The lesson from Refco

Refco has gone into bankruptcy, the latest event in the firm’s unraveling after disclosure that its CEO owed it $430 million. As BusLawProf notes,

[o]ne of the troubling aspects of Refco’s implosion is that Refco just went through the IPO process.  Outside of an ex post government or internal probe, a company receives no greater scrutiny than from an IPO due diligence investigation. . . . Clearly, the $430 million loan to the CEO should have been disclosed.

Moreover, as I discussed yesterday, Sarbox didn’t catch the problem either.

How could this have happened?  Well, there are two explanations, both contained in this article in today’s W$J.  One is that Refco’s derivatives business “fell through the regulatory cracks.” So Refco’s collapse will trigger more calls to regulate derivatives.

The other explanation concerns the limits of regulation in general and disclosure regulation in particular.  As summarized in the WSJ, Refco's prospectus did disclose "receivables," but not the critical fact that they were owed by its CEO or other "related party."  It seems, however, that the related party nature of the transaction was disguised by cycling the loan through a customer. The prospectus also disclosed that the auditor had found "two significant deficiencies in our internal controls over financial reporting" including a "lack of formalized procedures for closing our books." 
An unnamed SEC official explained to the WSJ that "[w]e're not a merit regulator."

I pointed out yesterday the limits of regulation in catching fraud. Refco further illustrates that, even when red flags are disclosed, they may be hard to see in the mass of information the SEC requires companies to dump on investors. Moreover, investors may be lulled, especially in IPOs, by the persistent tendency to think that securities "passed" by the SEC are "safe."

Some will say that the lesson from Refco is that we need more disclosure regulation, specifically for derivatives. That’s nonsense.  The real and much simpler lessons concern the inherent ineffectiveness of disclosure regulation in catching CEO fraud, and the limits of disclosure in alerting "ordinary" investors to problems.

More importantly, broad additional regulation of derivatives could reduce the role of these instruments in promoting market efficiency by saddling this business with regulatory risks and costs and potentially open-ended liability.

Comments

[Bill Sjostrom]

Thanks for the plug to the Bus Law Prof blog.

[Robert Schwartz]

Oh, so due dilligence doesn't work. Why is this news? Every time there is a major securities fraud, all of the usual suspects stand up and point their fingers at somebody else and say: "it's not my fault."

More laws and more bureaucrats are not going to help. Longer prospectuses with more dire risk factors are a waste of trees.