Warning Flags Were Raised in MF Global Transfers

Some MF Global employees were aware of a shortfall in the firm’s customer accounts days before filing for bankruptcy on Oct. 31, according to people involved in the case, a revelation that raises questions about why the firm failed to safeguard client money and whether it withheld information from authorities.

One such indication came from an internal document suggesting that the firm was putting customer funds at risk on Oct. 27, an MF Global executive, Christine Serwinski, is expected to tell a Congressional panel on Wednesday. Specifically, the firm had burned through a buffer of its own money and was using the cash of customers who were trading overseas, according to one of the people involved in the case.

The misuse of customer money is expected to be a focus of the hearing before the oversight panel of the House Financial Services Committee. It will feature testimony from central figures at MF Global, including Laurie Ferber, its general counsel, and Ms. Serwinski, the chief financial officer for North America.

“Our goal all along is to do an autopsy and to figure out exactly what happened,” said Representative Randy Neugebauer, a Texas Republican who is chairman of the oversight panel.

While using customer funds was a serious red flag at MF Global, it was not necessarily illegal.

A little known loophole in futures regulations permits firms to spend some money belonging to customers who traded abroad, an exemption that contradicts a cornerstone of the industry to always protect client funds. It also differs from the law policing trading in the United States.

Other employees in the firm’s back office have also told lawyers that they knew of a potential deficit in customer accounts on Oct. 27, according to the people involved in the case. One employee on Oct. 30 told an outside firm that was reviewing MF Global’s books that the brokerage firm was worried about a shortfall earlier in the week, according to one of the people involved in the conversation. Federal authorities are also investigating whether MF Global was improperly using customer money as early as August, one of the people involved in the case said.

It is unclear whether the firm’s top executives were aware of a potential shortfall.

The details are the first significant indications that MF Global received early warning signs that customer money was in jeopardy at the commodities brokerage firm. MF Global officials have maintained they did not know the shortfall was real until hours before the firm filed for bankruptcy, arguing in part that earlier indications were attributed to accounting errors.

Despite the internal alarms, MF Global employees continued to transfer customer money out of the firm. By Monday, Oct. 31, the shortfall ballooned to more than $1 billion. Little has changed since.

The cash belongs to farmers, grain operators, hedge funds and other customers. In the ensuing months, as regulators and prosecutors have investigated the collapse of the firm, those clients have grown weary waiting for their cash.

Regulators had been seeking assurances about customer money for days leading up to the bankruptcy filing, but MF Global “was not forthcoming with information,” according to a Congressional memo drafted for a House hearing on Wednesday. The firm gave the Commodity Futures Trading Commission documents indicating the whereabouts of customer money. But when the regulator asked for more proof, MF Global requested more time, according to a person familiar with the matter.

In prepared remarks released on Tuesday, Ms. Serwinski cited the internal MF Global document that suggested the firm was close to misusing customer funds on Oct. 27, four days before it filed for bankruptcy.

The document showed “a substantial deficit” in the amount of firm money used to protect customer accounts, according to the prepared testimony by Ms. Serwinski, who was planning to leave MF Global. Futures firms typically keep a cushion of cash in customer accounts as a buffer to cover losses in case of volatile market swings.

The deficit did not in and of itself violate federal laws, because of the loophole for extra cash in foreign trading accounts. The loophole dates to 1987, when few American traders kept money overseas, and was intended to add controls to a market that was essentially unregulated.

But Ms. Serwinski, who was on vacation during MF Global’s final week, had stated “clearly and repeatedly” that the firm should keep a surplus of cash to protect customer money.

“To me, even though the regulations would allow it, I was not comfortable with the firm putting customer funds at risk even just overnight in that manner,” Ms. Serwinski, who cut her vacation short to return to the firm, said in the prepared testimony. She added: “I communicated with my office and was assured that the matter was under control and being addressed and that the funds would be returned on Thursday.”

But on Saturday, Oct. 29, she was told that customer money was missing. Ms. Serwinski was assured that the customer shortfall was an accounting error and that the firm was “under control.”

Still, regulators were not notified of the potential hole in customer accounts until Sunday at 2 p.m. The deficiency was at first attributed to an accounting error.

A flurry of transactions engulfed the firm in the week before it filed for bankruptcy, as $105 billion of cash shuttled in and out. Amid the chaos, the employees became overwhelmed.

“It’s like being at the bottom of Niagara Falls,” an employee recalled in a meeting with federal authorities, according to one of the people involved in the case.

The missing customer money was the result of three different types of transactions, according to the Congressional memo. The firm’s own securities customers were withdrawing piles of money as the firm teetered on the brink, and about $300 million of that came from accounts belonging to commodities customers, according to a person briefed on the matter.

Hundreds of millions also disappeared through daily loans the firm’s securities unit took from commodities customers. Such borrowing is common in finance, but assumes the return of borrowed money. Ms. Serwinski noted in her testimony that the firm had not promptly returned one of these loans on Oct. 27, which left the buffer account short.

The final cause of the missing money was a transfer of $175 million on Oct. 28 to replenish an overdrawn account at JPMorgan Chase. The bank, which also held customer accounts on behalf of MF Global, was suspicious about the origins of the cash.

Bank officials called MF Global’s chief executive, Jon S. Corzine, to alert him of their concern. JPMorgan then followed up with a letter seeking assurances that “all transfers” were done “in accordance with applicable rules and regulations,” according to a copy of the letter. The letter was addressed to Edith O’Brien, the Chicago employee who facilitated the transfer.

But Ms. Ferber, the general counsel, said the letter was too broad. So the bank sent another letter, which still did not sit well with Ms. O’Brien or Ms. Ferber. Ms. O’Brien is also expected to appear on Wednesday before the House panel, though it is likely she will invoke her Fifth Amendment constitutional right against self-incrimination.

The final draft of the JPMorgan letter narrowed the scope to the “transfer and withdrawal made on Oct. 28,” according to the letter. Ms. Ferber, satisfied with the draft, delegated the matter to a deputy. But no one at MF Global signed the letter.

Susanne Craig contributed reporting.