MF Global and the Problems With Murky Accounting

The collapse of MF Global shows how easy it is to obscure risky investments and the pitfalls that can occur when those problems surface. By minimizing its exposure to European sovereign debt, the firm lost credibility in the market and eventually got hammered as fears over possible bond defaults rose.

In the aftermath, more than 1,000 MF Global employees have been laid off, customer accounts have been frozen, and federal investigators have been trying to sort through the mess.

The firm’s troubles center on its exposure to $6.3 billion of European sovereign debt. MF Global kept these investments off its balance sheet by structuring them as repo transactions that could be accounted for as a sale or purchase rather than an asset it was holding.

While MF Global’s accounting for the sovereign debt may have been acceptable, the Financial Industry Regulatory Authority was concerned enough about the firm’s potential exposure to require it to increase its capital cushion. As DealBook reported, Jon S. Corzine, MF Global’s chief executive, fought FINRA’s demand by lobbying the Securities and Exchange Commission to give its imprimatur to the firm’s treatment of the investment — a battle he ultimately lost.

MF Global appeared to view its investments in European sovereign debt as something that should be of little concern to shareholders, and perhaps even a potential bright spot. In a quarterly financial report filed with the S.E.C. in August, it stated, “volatility in the European sovereign debt markets created occasional dislocations in the cash and repurchase markets for certain short dated securities, providing more trading opportunities.”

The firm’s exposure to risky European sovereign debt was not particularly large, but the perception of increased risk, and a failure to recognize the potential problems the investments posed, spooked the markets and contributed mightily to MF Global’s downfall. Had the firm disclosed its exposure when it first entered into the transactions, the market’s reaction might well have been more muted.

Since MF Global filed for bankruptcy, more significant problems have emerged that call into question whether its aggressive accounting for the European sovereign debt might be a sign of much deeper issues. Scott D. O’Malia, a commissioner at the Commodity Futures Trading Commission, the agency leading the investigation of the firm, said its records were “a disaster.” If investigators determine that any false filings were made to the agency, the Justice Department could pursue criminal charges against those responsible.

Investigators are also still trying to track down $600 million in missing customer money that should have been placed in segregated accounts – another potential avenue for criminal charges if the money was misused. The Commodities Exchange Act, 7 U.S.C. § 13(a)(1), makes it a crime punishable by up to 10 years imprisonment for anyone associated with a commodities dealer

to embezzle, steal, purloin, or with criminal intent convert to such person’s use or to the use of another, any money, securities, or property having a value in excess of $100, which was received by such person or any employee or agent thereof to margin, guarantee, or secure the trades or contracts of any customer or accruing to such customer as a result of such trades or contracts or which otherwise was received from any customer, client, or pool participant in connection with the business of such person.

Executives at MF Global, including Mr. Corzine, may also face claims from investors who bought $325 million in senior notes the firm sold in August 2011. Ironically, the securities contain a “key man” provision that would increase the interest rate by 1 percent if Mr. Corzine were nominated to a White House cabinet position before July 2013, an unlikely prospect now. The notes have lost nearly half their value in just three months since their issuance, so buyers are going to be looking to recover a portion of their losses.

The prospectus filed by MF Global in early August did not reference the discussions between the firm and FINRA over increasing its capital levels in light of the firm’s European sovereign debt exposure. This could be the basis for a claim to recover losses under Section 11 of the Securities Act of 1933 on the grounds that the failure to disclose the need to increase its capital was a material fact that should have been included in the offering documents.

Directors and officers of a company can be held personally liable for investor losses under Section 11. The provision does not require proof of any intent to defraud, or even negligence, which makes it a powerful tool to recover damages from individuals at the firm and the underwriters of the bond offering. With MF Global in bankruptcy, investors will be looking for any pool of money available outside the bankruptcy court, where they have little prospect for a quick recovery.