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Much about Refco Inc.’s sudden collapse remains a mystery, but enough facts have come to light to remind us of Yogi Berra’s classic observation: “It’s d�j� vu all over again.” First, the modus operandi of the fraud is a familiar one: A chief executive officer periodically shuffles liabilities just before the close of the quarter to a nominee (here, a hedge fund called Liberty Corner Capital Strategy) in order to avoid disclosing that he owes his firm some $430 million; then, after the close, the transaction is reversed and the original liability is restored until the next quarter. This periodic, back-and-forth transfer of liabilities to avoid disclosure closely resembles the fact pattern in U.S. v. Dixon, 536 F.2d 1388 (2d Cir. 1976), in which Judge Henry Friendly upheld a conviction for securities fraud despite the defendant’s claim that he believed in good faith that he had complied with the proxy rules’ disclosure obligations. BENNETT’S MOTIVE WAS UNIQUE: TO MARKET THE IPO What is different, however, is the motive. Refco’s CEO, Phillip Bennett, does not appear to have enriched himself from these loans; rather, he apparently assumed the obligations of defaulting clients to his firm. Why? Refco had extremely thin equity (only $150 million of equity, in contrast to $49 billion in assets, as of early 2005), and thus a writedown of $430 million in the debts of defaulting clients would have wiped out Refco’s razor-thin equity. Bennett may have been willing to assume liabilities in order to preserve Refco’s ability to do an initial public offering. This is a new twist on an old theme, but, as usual, the CEO was cosmetically window dressing his firm’s financial statements in order to market its stock. Second, in August, two months before Refco’s surprise announcement that it had placed its CEO on leave, it conducted a large $583 million initial public offering. Once again, the issue surfaces as to whether underwriters and auditors take due diligence seriously today. Once again, the underwriters will point their fingers at the auditor, and the auditor will in turn blame the management who lied to it. Finally, once again, courts must re-examine the issue of liability under �11 of the Securities Act of 1933. In the wake of the recent decision in In re WorldCom Inc. Securities Litigation, 346 F. Supp. 2d 628 (S.D.N.Y. 2004), which declined to grant the underwriters’ motion for summary judgment based on their affirmative defenses under �11, the scope of these defenses has become controversial. Third, amid a growing corporate backlash against �404 of Sarbanes-Oxley, which mandates a costly annual evaluation of internal controls, Refco provides a vivid illustration of their importance. In its Aug. 8, 2005, registration statement, Refco disclosed “significant deficiencies” in its internal controls, particularly with regard to its ability to prepare financial statements “that are fully compliant with all S.E.C. reporting guidelines on a timely basis.” This warning proved prophetic. From a criminal law perspective, Refco does involve some new twists. Unlike Ken Lay at Enron or Bernie Ebbers at WorldCom, Bennett did not remain remote from the scene of the crime. Although the materiality of his omission seems evident, Bennett’s assumption of liabilities arguably benefited his firm and may not appear as self-seeking as the conduct in more traditional fraud cases. Yet, as a result of Sarbanes-Oxley, Bennett faces new criminal charges that are easier to prove. First, �303 of Sarbanes-Oxley forbids any person from taking “any action to fraudulently … mislead any independent public or certified accountant engaged in the performance of an audit of the financial statements.” Presumably, Refco’s accountants, Grant Thornton & Co., will testify that they were misled by Bennett. Second, �402 of Sarbanes-Oxley, now codified at �13(k) of the Securities Exchange Act of 1934, forbids a public corporation, directly or indirectly, to extend “or to renew an extension of credit, in the form of a personal loan, to or for any director or executive officer … of that issuer.” Depending on how the liability shuffling was structured, the unwinding of the loan to Liberty Corner and the substitution of Bennett can be viewed as an impermissible “renewal” or “material modification” of the original extension of credit, which Sarbanes-Oxley expressly forbids. TWO AFFIRMATIVE DEFENSES CAN BE RAISED BY DEFENDANTS From a public policy perspective, the central drama in the Refco affair will be the attempt by the plaintiffs to assert liability against Refco’s directors, auditors, underwriters and controlling persons. Under �11, the plaintiff need not prove fraud, but only a material misrepresentation or omission; then, the burden shifts to the defendants, who have basically two affirmative defenses: a “reliance” defense under �11(b)(3)(C) of the Securities Act of 1933; and a “due diligence” defense under �11(b)(3)(A). Under the reliance defense, the underwriters and directors will predictably argue that they reasonably relied on Grant Thornton, Refco’s auditor, to determine if there were “related party” transactions between Refco and any insider. But, under �11, this defense works only so long as those asserting it “had no reasonable ground to believe” that the expert’s report was “untrue” or contained material omissions. Here, the defendants will encounter several problems. First the WorldCom decision found that a “red flags” exception has long existed to the reliance defense. If “storm warnings” surround the financial statements, then the underwriters and directors cannot rely on the auditor’s report and must conduct their own investigation. In WorldCom, WorldCom’s unusually low ratio of line cost expense to revenues (its “E/R ratio”) was found by the court to be such a red flag. Controversial as that ruling may have been with the bar, much clearer red flags have surfaced in Refco. First, Refco had concededly weak internal controls, as it accurately disclosed. Second, its chief financial officer had recently resigned, and the president of its brokerage subsidiary was then being investigated by the Securities and Exchange Commission, which was seeking to bar him from any supervisory capacity in the securities industry. Yet Refco still retained him as president. Finally, the $430 million indebtedness to a single hedge fund also seemed mysterious for a firm with equity as thin as Refco’s. If these factors amount to red flags, Refco’s board and its underwriters would be under a duty to investigate further. A second problem is that the omissions in Refco’s registration statement do not relate exclusively to its audited financial statements. Refco’s Aug. 8, 2005, initial public offering was necessarily on Form S-1, which incorporates Item 404 of Regulation S-K, which in turn requires disclosure of any transaction, or series of similar transactions, in which the amount involved exceeds $60,000 and a director or executive officer had “a direct or indirect material interest.” Thus, if after the end of the quarter, Liberty Corner repaid its loan from Refco and a loan to Bennett was thereafter reinstated, this would appear to be a “transaction” requiring disclosure. This omission was outside the financial statements and hence may require a “reasonable investigation.” For all these reasons, the liability of the secondary defendants in the Refco litigation may hinge less on the reliance defense and more on whether they conducted a “reasonable investigation” of the Aug. 8, 2005, registration statement under �11(b)(3)(A). Here again, WorldCom made clear that those seeking to assert this defense must do more than simply ask questions of management and rely on their assurances. Fact checking is required. At present, it is too early to evaluate this issue in the case of Refco, but only extensive due diligence can satisfy the WorldCom standard. Yet, curiously, such due diligence has largely disappeared from the public offering process. Why? In part, time pressures forced underwriters to eliminate traditional due diligence, and in part the bar convinced itself that SEC Rule 176 had eliminated the need for due diligence in shelf registration offerings. WorldCom has laid the latter myth to rest, correctly holding that Rule 176 did not change the prior law and will not normally provide a basis upon which a defendant can obtain summary judgment. BETTER SAFE HARBOR RULE SHOULD REPLACE RULE 176 The net result is a policy dilemma and a liability crisis, which only the SEC, and not the courts, can resolve. Courts cannot rewrite the law, but the SEC can. So what should the SEC do? The time is more than ripe for the SEC to admit that Rule 176 has been a failure and to replace it with a safe harbor rule that would define the elements of a continuing due disclosure system that focused on the issuer’s filings under the Securities Exchange Act of 1934, as they were prepared and filed. To be sure, such a system would have costs: Independent counsel would need to be retained to examine and test the corporation’s prospective disclosures, and ideally such counsel should report to the issuer’s audit committee, not its management. But the costs under this system would likely be far less than the costs of insuring and defending independent directors under the current system. Moreover, mandating a year-round system of due diligence should reduce the risk of fraud. The fog has not yet fully lifted over Refco. But at a minimum, it reminds us that weak internal controls can lead to financial collapse, that our contemporary system of due diligence seems dysfunctional and that outside directors are today exposed to high liability under �11 but can do very little to protect themselves. Something must change. John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and director of its Center on Corporate Governance.

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