This week’s newsletter was supposed to be a spotlight of one of our top ranked managers- a celebration of research, innovation, performance and risk management. Instead, we find ourselves staring at a blinking cursor on our screen with a mix of disbelief and rage.
When we originally penned our white paper, How to Save the Futures Industry, we had no idea that we would be staring down the same deficiencies less than a year later. Today we learned that PFGBest has had a customer fund shortfall amounting to approximately $220mm (perhaps dating back to 2010). As the story has unfolded, the details have been at turns nauseating and infuriating, as a web of deceit unravels before our eyes.
MF Global had us angry, but this time, it’s personal. Our clients have money with PFGBest. We have money with PFGBest. We were misled by senior leadership that we trusted in business. We were let down by regulators. We were failed by our government.
Enough is enough. Here, we’ll break down what we know so far, the possibilities on the horizon, and the swift, decisive action necessary to keep this travesty from becoming the final nail in the coffin of a marketplace that serves as a heartbeat of our global economy. Because, to borrow a phrase from Captain John Paul Jones, we have not yet begun to fight.
PFGBest is a non-clearing FCM based in Cedar Falls, Iowa. Prior to today, the firm had roughly $440 million in assets- at least, on paper. It was certainly a smaller firm compared to the MF Global’s of the world, but we had always received excellent customer service from them. The firm was buzzing over Wasendorf’s August nuptials.
After MFGlobal, Attain began enhanced due diligence on the FCMs with whom we have relationships. During this time, we had multiple conversations with both Wasendorf and other executives with PFGBest, where all questions were answered satisfactorily. The firm was in compliance with the NFA and CFTC, and had shored up our confidence with the right responses and attitude. They were a firm focused solely on futures and forex clearing, and beyond that – weren’t has tied to short term interest rates with their slightly different model of providing ‘product’ to their customers at slightly higher revenue.
However, because of the way MF Global played out, we also committed ourselves to enhancing the ongoing due diligence process for our FCM relationships. After all, due diligence is not a one-time conversation. Again and again, we were assured of the firm’s health and compliance, even after they were smacked with a hefty fine and lawsuit over their forex dealings. Those who have been in the futures industry long enough will tell you that any FCM that’s been around for longer than a blink has at least one of these on their record, necessitating contextualization in their consideration, and after hearing from several within the company that the lawsuit was “frivolous” and checking with our own attorney’s on the possible effects of having to pay the entire fine – we did not feel immediate action was necessary with our accounts there, though we did begin establishing additional FCM relationships in addition to the backups we already had in place.
It was around 2:30 PM on Monday that the calls started. Initially, it was another industry participant who wanted to know if we’d heard the news- PFGBest had been put on liquidation only following an apparent suicide attempt by Wasendorf. The story, in our minds, seemed absurd, but before we could even get off the call, other FCMs were calling, offering their support in our time of need. We tried calling the trading desks at PFGBest, and hit a continuous busy line. After finally making contact with members of other departments at PFGBest, the rumors were confirmed. Russ Wasendorf Sr. had attempted to commit suicide, and the firm was, indeed, on liquidation only.
At 3:09 PM, we received the following email:
We began to prepare the necessary paperwork for a bulk transfer of our customer accounts to another FCM, talking with other FCMs we work with to see who could facilitate the transfer the easiest. In the meantime, we called our contacts throughout PFGBest, hoping for more clarity. Here we learned that one of the Iowa PFG employees had seen from her office window that Wasendorf’s car was parked in the company lot in a different place than it should have been. Wasendorf’s son was notified of the irregularity, and upon going down to the car found his father locked in his car with a tube attached to the exhaust in an apparent suicide attempt. The suicide note indicated something along the lines that they would find an accounting error in the company books
At first, we had hoped, especially knowing Wasendorf, that the “error” would be (relatively speaking) small- perhaps relating to his personal trading account or some kind of tax discrepancy. It wasn’t long before the NFA released a report that quashed those hopes. It contained the following affidavit:
There was no misunderstanding. Fraud was committed. PFGBest had submitted false confirmations of account balances. And segregated funds- ours and that of our clients- was missing. Those we spoke with at PFGBest claimed they had been taken off-guard just as much as we had, and we then heard reports that, following a staff meeting this afternoon, some employees began to pack up their desks.
As of last night, we had granted our managers discretion in choosing whether or not to liquidate positions. As of this morning, we’ve received word that Jeffries raised margin requirements for all PFGBest accounts, knowing the firm could not meet the financial obligations and it would force the positions into liquidation. The following email was received this morning:
And all of this a mere months after Wasendorf, Jr. promised the world that PFGBest was no MF Global.
The situation right now is fuzzy at best. We don’t know where the $220mm is, and we likely won’t for days at a minimum. We don’t know whether the situation will be handled via receivership, a la REFCO, or like a Broker Dealer bankruptcy via SIPC as MF Global was (please don’t do that again). What we do know is that this catastrophe is the inexcusable consequence of deceit and ineptitude.
It was eight months ago that we laid out the steps that needed to be taken to set the futures industry back on track, and despite the best efforts of many a well intentioned futures markets participant, very few have been taken. Since the message has clearly not been received, let’s revisit the changes we need, shall we? Maybe this time, people will listen.
Extend SIPC protection to futures investors.
SIPC protection is currently only offered to securities customers- meaning only those trading stocks and bonds are covered in the case of their broker losing their money through a bankruptcy. In our minds, there is zero reason why investors in traditional asset classes should be afforded such protection while investors in the alternative space are not.
As such, we propose that regulations governing the SIPC be amended to ensure protection of futures clients’ holdings as well, with guarantees on the individual account level (the sub-account of the customer segregated account on the FCM’s books) and not just the main overall account level containing all of the customer funds.
The CME and ICE should cut 10% off their marketing budget and put that to lobbying Congress for this protection. This isn’t 1970, when stocks and bonds were the only game in town. If the world turns to the CME to manage risk, the CME needs to turn to Congress to lower the risk of managing that risk. While there was some discussion in the months that followed the MFGlobal collapse of creating an entity similar to SIPC for futures investors, no action has been taken, leaving PFGBest clients wondering what comes next- ourselves included.
Establish regulation outlining standard operating procedures in the wake of an FCM bankruptcy.
Part of the reason that the MF Global situation was so chaotic was the result of poor planning. Positions were stuck in limbo. There was no infrastructure for facilitating an orderly transfer of accounts, which led to an ad-hoc distribution among arbitrarily selected FCMs without the transfer of legal documents- including those necessary for a CTA to trade on behalf of a client. Without any stipulations regarding timeframe, the process was drawn out to the detriment of all parties involved. Add to that a failure to effectively communicate what was going on to the clients involved, and it’s no wonder the situation turned into the nightmare it did.
In the wake of both the Refco and Sentinel scandals, one would think that remedies would already have been put into place for such administrative Bermuda Triangles, but unfortunately, that did not occur. In order to prevent such a disorderly dissemination from occurring again, we suggest that new regulations be developed; outlining exactly what is to happen in the event of an FCM going bankrupt. The old plan seemed to be, wait for a suitor to step up and take on all of the accounts. That clearly worked out wonderfully this time around. Coming up with standard operating procedures outlining the immediate impact on open positions, where the client funds are to be transferred to and within what timeframe, and so forth would help avoid the confusion we’ve seen to date.
This was probably the easiest change we proposed, but steps have yet to be taken to even draft such procedures.
We’ll add a new twist to this solution, saying that such a blueprint or plan should also cover what to do in the case of an FCM being found to have a shortage in customer funds.
Establish regulation under which language must be added to all creditor agreements for any registered FCM in which those creditors agree to the assignment of the customer segregated accounts as the primary lien holder on all assets of the company.
Under current provisions, segregated accounts are given what is, in our minds, inadequate protection during the bankruptcy process. True, their accounts cannot be tapped to meet outstanding financial obligations of the bankrupted FCM, but there’s also no guarantee of those funds being made whole in the event of a shortfall, nor protection from a too big to fail bank like JP Morgan sending in armies of attorneys arguing that their claim should take precedence over the customers. While clients may, after a pro-rata distribution, file a claim with the Trustee in an attempt to get their missing money back, it appears that there are back door methods for big creditors like JP Morgan Chase and those who held MF Global bonds to get in front of the customers in the claims process. As TheStreet summarized:
“The group of customers, led by James Koutalas, chief executive of a Chicago-based commodities trading firm, are taking issue with a lien and other protections offered to JPMorgan in exchange for a $8 million loan the bank extended to MF on the first day of its bankruptcy, according to the report. That would allow JPMorgan the right to some assets over other creditors.”
In our minds, segregated account holders should absolutely come first in the claims process. Unlike the creditors and bold holders, who knowingly accepted the risk of default when they handed over their money, MF Global clients were paying MF Global to hold their funds- not lose them. With this in mind, we believe that the law must designate segregated accounts as the primary creditor if an FCM goes belly up, ensuring that, should there be a shortfall in client segregated funds, available assets of the bankrupt FCM will be tapped to make those accounts whole before any other creditor gets their day in court.
Again, a missed opportunity in the industry. There is no such protection here. In the MF Global case, founder of the CCC, James Koutoulas, indicated that the declaration of bankruptcy by the securities side of the business helped enable JPMorgan to stand first in line for reimbursement of debts. While PFGBest was primarily focused on clearing futures and forex, they, like MFGlobal, have a smaller securities arm. Oh, and guess what? Some of the funds for the firm were being held at JPMorgan here, too. We have no idea whether tomorrow will bring news of receivership or bankruptcy, JPMorgan liens or otherwise, but should the case be bankruptcy, our concern is that the industry’s failure to act in this area of regulation could end up burning investors once more.
Unfortunately, it’s not just a matter of the same problem popping up again. Putting aside personal involvement, the aspect of this situation that is so desperately disconcerting relates to the regulators. The PFGBest case highlights additional problems in the regulation of the futures industry- particularly relating to the competency of the CFTC and NFA.
We now know that there were false statements made all the way back in 2010. We know that the NFA is the self-regulatory agency charged with overseeing PFGBest. Think it through:
- Regulators conducted spot checks on all FCMs following the MF Global bankruptcy. No action was taken against PFG at the time.
- Regulators have been in the process of conducting a regular audit of PFG for the past several months- an audit which takes place on an annual basis. In our experience, both with Attain and other firms, this includes direct contact with the banks holding firm and customer money to confirm the numbers provided by the firm being audited. In fact, the NFA just switched to a 3rd party firm to conduct these confirmations, aptly named confirmation.com. Below is an example of just such a digital confirmation request generated by this confirmation software.
Sample Confirmation Authorization Request from NFA
- FCMs are required to provide daily and monthly segregation reports. These only require confirmation of the accuracy by the individuals submitting the report, but the NFA still failed to even due a minimum in vetting of these reports.
- According to the NFA, “A Form 1-FR for the FCM’s or IB’s fiscal year-end must be certified by an independent public accountant.” Who was the auditor who confirmed the balance of money at U.S. Bank? And did the NFA properly analyze the audit?
The failure of the NFA to catch this apparent fraud is a travesty, at best. As members of the NFA, it is our dues that pay for the “regulation” provided by the NFA. Excuse us, but can we have our money back?
Outside of our frustration as members, it has become abundantly clear that our regulators are asleep at the wheel. The NFA answers to the CFTC, and the CFTC is to answer to Congress. Yet, the CFTC clearly failed to monitor NFA responses to the MF Global crisis, and we saw in the MFGlobal Congressional proceedings that our elected officials are more interested in political grandstanding than thorough investigation and effective questioning. Perhaps more importantly, they have little to no understanding of the way the markets they regulate over oversee operate.
So, what, exactly do we want to see happen in the coming days and weeks to address this egregious failing?
- Timely liquidation of all PFG related assets to satisfy the shortfall of client funds.
- If there is still a shortfall – the CME and other major players in the industry stepping up to make customers whole (yes, it sets a precedent, but you will earn it back 10 fold in karma and respect)
- A full investigation of PGFBest by the Attorney General, along with prosecution to the fullest extent that the law allows for any crimes committed, either by auditors, the firm or individuals within.
- A full investigation into the practices and behavior of the NFA, and, should the findings support it, prosecution of the NFA for losses incurred due to their failings.
- Congressional hearings on the failings of the NFA and CFTC in this instance without the soft balling seen in Dimon’s questioning.
- The commission of a report by the Government Accountability Office into the practices of futures SROs, the CFTC, and Congress in terms of efficacy and consistency.
While the solutions we discuss may seem, at times, lofty, they could not be more necessary. This isn’t just about a couple hundred million in client funds. This is about the existence of an entire global marketplace.
You hear of banks being too big to fail, but this is a totally different level of significance. This is an industry that is tooimportant to fail. The recency of the MFGlobal scandal, coupled with this new crisis at PFGBest, has decimated confidence in the futures industry. Take one glance at the Twitter feed for PFGBest right now, and you’ll find a litany of comments regarding the “death” of the futures industry. If people cannot trust their FCMs to safeguard their funds, they will pull the money out of the markets. What happens when futures markets become shells of themselves?
John Highland, CIO of United States Commodity funds, explained in a post we put out on oil speculation several months ago, “We go back to the 1970′s where OPEC posts the price of oil. You don’t like it? Tough. Maybe we go to a market like Iron Ore, where six private companies hold shadowy negotiations to set the price in an opaque manner. The third choice is that you have more participants involved, but because of the inability for players to hedge their positions, you’d be far more susceptible to higher price volatility, and, on average, higher prices.”
“No one will finance an oil company at the current rates in this scenario, but if we assume that they would, all the sudden, you can no longer [transparently evaluate the prices as collateral], so you either charge them more, which leads to higher prices [transferred to the consumer], or you loan them less, which will lead to less capacity coming on stream.”
So either we go to a dictated price, a shadowy oligarchy determined price, or a small market that’s rolling dice and exposed to maximum risk, all of which lend themselves to higher price volatility. Oh, and financing complications result in higher commodity prices across the board.
Think this is all just hot air? IHS released a report which detailed the impact of trading limitations- not the decimation of futures markets, but trading limits- in the energy sector. Their take? Severe limits alone would have such an impact on liquidity, price volatility and transparency that we’d be staring down massive costs to our economy.
Again, this was just derived off of limits being put in place. Imagine the consequences we would face should our futures markets fall into a state of utter dysfunction.
Let us make this clear- we are positively irate. We feel we have been betrayed by our business associates, regulators and government. We know the best course of action is to be level headed and deal with the facts as they come in, but the Chicago in us isn’t about to take this laying down. We have offered our resources to the CCC, and will do all we can to do right by our customers. You can follow along on our blog and on Twitter for ongoing coverage. We’re not anticipating a lot of sleep in the coming weeks.
This isn’t just about our business- it’s about clients, and their hard earned money. It’s about their lives’ savings and the futures they’ve been building. If this sounds personal, it’s because it is. Our clients are our family. And we’re not giving up without a fight. That’s a promise.