Lessons We’ve Learned from MF Global


by Linda H. Smith, DTN Markets Editor

OMAHA (DTN) — Risk comes with the turf for farmers and ranchers. But the risk of being caught in a brokerage and clearing house collapse was not even on the radar screen for most hedgers when MF Global declared bankruptcy Oct. 31. What have we learned and what actions can producers take?

First and foremost is that client funds are not always sacrosanct, as once widely believed. “A broker-dealer may re-pledge or re-hypothecate customer account assets in the U.S. up to 140{962fe9be9a8a5c386944bfa41f48d98b010325707b70b1fa6182bcabd27c5d7f} of the net value of those assets,” said Ed Pekarek, an attorney, professor at Pace Law School in White Plains, N.Y., and assistant director of the Pace Investor Rights Clinic, explaining that hypothecate means using the assets as collateral against which to borrow for the firm’s own leveraged investments. Furthermore, the fine print in some contracts specifically gives the brokerage company that right, he added.

In the 2005 Refco bankruptcy, clients were simply treated as creditors, and in most cases did not regain all of their money. In the case of Refco, the big bank creditors employed “claw back” provisions that allowed them to pursue additional money from clients. Pekarek is doubtful they would have success in this case, however.


What can you do if that kind of situation arises in the future? “One strategy is to work with a local broker,” said Pekarek. “But that is not a total solution — you need to find out who does the clearing for the broker and who holds the money — the ‘back office’ functions.”

Read brokerage contracts closely. “The terms and conditions will play a big role in how the residual funds are distributed,” he said. “Contracts that specifically agree to hypothecation and/or ‘re-pos’ mean that the company’s use of account assets may have been perfectly legal within the applicable laws.”

Another way to minimize your exposure is to use a “cash account,” transferring money in and out only as needed, so your brokerage account doesn’t accumulate a large quantity of cash. Since the MF Global debacle, many grain elevators now sweep their margin accounts daily so no excess funds accumulate.

Do your homework — look up records for your local broker, his or her firm and its clearing firm. You can start with your state licensing bureau or local attorney general’s office. The National Futures Association’s (NFA) web site has an “Investor” tab where you can check a broker’s history regarding complaints or arbitration cases. “NFA also has a phone bank of people who can answer questions about situations,” said Alison Archer, senior counsel with Bowman and Brooke LLP in Minneapolis, who was a compliance officer for NFA and later served as compliance manager for Cenex Harvest States.

Another place to check is the Commodity Futures Trading Association’s (CFTC) website tab for Consumer Protection. There, you can look up brokers under (active) Case Status, Disciplinary History and Sanctions in Effect.

“Where a company is registered may offer a warning sign,” Pekarek said. “I would think twice about doing business with someone in bank secrecy havens such as the Cayman Islands, for example.”

He urges producers to form a bargaining group to increase their clout with brokerage firms to get more client-friendly terms. “You can be sure that big firms and hedge funds negotiate what can be done with their account proceeds,” he noted. “A single farmer may not be able to do that, but an entity representing a large number of them might be able to strike a better deal.”


Another thing we’ve learned is that we don’t learn from past mistakes. “The horse was out of the barn almost seven years ago, when Refco failed,” he said, noting that Refco used customer assets to make loan payments on behalf of one of the firm’s units.

“It is widely reported that MF imploded due to excessively leveraged European sovereign debt investments. If so, it may not have violated any laws regarding the assets it purchased using customer account assets as collateral,” said Pekarek. At the time, CFTC Rule 1.25 expressly allowed purchase of sovereign debt using customer-segregated funds in a broker’s daily business, although it has since been amended.

Another headwind regarding possible criminal charges against MF Global is U.S. law’s principle-based framework, said Pekarek: “If you read the language used by the three MF executives [in congressional testimony] — ‘never intended,’ ‘never instructed,’ and so on, it raises the question of whether they are culpable … If it is unintentional, it creates problems for regulators and courts.”

Close ties in the financial industry are also a problem. “If we are in a world where industries are self-regulated, potential cronyism or undue influence should be sought and addressed. Self-regulators should be held to highest standard available,” Pekarek said. He pointed to the Commodity Futures Trading Commission’s 2010 proposed change in Rule 1.25, which would have removed foreign debt instruments from approved investment of client funds. “MF Global was a staunch opponent of the CFTC proposal in a December 2010 comment letter submitted jointly with Newedge USA. The proposal was delayed — then passed unanimously after the MF Global collapse.”

Harmonizing laws among countries could also eliminate temptation for companies to overextend themselves, Pekarek added. “MF probably used its UK subsidiary to provide customer account funds as collateral against leveraged purchases of European sovereign debt instruments because, unlike the 140{962fe9be9a8a5c386944bfa41f48d98b010325707b70b1fa6182bcabd27c5d7f} leverage allowed by U.S. law, the UK has no such limit — it is whatever the market will bear,” he explained.

“We need to foreclose the incentive to go where regulation is lowest and opportunity hence is greatest. Canada has such stronger measures in place, and its MF customers were made whole in November, while U.S. clients were still waiting a month later,” said Pekarek.

Some experts think commodity traders need insurance to protect their accounts, similar to the Securities Investor Protection Corporation that protects customers of stockbrokers. Dubbed the Futures Industry Securities Corporation, such a fund would reimburse customers in firm-liquidation cases. Pekarek said the proposal is “entirely appropriate,” even though the industry may resist new transaction fees to provide the funding.

“We really don’t need more laws, we need more effective laws. We need fine-tuning and stronger enforcement of the regulations already in place,” Pekarek believes.

For more information, download “Investor Guide to Disputes” from the Investor Rights Clinic, at www.finrafoundation.org/InvestorGuidetoDisputes or e-mail your request for a free copy to jjls@law.pace.edu.


© Copyright 2012 DTN/The Progressive Farmer, A Telvent Brand. All rights reserved.

Posted with DTN Permission by Haylie Shipp


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