Over the years I’ve often heard the question “why are the U.S. House and Senate Agricultural committees given jurisdiction and oversight of financial firms?” This question sometimes appears in the managed futures course I teach at DePaul University.

With the testimony of Jon Corzine former CEO of MF Global before the House Agricultural Committee on December 8th, 2011 and his testimony with the Senate Agricultural Committee on December 13th, 2011 regarding the bankruptcy of MF Global, the 8th largest U.S. bankruptcy, this would be a good opportunity to discuss this question.

Let’s start with the basics:

The U.S. Senate Agriculture, Nutrition and Forestry Committee maintains jurisdiction on 17 topics including agricultural economics and research, agricultural commodities and price stabilization. Four of the five subcommittees including the Subcommittee on Commodities, Markets, Trade and Risk Management have oversight of the Commodity Futures Trading Commission (CFTC).

The U.S. House of Representatives Committee on Agriculture has jurisdiction of oversight on 20 various topics including agricultural economics and research, stabilization of agricultural prices and commodity exchanges. The General Farm Commodities and Risk Management subcommittee maintains oversight of the commodity exchanges.
Of course this begs the question, why are these committees given jurisdiction over commodity exchanges and the CFTC?

To find the answer, let’s take a walk down history lane:

By the 1840s agricultural prices were experiencing price volatility. We can use Chicago as an example of this. Farmers would bring their crops to market and try to sell it. If they couldn’t sell the crops, they sometimes burned it or dumped it into Lake Michigan. By 1848 the Chicago Board of Trade (CBOT) was organized with the intention to give farmers and other grain market participants the ability to manage price volatility risk. In 1898 the Butter and Egg Board began and renamed in 1919 as the Chicago Mercantile Exchange (Now the CME Group).

February 18th, 1859 the Governor of Illinois signs an act giving the CBOT a corporate charter. The act empowers the CBOT as a self-regulatory authority; it standardized grades of grain and gave CBOT grain inspectors binding decision of grain quality. Some have debated if 1859 is considered the beginning of futures trading of CBOT wheat, corn and oats.

The United State Dept. of Agriculture (USDA) was signed into law under President Lincoln on May 15, 1862.

By the 1880s many futures commodity exchanges were organizing around the country. Over the next 40 years, an estimated 200 bills were introduced in congress to regulate, ban and tax futures trading. Some bills were debated in the Supreme Court as unconstitutional. In the 1920s the Federal Trade Commission released a seven volume grain trade and futures trading report. Some of the volumes discussed the need for regulation of futures trading.

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Copyright ©2011 Mark Shore. Contact the author for permission for republication at info@shorecapmgmt.com, www.shorecapmgmt.com. Mark Shore publishes research, consults on alternative investments and conducts educational workshops. Mark Shore is also an Adjunct Professor at DePaul University’s Kellstadt Graduate School of Business in Chicago where he teaches a managed futures/ global macro course.

Risk Disclosure:
Past performance is not necessarily indicative of future results. There is risk of loss when investing in futures and options. Always review a complete CTA disclosure document before investing in any Managed Futures program. Managed futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.

With all eyes focused on Jon Corzine’s testimony relative to MF Global Thursday, perhaps it might be time to consider that MF Global might only be one act to consider in this multi-act and often undisclosed tragedy.

The whispered story of private citizen Corzine’s toppling of a regulator at the Commodity Futures Trading Commission (CFTC) is something to which light should be shown.  In fact, the battle that took place in the late 90s between then CFTC Chairwoman Brooksley Born and then Goldman Sachs Chairman Jon Corzine, who is said to have directed lobbying efforts and the Washington D.C. “Working Group” to dispense with the “irascible” Ms. Born.  This is a story that has dramatically impacted society, leaving a scare of undisclosed leverage that can even be seen in today’s debt crisis.

What surprises me most about this story is the fact that it has generally remained untold.  Hopefully at Mr. Corzine’s congressional hearing tomorrow tough questions, listed at the end of this article, will bring forth additional details regarding the actions of Mr. Corzine and the Working Group.

Mr. Corzine’s tale really should be told by considering a pattern of behavior where the Goldman superstar ignored advice of risk managers and arrogantly rolled over regulators, literally toppling those who dare question his methods of non-transparent leverage management.  Contrast this to Ms. Born’s efforts to simply make the leverage transparent and traded on an open, regulated exchange and consider what was left in the wake: the explosion of Long Term Capital Management, the Enron debacle, the deceptively wrapped mortgage credit default swaps that imploded in 2008, and the fireworks display to end Mr. Corzine’s career, MF Global.

To the determent of society, Mr. Corzine has utilized undisclosed leverage throughout his career in a way that is yet to be properly recorded.  Ms. Born’s story is simply one her trying to enforce basic derivatives management practices vs Mr. Corzine’s “new school” attitude that bended or broke rules that the U.S. citizen simply didn’t think applied to him or his colleagues at Goldman Sachs.  If you think it was a fair fight between a principled regulator with old school derivatives management philosophy and a Wall Street oligarchy, I have a trading floor to sell you.

This article addresses how powerful private enterprise forces controlling the levers of financial engineering literally ran through regulators on their quest to impose their unsustainable methods of leverage management on society.

Mr. Corzine’s Rolling of Brooksley Born

Brooksley Born was a demure lawyer, well known and highly respected in the derivatives industry during an era of time when derivatives industry experience mattered at the top of the Commodity Futures Trading Commission (CFTC).  Upon taking over at the CFTC on August 26, 1996, life-long derivatives industry executive Ms. Born likely never though her career would abruptly end less than three years later, forced from office by the powerful financial services lobby.

Ms. Born discovered an issue that might similarly catch the attention of many in the derivatives industry if they were in her shoes.  She discovered massive undisclosed leverage in mortgage derivatives over the counter trading and wanted such potentially toxic assets to transparently disclose their contents and be traded on a regulated exchange.   Logical enough.  The regulator then dispatched Michael Greenberg, head of the divisions of trading and markets, to simply prepare a list of questions to be answered about the over the counter market.  The document asked questions and raised issues regarding previous industry fraud, potential default and market collapse and the growth of the OTC industry.  This internal CFTC document was titled the “Concept Release” [link:http://www.cftc.gov/opa/press98/opamntn.htm] and was designed to be nothing more than a thought piece.  Little did Ms. Born recognize that freedom of thought might get her in trouble with the financial oligarchy.

“I thought asking questions couldn’t hurt,” Ms. Born was later quoted as saying. “I was shocked at the strong negative reaction to merely asking questions about a market.”

The Concept Release was said to be shock to the system in both New York and Washington D.C.  It was at this point private citizen Corzine is said to have called the “Working Group” into action, an elite club of financial engineers who determined the future of the world economy.  Operated at a high level by the likes of  Robert Rubin with Alan Greenspan and Larry Summers at his side, the group was said to have a second layer of devotees with tentacles that spread throughout all major economic levers of power in Washington D.C.  In response to the Concept Release, Working Group leader Robert Rubin called an emergency meeting of group participants to muster support for silencing Ms. Born.

Concept Release now public, it was the summer of 1998 and Born started testifying before Congress.  She simply told the truth about transparency and unregulated derivatives – and the financial oligarchy really became uncomfortable.  Ms. Born warned about how mortgage derivatives traded in unregulated over-the-counter markets lacked transparency and could explode upon the economic landscape. Such heretical talk enraged the working group.

Silencing the Principled Regulator Because She Requested Transparency

The orders to the working group were clear: silence the regulator who is requesting transparency and OTC derivatives trading on open markets.  The Working Group’s first tactic was arm twisting.  Ms. Born was first called before Goldman alumni Robert Rubin, who flatly told Ms. Born her agency lacked the authority to regulate derivatives, a move that had some in the derivatives circles shaking their heads in disbelief of Rubin’s remarks.  This didn’t stop Ms. Born, so the working group turned to the next man on the enforcer list, who happened to be then SEC chairman Arthur Levitt.  Mr. Levitt’s attempts at persuasion were similarly unsuccessful.  Thus, the third hitter up to bat was Alan Greenspan.  In published reports, Mr. Greenspan’s face was said to have turned red during the meeting as she told Ms. Born of dire consequences if mortgage derivatives were made transparent.  Ms. Born held her ground, and the phone lines between D.C. and New York were ablaze with talk of “teaching Ms. Born a lesson.”

With the Working Group’s favored behind the scenes leverage tactics experiencing surprise rare defeat, they turned to overt pressure through Congress.  Later that year Born received her rebut from Congress, the censure of her powers.  She later resigned from office effective June 1, 1999 and Mr. Corzine had drawn the blood of his first federal regulator.

One note about the financial oligarchy is that while members may be individually brilliant, the notion that thought on issues can be independent isn’t always valued.  The group mind think at the time was that non-transparent leverage was positive for the economy (or at least there was sufficient profitability in the deceptive mortgage derivative products to make it positive).  Thus, any attempts to shine light on proper derivatives management were outed.

This shouldn’t have been a big issue; “old school” derivatives management dictated that proper leverage management was transparent and traded on open exchanges.  Unfortunately for society, this is when Born ran into the “new school” of derivatives management, one that didn’t feel any need for transparency, eschewed disclosure into the actual leveraged components and thought trading on regulated exchanges was a burdensome detail. In short, Ms. Born was introduced to Mr. Corzine’s philosophy.  It was this moment, newly minted CFTC chairwoman Brooksley Born fought an unexpected a battle between “old school” commodities management and a powerful new school that would soon silence the demure regulator – and any future regulator that dared challenge the Wall Street power base.

With a history of rolling over regulation, Mr. Corzine’s behavior with MF Global should come as no surprise, but the financial oligarchy he lead has not always come out on top.

Wall Street Doesn’t Get Its Way All the Time – Just Most of the Time

To be clear, there have been rare successes when the derivatives industry has faced off with equity interests.  One highly visible example took place when German futures exchange, Eurex, looked to take control futures on the U.S. yield curve in the early 2000’s. This effort of off-shore control of futures trading on interest rates, backed by Goldman Sachs, was one of the rare points when the commodity industry successfully fought off Goldman’s powerful Wall Street force.

In this instance, the whispered story that emerged years after the event was one of the financial services industry and Washington D.C. saying NO to Goldman Sachs.  At the time of this fight, Goldman wasn’t the current omnipresent force it is now.

Significant preparation for the fight with Eurex was said to take place, but a generally calm approach was taken by those at the top of the CBOT.  In stories that have emerged long since the event occurred, the real battlefield was said to take place at a dinner in Washington D.C. and private meetings in New York.  In Washington D.C. a simple argument was said to be made: U.S. control of futures on the yield curve could one day prove to be strategically critical at some future point.  Fast forward to 2011, with a debt crisis swirling around, this derivatives industry warning could be viewed as accurate.  In this case, influential forces in Washington recognized the logical argument regarding national interest.  This was also a time when the omni-potent force of Goldman Sachs did not prevail, to the surprise of some.  After successful meetings in D.C., the New York meetings were said to have a different tone.

The D.C. argument was said to be different than the equity industry argument.  In stories that have emerged years after the events took place, CBOT officials were said to gather the major Wall Street players with the exception of Goldman Sachs, of course.  The core argument was made that it simply wasn’t appropriate for Goldman Sachs to have such omnipresent control over the U.S. futures markets and the financial industry at large.  Such accurate and prophetic words, as the battle was won but the war was lost.

In short, the battle over the U.S. yield curve was won by the U.S. futures exchanges, racking up a rare loss for Goldman Sachs.  But ironically the omni-present control by one financial services firm continues.  With Goldman Sachs now the un-disputed heavyweight champion in financial circles in both New York and Washington D.C., it is ironic that their leader, the man who as a private citizen helped draw first blood from a regulator, was now in front of Congress after a reign of terror through the halls of MF Global.

Betting on a Bailout and Benefiting from “Working Group” Connections

Upon taking over at MF Global, Mr. Corzine was said to show little if any interest in the industry in which his firm operated.  The derivatives markets and its old school methods of leverage management were of little concern, even less concern than were regulators.  Perhaps it is for this reason when the CFTC gave MF Global a warning regarding toxic sovereign debt over a year before the firm declared bankruptcy, that warning could have been so easily ignored by Mr. Corzine along with warnings form MF Global internal risk managers.  Instead, Mr. Corzine is said to have relied on inside whispers from contacts in Washington D.C.  U.S. Treasury Secretary Timothy Geithner is said to have re-assured Mr. Corzine that European bonds would not be allowed to drift into default.  In other words, Mr. Corzine could ignore the warnings of regulators so as to rely on another government bailout to support his adventures in sovereign debt.   The rest, as they say, is history.

With this as a backdrop, perhaps it is time to get answers to important questions on the record.

Questions that Congress should Ask Mr. Corzine

Mr. Corzine, you were warned on the risk in your positions on several occasions. First, you violated an old school risk management principal to diversify risk away from one significant economic headwind.  That diversification technique might not be as “sexy” as concentration of risk towards positive economic outcomes, but it tends to work well in a variety of market circumstances.  Here is the big question: How many times were you warned the risk in your sovereign debt position was too much exposure in one direction?  Who were the people that warned you regarding sovereign debt and when did those warnings take place?  Did the CFTC provide MF Global a specific warning regarding sovereign debt?  Why was that warning ignored?

When U.S. Treasury Secretary and former Working Group member Timothy Geithner visited Wall Street this year, what was the focus of conversations?  Did Mr. Geithner assure you that governments in Europe wouldn’t be “allowed” to collapse? How did reliance on a government bailout impact your decision relative to highly leveraged investments in sovereign debt?

Mr. Corzine, describe your relationship with regulators and regulation in general.  Specifically, what discussions did you have with a “Working Group” in Washington D.C. regarding the deposition of Brooksley Born as CFTC Chairwoman?  The first tier of Working Group participants has been placed in the public domain.  Will you name the second tier of the Working Group and disclose their current positions in the U.S. Government?

Mr. Corzine, the American public finds itself in debt crisis that as early as this summer many in the public didn’t really recognize.  It seems to me that the level of leverage and methods to manage this leverage have pretty much been undisclosed.  I would like your recollection of how undisclosed leverage was defended in 1998 during fights with CFTC Chairwoman Brooksley Born, and then more appropriately how undisclosed leverage led to the downfall of MF Global?  Can you tie together your involvement in the following and specifically touch on how undisclosed leverage was a factor in the demise of Long Term Capital Management, the mortgage / credit crisis of 2008 and your current situation at MF Global?

Mr. Corzine, if you can reflect on the past 15 years of your career, a period of time when one Wall Street financial services firm with one groupthink mentality clearly dominates financial decision making in governments across the world, can you assess the impact undisclosed leverage might have on society’s future?

Mark H. Melin is author / editor of three books, including High Performance Managed Futures (Wiley, 2010) and was an adjunct instructor in managed futures at Northwestern University.  Follow him on Twitter @MarkMelin.

Risk Disclosure: Managed futures can be a volatile investment and is not appropriate for all investors.  Past performance is not indicative of future results.

The opinions expressed in this article are those of the author, may not have considered all risk factors and may not be appropriate for all investors.

To say the MF Global situation is a mess may be the understatement of the century. What began as an excuse to extol the segregated account’s safeguards against an FCM stock slide as MF Global shares lost 70% of their value in a week rapidly morphed into a full-fledged industry disaster as bankruptcy papers were filed and executives acknowledged a shortfall in those previously sacrosanct accounts.

This admission, in conjunction with the bankruptcy, has caused over $5 Billion of customer funds held by MF Global to be frozen, unable to be accessed or transferred out.  Right on cue, the lawyers have begun to circle, with employees, bondholders, and the customers themselves filing claims for their piece of the $40 Billion in Assets MF Global reportedly had on hand.

What was a very small probability just two weeks ago now looks to be a near certainty – that over 150,000 futures industry customers who held accounts at MF Global will have their money locked up for anywhere between several months to several years. Before a single penny can be distributed, a legal team charging $1,000 an hour will have to go line by line through books that have been described by regulators as a “disaster,” making the potential (and incentive) for a speedy turnaround non-existent. Even then, once the books have been closed on the accounting side, the legal battle royale begins, and if the Sentinel case is any indication, we’ll be waiting for quite a while to run through all the cases,

My firm, Attain Capital, uncomfortable with the direction MF Global was taking, moved all of its accounts from MF Global 2.5 years ago. Even with that foresight, we have had clients close their accounts in the MF Global aftermath because they are worried about the safety of their segregated funds, while many others heatedly question what the industry is going to do to make sure this never happens again.

While the lawyers fight with JP Morgan over who should get what money (how would you feel about being a taxpayer who bailed out the big banks only to have them get priority over your money in bankruptcy?), the rest of the industry needs to be talking about how to salvage our collective business.

Many of you may be feeling lucky you didn’t have exposure to MF Global, or even enjoying an uptick in business because of the MF Global accounts being transferred to you, and that’s understandable. However, that joy becomes short-lived as one realizes that this mess threatens the continued growth of not only your firm, but our entire industry.  Brokers, CTAs, service providers, technology companies, and more will all go out of business because of this – some immediately because they won’t get their most recent payments due from MF Global, and others over the next several months as their business falls due to their client base’s inability to access the funds held at MF Global that they need to trade.

But the biggest threat is to the future. It’s that large investor who would have happily opened a futures account just a month ago, but now chooses not to because he is unsure what would happen to his funds should a bankruptcy occur at his broker of choice.

How do we make sure that such an investor regains confidence in the industry, and chooses to go ahead with that investment? The hollow emails by FCM presidents and owners to their clients saying they care is simply not enough; actual solutions and fixes to the problems which allowed the MF Global mess to happen need to be enacted.

The industry needs to change to protect that which was formerly held most dear – the segregated account. Here is what we propose:

Create a coalition to make all the MF Global customers whole, immediately.

There are billions of dollars of profits between the exchanges, brokerage firms which just received free business from the MF Global demise, and others in the industry.  Someone (ahem… CME)  needs to step up and create a coalition of these industry giants and pony up the money to make each and every one of the MF Global accounts whole, immediately.

If the government didn’t think that MF Global was too big to fail, the industry surely needs to. Do you think the CME put forth their $250 million guarantee or $50 million recovery fund out of the kindness of their hearts? No- they are worried about volumes, and rightfully so. With about $5 Billion worth of customers now unable to trade, the sooner those customers can pump those funds back into the markets, the better for the CME’s bottom line.

How is this supposed to work? We’re not saying this coalition needs to pony up the money and never get repaid. We’re saying they should step in and cover the money until the bankruptcy runs its course and the funds are released.  Why can’t the industry put together a fund which covers the customer segregated funds, and in exchange for making the customer whole, the customer signs over any claim they had to their money in bankruptcy court to the fund?

Think of it more as fronting the money. After all, nearly all agree that it is just 10% or so of the money which is missing.  At worst, the fund would be out the $600 million in missing segregated funds (and that’s only if the trustee is unable to get any of the $41 Billion in MF Global assets to cover that shortfall). The problem here is less about there being no money than it is about the money being frozen up.

The industry simply can’t afford to wait for the bankruptcy to run its course. Every moment of inaction that passes is a moment without those funds coursing through the industry’s veins. Consider that MF Global reported in its Q2 financials that it cleared 575 million contracts over the three months that ended June 30^th, 2011.  If  the exchanges are getting $0.25 per contract, without taking action, that’s about $575 million in lost revenues per year. If the brokers who just received the accounts could get $0.25 per contract on the business moved to them, that’s $575 million in new revenue for them (assuming those accounts can get back trading).

There is plenty of money to go around, especially in the name of saving what has been the cornerstone of this industry since its inception- the sanctity of the segregated account. Hell, Attain will even pony up our share. Without taking this step, there is little any of us can do to help our clients feel secure. Industry participants will likely be worried about setting a precedent, but that is, in fact, the whole point. We need to be able to point to this time in our industry’s history and say, “Yes, it was ugly, but the industry stepped in and made the accounts whole.”

If you’re still not on board, why not backstop the coalition fund with a rule granting the ability to increase NFA fees from the current $0.02 per trade to $0.03 to cover any shortfall the fund has to cover? And as a final brushstroke, how about making the coalition member’s investments in the fund count 100% towards their net capital computations, treating it like cash in the bank?

The choice is a known cost in a temporary, defined and shared burden or an unknown cost in an inequitable and unquantifiable loss of business in the long run. How’s that for risk calculation?

Preventative Measures

While this may put out the fires in the short-term, at the end of the day, there’s still much more work to be done. It’s not enough to simply react; we need to be proactive about preventing this from ever occurring again. How? We’re glad you asked.

1. Extend SIPC protection to futures investors. When it came to light that the SIPC was rapidly moving to ensure that all claims to the assets of MF Global were resolved, the initial reaction of many industry participants was to breathe a sigh of relief. However, as many soon found out, SIPC protection is currently only offered to securities customers- meaning only those trading stocks and bonds would be covered, and not our beloved exchange traded futures investors. In our minds, there is zero reason why investors in traditional asset classes should be afforded such protection while investors in the alternative space are not.

As such, we propose that regulations governing the SIPC be amended to ensure protection of futures clients’ holdings as well, with guarantees on the individual account level (the sub-account of the customer segregated account on the FCM’s books) and not just the main overall account level containing all of the customer funds.

The CME and ICE should cut 10% off their marketing budget and put that to lobbying Congress for this protection. This isn’t 1970, when stocks and bonds were the only game in town. If the world turns to the CME to manage risk, the CME needs to turn to Congress to lower the risk of managing that risk.

2. Amend CFTC rule 1-25 to limit segregated funds investment to US Treasuries only. One of the issues that’s gotten a lot of press since the shortfall in funds at MF Global went public is the idea that Corzine might have used those funds to finance his European bets. There’s no proof of this yet, but the concept alone rattled many. The general belief was that FCMs could not, under any circumstances, touch segregated funds.

That’s not true. Under 1-25, FCMs are allowed to gain interest on excess segregated funds through specific investments under explicitly outlined circumstances. There are three limitations that really matter here: preservation of capital, preservation of liquidity, and adherence to risk standards.

Under the rule, FCMs can invest in 6 different vehicles (U.S. treasuries, state bonds, government agencies, commercial paper, corporate notes or bonds, sovereign debt, and money market mutual funds), but, with the exception of U.S. Treasuries or money markets, these vehicles have to have the highest rating possible from one of the NRSROs- or, official ratings agencies. This means that, technically speaking, the allegations flying around that FCMs may legally use segregated funds to invest in high-risk junk bonds are utterly incorrect. That being said, we’re still not satisfied with the requirements.

If we learned anything from 2008, it is that ratings agencies were doling out the highest ratings possible on toxic mortgage-backed securities right up to the point that things blew up. In fact, the rating agencies even downgraded MF Global…wait for it…. after they went bankrupt.  Our trust in their ability to assess risk adequately enough to ensure the preservation of segregated client funds is nil. As such, our recommendation is that 1-25 be amended to prohibit investment of segregated account funds in anything but U.S. Treasuries. While a statement issued today by CFTC Commissioner Scott O’Malia pointed out that we do not know the root cause of the missing funds, and that it’s possible the missing funds have nothing to do with investments permitted under 1-25, in our minds, this changes nothing; this rule needs to be altered regardless of the MF Global investigation’s conclusions.

3.  Establish regulation under which language must be added to all creditor agreements for any registered FCM in which those creditors agree to the assignment of the customer segregated accounts as the primary lien holder on all assets of the company. Under current provisions, segregated accounts are given what is, in our minds, inadequate protection during the bankruptcy process. True, their accounts cannot be tapped to meet outstanding financial obligations of the bankrupted FCM, but there’s also no guarantee of those funds being made whole in the event of a shortfall, nor protection from a too big to fail bank like JP Morgan sending in armies of attorneys arguing that their claim should take precedence over the customers.  While clients may, after a pro-rata distribution, file a claim with the Trustee in an attempt to get their missing money back, it appears that there are back door methods for big creditors like JP Morgan Chase and those who held MF Global bonds to get in front of the customers in the claims process. As TheStreet summarized:

“The group of customers, led by James Koutalas, chief executive of a Chicago-based commodities trading firm, are taking issue with a lien and other protections offered to JPMorgan in exchange for a $8 million loan the bank extended to MF on the first day of its bankruptcy, according to the report. That would allow JPMorgan the right to some assets over other creditors.”

In our minds, segregated account holders should absolutely come first in the claims process. Unlike the creditors and bold holders, who knowingly accepted the risk of default when they handed over their money, MF Global clients were paying MF Global to hold their funds- not lose them. With this in mind, we believe that the law must designate segregated accounts as the primary creditor if an FCM goes belly up, ensuring that, should there be a shortfall in client segregated funds, available assets of the bankrupt FCM will be tapped to make those accounts whole before any other creditor gets their day in court.

You can be sure that the big creditors would take an immediate and very big interest in insuring that any FCM they lend money to has the adequate procedures and safeguards in place to protect customer funds knowing that they are second in line behind said customer funds. If you can’t rely on morality to protect the funds, rely on greed and the invisible hand of those who would stand to lose money should the customer segregated funds be breached.

4. Establish regulation outlining standard operating procedures in the wake of an FCM bankruptcy. Part of the reason that the MF Global situation has been so chaotic was the result of poor planning. Positions were stuck in limbo. There was no infrastructure for facilitating an orderly transfer of accounts, which led to an ad-hoc distribution among arbitrarily selected FCMs without the transfer of legal documents- including those necessary for a CTA to trade on behalf of a client. Without any stipulations regarding timeframe, the process was drawn out to the detriment of all parties involved. Add to that a failure to effectively communicate what was going on to the clients involved, and it’s no wonder the situation turned into the nightmare it did.

In the wake of both the Refco and Sentinel scandals, one would think that remedies would already have been put into place for such administrative Bermuda Triangles, but unfortunately, that did not occur. In order to prevent such a disorderly dissemination from occurring again, we suggest that new regulations be developed; outlining exactly what is to happen in the event of an FCM going bankrupt. The old plan seemed to be, wait for a suitor to step up and take on all of the accounts. That clearly worked out wonderfully this time around. Coming up with standard operating procedures outlining the immediate impact on open positions, where the client funds are to be transferred to and within what timeframe, and so forth would help avoid the confusion we’ve seen to date.

A Call to Action

We are not about to claim that we have all the answers. Have we researched these subjects? Yes. Have we consulted with others in the industry? Absolutely. Does that mean that the solutions proposed here are perfect? NO.

But someone needs to start the dialog. The CME has made a nice first step with its $250 million guarantee to the trustee. The efforts of Koutoulas and Roe to provide a voice for the clients in the bankruptcy proceedings are certainly admirable. But at the end of the day, we all know that there is a long road ahead of us. Laws need to be changed and rules rewritten.  The industry needs to step up and reclaim its image. At the end of the day, perception is all that matters. If this situation is not resolved effectively, every CTA, FCM, CPO, Commodity Broker, Introducing Broker and Exchange will lose a sizable amount of business. There’s no getting around it. People aren’t going to invest in something where they don’t feel secure.

Make no mistake- these are extraordinary times we face, and they require an extraordinary communal effort to be survived. Despite the challenges on the horizon, we have no doubt that, in one way or another, this industry will rise to the occasion.  Because as important as it may be to understand what’s transpired and what’s at risk here, what comes next matters even more.

Sincerely,

JEFF MALEC
CAIA  |  CEO, FOUNDING PARTNER
ATTAIN CAPITAL MANAGEMENT, LLC.

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There is no very good intellectual case to be made for the present state of the law on “insider trading” in the United States.

I say this because I’ve been attending (too closely) to the predicament of former hedge fund manager Ralph Cioffi. Allow me to summarize that predicament briefly: Working within the Bear Stearns fold, Mr. Cioffi founded two hedge funds with absurdly long names, both of which sought to make money in the structured credit markets. In late March 2007, according to prosecutors, Mr. Cioffi transferred approximately $2 million of the money he had personally invested in one of those funds to another hedge fund. That transfer is the basis of the insider trading charge.
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I was astonished in recent days to learn that David Einhorn and his Canadian counsel, the distinguished R. Paul Steep, have been tripped up by what may be the most basic, and the best-known, principle of evidence in the common-law world: the exclusion of hearsay.

But there it was in black and white: Justice Katherine Swinton in a lecturing mode. Ontario’s corporate law is somewhat different from that of the state of Delaware, so phrases such as “oppression application” may sound odd on the sunnier side of Niagara Falls. Nonetheless, the rules of evidence are very much the same in Canada as in the United States, and for that matter in the mother country we share.

Hearsay is “an out of court statement offered for the truth of the matter asserted.” As such it isn’t admissible unless there is a good reason why it should be, and there are certain narrowly-defined good reasons, or exceptions, to the general rule of exclusion.

Greenlight sought to establish that as reasonable stockholders they would have expected that the role of one of their portfolio companies in one of its portfolio companies was to be relatively passive. Why was this expectation reasonable? Apparently because two representatives of the issuer, MID, had told a Greenlight figure, Venit Sethi, exactly that.

What if Sethi had prepared an affidavit saying, “They told me they weren’t going to bet on the horses”? Would that affidavit itself have constituted hearsay? No. It would have been the repetition of an out-of-court statement, but that statement would not have been offered for the truth of the matter asserted. It would have been offered in order to show something about the reasonableness of Mr. Sethi’s subsequent expectations, i.e. that he reasonably believed they thereafter weren’t going to bet on horses. That sort of thing is not hearsay, and when reasonableness is an issue in dispute, it is admissible.

The crucial point though is that Mr. Sethi didn’t sign any affidavit. According to the two judicial opinions now available: Mr. Einhorn signed an affidavit. This document said, in effect, “Mr. Sethi told me that they told him that they weren’t going to bet on the horses.” This was in fact offered for the truth of the matter asserted. Messrs Einhorn and Steep presumably wanted the court to infer that MID honchos had in fact told Mr. Sethi this. By definition, then, it was hearsay.

Mr. Steep, by the way, isn’t some straight-out-of-law-school greenhorn. He’s been a member of the Ontario bar for a quarter of a century. He recently spent four years as the chair of his law firm’s litigation group. I’m certain he knows the hearsay rule, which is precisely why I repeatedly sought to speak to him while working on a story on the case. Unfortunately, that conversation didn’t happen.

I have to suspect, in lieu of any other more plausible inference, that Mr. Steep was engaged in client management when he submitted Mr. Einhorn’s affidavit. He may have known he had a losing case on his hands, but wanting to seem to be earning his fee, he went through the motions anyway – and this hopelessly hearsay affidavit was a result.

I’m a big admirer of activist investors – both as a hedge fund strategy and, for that matter, more generally. Activism, even when it comes to the point of litigation, is an affirmation of the plain and vital truth that it is the shareholders who own the company, and that the managers work for them: all of them, of however large or small a stake.

Still, litigants in such a cause must expect to abide by the rules, especially rules that go back centuries. I wish the position into which Messrs Einhorn and Steep have worked themselves didn’t seem as untenable as it does. But it does.

With the news this morning that Bayou’s Samuel Israel has turned himself in to police in Southwick, Mass., the long and often bizarre saga of his legal battle, sentencing, faked suicide and RV flight seems to be at an end. His capture certainly is good news from a law-and-order perspective, as he did cheat Bayou Group investors out of some $400 million. But as observers to this strange tale, we can’t help but be a tad disappointed at what appears a rather anticlimactic ending.

Mr. Israel no doubt had his reasons for surrendering, just as he probably had some reason, albeit twisted, for running a pyramid-style scheme on investors in the Bayou fund group. But someone with the determination to flee the law, orchestrate a false suicide, and go on the run with a fully equipped recreational vehicle would seem as though he already had nothing to lose. Why turn himself in now?
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The Bayou case, especially given Samuel Israel’s status as a famous RV-dwelling fugitive, is on everybody’s mind these days.

Such matters are surely on the mind of Phillip Bennett’s attorneys. They’ve filed a reply to the government’s sentencing memorandum in his case that tries to draw a compelling Bennett-ain’t-Israel distinction.

Our HedgeWorld readers may remember the arguments of the government’s memo. To review: it suggested that the court should give Mr. Bennett, who once stood atop the Refco colossus, twenty or more years in prison because he “spent nearly a decade of his professional life … committing crime after crime, balancing and coordinating multiple acts of fraud on literally a daily basis,” on a scale that dwarfed … well, the Bayou matter, as well as many others of great notoriety.
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Jurisdictions may be like funds in taking advantage of opportunities—the smaller ones act faster, adapt more quickly. About $3 trillion are managed in Luxembourg funds, says Pierre Reuter, a lawyer with the Luxembourg office of Benelux law firm NautaDutilh. Why Luxembourg?

The place is certainly not cheap, so there has to be another reason. It does not lack regulation. Luxembourg provides, where possible, a little more flexible regulation, taking advantage of European Union directives a bit earlier than other jurisdictions, according to Mr. Reuter. The domestic market is small. Promoters go there to raise capital globally.

Now that everybody is used to Luxembourg funds, they favor these structures. Since 2007 Luxembourg has had a separate category, specialized investment funds, for hedge fund, private equity and other private placement money raising from well-informed investors. The regulator is responsive to the players and takes more of a consensus approach, Mr. Reuter says.

But there is plenty of competition for hedge funds from other smallish European locations, from Ireland to Malta.

Here’s a simple statement. The shareholders of a company are its owners.

Or maybe it isn’t so simple. Some people argue that the shareholders are “owners” only in some sophisticated, qualified, legalistic sense. My own view is that there is a common sense plain-English meaning of ownership, and that the shareholders own a company in that sense.

I tend to regard proxy fights as positive developments in the life of a company because they help remind the company management, their employees, of who they work for.
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Last week, at the annual meeting of a Canadian silicon-processing company, the chief executive said that the company has already sued someone for spreading dangerous rumors. Or maybe he said that it was going to sue someone.

It is, sadly, less than clear what Heinz Schimmelbusch was saying during the shareholders’ meeting for Timminco Ltd., in Toronto, Thursday afternoon. These were his words: “There are a few short sellers here, running up and down the streets here, making idiotic, bizarre … statements on the company … The matter is, by the way, before courts. If somebody oversteps a certain line, if he’s over the line, it’s straight going to the courts.”
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