After Peregrine: Examining the Logical Space for SROs

Commodities 21 Aug 2012

The Agriculture Committee of the U.S. Senate convened a hearing August 1 to examine how consumer protections may be expanded “to prevent future misuse of customer funds in the futures markets” in the wake of the recent meltdowns at both MF Global and the Peregrine Financial Group.

Since we at AllAboutAlpha have had our say about MF Global in many places and in some depth: here for example, and here, and here, we will focus today on those witnesses at this hearing who have directed their attention to Peregrine.

They included Gary Gensler, chairman of the Commodity Futures Trading Commission, Dan Roth, president and CEO of the National Futures Association, Ira Bodenstein, chapter 7 Trustee of Peregrine Financial, and Walt Lukken, president and CEO of the Futures Industry Association.

Here is a précis of the testimony of each of those four. They are not listed below in the order in which the testimony was delivered. I’ve rejiggered their ordering in an effort to see those testimonies as four parts of a logical whole

Gary Gensler

Gensler laid out the existing system. Peregrine is a registered futures commission merchant (FCM). The National Futures Association is responsible for its front-line oversight. This is as true for FCMs as it is for introducing brokers, commodity pool operators, and commodity trading advisers. As Gensler said, this is “the way our oversight system has been set up for decades.”

It is the responsibility of the NFA to conduct periodic audits of the FCMs’ customer funds, which are of course to be held in segregated and secured accounts. The NFA had audited Peregrine in May 2011 and it was doing so again in July 2012. As a consequence, the NFA reported on July 9 that Peregrine seemed to be missing much of its customers’ money, and the principal of the firm, Russell Wasendorf, Sr., on that day tried to kill himself.

The CFTC in turn oversees the NFA, “examining them for the performance of their duties” as Gensler put it. The CFTC brought an enforcement action against Peregrine in 2000, on the ground that the firm had broken net capital rules. It was ordered “to pay a civil penalty and to take steps to improve its financial controls, including retaining a second independent public accounting firm.”

It now appears that much more was wrong at Peregrine even in 2000 than was contemplated in that enforcement action. The charge against Wasendorf is, as Gensler puts it with simplicity, that “he took customers’ funds right out of the bank, and lied about it for years.” He was doing this and lying about it years before the turn of the millennium.

Dan Roth

Roth made the point that the NFA itself had adopted some rule changes in May, before the revelations about Peregrine, and Roth outlined those changes.

The NFA now requires that all FCMs must report their capital requirements, excess capital, and amount of customer segregated funds and other vital information which “will then be made available to the public on NFA’s web site.” Also, the NFA has decided that the sudden reduction of a level even of excess segregated funds is a waving red flag that requires acknowledgement.

Thus, the new rules require that an FCM that lowers its level of excess segregated funds by 25 percent in a single day “by making disbursements that are not for the benefit of customers,” must have a financial principal sign off on that disbursement, must at once notify the firm’s designated self-regulatory organization, and must certify its continuing compliance with all segregation requirements.

Ira Bodenstein

The chapter 7 trustee, Mr. Bodenstein, introduced himself to the committee as a member of the law firm of Shaw Gussis Fishman Glantz Wolfson & Towbin, a “boutique” firm “specializing in corporate insolvency and commercial litigation.”

He ran through the bankruptcy code provisions that are applicable to commodity broker liquidations, notably including 11 USC §766, which gives commodity customers “an important priority in the distribution of a bankrupt commodity broker’s assets,” subordinate only to some domestic support obligations, and some administrative expenses or claims.

Walter Lukken

FCMs are, as Lukken said at the start of his testimony, the “core constituency” of the FIA.

He emphasized in his testimony four points that together make up what he called the FIA’s Transparency Initiative.

First, regulators must have “the independent ability to electronically review and confirm customer segregated balances across every FCM at any time.”

Second, an automated confirmation process should be created that will provide timely information regarding the security of those funds.

Third, an “information portal” should be developed that would house firm-specific financial and related information for easy access by customers.

Fourth, he urged anew the adoption of compliance policies and procedures that the FIA had issued in February, as part of its response to MF Global.

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