11th July 2012
Investors do not often need to note 64 year olds in Iowa who narrowly fail to kill themselves by pumping exhaust fumes into their cars.
There's always the exception. The suicide attempt of Russell R. Wasendorf Sr. in Cedar Falls, Iowa earlier this week is one. He was the founder and chief executive of Peregrine Financial , a brokerage branded as PFGBEST, whose claimed $225m in accounts held for 1,845 clients was found to contain just $5m. It's posited as a rerun of the MF Global collapse last October where some $1.6bn evaporated from customer accounts. Wasendorf is now in hospital, guarded by Iowa state police.
A police report released on Tuesday said he had been found "breathing but incoherent" after running a hose from his exhaust pipe into the car. A suicide note found with him alluded to financial discrepancies.
As with MF Global, and financial crashes such as Madoff's ponzi scheme and numerous others, there are questions to be asked of regulators. But the biggest question investors need to ask is if they have become over-reliant and over-confident on the ability of watchdogs.
Heads must roll
Zerohedge has no doubts. It is calling for the head of Gary Gensler, the head of regulation at the CFTC, the agency ultimately responsible. Wasendorf Sr. apparently intercepted and forged banking documents for over two years to cover up losses. Yet, the watchdog gave the firm a clean bill of health in January 2012. Zerohedge alleges the CFTC failed to ensure the firm had "real not re-hypothecated, cash in their segregated client bank accounts." As it pronounced PFG clean just two months after the MF Global crash, the site says " For this Gensler has to be fired immediately, and with prejudice." The CFTC admits it has no idea where the missing funds are.
It's easy to blame watchdogs which fail to bark. But the problem is that regulators assume people play by the rules. If they do, then all is fine. But if they don't – and the temptation to raid customer accounts more and more to meet ever increasing shortfalls is always present – then regulation fails. This should be no surprise – laws against theft reduce burglary, but do not stop the practice. The determined criminally minded person will always have the upper hand against regulators or the law, at least for a time. In the case of brokerages, owners always assume they can use client money to trade their way back to financial health. They fail – and get deeper into the mire.
Two years of deceit
In Peregrine's case, regulators were fooled for at least two years. And without the suicide attempt, the deceit might have lasted longer. Wasendorf intercepted confidential regulatory documents from the National Futures Association (NFA) to what the industry group believed was Peregrine's bank. Instead the paperwork, used to independently verify a broker's bank balances, went to a post office box that Wasendorf had set up.
So Wasendorf, rather than a bank, was able to satisfy that regulator. He forged signatures and invented bank balances and returned the documents to the NFA. This is a level of criminality that regulators are not trained to spot. But this started to go wrong when the NFA moved to online confirmations instead of paper documentation, possibly precipitating the suicide attempt.
The scheme apparently began to unravel as the NFA shifted to electronic confirmations, which Wasendorf resisted. While regulators might have eventually discovered the problems without the suicide attempt, they failed to question why he was so against online confirmations. Regulators start with the presumption of innocence in what is usually a box-ticking exercise.
Investors are reacting in a number of ways. Some are moving away from the "one brokerage" model – if their money is not protected, then the next best is to spread the cash against the risk of theft. Another group intend checking how much physical cash they have. And a third intend to stop investing in this way – some of the Peregrine losers had already been burnt by MF Global.
As with MF Global, most of Peregrine's clients invested in fast moving futures and options where positions are often closed at the end of a trading session.
"It's déjà vu all over again," said John Roe, co-founder of the Commodity Customer Coalition (CCC), set up in the aftermath of MF Global's collapse last October to help clients recoup their money. "Anyone who thought things don't need to change will have to reappraise their position," Roe added.
Peregrine clients have no idea whether they will ever see any of their money again – and if so, when.
Peregrine calls for better regulation
In February 2012, and without a hint of irony, Peregrine published a "White Paper" it had commissioned entitled "Commodity Customer Protections and Regulations History and Potential Solutions 1938-2012." It was written by Susan Abbott Gidel, who had held a senior marketing position at MF Global.
Referring to MF Global, she spoke of the "violation of the sanctity of customer segregated funds" and calls for "improving the protection of customer funds in the futures industry."
Echoing the Commodity Customer Coalition, the publication calls for a number of additional safeguards including uniformity of dealing with organisations (currently some get more attention than others), require daily customer fund segregation reports, change US bankruptcy laws so that customers become the first recipients of recovered segregated funds, and to research and establish protection of funds.
Financial clients need to understand more – blame less
More generally, clients could sometimes help themselves by realising the limits of protection and the need to proceed with caution in investment.
Take the following true story of a UK brokerage client. He complains that the broker has sold his stocks without permission. He says the broker forged his signature.
The broker counters with the fact that the client had run up large losses on options on already extremely speculative shares purchased on the broker's credit.
The client does not deny this. His excuse? He was offered too much credit – it was £40,000 when it should have been £8,000. He believes regulators should step in to prevent his having to pay for his losses due to, what he considers to be, broker malfeasance.
But assuming the broker was over-generous with credit, the client did not have to spend it. Responsibility has to start somewhere.
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