Insight: Clients who fled MF Global face clawback risk

NEW YORK Thu Nov 10, 2011 4:59pm EST

A man exits the office complex where MF Global Holdings Ltd have an office on 52nd Street in midtown Manhattan New York, October 31, 2011. REUTERS/Brendan McDermid

A man exits the office complex where MF Global Holdings Ltd have an office on 52nd Street in midtown Manhattan New York, October 31, 2011.

Credit: Reuters/Brendan McDermid

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NEW YORK (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 October 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 October 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.

Sentinel had been given an exemption to receive FCM status but essentially had no commodity brokerage accounts and operated more like a hedge fund.

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." Keywords: MFGLOBAL CLAWBACK

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.

Any lawyer looking to claw back funds from customers who took money out of MF Global preceding the bankruptcy filing would have to argue against a mountain of law protecting commodities brokerage customers.

The bankruptcy court order said that no accounts transferred after the bankruptcy were subject to "avoidance" or "clawback". One lawyer interpreted that as applying to funds taken out prior to the bankruptcy as well, but other attorneys could not confirm that interpretation.

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 October 27 credit rating downgrade, segregated account funds fell by about $1.5 billion, data show, the biggest monthly drop in funds since at least January 2009.

As of October 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 August 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.

(Reporting by Jeanine Prezioso. Additional reporting by Jeffery Kerr and Robert Gibbons in New York; Ann Saphir in Chicago. editing by Edward Tobin and David Gregorio)

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