An Analysis of the Financial Implications of Fraud on Business Failure; the Case of Refco Inc. Usa

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This research report attempts to highlight the circumstances that led to the failure of Refco Inc.; a New York based multinational commodities and forex brokerage firm. It focuses on the strategy deployed by the company’s executives in perpetrating fraudulent acts in misrepresenting the company’s financial accounts; the revelation therein have been described by many as one of the largest bankruptcy cases in the history of the United State’s financial services industry. A critical analysis of the principal methods used in falsifying the company’s financial statements is crucial in providing a clear picture of the role played by financial information in the failure of Refco Inc. Thus an introduction to the term “Round Trip Loans” and its relevance in the Refco debacle is provided in the pages that follow in addition to a critique of the role of Refco’s finance team and its external auditors in the falsifications and cover-up.

B.Discussion & Analysis of Fraud and Loss at Refco Inc.
B.1 History of Refco Inc.
Refco Inc. was founded in Chicago USA in 1969 by Ray Freidman and his Stepson, Thomas Dittmer. The firm was christened Ray E. Freidman & Co. at inception but was renamed after its relocation to New York. Initially, investors appeared confident in the latency of the futures market and Freidman had gathered a sizable customer base to propel the company to a favorable start(Smith, 2005). By 1998, Dittmer left Refco and relinquished his responsibility as CEO to the then Chief Finance Officer of the company, Phillip Bennet during a period when the industry was faced with losses following the Asian currency crises and the Russian debt default. Regardless, Refco steadily grew to eventually become one of the largest commodities and futures trading brokerage conglomerate in the United States. This was due largely to the return on investments to its hedge fund clients, amassing a customer base in excess of 200,000 over the years on the one hand. On the flip side, the company had also garnered a history of regulatory sanctions and fines, but still managed in 2004 to attract prospective buyer Thomas H. Lee (THL) LLP, a renowned equity firm who eventually purchased Refco in a $450,000,000 leveraged arrangement and by 2005 introduced the stock of the “new Refco” to the New York Stock Exchange (Russ, 2011). Refco Inc., worth several billions of dollars operated in several other cities around the world including London, Paris, Singapore and Sydney.

B.2 Refco’s Fraud Activities
Refco’s business models involved extending loans to customers thereby empowering them to trade and further re-invest in larger deals subsequently earning Refco commissions, revenues and profits. However the more the client base grew the more porous the credit-worthiness examinations became. This exposed the company to huge losses from defaulters. By October of 2005, barely two months after the Initial Public Offering of its common stock, a statement was issued by Refco that its CEO had fraudulently concealed a $430,000,000 liability (Wikipedia, 2011). The revelation of this scandal led to the immediate and panic mass withdrawal of deposits by customers, shareholders and creditors of the company. Richard S. Miller, 2005 offered that at the climax of its short lifespan on the NYSE market, Refco stocks were traded at $30.55per share and crashed to $0.75 within a few days and was eventually delisted from the NYSE. The diagram below illustrates the trajectory of Refco’s shares from the date of its Initial Public Offer (IPO) to the suspension of the trading of its stocks. (The Economist, 2005)

Refco’s management devised a scheme to erase the uncollectable receivables from the company’s reports by concealing the bad debts. They are converted to “loans” and recorded as such; then transferred onto the books of a Refco subsidiary, Refco Group Holding Inc (RGHI), thereby parading the subsidiary as the debtor to its parent...
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