Given the initial coverage, you might think that the sad story of MF Global’s demise is all about John Corzine.
It’s a familiar story: The tragic flaw of hubris drives a former governor, U.S. Senator, and Goldman Sachs CEO to bet the farm and bankrupt a company that’s been around since James Man started a sugar trading business in 1783. Only a “master of the universe” type would joke to the press, just days after taking over the publicly traded company in March 2010, “I hadn’t heard of this company a week ago.”
Corzine surely blundered, but he was far from alone.
The second most obvious storyline is that regulators ignored the MF Titanic heading for a sovereign risk iceberg. Press reports have characterized CME Group as MF Global’s “primary regulator” but I’m not sure that’s a job the exchange operator wants. That honor belongs officially to the Commodity Futures Trading Commission. CME Group has been actively communicating with the media in an attempt to get ahead of any criticism for its role.
An already bad MF Global bankruptcy story spun out of control and careened off the road late Monday. That’s when MF Global executives admitted to the regulators that Interactive Brokers had refused to catch Corzine’s Hail Mary pass and buy the company because the numbers just didn’t add up. Regulators found hundreds of millions of dollars belonging to customers had gone missing - potentially more than $900 million -- and were investigating whether MF Global had used some of those funds to support its own bets.
And this is where we come to the party that up until now hasn’t received its fair share of scrutiny: PricewaterhouseCoopers, which as MF Global’s auditor was supposed to be the first-response regulator.
A week after I wrote in my "BankThink" column for American Banker that the relationship between PwC and MF Global was too cozy for my taste, the regulators are catching up. Late Thursday, regulators subpoenaed PwC for “information on the segregation of assets belonging to clients.”
The CFTC’s action against PwC probably came as a result of a shocking CME Group announcement late Wednesday: "It now appears that the firm [MF Global] made … transfers of customer segregated funds in a manner that may have been designed to avoid detection." These transfers, CME Group said, appeared to have taken place after its audit team showed up last week at MF Global to take a look and found everything to be in order.
CME Group couldn’t have been hoodwinked like that if PwC had been doing its job all along. You can't circumvent controls unless there are none or there are holes. It was PwC’s job to review controls and the adequacy of policies and procedures to support them.
Since MF Global is a broker-dealer and a Futures Commission Merchant, PwC’s job went well beyond a standard audit. The auditor for a firm like this must annually review the procedures for safeguarding customer and firm assets in accordance with the Commodity Exchange Act. The annual audit must include a review of a firm’s practices and procedures for computing the amounts that, by law, have to be set aside in clients’ accounts each day. MF Global also had to send regulators an annual supplemental report from PwC. This report would describe any material inadequacies existing since the date of the previous audit and any corrective action taken or proposed.
I’m sure the CFTC wants to know if PwC ever documented any material inadequacies in MF Global’s controls over safeguarding customer assets. But wouldn’t they already know that? Regulators like the CME Group, the CFTC, the SEC and FINRA received audited financial information annually, unaudited information semiannually and monthly reports that provided a capsule view of MF Global’s financial position. MF Global is required to perform calculations daily (by the CFTC) and weekly (by the SEC) to ensure that the proper amount of customer funds is set aside in the separate accounts.
The regulators read these reports and do periodic check-ups, but they’re not primarily looking for ways that someone can fudge them or overrule procedures and systems. That’s PwC’s role. (The firm declined to comment for this article.)
I’d like to say that financial services firms and their auditors have had no problems complying with these customer asset segregation regulations. But I can’t.
For example, in August of 2007, the SEC needed an emergency temporary restraining order to stop Sentinel Management Group from continuing to loot customer accounts after declaring bankruptcy. Sentinel, which prior to filing for Chapter 11 protection claimed to have $1.2 billion in assets under management, defrauded its clients by improperly commingling, misappropriating and leveraging those clients' securities without their knowledge in violation of the Investment Advisers Act of 1940.
Among its improper activities, Sentinel transferred at least $460 million in securities from client investment accounts to Sentinel's proprietary "house" account. Sentinel also used securities from client accounts as collateral to obtain a $321 million line of credit as well as additional leveraged financing.
More recently, last year JPMorgan Chase's futures and options desk neglected to segregate billions of dollars of client money, largely belonging to hedge funds. PwC, the auditor of JPMorgan Chase, and the bank - which is also MF Global’s main banker - admitted to U.K. regulators that for at least seven years, about $23 billion dollars of clients' assets had not been properly segregated. JPMorgan Chase was fined 33.3 million pounds and PwC is subject to sanctions.
Imagine if JPMorgan Chase weren’t the fortress that came out of the 2008 financial crisis as a relative winner. If the bank had collapsed like Lehman, the client asset segregation problem uncovered in the U.K. last year would have caused chaos. Ernst & Young, Lehman’s auditor, is also under investigation in the U.K. for similar lapses in its audits of compliance. Many hedge funds are still fighting costly and protracted litigation because of the asset segregation failures at Lehman.
If only the idea of someone moving customer assets to the “house” account in response to a liquidity crisis were beyond the scope of the imagination. But such shenanigans have happened in real life. And if they did happen at MF Global, it would be PwC’s fault as much as Corzine’s.
Francine McKenna writes American Banker's "BankThin" blog. She worked in consulting, professional services, accounting and financial management for more than 25 years.