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  Same old shenanigans to blame for Refco collapse

BENJ GALLANDER and BEN STADELMANN

Friday, October 28, 2005

Spider Robinson wrote a short story called "God Is an Iron," in which the main character posits that the omniscient being running the universe has a penchant for irony.

Well, the irony is thick on the ground as details emerge about the incredible disintegration of Refco, the largest commodity trader in the United States. Just last August the firm went public, raising $583 million (U.S.) with a highly successful initial public offering backed by the cream of Wall Street, including Goldman Sachs, Credit Suisse First Boston and Bank of America.

And why not have an IPO? Surely open investigations by both the U.S. Attorney in New York and the Securities & Exchange Commission were not enough to suggest that plans should be shelved until everyone was sure that all was right in Refco's world? And should anyone be concerned if the company's chief financial officer happens to depart shortly before the IPO? Nah, just another day at the office.

Despite heavy insider selling (What? We should hold? Forget it — let's give more to the public!), the stock climbed beautifully, giving the broker a market capitalization of over $3.6 billion. Then, on October 10, chief executive officer Phillip Bennett was suspended for allegedly hiding a $435 million loan; two days later he was arrested by the feds.

A scant eight days on, the company filed the fourth-largest bankruptcy in U.S. history. Now it's up to the courts to sort this mess out, overseen by none other than Judge Robert Drain. What an appropriate name.

And a murky dog's breakfast it is. Many hoped that the new regulations mandated by the Sarbanes-Oxley Act would curb the corporate shenanigans in the Enron mould. Instead, the same old ingredients are being brought to the table: allegedly corrupt management, off-book accounting, an ostensibly lucrative derivative business, and the illusion of safety provided by the participation of powerful financial institutions.

How did the hazards escape the notice of the auditors and all the big brains doing their pre-IPO due diligence? Mr. Bennett's loan was apparently kicking around for at least seven years, dating back to huge trading losses incurred during the so-called Asian Contagion currency crisis of the late 1990s.

The red ink was disguised as a receivable from a customer account, and was transferred to a different corporate affiliate every year, kind of like a game of three-card monte.

The situation deals another nasty blow to the reputation of Refco's auditor, Grant Thornton, who took over from the defunct Arthur Andersen. The accounting firm has already been sued for billions of dollars for its role in the accounting scandal surrounding Parmalat, the Italian dairy giant.

But in Grant Thornton's defence, the prospectus for Refco's IPO did include red flags regarding the lack of a formal process for closing the books each quarter and warned that finance personnel were inadequate for filing compliant financial statements.

It is extremely difficult for investors to plow through horribly long and boring prospectuses. While it's a worthwhile chore, it's better suited to their stockbrokers or financial planners who recommend these investments.

Even with experience, it is difficult to separate the noteworthy from the routine as one pores through so much standard boilerplate material detailing various risks. But when there are serious accounting weaknesses, the time is at hand to bring out the yellow highlight marker.

BusinessWeek reported that eight companies that went public this year listed significant deficiencies in internal controls. The average return of these outfits is a loss of 27 percent. It should be clear that bad books and capital preservation don't mix.

But the lesson for investors is even more basic. When a sector is hot, as commodities trading is now, there is a strong urge for managers who have been in the business for a long time to make the big score. Underwriters see an opportunity to make quick profits, so those pesky risks are soft-pedalled.

Throw in complex derivatives, whose valuations are volatile and a nightmare for auditors to follow, and you get a nexus of greed and opportunity that makes for rich insiders and miserable shareholders.


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