Recently I received a call from a reader who wanted my opinion on whether it was better to use a large broker, say a Merrill Lynch, over a specialized futures broker, considering what happened to Peregrine Financial Group (PFG).
I couldn’t give him a recommendation, but I did tell him that many of the changes being implemented by the National Futures Association (NFA) would — hopefully — prevent another PFG from happening, and in fact, the electronic check of daily seg fund balances was the key to PFG CEO Russ Wasendorf’s downfall. That said, I told him to get to know the broker, visit the firm, review audits, check out complaints... and that applies to both big and small firms. I reminded him that MF Global, the first major black eye for the industry, was a large firm — so size doesn’t always matter. Leadership does. I also said that in the PFG case, although there were warning signs the NFA should have seen, Wasendorf was determined to commit fraud.
This call happened about the time the Berkeley Research Group “Report of Investigation” on the NFA’s audit procedure of PFG and subsequent recommendations was released. The study makes for a good read (go to futuresmag.com for report). But here are some highlights:
- NFA conducted 27 audits, including 17 unannounced ones, of PFG between 1995 and 2012. In seven of 17 annual audits, the NFA sent a bank confirmation to U.S. Bank, where PFG had its account. None of the audits found any material issue with confirmations until 2012, when the electronic confirmation process was started and the fraud was uncovered.
- The NFA auditors had little interaction with PFG’s outside auditor, which turned out to be a one-person shop.
- Reminiscent of MF Global, PFG was doing reverse repurchase agreements that the NFA auditors didn’t see as high-risk despite “1) the magnitude of the balance; 2) lack of separation of duties and weak internal controls over cash and investments and 3) repeatedly noting that the value of PFG’s repos was omitted from the ending balance on the bank statement yet included in the confirmation amount,” according to the report. Further, there were no daily confirmations on sweep funds, a practice stopped in 2009. The report found it odd no auditor questioned PFG on why it would leave $200 million in an account overnight instead of doing short-term investments.
- Apparently the field auditors were intimidated by PFG Director of Compliance Susan O’Meara, although this was not told to senior NFA officials.
- Perhaps the biggest oversight was when the NFA field supervisor got a bank confirmation of a very low (and real) $7.1 million in seg funds from U.S. Bank, but there seemed little or no reaction, except from Wasendorf who is quoted as saying, “I’m caught.” Still, he somehow was able to send a “corrected” amount to the NFA, which the audit team accepted without any more investigation.
From this investigation, Berkeley generated 21 recommendations, which the NFA stated it would adopt. They included better auditor training, hiring practices and courses for auditors to learn and understand past events, new industry developments and new products. They also suggested tightening audits of futures commission merchants’ internal controls. Further, the NFA should confer with a firm’s outside auditor and use information in its audit. Auditors also need to be aware of a firm’s financial performance.
Oddly the last recommendation is perhaps the most important: The NFA should continue in its efforts to electronically obtain daily segregation balances directly from all depositories. What is still a mystery to me is why it took so long to implement electronic confirmation when trading electronically has been in place since the 1990s. Apparently, protecting the money isn’t as important as making (and losing) the money.