as part of their final due diligence. Then a shortfall of $633 million in customer funds was discovered (later upped to more than $1.2 billion) and that put an end to the IB offer. 

At first, MF Global executives claimed it must be an error, but after a frantic search for the money, they acknowledged it had been transferred out of the firm. With the shortfall confirmed, the clock now was ticking faster, and lawyers and executives hastily moved to complete the bankruptcy preparations.

On Monday morning, Oct. 31, MF Global Holdings filed for a Chapter 11 bankruptcy and, later the same day, the Securities Investor Protection Corporation (SIPC) filed for protection and liquidation rights over MF Global Inc. The futures industry had experienced brokerage bankruptcies before, but on this day events were to unfold as never before in the industry. 

Under court order, access to exchanges and accounts was blocked, creating unlimited risk to customers and later forcing massive losses and liquidations by moving positions, such as long options, with inadequate underlying capital. 

Some early moves didn’t seem to make sense, but it would take weeks before critical questions began to be asked. For example, why was the firm’s subsidiary, MF Global Inc., practically a 100% FCM, put into protection under SIPC, which is designed for the securities industry? With only 318 securities accounts, how could the chairman of SIPC, Stephen Harbeck, possibly characterize MF’s securities business as “substantial” to a federal court?

But more importantly, with approximately $5.5 billion in segregated customer assets and an identified $633 million (at the time) shortfall in customer funds, how could MF Global Holdings, a self-identified brokerage firm with the bulk of all earnings from its brokerage unit, rush into a Chapter 11 reorganization and not Chapter 7, which is required for liquidation of brokers? 

A Chapter 11 is used to reorganize an entity, and this provides advantages to creditors. As Anita Krug, assistant professor of law at University of Washington, explains, “A  Chapter 11 proceeding permits the company to keep operating, possibly without a trustee, requires the appointment of a creditors’ committee and permits the estate to pay for the committee’s professionals — obviously good things for creditors. Although Chapter 7 permits a creditors’ committee under limited circumstances, that committee has a restricted role and, importantly, the estate generally does not cover the associated professional fees.”

Securing Chapter 11 could be done only if the brokerage unit was broken off into a separate proceeding. Doing this created not only more confusion and loss of customer priorities, but would foster conflicts between competing trustees. Washington D.C. Bankruptcy Attorney Wendell Webster says, “Allowing Holdings to reorganize under Chapter 11 may have created an inherent conflict between the trustees, precluding adequate protection of the brokerage customers. This potential conflict is disturbing particularly given the disproportionate number of brokerage accounts and customers.”  

And the law may not be absolute that a dually registered brokerage must fall under SIPC liquidation. The guidelines are: “Because stockbroker and commodity broker cases are very rare and can present unusual issues, the United States Trustee should notify and consult with the Office of the General Counsel immediately upon the filing of such a case.” 

All considered, the CFTC logically should have been guided by the overwhelming weight of commodity customers and futures market protection instead of abdicating its Congressional mandate to the SEC to put MF Global Inc. under the protection of SIPC.  

As the SIPC actions kicked in on Monday afternoon, not only were titled assets frozen, but liquidation of open positions became practically impossible under a court order granted in deference to the SIPC trustee who had never before handled commodity brokerage liquidation. 

With the brokerage now separated from the parent company, Holdings was free of customer protection rules under the Commodity Exchange Act and Bankruptcy Code (see “A distinction without a difference”).

Nov. 1 hearing

When a firm enters bankruptcy, the first priority is to secure assets for all parties. If funds are missing from the safe or if there are indications of “fraud, dishonesty, incompetence or gross mismanagement of the affairs of the debtor by current management,” the court has cause and may be compelled to appoint an examiner or trustee immediately as required by the bankruptcy code. 

Millions of dollars were unaccounted for, but this did not happen. Holdings was allowed to operate on its own for another three weeks without a trustee until Nov. 28, and intercompany money transfers among the units were permitted to continue under the authority of current executives. The transcript of the day-one hearings reveals how. But first, we must point out that MF Global’s major creditors (mostly JPMorgan, to the tune of $1.2 billion) had significant sums at risk with the firm. Because a brokerage only can enter a Chapter 7 or SIPC protection, breaking the brokerage unit off into a separate filings enabled Holdings  to secure a creditor-friendly Chapter 11 filing status. 

Competing filings added to the tangle of multiple regulators and investigators, with the Federal Bureau of Investigation, the Department of Justice, the CFTC, the SEC and Congress all separately looking for the “missing money.” Or, as The Wall Street Journal ludicrously would come to characterize it — the “vaporized” funds. This bankruptcy structure also allowed Chapter 11 Trustee Louis Freeh to withhold information from investigators under attorney-client privilege, which appears to have added to the ongoing confusion. As with any struggle over resources and assets, for those preparing the bankruptcy — attorneys for MF Global Holdings, creditors and regulators — pre-programmed confusion can offer a tactical advantage.

CFTC Chairman Gary Gensler may have been sleeping and his staff unmotivated to assert their authority for commodity customer protection in the early hours on Monday morning, but other regulators were active, such as Robert Cook of the SEC, who in 2009 left a multi-million dollar partnership with Cleary Gottlieb Steen & Hamilton LLP, representing the securities and banking industry, for a top position at the SEC as director of the Division of Trading and Markets. When MF Global was burning, his SEC division would consult with Holdings’ attorneys regarding the bankruptcy structure under which commodity customers were to become creditors with their priority status to be fought out in the court. 

Criminal negligence and bankruptcies happen all the time, but with so much customer property gone while regulators literally were on-site, this event was a massive regulatory failure. This bankruptcy structure not only positioned creditors and MF Global executives with the best possible stance, but also allowed regulators to take a backseat to the bankruptcy proceedings and point fingers of responsibility at each other. 

So here we have it: Bankruptcy filings structured to allow the parts of MF Global and its customers to compete for remaining assets. A reorganization Chapter 11 bankruptcy, with a creditors’ committee securing their interests, choosing their trustee weeks later and paid from the estate for their trouble. A structure in which commodity customers would be deemed unsecured creditors left “to meekly fill out the claims forms presented by the SIPC trustee,” as CFTC Commissioner Scott O’Malia said in a January 2012 speech.

How did we get there? 

Then came the fateful error: The day after the bankruptcy declaration, Ziman walked into the U.S. Bankruptcy Court at One Bowling Green in New York. He had been up all night with the team of  interested parties and attorneys preparing for the hearing. The groundwork was in place, but there might be a problem. If the court determined the millions of dollars of missing customer funds in the brokerage unit indicated “fraud, dishonesty, incompetence, or gross mismanagement,” a Chapter 11 filing might not be approved. The judge might put the proceeding into a court-appointed trustee or outside examiner. Regulators would be brought back into the loop; remaining assets in Holdings might be frozen. The creditors would lose standing and Holdings would not be allowed to continue operations on its own. 

There was a lot to accomplish at this hearing, including an $8 million loan from JPMorgan for a superiority lien on the estate. But getting Holdings into Chapter 11 was paramount. If Judge Glenn were to ask Ziman about the shortfall, how could Ziman reply? The courtroom was packed and legal counsel from the SEC, CFTC and U.S. Trustee’s Office of the Department of Justice all were in attendance.

Then the question was asked by Judge Glenn about missing customer funds and Ziman answered, “All funds are accounted for, and I’m talking about the broker-dealer.” 

Yet everyone in the room, including counsel for regulators — ostensibly there to protect the public interest — knew there was a massive shortfall. MF Global General Counsel Laurie Ferber confirmed the prior evening to the CFTC and SEC that there was a “significant shortfall in its segregated funds account” at the brokerage unit. That fact had not changed. 

But the plan worked. The bankruptcy filing was accepted substantially as prepared. Ziman’s hesitant, rambling misstatment of the facts brought no objections from regulators. (The day before, the SEC and CFTC agreed the broker-dealer would be liquidated through SIPC because of its dual registration.) When Ziman refers to the broker-dealer in this testimony, he was referring to MF Global Inc., the FCM and broker-dealer, a single entity. This connection is critical and is the very reason CFTC Commissioner Jill Sommers testified to Congress that MF Global Inc. had to be put under SIPC protection. “They cannot be separated,” she stated. 

When contacted, Ziman had no comment on the hearing or MF Global. 

The original sins of the MF Global bankruptcy, with its programmed confusion, continue to work. Actions taken by attorneys for Holdings and U.S. regulators determined the outcome. 

When a Senate aide recently requested answers from the CFTC on the bankruptcy structure and its inaction to secure threatened customer property while on site in the days before the bankruptcy, he was brushed off with: “The funds that were taken out of segregation were mostly done so at the broker-dealer.”  

Today, executives that may in the future face criminal charges still are working for MF Global Holdings. This includes Henri Steenkamp, the CFO who continues to sign off on millions in legal bills submitted to the Holdings Trustee, despite the assertion by MF  Global Inc. Trustee James Giddens that there are valid claims of “breach of fiduciary duty and negligence against” him and other former MF Global executives. 

Elaine Knuth is managing principal of Davenport Advisors, LLC and author of “Trading Between the Lines: Pattern Recognition and Visualization of Markets” (Bloomberg Press and John Wiley & Sons, Inc. 2011).

A distinction without a difference

By Daniel P. Collins

Bankruptcy law is complex and confusing. Throughout the MF Global saga competing interests have claimed that the process has been distorted to prevent futures customers from receiving the priority to recoup their funds, which was their right based on customer segregation rules. 

As many have stated, they are customers, not creditors, and their funds were required to be segregated from the assets of the firm. 

The Commodity Customer Coalition (CCC) and attorneys for Sapere have argued that the MF Global Holdings Chapter 11 bankruptcy should be converted to a Chapter 7 bankruptcy to ensure this priority. 

This has frustrated CFTC Commissioner Jill Sommers who maintains futures customer priority remains intact regardless of the bankruptcy structure. While the liquidation is administered through SIPC, CFTC Part 190 customer priority rules stand, she has argued. 

One person who doesn’t seem to agree with this is MF Global Holdings Trustee Louis Freeh, who has challenged this priority at several turns. If the bankruptcy judge rules in his favor, whether or not a Chapter 7 vs. Chapter 11 procedure protects customer priority is a distinction without a difference, and is why allowing a firm that operated as one entity to be split into separate bankruptcy proceedings was the original sin in this mess.

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