House Panel Report on MF Global Recommends Legislation, Enhanced SEC and CFTC Regulations and Inter-Agency Cooperation

The House Financial Services Committee released a report on MF Global recommending that the SEC investigate whether the firm, a futures commission merchant and a securities broker-dealer, violated federal securities laws and regulations in connection with its disclosures about its European repurchase-to-maturity (RTM) trades and the firm’s overall financial health. The report was prepared under the auspices of Rep. Randy Neugebauer (R-TX), Chair of the Oversight and Investigations Subcommittee, who has been leading the congressional investigation.  In order to restore investor confidence in the futures markets, the Subcommittee also recommends that Congress enact legislation imposing civil liability on the officers and directors that sign the financial statements of a futures commission merchant or authorize specific transfers from customer segregated accounts for regulatory shortfalls of segregated customer funds.

Noting the lack of meaningful cooperation between the SEC and the CFTC regarding MF Global, the Subcommittee recommends that Congress explore whether customers and investors would be better served if the SEC and the CFTC streamline their operations or merge into a single financial regulatory agency that would have oversight of capital markets as a whole. Referencing MF Global, the House panel discerned an apparent inability of the SEC and CFTC to coordinate their regulatory oversight efforts or to share vital information with one another, coupled with the reality that futures products, markets and market participants have converged. Had the SEC and the CFTC coordinated their supervision and shared critical information about MF Global, said the report, they might have gained a more complete understanding of the company’s deteriorating financial health, and they might taken action to better protect the company’s customers and investors before it collapsed.

On October 31, 2011, MF Global filed for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code.  On the same day, the Securities Investor Protection Corporation began liquidation proceedings for MF Global’s U.S.-based subsidiary, MF Global, Inc.and the U.S District Court appointed a trustee to handle the company’s liquidation. Although initial reports estimated that $700 million in customer funds required to be housed in separate accounts for safekeeping were missing, said the House report, it is now known that  MF Global’s collapse resulted in a $1.6 billion shortfall in customer funds.

MF Global’s ability to amass more than $6.3 billion in European sovereign debt without fully disclosing the size and nature of its European portfolio also raises congressional concerns about the sufficiency of off-balance sheet reporting requirements under US GAAP and SEC regulations, said the report, which noted that FINRA has proposed a rule requiring member companies to disclose the gross contract value of  European RTM trades that are derecognized from their balance sheets in a supplementary schedule for quarterly FOCUS reports. In addition, FASB has tentatively voted to amend its accounting guidance to require RTM transactions to be accounted for as secured borrowings.

An RTM differs from a traditional repurchase agreement in one important respect.  In a traditional repurchase agreement, the securities held by a counterparty are returned to the borrowing company before the securities collateralizing the borrowing reach maturity. By contrast, in an RTM transaction, the counterparty keeps the pledged securities as collateral until they mature, whereupon the counterparty may either return the securities to the borrowing company or redeem them from their issuer at par value. According to the House report, MF Global learned that by entering into RTM transactions collateralized with European sovereign bonds (the European RTM trades) it could realize an immediate profit on the difference between the interest the issuer of the bonds paid to MF Global and the rate the company paid to its counterparty to repurchase the bonds, and that it could derecognize the bonds from its balance sheet.

Regarding credit rating agencies, the report noted that, while Moody’s and S&P acknowledged that MF Global’s transformation into an investment bank would increase the company’s risk profile as it took  on greater proprietary trading positions, the credit rating agencies did not sufficiently review MF Global’s public filings to identify these risks when they did emerge. Indeed, the Subcommittee found that, despite the information that was available to them for a period of five months, Moody’s and S&P did not factor MF Global’s European sovereign debt exposure into its public credit assessments until one week before the firm filed for bankruptcy. 

In order to address the problems raised by sudden downgrades, the Subcommittee called for a congressional review of whether the SEC should require each NRSRO to establish and enforce written policies and procedures reasonably designed to provide for periodic monitoring of credit ratings and periodic communications to the market about the NRSRO’s monitoring practices. The Subcommittee believes that some form of periodic review could instill a greater level of scrutiny and diligence in the ratings process and give investors more confidence that the ratings they receive are current.

The report found that MF Global customers who traded abroad faced the risk that the funds set aside in secured accounts would not readily be available to satisfy their claims upon the firm’s bankruptcy and subsequent liquidation.  Customers who traded foreign futures and options executed and cleared trades on foreign exchanges, which were beyond the jurisdiction of U.S. authorities.  In light of this, the Subcommittee recommends that the House Committee on Agriculture consider whether to direct the CFTC to study whether it can better mitigate the risks that customers of futures commission merchant face when customer funds are placed in secured accounts subject to the law of a foreign jurisdiction.

In conducting any such study, said the Subcommittee, the CFTC should consider whether the rules that govern trading on foreign exchanges should be amended to establish protections comparable to those that govern domestic transactions. In particular, the CFTC should consider whether any potential rule change could impose costs on futures commission merchants and their customers that would place foreign futures and options trading at a competitive disadvantage to similar products and services.

Under its primary dealer program, the New York Fed grants financial companies the privilege of acting as counterparties to open market operations executed by the New York Fed. In the view of the Subcommittee,  MF Global’s risk management failures, chronic net losses, and untested business strategy, combined with the New York Fed’s internal concerns that MF Global posed reputational risks, should have given the New York Fed pause before conferring primary dealer status on MF Global. Even though the subsidiary met the basic requirements to become a primary dealer, the New York Fed should have, at a minimum, placed the firm’s application on hold until MF Global’s new business strategy had been successfully implemented.  

Thus, in order to discourage companies from utilizing a primary dealer designation beyond its intended purpose, the Subcommittee recommends that the New York Fed strengthen its application guidelines to expressly forbid companies from speaking publicly about their application status during the pendency of the application unless required for regulatory disclosure purposes.  If an applicant company ignores the disclosure prohibition, emphasized the House panel, the New York Fed should consider instituting a cooling-off period, similar to the one-year delay for material regulatory actions. The Subcommittee further recommends that the New York Fed consider re-examining its primary dealer selection process to provide for greater scrutiny of companies with questionable financial health, risk management histories, and ambitious business strategies.