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The Collapse of MF Global: Summary & Analysis

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The Collapse of MF Global: Summary & Analysis The Collapse of MF Global: Summary & Analysis By: Cause of Action Introduction Less than two years after Jon Corzine became CEO of MF Global Holdings, Ltd., the international commodities broker filed a voluntary petition for bankruptcy under Chapter 11 on October 31, 2011 – fittingly enough on Halloween, the most frightening day of the year, as MF Global’s brokerage customers would soon discover. The company’s failure has since been blamed on a risky trading strategy that Corzine introduced to increase revenues in the face of MF Global’s declining core business. Corzine effectively engineered a more than $6 billion bet on the sovereign debt of Ireland, Italy, Spain, Portugal and Belgium through the use of a financial transaction commonly referred to as a “Repo to Maturity” (RTM). Although Corzine was prescient in betting that European sovereign debt would not default, margin calls by MF Global’s counterparties ultimately overwhelmed the company and triggered a classic liquidity crisis. By the time the tailspin had reached its natural conclusion, $1.6 billion of customer funds were missing due to sloppy bookkeeping and mismanagement. As a financial services holding company, MF Global Holdings has a number of subsidiaries throughout the world. MF Global, Inc. (MFGI) was the company’s U.S.-based futures commission merchant (FCM) and registered broker-dealer, subject to regulation by both the CFTC and SEC. MFGI was also a designated primary dealer in U.S. Treasury securities. MF Global’s UK-based subsidiary (MFGUK) was instrumental in the vast majority of the trades the firm embarked. A traditional bankruptcy trustee has been appointed to oversee the liquidation of MF Global Holdings, the parent company, while the Securities Investor Protection Corporation has appointed its own trustee to liquidate MFGI, the FCM/broker-dealer. It is the job of the “SIPA Trustee” – so called because of the Securities Investor Protection Act, which created SIPC – to maximize the return of customer funds to their proper owners. As a futures commission merchant, MF Global was required to keep certain customer funds in segregated accounts. In spite of the segregation requirements, the SIPA Trustee has returned $4.9 billion to customers and anticipates a $1.6 billion shortfall.1 Each of the trustees has produced an extensive reports detailing MF Global’s collapse, as has the House Financial Services Oversight Subcommittee. What follows is a brief summary of their findings, along with appendices listing questions about the investigation and the answers so far. 1 Dow Jones Newswires (December 5, 2012), MF Global Trustee Cites Progress in Resolving Disputes, http://www.nasdaq.com/article/mf-global-trustee-cites-progress-in-resolving-disputes-20121205- 00978#.UMX9ZoPAdkt. History of MF Global The Origins of an International Commodities Broker MF Global started out as a unit of Man Financial, a financial conglomerate that began as a London sugar brokerage 229 years ago. MF Global spun off from Man Financial in 2007 and went public in what turned out to be a rather disappointing initial public offering (IPO) - management had hoped to raise $5 billion, but they netted only $2.9 billion in no small part because of the dark clouds forming over Bear Stearns, Lehman Brothers and other financial institutions. 2 A year later the company’s shares dropped 28% after a rogue trader lost the company more than $140 million in unauthorized trades on wheat futures in February of 2008. In response, CFTC fined the firm $10 million after identifying weaknesses in MF Global’s internal controls and risk management procedures. 3 MF Global soon found itself unable to repay a revolving credit facility it had drawn on, driving the company into the arms of J.C. Flowers, a private equity titan and former colleague of Jon Corzine’s at Goldman Sachs. Flowers helped MF Global refinance its debt in return for two seats on MF Global’s board. 4 In October of 2008, the board appointed Bernard Dan as CEO, whose first order of business was to persuade the NY Federal Reserve to designate MF Global a primary dealer. 5 The NY Fed, however, had recently changed their rules for primary dealer designation and required that at least a year transpire after the rogue trading fiasco. MF Global also saw its credit rating downgraded multiple times by Moody’s and S&P between 2008 and 2009. Unable to return the firm to profitability, Dan resigned in November of 2009. 6 As a brokerage firm, MF Global’s primary source of revenues came from interest it charged customers for trading on margin. But because interest rates had been so low as a result of the Federal Reserve’s loose monetary policies following the 2008 financial crisis, earnings were suffering and the company was seeking new opportunities to generate the revenue it needed. One option they pursued was securing designation as a primary dealer in U.S. Treasury securities, but the change in Fed Policies meant they would have to wait at least a year after the regulatory action by the CFTC.7 2 Jacob Bunge, MF Global: History From IPO to Bankruptcy, WALL ST. J. (Oct. 31, 2011), http://blogs.wsj.com/deals/2011/10/31/mf-global-history-from-ipo-to-bankruptcy/. 3 Id. 4 th HOUSE FINANCIAL SERVICES COMMITTEE, SUBCOMMITTEE ON OVERSIGHT AND INVESTIGATIONS, 112 Cong., Staff Report (November 15, 2012), available at http://financialservices.house.gov/uploadedfiles/256882456288524.pdf [hereinafter House Subcommittee Report]. 5 Id. 6 Sarah Lynch, A persistent MF Global won NY Fed dealer status, Reuters (December 14, 2011), http://us.mobile.reuters.com/article/internal_ReutersNewsRoom_ExclusivesAndWins_MOLT/idUSTRE7BD2B920 111215. 7 Supra note 2. After Dan’s resignation in March of 2010, J.C. Flowers approached Jon Corzine about the position. Having just lost reelection as New Jersey’s governor, Corzine was itching to return to work in financial services and accepted the offer.8 Corzine’s Strategic Makeover Corzine set about transforming the firm from a sleepy securities and commodities broker into a small investment bank along the lines of Goldman Sachs. He immediately set upon a two- fold strategy to bring MF Global back to profitability: first, to obtain the designation from the Federal Reserve Bank of New York as a primary dealer for trading U.S. Treasury securities; second, to generate additional revenue using MF Global’s available capital in aggressive, highly leveraged trades in European debt securities. After Corzine took the helm, MF Global embarked on a risky trading strategy in European debt securities that involved transactions known as “repos to maturity” (RTM). Acting on Corzine’s belief that the market had overestimated the risk of sovereign default, MFGI purchased short-term European sovereign debt with a maturity date prior to June 30, 2013, the date that the European Financial Stability Facility – a bailout fund for European sovereigns – is due to expire.9 The purchases were typically made through MF Global’s UK subsidiary (MFGUK) acting as an intermediary.10 MFGUK would then undertake a reverse11 “repo to maturity” (RTM) with the American subsidiary, MFGI, in which it purchased the European debt securities from MFGI, while MFGI simultaneously agreed to repurchase the securities at a specified price on their maturity date.12 At the same time, MFGUK would itself repo the European sovereign debt to yet a third party13, i.e. sell them while simultaneously agreeing to buy them back at a set price immediately before maturity.14 The terms of the RTM allowed MFGUK, the counterparty to the trade, to demand 8 Id. 9 Miles Weiss et al., Corzine Pushed Europe Bet to $11.5bn, Bloomberg (Nov. 29, 2011), http://www.bloomberg.com/news/2011-11-29/corzine-pushed-fatal-europe-bet-to-11-5-billion-as-mf-global-board- balked.html. 10 First Rep. of Louis J. Freeh, Chapter 11 Trustee of MF Global Holdings Ltd., et al., for the Period Oct. 31, 2011 through June 4, 2012, at 33, In re MF Global Holdings Ltd., Case No. 11-15059 (MG) (June 4, 2012) [hereinafter Freeh Report]. 11 The term “reverse repo” describes the repo transaction from the perspective of the counterparty, i.e., the party “buying” the securities (that is to say, lending the cash against the securities as collateral). See id., at Annex 1. 12 Actually, MFGI agreed to repurchase the securities two days before of their maturity date, but close enough to the actual maturity date that the impact on the accounting treatment is immaterial. Id. 13 That third party was typically LCH.Clearnet. Hearing on the MF Global Bankr. Before the House Comm. on Agric., 112th Cong. 68 (December 8, 2011) (Statement of Jon S. Corzine., Former Chief Executive Officer, MF Global, Inc.) [hereinafter Corzine Statement of Dec. 8, 2011]. 14 Freeh Report, supra note 10, at 33. additional margin15 from MFGI in the form of either cash or securities should either MF Global or the collateral lose value.16 Unfortunately, Corzine’s strategy simply overlooked the risk that the European sovereign debt used in these RTM transactions would lose value to such extent that margin calls might drain the company of cash – precisely the scenario that ultimately brought MF Global down. The irony is that Corzine’s bet has so far proven correct: those counterparties who seized the collateral have since either watched the securities increase in value or have been paid in full by the issuer upon maturity. The story of MF Global is thus a classic illustration of the bromide made famous by John Maynard Keynes, himself a commodity trader: the market can stay irrational longer than a trader can stay solvent. These transactions were structured in such a way that the risk of ownership shifted from the subsidiary, MFGUK, to the American counterpart, MFGI, as per the demands of MFGUK’s counterparty, LCH.Clearnet.17 For accounting purposes, repo transactions are traditionally treated as a form of secured lending, in which the company “selling” the securities is actually borrowing cash subject to a liability in the amount of the repurchase price.18 The accounting treatment for RTM transactions is slightly different, however.
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