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In re Refco

March 17, 2009


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


In yet another chapter of this putative class action for securities fraud arising from the collapse of Refco Inc. and its affiliated companies ("Refco"), Joseph P. Collins ("Collins") and Mayer Brown LLP ("Mayer Brown") (the "Mayer Brown Defendants") -- move for dismissal of the Second Amended Consolidated Class Action Complaint ("the Complaint") as to them.*fn1 The core issue before the Court is whether the plaintiff-investors*fn2 can hold Refco's outside counsel liable for their injury pursuant to §§ 10(b) and 20(a) of the Securities Exchange Act of 1934. 15 U.S.C. §§ 78j(b), 78t(a). Although the Complaint alleges facts that, if true, would make the Mayer Brown Defendants guilty of aiding and abetting the securities fraud that harmed the plaintiffs, the Supreme Court and Congress have declined to provide a private right of action for victims of securities fraud against those who merely -- if otherwise substantially and culpably -- aid a fraud that is executed by others. Accordingly, the motions to dismiss must be granted.


The factual background of the fraudulent scheme to deceive investors and others about the true financial circumstances of the international brokerage firm Refco Inc. and its affiliated companies is set forth in detail in the Court's prior opinion in In re Refco, Inc. Sec. Litig., 503 F. Supp. 2d 611, 618-20 (S.D.N.Y. 2007), and in any number of additional opinions,*fn3 but the details will be repeated here to the extent that they are relevant. In reviewing a dismissal pursuant to Fed. R.Civ. P. 12(b)(6), plaintiffs' allegations are assumed to be true for purposes of deciding the motion. Lattanzio v. Deloitte & Touche LLP, 476 F.3d 147, 151 (2d Cir. 2007).

I. The Alleged Fraudulent Scheme

Prior to Refco's spectacular collapse, it was among the world's largest providers of brokerage and clearing services in the international derivatives, currency, and futures markets. Refco's business model involved extending credit to its customers so that they could trade on margin and leverage their capital into larger trades, for which Refco could again extend credit. (Compl. ¶ 2.) These trades generated substantial commissions, revenues, and profits for Refco, but over time Refco began making loans without adequately assessing customers' credit-worthiness or the risks associated with their trading activities. (Compl. ¶¶ 428-30.) These lapses began to have consequences in the late nineties, when several global financial crises caused a number of customers to suffer massive trading losses. (Compl. ¶¶ 3, 431-35.) The loans now became "uncollectible receivables" that Refco's customers were unwilling or unable to repay.

Rather than write off or disclose these uncollectible receivables -- the revelation of which would have had dire financial consequences for the company (Compl. ¶¶ 426, 579-80) -- Refco's management allegedly devised a scheme to conceal them from the public and Refco's investors. (Compl. ¶ 3.) First, they transferred the loans onto the books of Refco Group Holdings, Inc. ("RGHI"), an entity owned and controlled by Phillip R. Bennett ("Bennett"), Refco's President, CEO, and Chairman. (Compl. ¶¶ 3, 33.) As a result of these transfers, RGHI owed hundreds of millions of dollars to Refco, but RGHI had no liquid assets and no operational functions (Compl. ¶¶ 31, 638), and thus it had no conceivable means of repaying the "loans." (Compl. ¶ 3.)

Next, to avoid the disclosure of large "related-party" receivables -- the sum of which dwarfed Refco's net income -- a series of fraudulent transactions were arranged by which the RGHI receivables were periodically made to disappear from Refco's books through so-called "round-trip loans" in which the receivables owed to Refco from RGHI were replaced with receivables purportedly owed by a third-party customer. (Compl. ¶¶ 3, 450-51, 627.)

These loans, which straddled the end of each fiscal year from 2000 through 2005 and at the end of several fiscal quarters as well, all worked in essentially the same way. (Compl. ¶ 451.) First, several days before Refco closed its books for each financial period, Refco Capital Markets Ltd. ("RCM"), a Refco subsidiary, would loan hundreds of millions of dollars to a third-party customer who then, through its account at Refco, simultaneously loaned the same amount to RGHI. (Id.) The loan agreements between the third party and RCM -- which were done on a book basis (the principal never changed hands) -- were meticulously structured so that they were essentially risk-free to the third-party customers; the customers' loans to RGHI were guaranteed by Refco and the customers profited for their participation in the "loans" through interest earned on their loans to RGHI, which by design exceeded the interest they were charged by RCM.*fn4

(Compl. ¶¶ 451, 633.) RGHI, in turn, used the loans from the customers to pay down the money it owed to Refco for its uncollectible receivables. (Id.) The net effect of these transactions was that at the close of each reporting period, Refco's books would show "loans" to third-party customers and the RGHI receivables would be gone. Then, just days after the financial period closed, the transactions were unwound -- the "loans" repaid, and the uncollectible receivables from RGHI were returned to Refco's books. Thus, these transactions enabled Refco to lend money to itself, through third parties, to conceal its grim, multi-hundred million dollar losses from the public and from its investors. (Compl. ¶¶ 579-80.)

II. The Mayer Brown Defendants' Participation in the Alleged Scheme

From 1994 until Refco's collapse, Mayer Brown was Refco's outside counsel and was Collins's largest client.*fn5 (Compl. ¶¶ 76-78.) Mayer Brown and Collins -- the partner-in-charge of the Refco account -- had a close working relationship with Refco, in which the firm provided the company with a broad range of legal services and through which Mayer Brown collected approximately $5 million per annum in legal fees. (Id.) Accordingly, Mayer Brown was familiar with Refco's operations and finances and participated in seventeen rounds of the round-trip loan transactions between 2000 and 2005 by which Refco's uncollectible receivable were concealed. (Compl. ¶¶ 79, 451-52.) Specifically, the role of the Mayer Brown Defendants was to explain the structure and terms of the transactions to potential third-party participants, negotiate the loans, draft and revise the documentation for the transactions including the relevant loan agreements, promissory notes, guarantees and indemnification letters, transmit documents to the participants, distribute executed copies of the documents, and mark the third-party customers' promissory notes to RCM as "paid in full" when the transaction was unwound. (Compl. ¶¶ 451-52, 457-60, 471, 476, 482, 488, 494, 500, 506, 512, 514, 550-58, 564-65, 567, 569-72, 574.) Collins supervised all of these activities, approved bills for the work, personally negotiated and revised some of the loan documents, sent drafts of loan documents to Refco, and discussed the enforceability of the loans with Refco management. (Compl. ¶¶ 550, 556, 560, 567, 571-72, 574.)*fn6

III. The Mayer Brown Defendants' Participation in Statements that Refco Used to Issue Securities to Investors

While the round-trip loans concealed the trouble at Refco, certain Refco insiders began to consider cashing out of the company. Their plans began to unfold in 2004 when Refco issued $600 million in bonds (the "Bonds") to public investors in connection with a leveraged buy-out ("LBO"), and came to fruition approximately one year later when Refco conducted a $670 million initial public offering ("IPO"), during which Refco sold approximately one-fifth of its shares to the plaintiff class.*fn7 (Compl. ¶¶ 6-7, 195.) Both the LBO and the IPO yielded tens of millions of dollars in cash payouts to Bennett and other executives. (Id.)

The Mayer Brown Defendants participated in drafting the documents that were filed with the Securities and Exchange Commission ("SEC") in order to induce investors to purchase Refco's Bonds and, later, to effectuate the IPO. (Compl. ¶¶ 116, 127-28, 133, 135, 149-50, 152-53.) Specifically, with respect to the LBO, the Mayer Brown Defendants were involved, as were others,*fn8 in drafting and disseminating the Offering Memorandum to investors. (Compl. ¶¶ 115, 117.) The Offering Memorandum, which stated that Mayer Brown represented Refco in connection with the offering, concerned the creation of unregistered bonds that, through an underwriting by certain financial institutions, were purchased and immediately resold to certain institutional investors, including some of the plaintiffs. (Compl. ¶¶ 114, 116, 118.) The portions of the memorandum drafted by the Mayer Brown Defendants included the Management's Discussion & Analysis ("MD&A") and Risk Factors portions, which discussed Refco's business and financial condition in a way that, given Mayer Brown's involvement in the round-trip loan transactions and knowledge of the RGHI receivables, the Mayer Brown Defendants knew to be false. (Compl. ¶¶ 116-17.)

The Offering Memorandum, in turn, was used as the foundation for preparing the Bond Registration Statement whereby the Bonds issued in 2004 were exchanged for registered securities. (Compl. ¶ 165.) With respect to the Bond Registration Statement, the Mayer Brown Defendants, together with banks underwriting the Bonds received and reviewed SEC comment letters and participated in drafting sessions for amendments to the statement.*fn9 (Compl. ¶ 170.) Like the Offering Memorandum, the Bond Registration Statement contained untrue statements and omissions of material fact because it failed to disclose the existence and full extent of the related-party transactions and the related-party indebtedness between Refco and RGHI,. (Compl. ¶¶ 181-94).

Similarly, the Mayer Brown Defendants played a significant role in drafting and reviewing the IPO Registration Statement, which was prepared at the same time as the Bond Registration Statement. The IPO Registration Statement also specifically identified Mayer Brown as counsel to Refco. (Compl. ¶¶ 116, 201.) In that capacity, the Mayer Brown Defendants received and presumably reviewed the SEC's comments. (Compl. ¶ 204.) Both the IPO and Bond Registration Statements were materially false and misleading for the same reasons as the Offering Memorandum -- they misrepresented Refco's financial condition and failed to disclose multi-hundred million dollar receivable that were concealed through the round-trip loans that the Mayer Brown Defendants helped facilitate. (Compl. ¶¶ 181, 186, 203.)

IV. Plaintiffs' Claims

As a result of Refco's collapse, the value of plaintiff-investors' interests in Refco plummeted, allegedly causing them millions of dollars in losses. (Compl. ΒΆΒΆ 17-19.) Plaintiffs allege that the Mayer Brown Defendants knew, or were reckless in not discovering, that Refco's statements made in the Offering Memorandum, the Bond Registration Statement, and the IPO Registration Statement were false or materially misleading and that, accordingly, defendants should be held primarily liable for those statements under Section 10(b), either because they participated in drafting the documents and were identified as counsel for Refco in two of the three offering documents, or because they documented the round-trip loans that enabled Refco to issue false and misleading financial statements. Plaintiffs ...

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