Refco's Painful Lesson for Investors

Buried in the reeling outfit's IPO prospectus was a warning of significant deficiencies in its accounting controls -- a key danger sign

By Aaron Pressman

After Wall Street picked over the remains of derivatives broker Refco in the weekend of Oct. 15-16 to see what, if anything, was worth salvaging, investors who bought the stock at its August initial public offering now face a bleak picture. On Oct. 17, Refco announced it was in "advanced negotiations" with a group of investors led by J.C. Flowers & Co. to sell its futures brokerage business, a step that could lead to its rapid dissolution.

The New York Stock Exchange halted trading of Refco's stock indefinitely on Thursday, Oct. 13, with shares down 64% from the $22 IPO price.

The complete story of the $430 million debt ousted CEO Phillip Bennett allegedly hid for seven years before the IPO, only to be revealed last week, has yet to be told. Bennett has been charged with securities fraud in an ongoing probe (see BW Online, 10/17/05, "The Family Man Behind Refco's Woes"). But the Refco mess holds a simple and straightforward lesson for investors: Be watchful for -- and beware -- companies that admit their internal systems for preventing accounting problems are not up to snuff.

Buried amidst the boilerplate discussion of various risks to its business disclosed in the prospectus Refco filed with the Securities & Exchange Commission on July 25, 2005 -- two weeks before the IPO -- was a paragraph noting that the company's accountants had found two "significant deficiencies" in its internal controls.


  Accounting firm Grant Thornton reported that Refco's finance department didn't have the resources to prepare financial statements that complied with federal law and that the company lacked a formal process for closing its books at the end of each quarter. The Chicago auditing firm, which is among the many involved parties being sued by shareholders, now says it was also among those fooled by Bennett's moves to hide the debt.

How obvious a red flag should such a warning have been to investors? Pretty obvious, if you consider the performance of all companies that made such disclosures this year when they filed to sell shares either in IPOs or secondary offerings.

Of 13 companies that listed significant deficiencies in internal controls, eight have completed their offerings, including Refco, with an average return of -27% through Friday, Oct. 14, according to BusinessWeek Online's data search of EDGAR Online Pro, a financial information Web site. The average IPO this year has gained 8%, according to Renaissance Capital, while the S&P 500 has lost almost 1% year to date.


  Refco's advisors, creditors, and investors huddled throughout the weekend of Oct. 15-16 to consider what options remain for the outfit that until last week had been the largest independent futures broker in the world, completing more trades than the Chicago Board of Trade or the New York Mercantile Exchange in its previous fiscal year. At best, the company is likely to be worth a sliver of the $4 billion stock market value it carried a week ago.

Investors in the bond market, where trading continued until Friday afternoon, are not giving Refco good odds to survive. Refco notes due in 2012 with a 9% coupon traded as low as 16 cents on the dollar on Oct. 14, down from 40 cents on Thursday and $1.08 last week before the crisis hit. Standard & Poor's downgraded Refco's senior secured debt to CC and its subordinated debt to C -- the last notch before D or defaulted.

"The company could be sold, but a buyer would only do that with a bankruptcy filing," says Tom Foley, a bond analyst at Standard & Poor's. Regulators are trying to orchestrate a smooth transfer of customers' positions from Refco to other brokers without disrupting the markets, he adds. "They're not concerned about the creditors or the shareholders at all," says Foley.


  After closing down businesses that helped investors trade stocks, bonds, and foreign currencies last week, Refco was left with only its futures brokerage operation. That's the core business Refco started way back in 1969. But in its most recent quarter, futures trading was only a portion of its derivatives operation. The upshot: Refco has already shut down for an indefinite period businesses that account for more than half of its operating profit in the last quarter (see BW Online, 10/12/05, "Can Refco Get Off the Ropes?").

Regulators from the Commodity Futures Trading Commission to the futures exchanges have been discussing "101 ideas" for dealing with Refco over the past few days, says one source familiar with the discussions. But finding a solution is complicated by the fact that whoever owns Refco might be subject to huge legal liabilities once an investigation of Bennett's alleged manipulations is complete.

At least regulators aren't faced with the high-risk quagmire that they confronted in 1998 when hedge fund Long Term Capital Management threatened to drag down the world's financial system. The giant hedge fund had taken sides on hundreds of billions of dollars of bets in markets around the world, and if it defaulted, other major investors and banks would have been jeopardized as well. Refco, as a broker, mainly facilitated transactions -- a role that can be easily taken on by others.


  Bennett and his lawyer have declined to comment to BusinessWeek Online and the rest of the financial press after the U.S. Attorney's office in New York charged the former CEO with one count of criminal securities fraud on Oct. 12. The crisis began last week when Refco announced that Bennett had been asked to take an immediate leave of absence and repay a $430 million debt (see BW Online, 10/12/05, "Following Refco's Bouncing Debt"). He was charged a few days later.

Refco said it thought the money was owed by a third party, but in fact it was owed by a company Bennett controlled. He paid off the full sum at the behest of Refco's board, but the company said its financial statements as far as back as 2002 could no longer be replied upon.

The fallout could mark the end of Refco as an independent entity. But it's likely to be only the start of a long unraveling of a complicated financial and legal morass.

Pressman is a correspondent based in BusinessWeek's Boston bureau

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