Fraud in the case of Refco

Floating standards

The rapid demise of Refco, a US futures broker, has been well publicised. On 11 August 2005, the company floated on the US stock market with a market capitalisation of $2.8 billion. On 25 October, it filed for bankruptcy protection in the US courts. What went wrong and why?

It has been reported that approximately $430 million worth of Refco debt was hidden by the use of a private company under control of the chief executive. It is claimed that the debt was concealed using a series of multi-million dollar loans in conjunction with at least one of Refco’s main clients. The concealment appears to have gone on for a considerable period and pre-dated the float.

In September 2005, questions about the debt were raised by an internal accountant at Refco and by its external auditors. It is not clear why the debt had not been disclosed as a related party transaction in Refco’s financial statements. In a post-Enron world, it is surprising that Refco floated without confirming that it was compliant with Sarbanes-Oxley.

It has been reported that there was a specific note in the prospectus that Refco would be exposed to risks relating to the evaluation of internal controls and that it intended to achieve compliance by February 2007. It is probably too early to understand why the nature of the loan got past the auditors and other advisers at the time of flotation. However, some general conclusions can be drawn.

First, it is clear that the futures broking industry is a highly fragile one which relies heavily on customer confidence. Refco’s initial statement assured customers that the debt had been repaid. This nevertheless led to a flight of confidence by its customers.

Second, it is clear that no amount of checks and controls by advisers can fully counter the effect of a dominant boss. This feature was also present in the collapse of many leading UK companies in the 1980s and 1990s.

Third, the need to comply with numerous detailed rules as to systems and controls will not deter somebody who is determined to find a way to window-dress or manipulate company accounts. Broad principles of corporate governance are needed to deter fraud and raise ethical standards within companies rather than a system which relies solely on detailed rules.

This article first appeared in our Litigation Annual Review January 2006. To view this publication, please click here to open a new window.