MF Global Was Just Following The Law Sort Of
There has been a lot of loud outrage about MF Global, but the civil suit filed by the Commodity Futures Trading Commission drew the usual ho-hum from people who know the fix is in for rich Wall Streeters in an administration that took two years to fire this popgun. The big argument was that MF Global stole money from customer accounts, an allegation that seems to be confirmed by the CFTC’s Complaint. Among others, the Dealbook blog at the New York Times says that investigators concluded that “… porous risk controls at the firm, rather than fraud, allowed the customer money to disappear….” That’s not what the complaint says, though.
The complaint begins by explaining that brokers can treat customer money differently depending on whether the customer intends to trade on US commodities exchanges or foreign exchanges. For US exchanges, the broker has to have an amount of money in the account sufficient to pay off all customer balances. ¶23. If the customer intended to trade on foreign exchanges, the rules in effect at the time allowed the broker to use some of the customer’s money for its own purposes, and only required a portion of the money to be held in a segregated account. The broker was free to use the rest for its own purposes. ¶24
The amounts due customers changes during the day. A lot of customers borrow money from their broker to pay for their positions. As prices fluctuate during the day, some customers are obligated to post additional collateral, and others do not need as much, so their obligations decline. You need a good internal system to determine the precise amount of funds in segregated customer accounts that belong to the broker and the amount that belongs to the customers at any point in time. Brokers add their own money to the customer segregated account to insure that there are sufficient funds to meet their obligations to customers; these are called “excess segregated funds”. Brokers are free to use excess segregated funds as they see fit.
CFTC rules permit the broker to invest customer segregated funds in a variety of permitted investments. The proceeds belong to the broker. Among those permitted investments were a variety of repo, reverse repo and tri-party repo transactions between the broker and the segregated accounts. That exposed the customers to the risk that the broker couldn’t pay off on the repo transaction.
These lax rules are meant to make sure that every last cent of money can be put to the use of the broker to make more money. Some of these rules were tightened up in proceedings that began before the failure of MF Global.
The complaint says that Corzine was told early in his tenure at MF Global that the internal systems for calculating customer balances were not accurate. He did nothing to fix them. On October 25, 2011, Corzine and O’Brien were told that there was almost $300 million in excess segregated funds available. On October 26, O’Brien and her staff transferred over $500 million from the customer segregated accounts to the MF Global proprietary account, which she knew was illegal. NOte the use of the active voice. O’Brien knew that she was transferring more than the excess segregated funds, which is arguably legal. She did something similar the next day and the day after. The ultimate total of lost customer funds was over $1 billion.
The allegations against Corzine are less clear. He knew there were liquidity problems, and he knew MF Global was transferring money because it was still in business, but apparently the CFTC isn’t willing to allege that he knew what O’Brien was doing.
At approximately 9:00a.m. ET, [October 28] Corzine instructed O’Brien to transfer funds to pay for the overdrafts [due to JPMorgan]. Corzine told O’Brien that it was “the most important thing she can get done that day.” Corzine asked no questions to ascertain how O’Brien would find funds to pay for the overdrafts, notwithstanding his knowledge of the Firm’s extremely limited sources of cash. Nor did Corzine inquire of O’Brien how the Firm would fund its other needs for cash that day. ¶ 64h.
The complaint says that O’Brien knew what she was doing was a violation of the law. ¶ 64t.
As O’Brien explained to a colleague from MFGUK the next day on a recorded telephone line: “the only place I had the 175 million, ok, was in seg.” O’Brien also commented during this conversation that she “move[ s] money all time … from seg over to house and house over to the BD [broker-dealer] .. OK, that’s what we do all the time because we don’t have enough capital. .. ” ¶ 64i
The complaint says that JPMorgan knew this was customer money and knew that MF Global was failing, so it asked Corzine for a letter saying it was legal. Corzine couldn’t find anyone, including O’Brien, who would sign the letter. JPMorgan kept the money. Corzine did nothing to stop further transfers of customer money.
But apparently, the US Attorney for the Southern District of New York, Preet Bahara, and Attorney General Eric Holder can’t find a crime in this. Did the CFTC refer the matter to the Department of Justice for criminal prosecution? No member of the media asked. Do Bharara and Holder think using segregated customer funds for the benefit of a broker isn’t a federal criminal offense? Is that what the CFTC thinks? Do they think they can’t prove it happened? Is there some intent issue? What exactly do they think? We’ll never know.
John Dillinger would love this business.
Photo by Tony Fischer under Creative Commons license