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In re Refco Capital Markets

September 13, 2007


The opinion of the court was delivered by: Gerard E. Lynch, District Judge


In this securities class action, plaintiff customers of Refco Capital Markets, Ltd. ("RCM"), a securities brokerage, allege that corporate officers improperly lent assets from customers' trading accounts to affiliated Refco companies. This opinion addresses motions to dismiss by various corporate officers, Refco's auditor Grant Thornton LLP, and a group of defendants affiliated with Thomas H. Lee Partners, L.P. (the "THL Defendants"*fn1 ) who collectively owned a majority interest in Refco at the time of the alleged scheme. Because plaintiffs have failed to allege that defendants engaged in deceptive conduct, the motions to dismiss will be granted; however, plaintiffs will be given leave to replead.


This is one of a number of cases arising from the fiery implosion of the brokerage and trading company Refco and its several affiliates. See Am. Fin. Int'l Group-Asia, L.L.C. v. Bennett, No. 05 Civ. 8988, 2007 WL 1732427 (S.D.N.Y. June 14, 2007); In re Refco, Inc. Secs. Litig., No. 05 Civ. 8626, 2007 WL 1280649 (S.D.N.Y. Apr. 30, 2007) ("Refco I"); Thomas H. Lee Equity Fund V, L.P. v. Bennett, No. 05 Civ. 9608, 2007 WL 950133 (S.D.N.Y. Mar. 28, 2007); In re Refco, Inc., No. 06 Civ. 1888, 2006 WL 1379616 (S.D.N.Y. May 16, 2006); Krys v. Official Comm. of Unsecured Creditors of Refco Inc. (In re SPhinX, Ltd.), Nos. 06-11760, 06 Civ. 13215, __ B.R. __, 2007 WL 1965597 (Bankr. S.D.N.Y. Jul. 05, 2007). The alleged scheme at issue, however, is distinct from the schemes alleged in those cases.

I. The Alleged Scheme

Plaintiffs essentially allege that Refco improperly lent itself money from accounts belonging to a subsidiary's customers. The scheme involved a Refco subsidiary known as Refco Capital Management Ltd. ("RCM"), a corporation organized under the laws of Bermuda with its principal place of business in New York City. (Compl. ¶ 17.*fn2 RCM "purported to be an offshore securities broker and foreign exchange broker," and was one of Refco's three principal operating subsidiaries. (Id.)

RCM advertised itself as an offshore brokerage, not subject to U.S. brokerage regulation. (Id. ¶¶ 47, 72.) According to the complaint, RCM specifically considered itself exempt from the requirements of 17 C.F.R. § 240.15c3-1, which sets forth requirements involving the maintenance of a certain quantity of net capital, and 17 C.F.R. § 240.15c3-3, which requires, inter alia, that broker-dealers segregate certain customers' funds and securities. (Compl. ¶¶ 47, 68.) According to plaintiffs, RCM was a "sham entity" with no offices or employees of its own and "no independent existence." (Id. ¶ 73.) All transactions on behalf of RCM were handled by employees of Refco Securities, LLC ("RSL"), another Refco affiliate. (Id. ¶ 74.) Plaintiffs claim that RCM existed only on the books of other Refco entities, functioning entirely as a device for the avoidance of U.S. securities laws (id. ¶ 73), and that because RCM had no employees of its own, RSL employees in New York performed all essential tasks for RCM. (Id. ¶ 56.)

Plaintiffs bring this action on behalf of a putative class of "all securities brokerage customers" of RCM. (Id. ¶ 39.) The complaint does not explain exactly what services RCM promised to perform for its "securities brokerage customers." Nor does the complaint give any details as to the procedures and agreements under which RCM normally handled customers' assets or how, exactly, the alleged fraudulent mishandling of assets was accomplished.

The complaint alleges that "securities held by RCM on behalf of its customers were secretly sold," and the "proceeds diverted" to other Refco entities. (Id. ¶ 46). The complaint never explains how customers' assets were managed in the normal course of business, which makes it difficult to understand what the word "diverted" means. For example, the complaint never explains whether the brokerage held securities on behalf of individual customers or pooled customer assets to purchase securities.*fn3 Similarly, the allegation that the securities were sold "secretly" suggests that RCM was under some obligation to seek prior authorization for or at least provide notice of the sale of the securities in question, but the complaint never explains the source of this obligation. Without knowing anything about the terms of the agreements pursuant to which RCM held securities "on behalf of" its customers, it is difficult to know what uses of those securities would constitute an improper diversion of funds.

It appears that two sets of transactions are at issue in this case, although plaintiffs never make clear exactly which of the transactions constituted the alleged fraud. The transactions were: (1) sales of securities held by RCM on customers' behalf, and (2) loans of the proceeds of those sales to affiliated Refco entities. (Id. ¶¶ 49-51.) Again, however, the complaint fails to explain what agreements, if any, governed RCM's ability to make such loans. It is clear from the complaint that RCM was, in some circumstances, in the business of making loans; plaintiffs elsewhere complain that the loans to Refco affiliates failed to conform to RCM's standard loan procedures. (Id. ¶ 55-58.) The complaint does not explain, however, whether RCM was permitted to make loans using the assets of "securities brokerage customers." Nor does it set forth the terms of the allegedly fraudulent loans themselves. It does not explain, for example, to whom the Refco affiliates owed their debt.

The complaint alleges that the loans in question were made for the benefit of Refco officials, rather than for legitimate business purposes. The transactions were allegedly initiated by "Refco senior management, including defendants Maggio and Bennett and other persons acting on behalf of [Refco affiliates] Refco Global Finance, [Refco Capital LLC ("RCC")] and Refco Group." These officers and others would communicate with RSL executives, who would in turn sell the RCM securities and transfer the proceeds to Refco Global Finance and then to RCC. (Compl. ¶¶ 49-50.) RCC would then disperse the funds wherever they were needed within the Refco organization, often to Refco Group, for various uses, including payroll payments and daily operations. (Id. ¶ 50-51.) The funds were also used to extend credit to customers of Refco affiliates (id. ¶ 51), to pay down Refco's debts, and to fund acquisitions (id. ¶¶ 52-53). The complaint also alleges that the Refco affiliates that received the loans never intended to repay them, and lacked the financial ability to repay them in any event. (Id. ¶ 57.) Plaintiffs say that the proceeds from the sales of RCM customer assets were essential to Refco's continued functioning; Refco's financial state was weak, and without the RCM customers' money, it would have collapsed "long before it did." (Id. ¶ 48.)

Plaintiffs also make a number of allegations pertaining to the process by which the loans at issue were approved. Plaintiffs allege that the RSL executives responsible for the transfers received substantial bonus payments for implementing these transactions; the bonus structure was specifically designed to maximize the amount of RCM customer assets "monetized" and "pushed upstream." (Id. ¶ 58.) They allege that no independent officer at RCM considered or approved the loans; Maggio, a senior Refco Group officer, was the senior risk officer at RCM, and RCM's board of directors, which was dominated by Bennett and Maggio, never considered the loans. (Id. ¶ 55.) Because the complaint does not provide any information about the agreements governing RCM's brokerage services, however, it is difficult to know what procedures plaintiffs believe should have been applied.

The complaint alleges that the defendants "fraudulently mischaracterized" the transactions at issue as "loans" to RCM "customers" (id. ¶ 46) and that some of the transactions were "undocumented." (Id. ¶ 50.) It does not, however, explain what it means by the term "undocumented." Elsewhere, the complaint alleges that "Refco management . . . kept track of the intercompany transactions and of the RCM customer funds that were available at any given time." (Id. ¶ 161.) It is not clear how management "kept track" of loans that were "undocumented." Nor, again, does the complaint explain the procedures that plaintiffs believe should have been applied in documenting the loans to Refco affiliates.

Reading the complaint in context, it appears that when plaintiffs allege that the loans were "undocumented" or "fraudulently mischaracterized" as loans, they mean that the true nature of the transactions was not fairly reflected in Refco's books. The complaint does not allege, for example, that Refco's books were altered to show fake counterparties for these transactions, or that the loans were made without any documentary record. Instead, it alleges that the Refco affiliates who received the loans were inaccurately identified as "customers" of RCM. (Id. ¶ 54.) The complaint assets that Refco Global Finance, RCC, Refco Group, and the other Refco affiliates who received the proceeds of the sales could not fairly be considered RCM customers (id. ¶ 55), because the loans differed from loans to other customers in a variety of ways: the Refco affiliates were not evaluated for risk or creditworthiness; the transactions were made "without fair or any consideration" (by which plaintiffs may mean simply that the affiliates' promises to repay were not sincere; the complaint does not deny that promises to repay were made for each loan or claim that the loans were interest-free); the transactions were made without proper documentation or observation of corporate formalities (id. ¶ 55); and the recipient affiliates were not required to post collateral, as would be the case with loans made in normal course. Id. The complaint also makes clear, however, that the transactions were identified as related-party transactions in Grant Thornton's audit report. (Compl. ¶ 85b.)

According to the complaint, approximately $2.6 billion in RCM customer assets was missing when Refco filed for bankruptcy on October 17, 2005. (Id. ¶ 46.) As noted above, however, plaintiffs do not say from where the assets were missing, that is, whether the missing money should have been available as cash, as debt, as securities held by RCM for individual customers, as securities held on behalf of a pool of customers, or in some other form.

The alleged scheme at issue in this case took place against a background familiar from other Refco cases, in which another fraud, the revelation of which eventually caused Refco's collapse, was ongoing. The complaint mentions, but does not discuss in depth, the allegation (central to other Refco actions) that Refco's management devised a scheme to hide the fact that several of Refco's significant assets had been rendered worthless by the Asian financial crisis of the late 1990s. (Compl. ¶ 4.) The details of this alleged scheme have been discussed in other cases. See Refco I, 2007 WL 1280649, at *1-*2. Essentially, to hide their worthless assets, Refco's management allegedly devised a "round-robin" scheme in which the uncollectible receivables were transferred onto the books of Refco Group Holdings, Inc. ("RGHI"), a non-party Refco affiliate. Then, another Refco subsidiary would lend money to a third party, which would in turn lend it to RGHI to pay down the uncollectible receivables, effectively erasing them from Refco's books. These transactions would happen shortly before the end of each relevant financial period, and be "unwound" shortly after the reporting period was over. See id. Nothing in the complaint suggests that the two frauds were directly connected; there is no allegation, for example, that proceeds from the sale of RCM customer assets were used in the circular transactions at issue in the round-robin fraud.*fn4 The only apparent connection is that both schemes were designed to hide financial problems at Refco and its affiliates from the public and from investors.

II. Refco's Collapse

Refco Inc. went public in an initial public offering ("IPO") on August 11, 2005. Nine weeks later, on October 10, 2005, Refco issued a press release announcing that it had discovered an "undisclosed affiliate transaction" involving a hidden receivable in the amount of $430 million owed to Refco by RGHI. The release explained that RGHI had assumed obligations owed by third parties to Refco, "which may have been uncollectible." Refco disavowed its financial statements for fiscal years 2002, 2003, and 2004. (Compl. ¶ 60.) The circular transactions had been publicly revealed, but the alleged fraud involving the RCM customer accounts had not.

After the public disclosure of the circular fraud, RCM customers began attempting to withdraw assets from their accounts. On October 13, 2005, citing liquidity concerns, Refco announced that it was imposing a 15-day moratorium on trading activity at RCM, including withdrawals. (Compl. ¶ 62.) On October 17, 2005, Refco and some of its subsidiaries filed for bankruptcy. (Id. ¶ 63.) See In re Refco Inc., et al., No. 05-60006 (RDD) (S.D.N.Y. Bankr.). In bankruptcy proceedings, Refco acknowledged that RCM owes its customers approximately $4.16 billion, but has only $1.905 billion in assets. (Compl. ¶¶ 65, ...

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