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Kirschner v. Bennett

August 25, 2009


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


Plaintiff Marc S. Kirschner, in his capacity as Trustee of the Refco Private Actions Trust ("Trustee" or "Private Actions Trustee"), originally filed this action in New York State Supreme Court on behalf of Refco's foreign-exchange customers (the "FX customers"), asserting claims under New York state law against certain Refco insiders, professionals, and advisors for, inter alia, breach of fiduciary duty, fraud, and conversion. (Compl. ¶¶ 210-38.) Certain defendants subsequently removed the action to this Court on the ground that the case is "related to" Refco's Chapter 11 bankruptcy, 28 U.S.C. § 1334(b). See Kirschner v. Bennett, No. 07 Civ. 8165, 2008 WL 1990669 (S.D.N.Y. May 7, 2008) (denying the Trustee's motion to remand or abstain). The Trustee alleges that the FX customers collectively suffered losses totaling more than half a billion dollars when insiders at Refco diverted assets from their accounts at Refco Capital Markets ("RCM") in order to bankroll the Refco fraud. This opinion addresses four motions to dismiss pursuant to Rules 12(b)(1) and 12(b)(6) filed by Grant Thornton LLP, Ernst & Young LLP ("EY"), Mayer Brown LLP, and Mayer Brown International LLP (collectively, the "Professional Defendants").*fn1 The motions will be granted.


I. The Refco Fraud

Prior to its collapse in the fall of 2005, Refco*fn3 presented itself to the public as a leading independent provider of execution and clearing services for exchange-traded derivatives and a major provider of brokerage services in the fixed income and foreign exchange ("FX") markets. (Compl. ¶ 4.*fn4 ) Beginning in the late 1990s, Refco's controlling officer-shareholders -- Phillip R. Bennett, Robert C. Trosten, and Santo C. Maggio (collectively, the "insiders")*fn5 -- with the aid of certain professionals and financial advisors, orchestrated a complex fraudulent scheme to artificially enhance Refco's performance and conceal Refco's true financial condition, so that these insiders, through the company's August 2004 leveraged buy-out ("LBO") and August 2005 initial public offering ("IPO"), could cash out their interests in Refco on lucrative terms. (Compl. ¶¶ 2-3, 10-12, 26.) That scheme, which has been thoroughly discussed in this Court's prior opinions,*fn6 involved both concealment of Refco's uncollectible debt and the misappropriation of customer assets.

The concealment of Refco's uncollectible debt involved a two-part process. First, hundreds of millions of dollars in uncollectible trading losses and other operating expenses were converted into apparently legitimate receivables owed to Refco by RGHI, a related-party holding company, or "alter-ego" owned by Bennett and another Refco principal, Tone Grant. (Compl. ¶¶ 40-41, 47-48.) Although RGHI would never be in a position to repay this debt because RGHI's primary asset was its ownership of Refco stock -- the value of which hinged on the insiders' ability to conceal the very losses they were shifting off of Refco's books to RGHI -- the transfers had the intended effect of fraudulently increasing Refco's reported profits and concealing Refco's outstanding debt, the revelation of which would have devastated customer confidence and severely damaged Refco's business. (Compl. ¶¶ 45-47.) This facade was further improved by various fictitious transfers between Refco and RGHI, including those in which Refco charged RGHI as much as 35 percent interest on the sham receivables -- interest that Refco never, in fact, collected. (Compl. ¶¶ 57-59.)

Next, the insiders disappeared the receivables parked at RGHI through a series of so-called round-trip loans. This additional maneuver was necessary because the disclosure of large "related-party" receivables would have raised red flags among investors and regulators. (Compl. ¶ 50.) These "loans," which straddled the end of each fiscal year starting in 1998 and, after the LBO, at the end of several fiscal quarters as well, all worked in essentially the same way. (Compl. ¶¶ 49-55.) Several days before Refco closed its books for each financial period, a Refco entity -- usually RCM -- would lend hundreds of millions of dollars to a third-party customer who then, through the customer's account at Refco, simultaneously lent the same amount to RGHI. (Compl. ¶ 52.) The loan agreements between the third party and the "lending" entity -- 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.*fn7 (Compl. ¶ 53.) RGHI, in turn, used the loans from the customers to pay down the money it owed to Refco for its uncollectible receivables. (Compl. ¶ 49.)

The net effect of these transactions was that at the close of each reporting period, Refco's books would show apparently legitimate loans to third-party customers, and the RGHI receivables would be gone. (Id.) Then, just days after the financial period closed, the transactions were unwound -- the "loans" were repaid, and the uncollectible receivables from RGHI were returned to Refco's books. (Compl. ¶ 53.) Through these transactions, Refco lent money to itself, through third parties, to conceal its trading losses, its true operating expenses, and the fictitious nature of hundreds of millions of dollars in revenue. (Compl. ¶ 55.)

In addition to concealing Refco's debt, the insiders routinely misappropriated customer assets held at RCM in order to prop up other Refco entities with cash infusions. (Compl. ¶¶ 30-35, 61-62.) Some of these assets belonged to the FX customers, who maintained accounts at RCM for the sole purpose of engaging in FX trading pursuant to their instructions.*fn8 (Compl. ¶¶ 9, 20-25, 28.) The insiders, however, directed that all but a de minimis portion of the assets held in the FX customers' accounts be diverted from RCM to Refco Capital LLC ("RCC"), another Refco subsidiary, under the guise of "loans" to "customers." (Compl. ¶¶ 18, 68.) RCC, in turn, functioned as a disbursing agent and distributed the looted assets wherever they were needed in the Refco organization, without compensation, security, collateral, or appropriate documentation. (Compl. ¶¶ 19, 34, 66, 69-70.) These receiving Refco entities were not, of course, "customers" in any traditional sense -- they were intercompany, related parties -- nor could they repay these "loans." (Compl. ¶¶ 32, 61, 67-70.) Nevertheless, Refco's overall financial health depended on the steady influx of illicit RCM assets (Compl. ¶¶ 32, 64-65), so the insiders kept careful track of these transactions and distributed among themselves daily "cash flow" statements that calculated the amount of customer assets available for diversion to other Refco entities. (Compl. ¶ 67.) The size of these uncollateralized intercompany transfers -- like the size of Refco's concealed debt -- was substantial; the transfers involved hundreds of millions of dollars and dwarfed Refco's total capital. (Compl. ¶¶ 62, 64, 137-40.)

At the time of the LBO, Refco affiliates owed RCM approximately two billion dollars. (Compl. ¶ 35, 62.) By falsely presenting RCM to the public as a robust entity, the insiders enabled RCM to attract a substantial volume of business from the FX customers and made the enormous quantities of cash associated with their business available to the Refco organization for improper diversion. (Compl. ¶¶ 32, 38, 64-65.)

II. The LBO and IPO

The illusion of a thriving company also allowed Refco insiders, with the aid of the Professional Defendants, to position Refco for, and ultimately to carry out, what appeared to be a legitimate "buy-out" of the insiders' interests for far more than those interests were worth. (Compl. ¶ 71.) In 2004, Thomas H. Lee Partners ("THL"), a private equity firm, purchased -- by buying out the insider-owned RGHI -- a controlling interest in Refco as part of a leveraged buyout transaction ("LBO"). (Id.) Although the uncollaterized "loans" from RCM totaled almost two billion dollars -- a fact that would have been obvious to the Professional Defendants helping the insiders to execute the transaction -- Refco acquired an additional $1.4 billion of bank and bond debt through the LBO, which Refco could not possibly repay. (Compl. ¶¶ 71, 73-75.) That additional debt was especially problematic because, contrary to an Offering Circular that represented that the bond debt was "effectively junior to all existing and future liabilities," the debt, in fact, became senior to the debt owed to RCM. (Compl. ¶ 74.) The Offering Circular fiction, however, had the intended result of lulling RCM's customers into believing that RCM's obligations to its customers would be satisfied before its obligations to the LBO creditors. (Id.)

Less than a year later, with Refco still concealing its grim financial condition and having filed a fictitious S-4 with the SEC, Refco insiders and THL led Refco through an initial public offering of its stock. (Compl. ¶¶ 83-86.) Some of the IPO proceeds were used to retire part of RGL's LBO debt, but no proceeds were used to repay the amounts owed to RCM. (Compl. ¶ 83.) Weeks after the IPO, the RGHI receivables were revealed and RCM customers, including the FX customers, instructed RCM to return their deposits. (Compl. ¶ 5.) Refco responded by imposing a moratorium on all withdrawals from RCM customer accounts. (Compl. ¶ 65.) Days later, Refco and its subsidiaries and affiliates declared bankruptcy. (Compl. ¶¶ 88-89.)

III. Refco Private Actions Trust

On December 15, 2006, approximately fourteen months after Refco filed for bankruptcy, the United States Bankruptcy Court for the Southern District of New York confirmed the Modified Joint Chapter 11 Plan of Refco Inc. and Certain of its Direct and Indirect Subsidiaries (the "Plan"). (See Kirschner Decl. ¶ 6; id. Ex. A.) The Plan provided for the establishment of a Private Actions Trust ("PAT"), which was formed to prosecute "non-estate" claims -- i.e., claims owned by Refco creditors or shareholders that were "independent" of those held by the Refco Debtors.*fn9 (Id. ¶¶ 12, 14.) On December 26, 2006, the PAT became effective and plaintiff Marc Kirschner was appointed as the Private Actions Trustee. (Kirschner Decl. ¶¶ 10-11, 14.)

IV. The Movants

There are four separate motions to dismiss pending. This section briefly identifies the movant behind each of the motions.

A. Grant Thornton

Grant Thornton LLP served as outside auditor to Refco and issued clean and unqualified audit opinions on the company's financial statements for the fiscal years 2003, 2004, and 2005. (Compl. ¶¶ 14, 136-37.) Grant Thornton also audited Refco subsidiaries, including RCM, on a "stand-alone" basis (Compl. ¶ 129), and FX customers periodically received Grant Thornton's statements for RCM (Compl. ¶ 14). Given its multiple roles, Grant Thornton was "on both sides of the fence," giving it a complete picture of how Refco, and the Refco fraud, functioned. (Compl. ¶ 130.)

B. Mayer Brown LLP and Mayer Brown International LLP

Mayer Brown, which the Trustee claims is a "combination" of two limited liability partnerships -- Mayer Brown LLP and Mayer Brown International LLP*fn10 -- served as Refco's principal outside counsel from 1994 until October 2005. (Compl. ¶¶ 13, 92.) Mayer Brown provided a broad range of legal services to Refco, including drafting customer agreements, providing Refco with tax and corporate governance advice including advice on the repatriation of RCM, participating in discussions related to the LBO and IPO, and drafting the documents for the so-called "round-trip" loans, which concealed the RGHI receivables. (Compl. ¶¶ ...

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