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From: Douglas Bry & Ernest Jaffarian CTA/CPO Representatives Date: Re: 13 February 2012 MF Global Issues and Proposals
The MF Global bankruptcy and its aftermath have created the potential for irreparable harm to the futures industry, a key component of the global financial system. National Futures Association (NFA) is in a unique position to take a leadership role helping to recover customer funds, restoring the publics trust and confidence, and implementing changes to further codify the already existing public policy that customer funds are sacrosanct.
missing customer funds in a segregated customer account under the control of the FCM. Indeed, this is the first time in the industrys history that a customer has suffered a loss as a result of a clearing members improper handling of customer funds.
Northfield Trading LP managed 18 client accounts which cleared MFG and totaled $31M, about 11% of Northfield's assets under management. Douglas Bry had two personal accounts at MFG and has filed claims to recover $97,541.56 in bankruptcy court. Neither Ernest Jaffarian nor Efficient Capital had any accounts at or direct business with MFG.
In the weeks leading up to MFGs collapse Jon Corzine repeatedly and vocally defended the leveraged European sovereign debt trade in the face of significant doubt expressed by various MFG executives and members of the MFG Board. (Ahmed, Azam, et al. A Romance With Risk That Brought On a Panic. NYT Dealbook. 11 December 2011.) Poor earnings reports and a drop in the value of the sovereign debt led to increased investor concern and brought more scrutiny, causing a selloff in MFGs stock from just below $9 a share in April to $3.55 on October 21. MFGs bonds also dropped in value. In the early morning hours of October 31, unable to raise sufficient capital to meet its obligations, and after a deal to sell to Interactive Brokers fell through, MFG reported to the CFTC a possible shortfall in customer funds, and filed for bankruptcy later that morning. (Protess, Ben, et al. Regulators Investigating MF Global For Missing Money. NYT Dealbook 31 October 2011.) Jon Corzine testified before the House Agriculture Committee and defended his actions by asserting that there had been no default of the sovereign bonds. (Protess, Ben. Corzine Defends His Actions at MF Global. NYT Dealbook 8 December 2011.) Even if the investments were permissible, taking a 30:1 or greater leveraged position with firm capital was a breach of MFGs fiduciary duty to its shareholders and its customers, and it was this excessive risk that brought MFG down.
reported futures industry consultant Elaine Knuth, who contributes to a blog at www.mfgfacts.com. In testimony before the House Committee on Agriculture on December 8, Commissioner Sommers acknowledged that the CFTC agreed with Mr. Cooks decision to favor a SIPA liquidation over a Chapter 7 bankruptcy with protections for segregated accounts. Per Ms Knuth: "What is clear is under its Congressional mandate, the CFTC should have absolutely prevented market disruption and freezing customer assets by a Securities Industry SIPC liquidation and immediately asserted special priority distribution of such property under the US Bankruptcy Code contained in Chapter 7. For the CFTC to give up and throw away critical market protections and allow that to happen in this case is not only absurd to the highest degree, it questions why then the agency even exists." The bankruptcy situation is further complicated by the fact that there are three separate filings and cases, each with their own trustee: (i) MF Global Holdings, the parent company for 45 separate MF Global entities around the world, only 5 of them in the US, including (ii) MF Global Inc, the primary US entity which was the Broker Dealer/FCM, and (iii) MF Global UK. While MF Global Holdings was a US entity, the 40 companies it controlled outside the US are domiciled in numerous countries, each with their own local bankruptcy laws which have varying levels of protections for customer funds. If the bankruptcy had been filed under Chapter 7, the customers could have claimed priority over all the assets of the various MF Global entities, estimated to be $41B versus liabilities of $39.7B at the time of the filing, leaving a surplus of $1.3B that could have been applied to the shortfall. (Korablev, Irina, et al. Public Firm Default Report: MF Global Holdings Ltd. Moodys Analytics October 2011.) Despite the filing under SIPA, and the missed opportunity to contest it, counsel for MFG customers are continuing to assert that their claims are superior to those of general creditors (see below).
Monday, October 31, 2011. Status Update from the Office of James W. Giddens, Trustee for the Liquidation of MF Global Inc., Concerning the Trustees Investigation. 6 February 2011 (hereinafter Giddens 6 February Update). Further, CME Executive Chairman Terry Duffy testified before Congress that MFG provided false segregated funds reports. (Terrence Duffys Testimony Before Senate Agriculture Committee. Bloomberg 13 December 2011.) Sorting through numerous and conflicting reports, and reviewing the Giddens 6 February Update, reveals a number of purposes that MFG may have used Seg Funds for: customer money was used to meet margin calls on (i) the leveraged firm investment in proprietary European sovereign debt, or (ii) the Seg Funds investment in European sovereign debt, or (iii) house prop trades customer money was transferred to other MFG entities, primarily MF Global (UK) customer money was transferred internally at MFG to operating accounts and was used to fund the daily activities of MFG
The Trustee has overcome the initial difficulty of tracing the thousands of transactions involved, and is now reporting that the whereabouts of most of the Seg Funds are known. Giddens 6 February Update
In a true David v. Goliath undertaking, up against some of the worlds most powerful law firms representing JP Morgan (JPM) and other creditors, relying on donations, and with little prior litigation and no bankruptcy experience, Mr. Koutoulas, with the help of the law firm of Barnes & Thornburg assisting at discounted rates, has: limited JPMs requested use of cash collateral and blocked an attempt by JPM to receive a super priority over customer funds maintained the position that the customers are not creditors and have a superior claim to assets of both MF Global, Inc. and MF Global Holdings, Ltd. submitted a brief that (i) customer funds retain their character and can be clawed back regardless of their locus, and (ii) outlined recommended classification of funds that left MFG as statutory or constructive trusts requested that NFA and CFTC submit amicus briefs on the issue of The Allocation and Distribution of Customer Property brought to light the conflicts of interest of JPM (CNBC Video Gallery) helped to obtain a letter from 5 members of Congress supporting the CCC position in the bankruptcy proceedings that 100% of customer funds should be released immediately authored many of the questions used by Congress in the Financial Services and Senate Agriculture Committee hearings received a formal request from Debbie Stabenow, Chairwoman of the Senate Committee on Agriculture, for assistance and recommendations on market safety and customer protections objected to the Bankruptcy Trustees original plan to return 60% of customer funds beginning in July 2012, and instead, with the help of the CME, won a court ordered distribution to customers of 72% of their US Seg fund balances by the end of December 2011
JP Morgan
JPM was MFGs custodian of customer Seg Funds, prime broker, clearing broker, settlement agent for house trades, and primary lender to MFG, providing a $1.2B revolving credit facility. Playing all these roles created numerous actual and potential conflicts of interest, and JPM is the largest creditor of MFG in bankruptcy with a claim for $1.2B. As MFG sold billions of dollars of securities to raise cash in the week leading up to the bankruptcy, its executives came to believe that JPM, as one of MFGs primary bankers and a middleman, was dragging its feet in forwarding funds. The delays contributed to a 8
serious cash shortage, worsening MFGs distress, and hundreds of millions of dollars of MFG money may still be in accounts at JPM. (Mollenkamp, Carrick, et al. In MF Global, JP Morgan Again at the Center of a Financial Failure. Reuters. 19 January 2012.) JPM was also involved post-bankruptcy in a transaction in which George Soros bought $2B of MFGs European Bonds below the market price. (Zuckerman, Gregory, et al. Corzine's Loss May Be Soros's Gain, Online Wall Street Journal. 9 December 2011.) After receiving $200M from MFG three days prior to the bankruptcy, JPM requested a letter stating that the funds were not customer Seg Funds. No letter was provided, yet JPM has not returned the $200M to the bankruptcy trustee so that it could be distributed to customers. (Patterson, Scott. MF Global Transfer Draws Scrutiny, Online Wall Street Journal. 21 December 2011.) JPM is resisting customer requests for discovery in the bankruptcy proceedings, objected to the Third Bulk Transfer of assets to customers, objected to customers having priority over MF Global Holding Company assets, and retaliated personally against James Koutoulas by cancelling his credit card and bank account without prior notice after he appeared on CNBC for an interview during which he requested a boycott of JPM. It is possible that a significant portion of the missing Seg Funds are at JPM, perhaps as a result of JPM holding on to the proceeds from asset sales it was clearing for MFG as MFG tried to raise cash to avoid bankruptcy. (LaCapra, Lauren, et al. MF Global Sold Assets to Goldman Before Collapse: Sources. Reuters 3 January 2012.) JPM has fought aggressively in bankruptcy court to protect its interests, and received a lien on some of MFG's assets in exchange for granting $8 million to fund the bankruptcy costs. The lien puts JPM's interests ahead of MFG customers. (LaCapra, Lauren, et al. MF Global Sold Assets to Goldman Before Collapse: Sources. Reuters 3 January 2012.)
a reserve of 15-20% held by the Bankruptcy Trustee after the Third Bulk Transfer, perhaps $1B. (Sandler, Linda. MF Global Trustee to Return Up to $2.1 Billion to Customers. Business Week 6 December 2011). lawsuits against Jon Corzine, the Directors of MFG, CME, and MFGs accountants, although any successful damage claims will presumably have a lower priority than those of customers possible clawbacks from numerous entities separate and apart from MF Global as well as among the subsidiaries controlled by MF Global Holdings
Various standards and procedures apply to each of these potential sources of funds, and litigation to resolve all the issues could take years and generate significant fees (the Bankruptcy Trustee is charging the discounted rate of $891 per hour), further depleting the pool of assets that might be left to satisfy customer claims. Subject to what the Bankruptcy Trustee is able to recover, and legal rulings on the priority of customer claims, the final shortfall may be a lot less than $1.6B. Note that CME helped with the recovery of 72% of customer funds in the Third Bulk Transfer by pledging $500M towards recovery of 75% of US Seg Fund balances, and that CME may be able to provide $50M to help pay the Bankruptcy Trustees legal fees. Since it is estimated that the Trustee has sufficient assets in reserve to return up to 83% of US Seg Funds, it appears that the CMEs pledge will be fulfilled, and unless modified, it will not apply to close the gap of any additional shortfall.
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cattle industry who lost tens of thousands of dollars on hedge positions they were unable to exit in the week and a half after the MFG collapse. As a direct result of the MFG bankruptcy she closed her business and withdrew her registration on November 17th because she could no longer tell her clients that their money was safe. The full interview can be found at Puplava, James. The Entire Futures/Options Market Has Been Destroyed by the MFG Collapse. Financial Sense 1 December 2011. An MFG customer, Dean Tofteland, a farmer from southern Minnesota, in testimony before the Senate Agriculture Committee on December 13th, related that he had an account at MFG that he used to hedge his crops and lock in prices. He called his broker at MFG when he heard that MFG was having trouble and was told not to worry, that his funds were segregated and safe. After the bankruptcy his $250K account was frozen and he was unable to adjust his hedges despite adverse market moves. He also used the MFG account as collateral against an operating loan at his local bank, and is now facing serious financial problems. Testimony of Dean Tofteland.
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Proposal for NFA to Facilitate The Futures Industry Raising Funds to Cover The MFG Shortfall
Given our history of strong self-regulation and the makeup of NFAs Board which includes representatives from all sectors of the futures industry, NFA is in the best position to coordinate an effort to raise funds to cover the MFG shortfall. Similar to the pledge made by CME to cover the return of US assets up to 75%, we propose that NFA work with the Clearinghouses, Exchanges and FCMs to find a way for all of us to stand in the shoes of the customers and make them whole. Specifically, we propose that a working group comprised of NFAs President, Chairman, key staff, and members of Board be formed with the authority to contact industry participants and explore all options. As a possible supplemental source of funds, consistent with the purposes and mission of NFA as set forth in Article III of the Articles of Incorporation, it is within the power of NFA to augment the NFA fee and use the proceeds to secure loans sufficient to help cover the MFG shortfall. Implementing the needed changes to the Bylaws would require approval of a 2/3 super-majority of NFAs Board and approval of the CFTC. Specifically, we request that the Board direct staff to develop proposals pursuant to which NFA could, through either a direct or indirect assessment, raise funds to help cover the MFG shortfall, and report back to the Board by March 31, 2012.
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Proposal for NFA to Directly Monitor and Make Transparent Seg Fund Investments for all FCMs
If customers knew today what FCMs are actually doing with their money would they feel safe or run for the exit? As a better and simpler approach than continually amending lists of permissible investments in a political arena, post-MFG customers have a right to know where their money is invested at all times. Making Seg Fund investments transparent in real-time will let the marketplace determine what level of risk is acceptable. Banning all non-exchange traded instruments for Seg Funds and prohibiting hypothecation go hand-in-hand with transparency. NFA already has in place an online interface for FCMs (for which it is the DSRO) to file a monthly Segregated Investment Detail Report (SIDR). The SIDR (pronounced cider) report provides a detailed breakdown of an FCM's investment of Seg Funds and identifies the carrying brokers and other depositories holding the funds. While currently filed monthly, SIDR filing requirement should be made daily, with all FCMs required to report their Seg Funds investments to NFA (even if NFA is not the DRSO), with the results then made public through a website. Further, NFA should have the authority to monitor and spot check the balances. To further protect Seg Funds, NFA could approve investments and transfers before they occur, and also require that all customer funds be held by a third party custodian or at the Clearing House. FCM executives should be required to sign off daily on all Seg Fund balances and investments, with criminal penalties for any misrepresentations or malfeasance.
Proposal for NFA to Pursue Legislative Changes to Secure the Status of Seg Funds
We need to make sure once and for all that existing public policy is codified: that there is no doubt going forward that customers have first priority rights over the assets of any FCM, or FCM affiliate or parent company, and NFA should seek appropriate amendments to the Bankruptcy Code, CEA and SIPA, as well as NFA and CFTC Rules.
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Conclusion
While some of us may find ourselves on opposite sides in courtroom battles over MFGs assets in the months and years to come, as an Association we need to work together and put the interests of the customers first. Doing so will help the customers, restore investor trust and confidence, and serve everybodys long-term interests. The investment in our future is a small price to pay to see positive headlines along the lines of:
Futures Industry Steps Up to Make MF Global Customers Whole Sanctity of Futures Segregated Funds Preserved NFA Brings Futures Industry Together To Repay MF Global Customers
Going forward, no customer, FCM, CTA, IB or Exchange should have to go through an ordeal like the MF Global Bankruptcy, or worry about the safety of customer funds. We have an opportunity to define the moment, restore trust and build a strong foundation for our future. Lets preserve the truth of the statement: Nobody has ever lost a dollar of segregated funds.
Respectfully submitted,
Douglas Bry, President Northfield Trading LP 3609 South Wadsworth Blvd, Suite 250 Denver, CO 80235 Phone: 303-985-3366 Fax: 303-985-3225 Email: doug@ntlp.com
Ernest Jaffarian, President and CEO Efficient Capital Management, LLC 4355 Weaver Parkway, Suite 200 Warrenville, IL 60555 Phone: 630-657-6800 Fax: 630-657-6686 Email: jaffarian@efficientcapital.com
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