INSIGHT-Clients who fled MF Global face clawback risk

Thu Nov 10, 2011 1:00am EST

* MF seg funds outflow in August biggest in since Jan '09
    * Unclear if MF Global used customer funds to trade
    * Customers of other bankrupt FCM settled out-of-court
    By Jeanine Prezioso
    NEW YORK, Nov 10 (Reuters) - Former MF Global customers
like Koch Industries, who pulled billions of dollars out of the
stricken broker's accounts weeks or months before its collapse,
have counted their blessings in recent days.
    But their relief may prove premature depending on the
outcome of a separate, four-year-old bankruptcy case involving
Sentinel Management Group Inc. The lawyer overseeing that case
has gone to court to try to force some of Sentinel's former
clients to take a share of the losses.
    Thousands of MF Global's commodity clients have been
clamoring over more than $1 billion in cash and collateral that
is still frozen. Yet many customers pulled out a large sum of
cash before the company declared bankruptcy on Oct. 31,
regulatory data and exchange estimates show.
    "Everybody and their brother started pulling money out
early," said one commodity hedge fund manager who withdrew some
of his funds prior to MF Global's fall. "People pulled money
out of Lehman and Bear segregated accounts when they knew they
were going bankrupt and nothing happened to them. It doesn't
mean it can't happen, but I don't see it."
    At issue is MF Global's "segregated accounts" -- client
money meant to be kept strictly separate from the broker's own
funds, but which regulators say is now $600 million short.
    That pot of money shrank by $1.5 billion in August alone,
government data showed. Another $1.8 billion fled over the
following two months, according to preliminary estimates.
    In total, customers pulled out more than a third of their
accounts in the three months leading up to MF Global's
downfall, much of that in the frenzied final days, traders
reckon.
    For instance, privately held Koch Industries -- whose
businesses make it a leading commodities trader -- sent a
letter to trading partners on Oct. 3 saying it was switching
eight accounts from MF Global to Mizuho Securities USA.
    Koch Industries did not comment on the reason for its
move.
    It remains unclear how many customers who withdrew funds
from MF Global were influenced by the broker's financial
condition or Chief Executive Jon Corzine's euro zone debt
trades that led to its collapse. Whether they will be able to
keep the money they withdrew may depend on the outcome of legal
actions stemming from the Sentinel case.
    Frederick Grede, trustee for the bankruptcy of futures
commission merchant (FCM) Sentinel, has sued 50 of its former
customers to recoup some $600 million in funds that were
withdrawn prior to its bankruptcy.
    He has already settled out of court with some customers and
recovered about $25 million. The rest remains in litigation,
filed before the two-year statute of limitations ran out.
    His view is that the loss of funds should be shared
equally, on a pro-rata basis, among all customers, not only
those who were left holding the bag when Sentinel filed for
bankruptcy.
    Grede says his case differs from that of former customers
of Bernard Madoff Investment Securities. For one thing, he
insists that he does not have to prove fraud occurred in the 90
days preceding the Sentinel bankruptcy, the timeframe he is
focusing on.
    "Sentinel was a case of misappropriating funds," Grede
said. "They used customer funds for speculation for their
accounts. Ultimately it's my position that all customers should
be treated equally. I don't have to prove that they knew the
company was going bankrupt (before they took out the funds)."
    CLAW BACK EXPOSURE
    Sentinel was a different type of FCM than MF Global, and
served as a professional "broker for brokers", clearing trades
on behalf of other brokerages -- including MF Global itself.
    But the Sentinel case still could set a precedent for MF
Global if attorneys for former clients can show that MF Global
used customer funds to trade its own book.
    FCMs are strictly limited to what they can invest in using
segregated customer funds, essentially the money that customers
use to trade and post collateral.
    Those monies are explicitly meant to be kept separate from
those of the firm. The U.S. Commodity Futures Trading
Commission permits segregated customer funds to be invested in
certain liquid, high-investment grade securities such as
corporate and government bonds.
    In Sentinel's case, those bonds were removed from
segregation and used to pledge for bank loans, Grede said.
    Proceeds from the loans were then improperly used to trade
in the firm's proprietary trading account.
    Former MF Global customers are concerned that trustee James
Giddens may seek a similar route to recoup funds unless he can
find the roughly $600 million that is still missing.
    Chris Hehmeyer, CEO of Chicago-based proprietary trading
firm HTG and an advisor to futures brokerage Penson, moved "a
chunk" of his business earlier this year to MF Global. But by
June, he decided to take his business elsewhere because MF
Global stopped offering a financing service that HTG needed.
    "With the Sentinel bankruptcy, the industry did not pay
nearly enough attention to the claw back issue, and it's still
out there, four and a half years later," he said. "I understand
I could still have some exposure because this issue hasn't been
resolved."
    Kent Jarrell, a spokesman for the MF Global bankruptcy
trustee, told Reuters the trustee will "explore all possible
causes of action."

  
    UPHILL BATTLE
    Experts say it would be a long shot to claw back
withdrawals by clients who may have known nothing about MF
Global's impending collapse. But that has not stopped several
lawyers from attempting it.
    Ronald Filler, a professor of law at New York Law School
who also worked on the Lehman Brothers bankruptcy, said that to
the best of his knowledge, case law on this matter is
nonexistent. In the cases of Lehman Brothers, Bear Stearns and
former FCM Refco, segregated funds were never at issue -- the
money was never touched.
    "It would be a case of first precedence," Filler said. "As
long as they acted during the normal course of business and
they didn't have knowledge of the bankruptcy, there's not
enough case law to prove any of these theories."
    In the Sentinel case, some of the customers who paid
out-of-court settlements may have decided it was cheaper simply
to settle than go to court and incur hundreds of thousands in
legal fees, Filler added.HOW MANY LEFT
    While it's not yet clear exactly how many customers fled MF
Global in its last ailing week after it suffered credit
downgrades, regulatory and exchange data suggests the run may
have occurred much earlier and been more severe than previously
understood.
    During August, as its share price began to slide but well
before its Oct. 27 credit rating downgrade, segregated account
funds fell by about $1.5 billion, data show, the biggest
monthly drop in funds since at least Jan. 2009.
    As of Oct. 31, the CME estimated that MF Global Inc.'s
"current segregated funds requirement" was $5.45 billion,
according to a bankruptcy court filing on Wednesday seeking
permission to transfer customer accounts in bulk.
    That compares to $7.27 billion reported to the CFTC as of
Aug. 31, according to a monthly filing required of futures
commission merchants. It was the lowest since July 2010.
    Since reaching $8.8 billion in July, holdings fell by 38
percent in just three months. A last-minute scramble to extract
cash from the broker in its final days was fruitless for some
unlucky customers who reported this week that checks cut on the
Thursday and Friday prior to its collapse were bouncing.
    Of those customers who remained, the process of returning
their funds has been frustratingly slow.
    Of the CME's $2.5 billion share of the total $5.5 billion
in segregated funds, about $1 billion in cash and collateral
remains frozen at MF Global. With other exchanges having moved
across similar funds, more than $2 billion may still be stuck.
    Most agree it's far too early to tell whether former MF
Global customers will have to return any money.
    "We're in unchartered waters now and it's interesting to
see what the outcome is going to be," said Filler.
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