Wall Street Journal reporters Carrick Mollenkamp, Ian McDonald and Peter A. McKay have authored this article of the day ($) in updating the fascinating story on the bankrupt, New York-based brokerage firm. Refco, Inc. (prior posts here). This WSJ report focuses on Refco’s unregulated Bermuda unit, which Refco allegedly used as sort of a piggy bank to make loans to customers on high-risk bets and to cover up losses on those bets. When Refco went into the tank after an Enronesque experience, the Bermuda unit — called Refco Capital Markets — was supposed to have at least $3.7 billion in customer account assets, but had only $1.9 billion in such assets. Now the customers who played such high-stakes poker with Refco are scrambling to pick up some scraps on their gambling losses in Refco’s bankruptcy case.
As an “exempt” Bermuda company, Refco Capital Markets wasn’t required to keep customers’ money seperate from Refco’s company funds, so customer and company money was routinely commingled in the Bermuda unit’s accounts and commonly used by various Refco entities to pay bills, make loans and finance investments. Apparently, even other Refco units routinely sent funds to the Bermuda unit to invest. According to the article, some investors are contending in the bankruptcy court that they were surprised by the Bermuda unit’s practices:

“That is not a business model of which I am familiar with,” Mr. [Richard] Deitz, the Moscow-based hedge-fund manager, said at a bankruptcy-court hearing. “It’s something that I think is more in common with three-card monte.”

I would suggest that Mr. Dietz was playing the equivalent of three card monte with Refco and that he knew it.

Although beyond the scope of the WSJ article, one issue that continues to baffle me regarding Refco and former Refco CEO Phillip Bennett’s criminal case is this — presuming as true the allegation that Bennett and Refco were running a scam, why on earth did Bennett take Refco public?
Had the fraud been discovered while Refco was a private company, matters probably would have turned out much differently for both Refco and Bennett. Bennett probably would have been forced to resign, but there would have been no obligation to disclose the resignation publicly and, if it was disclosed at all, probably would have been described in the euphemistic manner of ìpursuing other opportunities.î
As a private company, Refco would have no legal obligation to advise the market on why Bennett resigned and the financial press probably would not have connected it to fraud at Refco absent a leak from someone at Refco. Inasmuch as most folks would have never heard of Refco, Bennett’s resignation would not have been particularly newsworthy outside of Wall Street. Indeed, unless Refco alerted the authorities about the fraud — which it probably would not have done out of fear of triggering an Enronesque experience — Bennett would not have been arrested.
Meanwhile, Refco’s new management and board would have probably arranged an adjustment of the purchase price on the large investment that Thomas H. Lee Partners made in Refco in order to avoid a civil lawsuit that would have publicly disclosed the fraud. Perhaps the Refco board and management would have instituted some internal controls to lessen the risk of such a fraud occurring in the future. Most importantly, Refco probably would not have collapsed.
However, since the fraud was discovered after Refco had gone public, matters have played out quite differently. Refco went through an Enronesque experience and filed bankruptcy, Bennett was indicted, Thomas H. Lee Partners lost over $300 million on its Refco investment, and it is being sued for millions by Refco investors and creditors along with Refcoís board, Refco’s auditors (Grant Thorton) and the underwriters of the Refco IPO.
Perhaps the answer to the question of why Bennett took Refco public is simply that Bennett was greedy, wanted to cash out on the IPO, and thought he could continue to cover-up the fraud. But such questions are rarely answered so simply. Stay tuned.