On a lively Thursday in New York, Phillip R. Bennett, the former CEO of the big commodities broker Refco Inc., was indicted on multiple counts of securities fraud, wire fraud and of making false regulatory filings with the SEC at the same time as creditors in Refco’s pending chapter 11 case fought over the price to be paid for the company’s key regulated futures business. Previous posts about Mr. Bennett and the Refco saga are here and a copy of the indictment is here.
Refco filed a chapter 11 case on Oct. 17 a week after the company announced that a $430 million debt owed to the company by a firm controlled by Mr. Bennett had been concealed and then repaid by Mr. Bennett. Refco’s board placed Mr. Bennett on indefinite leave Oct. 10 and he was arrested on federal securities fraud charges shortly thereafter.
However, the indictment — as with the previous complaint that was the basis of Mr. Bennett’s arrest — is not particularly persuasive in its description of the alleged criminal conduct. The indictment alleges that, in the late 1990’s, Refco suffered hundreds of millions of dollars in bad debts as a result of customer trading losses. The customers were unable to make good on the losses, so Refco was left on the hook because it had extended credit to the customers. Rather than making Refco’s financial condition look less healthy by writing off the losses, Mr. Bennett allegedly had the losses assumed by a company that he owned and controlled — Refco Group Holdings, Inc. (“RGHI”) — and then hid that fact from auditors and investors on multiple occasions by arranging the following series of transactions:
A Refco subsidiary — Refco Capital Markets, Ltd. — would make a short term loan (usually, about a two week term) in various amounts ranging from $325 million to $720 million to an unidentified third party, but which was earlier identified as Liberty Corner Capital Strategies;
Liberty Corner would simultaneously make a short term loan to Mr. Bennett’s company, RGHI, in the same amount and with the same maturity of its borrowing from Refco Capital (but at a slightly higher interest rate), and Refco the parent would guarantee RGHI’s payment of the loan to Liberty Corner;
RGHI would use the loan proceeds from Liberty Corner to pay Refco the amount of its related party indebtedness at the time shortly before the end of an upcoming Refco reporting period. Inasmuch as the debt was paid prior to the end of the reporting period, Refco’s auditors did not report the amount of RGHI’s previous indebtedness to Refco as related party indebtedness; and
Upon maturity of the two short term loans — which was timed to occur after the end of Refco’s reporting period — the loans were “unwound” (apparently without telling Refco’s auditors) so that RGHI was put back in the position of owing the same amount of related party indebtedness to Refco that it owed before it borrowed the money from Liberty Corner.
Among other questions, the following issues are raised by the indictment:
If RGHI’s indebtedness to Refco was truly based upon assumption of third party debts to Refco, then why did the amount fluctuate from time to time?
How, precisely, was the arrangement “unwound” each time? The indictment is silent on that key allegation.
Was Refco’s guaranty of RGHI’s loan from Liberty Corner disclosed in Refco’s regulatory filings?
In essence, the indictment alleges that Mr. Bennett used Refco’s creditworthiness to arrange a third party loan to RGHI that was used to pay RGHI’s debt to Refco. Putting aside for a moment the disclosure issues raised by securities laws, is there really anything wrong with Mr. Bennett using Refco’s credit for that purpose?
Inquiring minds want to know.
Tom,
You are right. Ponzi schemes are not a fraud. And, we can both be overnight billionaires. Just form a shell LLC and have it issue yourself a note for $1 billion and start listing such as an asset. That’s really all the Bennet did here. The rest of the story is merely false bookkeeping entries to hide the reality.
Beyond that, the best evidence that what Bennett did was wrong was that Refco is now in bankruptcy.
Last, time for a little consistency on your part. A few days ago you were saying that Fastow was doing this, unknown to the other 100+ felons at Enron, and that it was illegal.
John, first, you state that Bennett formed a “shell” and parked a billion dollar note in the company to reflect that as an asset on Refco’s balance sheet. You may be right and that would likely be a crime, but that’s not what the indictment alleges. Rather, the indictment describes an arrangement under which Refco essentially provided a far below market loan to Bennett’s company to pay the related party indebtedness. As such, that should be the focus of the inquiry into Bennett’s alleged criminal conduct.
Second, lack of trust in the marketplace is not proof of illegality.
Finally, what Bennett did is far different from what Fastow has admitted that he did, which was effectively to embezzle funds from Enron for himself and his minions. There are no such allegations against Mr. Bennett.
As an aside, your apparent desire to make snarky comments toward me largely undermines the points that you are attempting to make.
wow! looks like i walked into a nice little spat here. for the record, bennett didn’t form a ‘shell’ to facilitate his activities. RGHI was an entity in which bennett had an interest, along with two other partners. it has been in existence for a number of years. eventually, bennett bought out the interests of the partners and ended up as the owner of the residual interests of the ventures he had co-owned with the partners. one of the ventures he ran with his partners was the acquisition of his ownership interest in refco, inc (he used RGHI to effect the transfer of control of refco from dittmer back in the 90’s).
this is not a classic andy fastow scam where shell companies were created for the sole purpose of disguising ownership of certain interests.
what happened with bennett seems to essentially be the same as what happened with nick leeson – someone didn’t want to admit to a trading loss and tried to hide it on the books. one fact of financial markets is that bad trades don’t turn into good ones, no matter how long you let them ferment. bennett tried to hide losses and got caught.
the question remains – is it a violation of law to knowingly and intentionally mislead investors as to the true nature of the financial reports filed with federal regulators and diseminated to the investing public. tom seems to believe it is not and that such behavior is a matter of corporate governance.
tom and i have been back and forth on this topic for quite a while. as a defense lawyer, he naturally believes almost no action is worthy of criminal penalties. as an investor who is well acquainted with the fact that the SEC is hopelessly inept and dysfunctional when it comes to enforcement, i believe something needs to be done by someone to hold people accountable who knowingly and intentionally file misleading financial statements with federal regulators in an effort to perpetrate financial schemes. on this (and on the subject of the astros) he and i disagree.
Geez, Charles, how did an innocent question about the propriety of Bennett’s use of Refco’s credit turn into “almost no action is worthy of criminal penalties.” ;^)
Look, if Bennett violated securities laws, then he ought to pay the price for it, although I would maintain that responsibility for such violations is usually better sorted out in a civil, rather than criminal, context. However, I really do not have a problem with criminal prosecutions in business cases so long as they are pursued fairly and clearly.
Having said that, the questions that I raised with regard to the complaint and indictment against Bennett remain valid and troubling. The state should be required to describe its charges against the defendant in a clear and precise manner, which the prosecution has not done in the Bennett case, at least yet. For an even more troubling version of the same problem, see the indictment in the Lay-Skilling-Causey case and the prosecution’s most recent revision of the charges in that case. They are incomprehensible.
Requiring the government to define and prove its criminal charges does not mean that business fraud should never be sanctioned with criminal penalties. It just means that we need to be darn careful in unleashing the power of the state to do so.
By the way, Charles, how do we disagree about the Stros?
I agree that we need to be extremely careful about unleashing the power of the state, especially when it comes to regulating internal business affairs of individual companies. Part of what is in play here is the fact that we often do not end up with the best and brightest making decisions in the U.S. Atty’s Office. In talking with certain well placed persons within the sphere of the federal judiciary in the So.Dist of TX, the U.S. Atty’s office is largely ridiculed and derided. They are most probably best kept on a VERY short leash. What is happening in So.Dist of NY, however, is an entirely different story. I find it interesting that Mike garcia has come out of the gates up there as aggressively as he has. Essentially starting his first day at work in ramping up the indictment of Oscar was a ballsy thing to do, especially since USA – So.Dist of Texas has been scared of even speaking the name of the esteemed OSW for almost 20 years. That Mike went after him so quickly is interesting. As far as Garcia’s moving on Bennett, I applaud it. Someone needs to do something to start cleaning up the crap that routinely goes on in the financial markets. NO ONE believes that the penalties for getting caught are meaningful. Mostly, because they aren’t.
Fair and clear, constitutional concepts that have lost their place as cornerstones in the wall of noble words the constitution’s framers tried to erect as a limit to governmental powers. I’m troubled by crime, and of course Tom is. Who isn’t? But I’m just as troubled — no, more so — by the prosecutorial power that has been unleashed these past few years. Last I heard there are 2 1/2 million Americans in prison, and some 20% of their sentences are for life. Every day I read of more indictments. Haven’t we, especially those of us here in Texas, seen enough? Consider Andersen and Olis, and the abominable behavior of the DOJ in the EBS trial and its wrongful convictions in the Nigerian barges trial — five fine family men are now rotting in jail. Are you just going to stand by calling those who say that something has gone seriously wrong with the criminal justice system soft on crime? This is how police states are born, with those collecting the power scaring their would-be minions into believing there’s a “crisis,” then using the powers subsequently ceded to them to “prove” there really is a crisis, etc. It’s a vicious cycle, which is upon us. Wake up, you’re next!
Preston,
Five fine family men are now rotting in jail?!?!? Thanks, I needed a chuckle on a slow day. Pure comedy gold! Let me guess – you are also a criminal defense attorney.
Tom, you say that REFCO lent Bennett’s company to pay the related party indebtedness. Since that company was a shell, this “loan” wasn’t an asset.
In sum, the transaction was exactly as I described, a trumped up loan, made to appear as an asset. Involving the 3rd party is merely window dressing, intentionally designed in an attempt to give the transaction a defensible spin.
Comedy gold? Are you suggesting, say, Dan Bayly is not a fine family man? Do you even know anything about the man? Or do you find it funny, as a general matter, that a fine family man, or men, are in jail? Or perhaps you think it not possible? Read some history, my man, current and ancient, and you’ll see — it’s possible.
In any event, shame on you in all regards.
John, based on the indictment, Refco used Liberty Corner and its subsidiary — plus Refco’s creditworthiness — effectively to make a loan to RGHI. However, the indictment does not allege — and you do not know — that RGHI is a “shell.” Frankly, given that Bennett arranged to pay RGHI’s indebtedness to Refco almost immediately after the arrangment was exposed, RGHI may have real assets and net worth for all we know.
Which goes back to the original question that I posed — putting aside for a moment the disclosure issues raised by securities laws, is there anything wrong with Refco making a loan at a below market interest rate to a company owned and controlled by Refco’s CEO and primary owner so that the company could repay a debt to Refco?
Dale Oesterle recently addressed the question in a roundabout way by pointing out in this post that this entire matter would have likely turned out quite differently had Refco remained a private company.
Tom,
According to the indicment, para. 5, Bennett did exactly what I understood that he had done.
That paragraph says, in part, “When customers were unable to make payments on the credit Refco had extended, Refco liquidated certain of the positions and assumed the resulting losses in the customers’ accounts. Rather than write off these losses on Refco’s books, Phillip R. Bennett, the defendant, caused these and other losses to be transferred to RGHI, with the result that Refco’s books showed a large receivable owed by RGHI.”
Since RGHI was an empty shell, this is the exact fraudulent scheme described in my opening comment. All Bennett did was declare that a worthless note from a shell company was a billion dollar asset. That is black and white fraud.
The cover up changes nothing.
As for the following post that this matter would have turned out differently, that is likely BS.
Refco surely used its financial statements to borrow, and in doing such committeed, inter alia, bank fraud (18 USC 1344). Sooner or later this “hole” was going to appear and someone was going to experience the loss. Banks, thankfully, have to submit SARs, so this case was likely on the way to a federal prosecution from day one and should have been.
John, you continue to assume that RGHI is a “shell” company (i.e., without any real assets) and that the A/R that Refco held from it was worthless. Both of your assumptions may turn out to be true, but neither allegation is made in the indictment and I find that curious. Moreover, the fact that the amount of Refco’s A/R from RGHI fluctuated over time is another indication that RGHI’s business transactions with Refco might have been more extensive than RGHI simply backstopping some of Refco’s losses.
However, my main point from the original post is that these, and other questions, have not been answered by the indictment. Indeed, Bennett has not even publicly explained his version of the events, although apparently his private explanation to the Refco board was not very persuasive. Notwithstanding this, you and others have already judged Bennett guilty of fraud based on an indictment filled with holes and even more sketchy media reports.
In the end, you may very well be correct that Bennett committed securities fraud. But that does make it right that you and many others pre-judge guilt based on incomplete information. That lack of skepticism only makes the government’s already overwhelming prosecutorial power that much stronger, as the Merrill Lynch defendants in the Nigerian Barge case discovered in spades.
Tom,
First, I wanted to comment briefly on this theory of yours that fraud is only an agency problem.
It is not for two reasons. First, dishonest companies badly injure competitors. Look at the damage done to SBC and ATT by MCI, etc., staying in business, etc.
Second, dishonest companies increase the cost of capital for honest companies. When people lack trust they won’t lend or invest and that hurts everyone.
Third,Bennett made the payment with the cash he got from the IPO.
Beyond that, if it was a bona fide transaction, Bennett would have had to disqualify himself and fully advise the Board, neither of which happened. These breaches of a fiduciary duty make Bennett’s case worse, not better, for they are prima facie “dishonest” services under 18 USC 1346.
As they say in the Ozarsk, “The more you shovel the deeper the hole.”
Second, the gov’t case in the Nigerian Barge case was overwhelming. The defendants there also “forgot” to testify, a rather common problem for Enron defendants.
As EBW and Morris Shenker always said, a WCCC where the defendant doesn’t testify is a slow guilty plea.
As for being skeptical, I am far more skeptical than you, being skeptical of the government, management, and accountants.
What especially continues to concern me is the government’s practice of not indicting all known co-conspirators, under its theories of wilful blindess that it uses very selectively. Selective use of wilful blindness is where the government is most unfair. Represent a small business trapped in that web sometime, if you want to see unfairness.
To argue that indictment of Bennet is somehow unfair is just silly.