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Employees at futures broker Lind-Waldock held a party one Friday in late April to celebrate an achievement: For the first time since October of last year, funds in customer segregated accounts exceeded the amount held when Refco Inc., then parent company to Lind-Waldock, collapsed into scandal and filed for bankruptcy.
For customers of regulated Refco business units, the protections afforded them under the Commodity Futures Trading Commission (CFTC) regulatory structure worked. Despite some uncomfortable moments, futures traders were able to access their funds, which were held in segregated accounts, and transfer those funds to another futures commission merchant (FCM) with a minimum of trouble. And for those who stayed with introducing brokers that cleared futures trades through Refco LLC, most were up and running again in a matter of days after Refco LLC filed for Chapter 7 and was auctioned to Man Financial Inc., a subsidiary of Man Group Plc. Customers of unregulated business units, such as Refco FX Associates LLC, have had another experience altogether.
"We are facing the fact that if our account is not released to us soon, we are going to have to sell our house or face losing it," says Gail Butler, a Refco FX account holder. A year after her husband lost his job, she received a private loan from a family friend and opened a $50,000 trading account at Refco FX. Less than one month later, 17,000 Refco FX trading accounts were frozen, hers included, when parent company Refco Inc. filed for bankruptcy. Butler says her family is now facing the certainty of personal bankruptcy.
How is it that life has returned to normal for futures traders and yet six months after Refco's collapse, thousands of retail forex traders may not remove funds from their trading accounts? What consumer protections do futures traders enjoy that foreign exchange customers do not? What regulations have kept trading accounts free and available to some while offering seemingly no protection to others?
Regulated vs. unregulated
The futures industry is regulated by the CFTC, which was founded by Congress in 1974 with the mandate to regulate commodity futures and options markets in the United States, and is charged with "protecting market users and the public from fraud, manipulation and abusive practices related to the sale of commodity and financial futures and options," according to its charter.
"There are three levels of regulation in the futures industry. There's the CFTC, then there's NFA and then there are the actual exchanges and clearing organizations that have rules that their members have to follow," says Larry Dykeman, a spokesperson for the National Futures Association (NFA). Futures brokers and FCMs must be registered members of the NFA. Regulation and membership creates an infrastructure based on the interdependence traders, brokers, FCMs and the exchanges and is enforced through mechanisms such as the centralized clearing of trades, minimum capitalization requirements and the segregation of funds.
Many forex brokers do fall under the CFTC's authority, as per the Commodity Futures Modernization Act of 2000 (CFMA). The CFMA required off-exchange platforms offering forex trading to retail customers to register with the CFTC. But some selling agents, such as the offshore RFX, were left out and the more stringent segregation rules were not imposed.
"The CFMA did give the CFTC limited authority over retail forex, if they are futures contracts," says Kathryn Page-Camp, associate general counsel at the NFA. The issue is that 'futures contract' is not defined in the act, as was demonstrated in the Zelener case. "It is a loophole and we are working with congress to close it" in the CFTC reauthorization process, she says.
Capitalization and segregation
FCMs are required by the NFA to maintain a minimum net capitalization of $250,000, and significantly more depending on many factors. Also, they are required by the CFTC to hold, in trust, performance bonds or margin accounts from clients, segregated from the FCM's own capital. Thus, anytime a client puts on a trade, the FCM collects an initial margin for the position. This margin is adjusted daily as the price of the position goes either for or against the client. And the funds in those segregated accounts are to be separately accounted for and available only for trading. The margin requirements vary based on the contracts to be traded and by exchange-specific requirements.
"In this way, if the FCM goes bankrupt or insolvent, all of the customer funds are intact and the customers aren't affected by the bankruptcy," explains David M. Matteson, head of the hedge funds practice group and investment management practice at law firm Gardner Carton & Douglas LLP.
The segregation of funds is one of the most important customer safety mechanisms in the futures trading industry and is designed specifically to protect futures traders in the event of insolvency. "Under part 190, the customer property is part of the bankruptcy estate, but it is treated as a priority creditor," says Eric A. Bloom, president and CEO of Sentinel Management Group Inc.
He explains if an FCM blows up due to proprietary trading, then the segregated accounts would be moved to a solid FCM and there would be no losses, which is essentially what happened with Refco LLC, the regulated futures division of Refco Inc. But even the segregation of funds doesn't provide absolute protection. "Segregated funds really just protect the customers from the creditors of the FCM themselves. Not from one another."
If an FCM blows up based on bad trades from Customer A, then Customer B could lose their money in the process of bringing that segregated account back to zero. And for that reason, Bloom also stresses the importance of using a sweeper account and removing any excess capital from the FCM, "Because once you remove it from the FCM, obviously, you cannot be asked to participate in the pro-rata distribution of the loss."
Without a net
This infrastructure simply doesn't exist for forex traders. Because foreign exchange is an OTC market, not a designated contract market, the CFTC does not regulate the foreign exchange dealers except in instances of fraud and in those cases where forex dealers are found to be trading off-exchange illegal futures and options contracts.
Forex dealers operate almost as if they were independent miniature exchanges, performing their own clearing functions. They are not required to segregate customer funds from the dealer's own assets. "Thus, if the foreign exchange dealer goes bankrupt or insolvent, it can take its forex customers' assets down with it, and the customers become claimants in the bankruptcy," Matteson explains.
However, many firms offer customer protections. Michael Weiner, co-founder and managing partner at COESfx Holding Inc., a forex platform provider, says, "even though we separate customer funds from corporate funds, they are not treated that way. We have an account that says 'corporate,' and only corporate funds go in there. We have one that says 'customer,' and only customer funds go in there." The intention is that in the case of a bankruptcy, the company and the customers would have documentation on which to build a claim. In addition, the firm also protects customer funds from any potential fraud perpetrated by COESfx employees through a Fidelity 14 bond.
Naturally, before committing funds to any sort of trading account, it is important to read the account agreement and to understand the customer protections and the risks involved. As RFX customers are finding out, verbal agreements and assurances are worthless if your funds are tied up in a bankruptcy proceeding.
"Refco played on the fact that they were the world's largest broker," says Paul M. Palley, a founder of Refco FX Account Holders, a message board for account holders to exchange information. "Again and again they said, 'your funds are segregated; they are safe, they are ring-fenced, no one can move them.'" He likens the conversations to those he would have with a banker. "Any normal human being takes them at face value. When you get a banking contract from a reputable company, you don't read all the fine print. What you do is you simply avoid small companies. And that's where we all fell. And in hindsight it looks like we were negligent, but it's not negligent. Everyone treats large companies in that way."
Norma T. LaVigne, a Refco FX account holder, transferred more than $50,000 from her IRA into the Millennium Trust Company to fund her Refco FX trading account, and despite this precaution, finds that her money is tied up in the Refco bankruptcy.
"People aren't born knowing these things, and there is no reason to expect with every other experience you have," she says. "With buying a house, they have to put it in escrow. You put property in a guy's warehouse, it's not his right to use the property you put in that warehouse as collateral for his own debt. Everything we know and accept as standard business practices in the United States would support the assumption that money was to be held segregated and appropriately held as in any other brokerage account. And if not, then the CFTC should have made that clear. And they never did, in any place."
In the NFA publication, "Trading in the Retail Off-Exchange Foreign Currency Market: What Investors Need to Know," the lack of safeguards are described: "You are relying on the dealer's creditworthiness and reputation. Retail off-exchange forex trades are not guaranteed by a clearing organization. Furthermore, funds that you have deposited to trade forex contracts are not insured and do not receive a priority in bankruptcy. Even customer funds deposited by a dealer in an FDIC-insured bank account are not protected if the dealer goes bankrupt." This is precisely the situation that Refco FX customers find themselves in.
Bankruptcy: A brief overview
"One of the fundamental principles underlying the Bankruptcy Code is equality of distribution," says Peter Roberts, a bankruptcy lawyer in Chicago with Shaw Gussis Fishman Glantz Wolfson & Towbin LLC. "Or as I like to put it, 'everybody ought to get screwed the same.' And what that means is that all creditors should get a pro-rata share of what ever is available out there," unless that unsecured creditor qualifies special treatment as recognized by the code, such as those with wage claims or tax claims.
Another exception in the code is carved out for the customers of stockbrokers. But for those provisions to apply, the company would have to fall under the bankruptcy code's definition of a stockbroker. "With a stock broker however, you throw into the mix this preferred class of creditors called customers that are treated better than everybody else," Roberts says. "And that is really where the dispute lies. The customers want that elevated status and the creditors committee is saying, 'Oh no. You need to treated like all the rest of us."
Customers of Refco Capital Management (RCM) won a preliminary ruling to convert RCM's bankruptcy case from a Chapter 11 to a Chapter 7, a so-called stockbrokers liquidation, giving preferential treatment to customers ahead of other unsecured creditors. While that bodes well for RCM customers, whether this will help the 17,000 RFX customers remains to be seen because of important differences between the two groups. While the majority of RFX customers are private individuals with retail trading accounts, customers of RCM are institutional traders and are represented by lawyers on the creditors' committee and in that courtroom, two distinct advantages that RFX customers, as of yet, do not share.
At the beginning of the bankruptcy process, J. Gregory Milmoe, a lawyer from Skadden, Arps, Slate, Meagher & Flom, the law firm representing Refco in the bankruptcy proceedings, declared: "It is Skadden Arps' preliminary view that these accounts are not customer property and therefore people who have given us money in the unregulated business are creditors." By declaring customers to be creditors, customer accounts have been frozen and could be used by Refco to pay back secured and unsecured creditors, despite marketing messages from Refco and reassurances from Refco employees that the customer funds were safe.
LaVigne is seeking to change that by petitioning the United States Trustee, to appoint counsel to represent the retail account holders. And while many Refco FX account holders are discussing the possibility of filing a class action suit, she says the difficulties are seemingly insurmountable given the limited time available. "It's pretty much an impossibility, which is what the creditor committee is counting on," LaVigne says. "The court, in recognizing that there are distinct categories of creditors here, should appoint a legal team that, in good faith and with their honest effort, should represent our best interests. Because as it is right now, the creditor team is looking out for Bank of America and the other big creditors."
Note: This feature length cover story by Chris McMahon originally appeared in the June 2006 issue of Futures Magazine.
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