The Refco Bankruptcy and its Impact on Retail Forex Trading

 The Refco IPO and Fraud Scandal

New York-based Refco Inc. was a large and well-known forex and commodities brokerage house that was one of the main futures brokers on the Chicago Mercantile Exchange. In 2005, the broker was forced into filing Chapter 11 bankruptcy from creditors in the wake of an announcement about fraudulent practices involving their CEO Philip Bennett hiding the company’s bad debts. This fraud was facilitated by loans from Bawag P.S.K, the fourth largest bank in Austria.

Interestingly, this blow came just after an Initial Public Offering of stock for Refco was made, raising suspicions that the forex broker’s management had been guilty of dressing its books to make the IPO more successful. The IPO shares were offered to the public at an initial price of $22 per share through a number of investment bankers that included Credit Suisse First Boston, Goldman Sachs, and Bank of America that were all supposed to have reviewed the broker’s finances as part of their due diligence.

Refco’s shares were traded publicly for just two months, and even hit a high of $30.12 on September 7^th of 2005, before the fraud was disclosed barely a month later on October 10^th. The announcement understandably panicked investors, sending the 26.5 million shares of the newly-public company crashing to just $0.80 a share.

Although the forex broker had previously boasted of annual earnings of 33% per year before being taken public, it was basically forced into declaring bankruptcy just two months later.

How the Bankruptcy Affected Refco’s Accounts

Phillip Bennett was the CEO of Refco. In October of 2005, Bennett was accused of padding the company’s finances by hiding $430 million in bad debts of a wholly-owned and unregulated subsidiary which he controlled by the name of Refco Capital Markets.

Refco’s forex brokerage arm, Refco FX, LLC, was holding over 17,000 retail customer brokerage accounts at the time that Refco declared bankruptcy shortly thereafter. In the bankruptcy proceedings, Bank of America and other large creditors managed to convince the bankruptcy court that Refco’s customers were actually unsecured creditors because of Refco’s failure to segregate its customer accounts from their own general funds, despite telling customers that it had done so.

This legal maneuver resulted in the unsecured customer accounts being considered as creditors only after the secured customers in the distribution of whatever funds were left to be distributed. Although FXCM made a reasonable offer in late 2005 to purchase the RefcoFX accounts, it was rejected and most of the broker’s 17,000 customers eventually received little or no compensation for the balances in their brokerage accounts at the time they were frozen by the bankruptcy.

The Refco situation perfectly illustrates how a forex broker’s financial troubles can result in the loss of their clients’ money on deposit without their customers having any effective legal recourse just by having client accounts comingled with their own.

The Impact of Refco’s Failure Today

Refco’s wide-reaching failure continues to impact the retail forex and commodities market, not to mention the billions of dollars lost for the initial investors in its now virtually worthless stock. The total fraud has been estimated at $2.4 billion, of which less than half was recovered for creditors.

While Refco had had problems with its reputation as a broker before the fraud was exposed, many of their retail forex customers were unaware of this and lost all of the money in their accounts. The lessons of Enron, which were still fresh in peoples’ minds at the time, were not heeded.

Avoid Brokers Who Co-mingle Accounts

In light of the Refco debacle, it pays to have an idea of what to avoid to prevent what happened to Refco’s forex clientele from happening to you. A number of simple considerations should be taken before opening a forex trading account with any broker.

The big mistake made by the Refco customers was that, whether they were aware of it or not, their funds were held in co-mingled accounts. In other words the customer account money was placed in a larger account which held money from a variety of sources, primarily Refco’s.

By having their money in co-mingled accounts, the customers could not claim their assets ahead of other creditors when the firm filed for bankruptcy. Accordingly, avoid co-mingled accounts.

Beware of Difficult Withdrawals

One item that seems to be missed more often than not is, once you have given the brokerage your money, how easy will it be to get it back. Many people open accounts without reading the fine print and are only made aware of key facts once funds are committed.

Basically, if a brokerage firm makes withdrawing money difficult, this could be a clear sign that they may not intend to give it back. Read all the fine print and make sure you can get your money out of your account without too much hassle.

Conclusion

The Refco scandal cost many people plenty of money. Remember, they were once fairly reputable and even boasted 33% earnings per year and issued millions of shares of stock while their CEO was committing a huge fraud for which he is now serving time. The Refco bankruptcy has taught everyone involved in trading forex a severe lesson.