Futures Shock

By Lawrence Carrel –
THE CORPORATE REPUTATION CAN be the most precious commodity of them all, derivatives broker Refco (RFX) discovered Monday. Shares of the financial intermediary sank 45% to $15.60 after the company suspended its boss for his alleged failure to disclose a conflict of interest.
CEO and Chairman Phillip Bennett controlled an entity that acquired a Refco receivable worth approximately $430 million, an internal probe determined. According to the company, this came as a surprise.

Because the debt was not reported as a related-party transaction, Refco warned that its financial statements dating back to 2002 can’t be trusted. The New York company also delayed fiscal second-quarter results that had been due next Monday. The announcement came two months after Refco’s well-received initial public offering.
The news is not all bad. Refco had viewed the debt Bennett came to control as possibly uncollectible, whereas the embattled boss rushed to repay it — with interest — Monday, the same day he began his open-ended “leave of absence.”
Another top executive, Santo Maggio, president and CEO of Refco’s securities and capital markets units, was also encouraged to take plenty of time off. Whereas Chief Operating Officer William Sexton, who announced his resignation just two weeks ago, reversed course and jumped into the hot seat as the new CEO. Two other executives, Joseph Murphy and Peter McCarthy, will divide Maggio’s duties.
Refco stressed that client funds on deposit “are unaffected” by the revelations. But it’s bringing in independent counsel and forensic auditors all the same.
This is not the first taste of scandal for one of the largest global dealers in futures and options. In May, Refco Securities received a “Wells Notice” of pending sanctions from the SEC as part of a probe into a private stock placement. In its IPO prospectus, Refco warned that Maggio could face a stiff penalty from regulators. At the time, Maggio was trying to negotiate a settlement that would have prohibited him from serving in a supervisory role for one year.
Yet investors who put $583 million into Refco’s Aug. 11 IPO didn’t seem to mind. The shares priced at $22, rose 25% on day one and hit an intraday high of $30.55 on Sept. 7. But while the stock had subsequently stalled heading into Monday’s implosion, Refco’s underlying business appears to be booming.
Though the earnings statement will be delayed, Refco did release some statistics about its most recent quarter. Derivatives brokerage and clearing volume increased 40% year-over-year and 2.5% sequentially to 212 million contracts. Foreign exchange volume surged 56% year-over-year and 17% sequentially to $477.4 billion. Not including the $433 million repaid by Bennett, Refco’s cash and cash equivalents stood at $648.6 million as of Aug. 31. Of that, about $230 million was subsequently used to redeem some of the company’s subordinated debt.
So why did the shares take a nosedive? As is usually the case with a company that seeks to reassure employees about “ample liquidity,” there are worries that Refco’s lenders will call in their loans, since these relied on the accuracy of its financial statements.
Good credit is vital to the company’s role as a clearinghouse for derivatives transactions. Yet Standard & Poor’s cut its rating on Refco’s counterparty debt from BB- to B+. “It’s very difficult to see any upside here because it raises so many questions about this company,” S&P credit analyst Tom Foley was quoted as saying by The Wall Street Journal. “We’re really concerned that creditors do have the right, or may have the right, at some point to accelerate the debt, because when the company borrows money, it makes a representation that its financial statements are true and correct and then today they basically said well, don’t rely on them.”
In its report for the May quarter, Refco listed $55.3 billion in debt. The company didn’t estimate when the investigation would conclude or when it might file second-quarter results. Refco declined to elaborate beyond the written statement.
“From our initial read, this transaction does not appear to affect operating results of the company, as the receivable was historically booked as revenue and the repayment of such actually improves the current balance sheet position,” wrote Goldman Sachs analyst Jonathan Tukman. “Rather, the issue is one of corporate governance, integrity of financial reporting, and potential regulatory and legal issues.”
Tukman doesn’t own shares of Refco; Goldman Sachs co-managed the company’s IPO.
Source: SmartMoney