So What Was I Supposed To Do?

Written by: Phil Feigin

A precious metals dealer client of mine called me late Monday afternoon, July 9, 2012, all in a tizzy. He had just received word that all accounts at PFGBest, the futures broker his company uses, had been frozen, and he needed advice on what to do. He added that he had just gone through a similar experience with their last broker, MF Global. I got as much of a handle on things as I could and advised him there wasn’t much for him to do at this point but wait for word from someone in charge, along with all the other PFGBest account holders.

Another fraud and scandal.

This week’s version is the PFG story, as we witness the previously microscopic Cedar Falls, Iowa, life of Russell Wasendorf Sr. being blown up exponentially on the financial world’s big screen. Along with it, we see the typical frustration inherent in the hunger for instantaneous information and clarity where there is none to be found. There are far more questions than answers, a scrambling for hard facts, and in their absence, innuendo, suspicions, and potential conspiracy and intrigue, and inevitably, but in this case a bit ahead of schedule, the recriminations, finger pointing, and harangues of regulatory failure.

What we know as of this morning is that a relatively prominent veteran of the futures industry lies in a coma in a University of Iowa hospital after what appears to be an attempted suicide. PFG’s accounts at U.S. Bank, the custodian for his firm’s client funds, are about $215 million south of what they are supposed to be holding. It is pretty clear Mr. Wasendorf Sr. fiddled with financial holdings reports and U.S. Bank account statements sent to the National Futures Association (NFA). Fueling contempt for regulators, there is some tantalizing indication that in early 2011 the NFA received word that PFG accounts at U.S. Bank held around $10 million—hundreds of millions less than was supposed to be there. However, when the NFA asked for clarification, they received a fax purported to be from the bank verifying the higher holdings. There is now suspicion the fax came from Mr. Wasendorf, not the bank. A bank employee is under investigation for potential complicity.

My client may well ask me, “So, what was I supposed to do?” He was not dealing with some unregistered outfit in Fort Lauderdale or Newport Beach he found on Yahoo. MF Global, and now PFG, were fully registered, regulated, long-established companies run by pillars of the industry. The law decrees that client funds must be segregated from firm money, held in trust, supposedly at independent, third-party custodian financial institutions. Everything was supposed to be overseen and audited by self-regulatory organizations (either the exchanges or the NFA) and the Commodity Futures Trading Commission. What more can you do or ask for?

From my client’s standpoint, my answer has to be, “Not much.” It’s tragic and appalling when time-tested, systemic protections collapse. Reactions are predictable. The regulators and those who believe in and support strong regulation will assert the regulators did all they could. The guy was a clever crook, it was a conspiracy, and there was no reasonable way to discover it earlier than they did. The system did work, in that the fraud was uncovered before he could do more harm than he had already done. Perhaps if they had stronger laws and more resources, they could have discovered the fraud sooner.

The detractors of regulation will assert the laws are fine as they are and the regulators have plenty of resources; they were just incompetent and dropped the ball. At the same time the fraud at PFG was being perpetrated, there were hundreds of thousands of transactions conducted at thousands of commodity brokerage firms across the country in a perfectly lawful manner. Those firms and all the honest professionals who work at them should not be tarnished and made to suffer more unnecessary regulations because of one crook in Iowa and regulatory shortcomings in detecting his fraud.

There will be the hearings, reports will be demanded, some sordid details will come out, the trustee in bankruptcy, trustee’s counsel and forensic accountants will make lots of money, anyone who received back more than they deposited will face clawback suits, account holders will get back X on the dollar, and we will eventually move on when the next catastrophic financial scam surfaces.

As I see it, there is some validity to all of these reactions. My client did his homework and did business with the kind of firm with which he was supposed to trade. Fraud and conspiracy to commit it are pernicious, underhanded crimes. You can only do so much to protect yourself from some things, like having your home burglarized, being hit by a drunk driver, being mugged on a busy street, or losing money to a criminal at a respected institution. Crooks are crooks, and they are the reason we have crimes, prosecutors and prisons.

On the other hand, I was surprised to see how easy it appears to have been to convince the NFA there was money in the bank. In this day and age of instantaneous electronic communication, how hard could it be to require each futures commission merchant (FCM) to report to some regulatory computer their custodial balances electronically, along with the clearing house settlement process after each market close? Wouldn’t it simply be another encoded transmission? Further, FCMs already identify their custodians to regulators. How hard could it be for the regulators to provide confidential codes to custodian banks, and have an electronic report on custodial balances, marked to market, sent to an NFA computer at the close of every business day? The computer would match balances and kick out any discrepancies. A discrepancy north of $100,000 would generate an official inquiry.

I’m not a back office guy, so perhaps what I suggest is already in place, or harder to institute than discovering the Higgs boson. Maybe the NFA proposed doing it, but the industry fought back because it would be too expensive. Maybe some clever computer guy at the bank could figure out a way to game the reporting system.

Maybe pieces of all of that.

I remain firm in my conviction that the surest way of preventing and detecting financial fraud is a two-pronged device. First, an independent, third-party custodian must be positioned between those who are supposed to be investing your money and those who are supposed to be holding it. Second, the custodian must provide reliable reports directly to those with an interest in protecting the sanctity of those custodial assets—either the client, regulators, or both—and those reports must be diligently reviewed, with discrepancies acted upon promptly and effectively, in direct communication with the custodian.

From initial reports, it appears the NFA was in the process of implementing some form of electronic reporting directly with the bank. That triggered the ultimate discovery of fraud at PFG. That’s a good thing, but apparently too late to help my client and his fellow account holders. What seems very, very bad for the NFA is that even when their earlier reporting system succeeded in detecting the gross shortfall at PFG more than a year earlier, in early 2011, the “fire alarm” could be turned off with nothing more than a fax—a form of communication that in this age of so many more forms of direct communication, seems about as reliable as a smoke signal or a whisper around a campfire. How did they know the fax even came from the bank? It could have come from anyone with a sample of U.S. Bank letterhead, word processing, an Internet connection, and a telephone number. Sadly, it appears it did. Someone at the NFA bought it. Perhaps the story will change as more as learned. But if it doesn’t, not good.