[Senate Hearing 112-647]
[From the U.S. Government Publishing Office]
S. Hrg. 112-647
THE COLLAPSE OF MF GLOBAL: LESSONS LEARNED AND POLICY IMPLICATIONS
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HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
SECOND SESSION
ON
EXAMINING THE LESSONS LEARNED FROM THE COLLAPSE OF MF GLOBAL
__________
APRIL 24, 2012
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Printed for the use of the Committee on Banking, Housing, and Urban
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Charles Yi, Chief Counsel
Laura Swanson, Policy Director
Jeff Seigel, Senior Counsel
Jana Steenholdt, Legislative Assistant
Andrew Olmem, Republican Chief Counsel
Mike Piwowar, Republican Senior Economist
Shannon Hines, Republican Professional Staff Member
Dawn Ratliff, Chief Clerk
Anu Kasarabada, Deputy Clerk
Riker Vermilye, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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TUESDAY, APRIL 24, 2012
Page
Opening statement of Chairman Johnson............................ 1
Prepared statement........................................... 32
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 2
WITNESSES
James W. Giddens, Trustee, Securities Investor Protection Act
Liquidation of MF Global Inc................................... 4
Prepared statement........................................... 32
Louis J. Freeh, Trustee, MF Global Holdings Ltd.................. 5
Prepared statement........................................... 42
Jill E. Sommers, Commissioner, Commodity Futures Trading
Commission..................................................... 7
Prepared statement........................................... 44
Robert Cook, Director, Division of Trading and Markets,
Securities and Exchange Commission............................. 9
Prepared statement........................................... 49
Richard G. Ketchum, Chairman and Chief Executive Officer,
Financial Industry Regulatory Authority........................ 10
Prepared statement........................................... 55
Terrence A. Duffy, Executive Chairman, CME Group Inc............. 12
Prepared statement........................................... 58
(iii)
THE COLLAPSE OF MF GLOBAL: LESSONS LEARNED AND POLICY IMPLICATIONS
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TUESDAY, APRIL 24, 2012
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:03 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Tim Johnson, Chairman of the
Committee, presiding.
OPENING STATEMENT OF CHAIRMAN TIM JOHNSON
Chairman Johnson. I will call this hearing to order.
Today's hearing will examine the lessons learned from the
collapse of MF Global. The misuse of customer accounts by one
of the world's largest commodities and derivatives brokers has
shaken confidence in our markets and deserves a thoughtful
discussion of how to better protect farmers, ranchers, and
investors going forward.
But before we get to these important issues, I would like
to express my deep concern that almost 6 months after MF
Global's bankruptcy, thousands of former customers--including
hundreds of South Dakotans--still have not recovered the $1.6
billion removed from what should have been protected customer
accounts. I know that the trustees, regulators, as well as the
FBI and Justice Department continue to investigate what
happened in the final chaotic days of MF Global, but these
customer funds must be returned without further delay to their
rightful owners, and those individuals and executives
responsible for transferring these funds must be held
accountable to the full extent of the law. Last, it is not
acceptable for MF Global executives to be given bonuses when
customers have not recovered funds improperly taken from them
by MF Global, and I thank Senator Tester for his leadership on
this issue.
Since the collapse of MF Global in October 2011, my staff
has worked closely with Senator Shelby's staff in conducting
extensive interviews and due diligence with the regulators,
self-regulatory organizations, and other parties involved in
overseeing MF Global and its bankruptcy. We have also
coordinated with the Senate Agriculture Committee--which has
primary jurisdiction over matters involving commodities--in
holding a series of bipartisan briefings for all Senate staff
with representatives of many of the organizations before us
today to help our constituents impacted by the firm's downfall.
As investigators seek to recover MF Global customer funds
and hold accountable those responsible for any wrongdoing, this
Committee will focus our attention on preventing future abuses
and the other critical public policy issues raised by the
collapse of MF Global.
Today's hearing provides a unique opportunity to ask an
important set of questions: How can we strengthen protections
for customer accounts at FCMs or broker-dealers, including
those firms that hold U.S. customer funds abroad? Given the
size of the shortfall in MF Global's customer accounts, what
should Congress understand about the idea of extending to
commodity accounts similar insurance protections that are
currently available to securities accounts under the Securities
Investor Protection Act? And how can we continue to improve
regulatory oversight and coordination for large, complex global
financial institutions?
MF Global may also provide some early lessons about the
Wall Street Reform Act since it is the first collapse of a
major financial institution since the law's passage. For
example, the story of MF Global teaches us that effective
customer protection and market oversight demands that we fully
fund our regulatory cops on the beat. In hindsight, there is
little doubt that the regulators responsible for monitoring MF
Global should have taken additional steps. But shortchanging
the CFTC or SEC of much needed funding will only force them to
delegate even more authority to self-regulatory organizations
in a way that could impair effective market surveillance. When
funding cuts prevent regulators from inspecting firms or
assigning necessary staff to monitor crises, the American
people and market confidence pay the price.
Additionally, a key pillar of the Wall Street reform bill
was to end too big to fail; and if MF Global demonstrates
anything, it is that those who take risky bets that bring down
their companies are now free to fail and will not receive any
more taxpayer bailouts.
To preserve time for questions, opening statements will be
limited to the Chair and Ranking Member. However, I would like
to remind my colleagues that the record will be open for the
next 7 days for additional statements and other materials.
I now turn to Ranking Member Shelby.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman. Thank you for
calling this very important hearing.
The collapse of MF Global is one of the largest
bankruptcies in U.S. history and the greatest consumer
protection failure since the enactment of the Dodd-Frank Act.
It has been 6 months or more since MF Global filed for
bankruptcy, and the ownership of $1.6 billion in customer
assets remains in dispute. Hundreds of MF Global customers are
still waiting to learn how much, if any, of their funds will be
returned to them.
The disorderly failure of MF Global occurred despite the
fact that it was regulated by not only the CFTC and the SEC,
but also the Financial Industry Regulatory Association, the
Chicago Board Options Exchange, the National Futures
Association, and the Chicago Mercantile Exchange. The job of
each of these regulators was to ensure that customer assets
were protected.
That $1.6 billion in customer assets that remain subject to
ownership dispute reveals a serious regulatory failure, I
believe. Accordingly, the purpose of today's hearing should be
to help the Committee determine which regulators failed to do
their job and why.
To assist this effort, I asked the CFTC's Inspector General
last November to examine the Commission's oversight and
regulation of MF Global. The Inspector General's findings,
along with other ongoing investigations, should assist Congress
in its efforts to hold regulators accountable for any
identified failures.
I also asked the CFTC's Inspector General to determine
whether Chairman Gensler's recusal was appropriate and whether
he should have recused himself much earlier in the process.
Prior to MF Global's bankruptcy, Chairman Gensler had
multiple contacts with MF Global and its CEO, Jon Corzine,
concerning the CFTC's regulation of the firm. If a recusal was
appropriate, it seems it would have been more appropriate to
start at Mr. Corzine's tenure at MF Global rather than after
the firm had failed.
Furthermore, this Committee's due diligence has revealed
that Chairman Gensler played an active role in the oversight of
MF Global during the week leading up to its failure. Yet
Chairman Gensler's recusal now shields him from explaining his
actions. I believe this is unacceptable. Chairman Gensler owes
the public a full accounting of his role in the fall of MF
Global. It appears by his absence today, however, that we will
have to wait a little bit longer for such an accounting.
MF Global certainly will not be the last financial firm to
fail. Failure is an inevitable part of the free market system.
But our goal should be not to protect the private market from
failure. Our goal, I believe, should be to establish a credible
regulatory system that protects consumers while leaving the
market free to innovate and to expand. We must then hold that
regulatory system accountable for its failures. This is
exceedingly difficult, however, when one of the main
participants refuses to speak here.
I look forward to the testimony today, and I thank our
witnesses for appearing. Perhaps 1 day, Mr. Chairman, we will
hear from Mr. Gensler. Today does not appear to be that day,
however.
Thank you.
Chairman Johnson. Thank you, Senator Shelby.
Now I will briefly introduce our witnesses.
Mr. James W. Giddens is the trustee for the Securities
Investor Protection Act Liquidation of MF Global Incorporated.
The Honorable Louis J. Freeh is a trustee of MF Global
Holdings.
The Honorable Jill Sommers is a Commissioner for the U.S.
Commodity Futures Trading Commission.
Mr. Robert Cook is the Director of the Division of Trading
and Markets for the U.S. Securities and Exchange Commission.
Mr. Richard Ketchum is the chairman and CEO of the
Financial Industry Regulatory Authority.
Mr. Terrence A. Duffy is executive chairman of the Chicago
Mercantile Exchange.
I thank all of you again for being here today. I would like
to ask the witnesses to please keep your remarks to 5 minutes.
Your full written statements will be included in the hearing
record.
Mr. Giddens, you may begin your testimony.
STATEMENT OF JAMES W. GIDDENS, TRUSTEE, SECURITIES INVESTOR
PROTECTION ACT LIQUIDATION OF MF GLOBAL INC.
Mr. Giddens. Chairman Johnson, Ranking Member Shelby, and
Members of the Committee, thank you for inviting me to testify.
I take seriously my duty as the trustee of MF Global Inc. to
treat commodities and securities customers and general
creditors equitably. I would like to provide some proposals
that may merit further study and, of course, input from
regulators, industry experts, and the public.
A lack of supervision and inattention to maintaining
segregation of customer accounts caused the shortfall of
customer funds. Thus, a possible remedy is imposing personal
liability on senior officers and directors when there is a
regulatory shortfall.
Consideration should also be given to requiring not only
financial operating principles but senior officers, including
the CEO and the CFO, to certify compliance with commodity
segregation requirements on a much more frequent basis.
Second, I suggest the establishment of a commodities
customer protection fund. We found that more than three-
quarters of the commodities customers had accounts of a value
of less than $100,000 each. Thus, a fund providing for
protection of up to a maximum of $100,000 would have made a
substantial number of the claimants whole within days of the
bankruptcy filing.
Third, we have learned that many commodities customers have
not fully understood the nature and risk of certain financial
products in which their funds were invested. Currently,
commodities customers are not subject to suitability
requirements as are securities customers. In my view they
should be.
As a fourth suggestion, futures commission merchants might
be required to segregate an amount in excess of 100 percent of
customer funds. That would help ensure that there is a
sufficient cushion at all times for commodities customers.
Let me now turn to funds held for U.S. customers trading on
foreign exchanges. Under current rules, FCMs are not required
to calculate the segregation requirements for foreign trading
in the same way as they do for domestic trading. Reliance on
this alternative calculation resulted in a substantial
difference in funds segregated. The alternative calculation,
had it been in place, would have required a greater
segregation. The alternative calculable should be eliminated.
Finally, I believe there is a great need for international
cooperation on insolvency laws. Customers would benefit from
greater harmonization of the rules governing the segregation of
customer funds for both commodities and securities customers. I
have been engaged in active discussions since November with the
administrators of MF Global U.K. Ltd. concerning the return of
approximately $700 million commodities customers' property.
This dispute is now being submitted to the U.K. courts for
resolution.
In concluding, my staff and I continue to work as quickly
as possible to return assets to all claimants. We have
distributed in excess of $4 billion. We have sought court
approval to distribute an additional $685 million to
commodities claimants.
Thank you, Chairman Johnson, Ranking Member Shelby, and
other Members of the Committee for this opportunity to testify
before you.
Chairman Johnson. Thank you.
Judge Freeh, please proceed.
STATEMENT OF LOUIS J. FREEH, TRUSTEE, MF GLOBAL HOLDINGS LTD.
Mr. Freeh. Thank you very much. Good morning, Chairman
Johnson and Senator Shelby and your colleagues. Thank you for
the opportunity to appear here.
You have my opening statement. I just want to highlight a
few things for you and leave sufficient time, obviously, for
your questions and my colleagues on the panel.
I was appointed as the Chapter 11 trustee effective
November 28th of last year. There are, in addition to MF Global
Holdings, five other subsidiaries to which I am acting as the
Chapter 11 trustee.
I think everyone understands the functions of the Chapter
11 trustee very distinct and very different from my colleague
Mr. Giddens. Under the Bankruptcy Code, my obligation is to
investigate the acts, conduct, look at assets, liabilities, and
the financial condition of the debtors, among other things.
Unlike Mr. Giddens, who is charged primarily with the
return of customers' investment property, the responsibility of
the Chapter 11 trustee is to maximize the value of the estate
for the creditors, and we have a list of many creditors,
including the top 20, which is, I believe, in the materials.
When I was appointed in November, I landed in the middle of
a number of issues: first, very ongoing, active investigations
by the agencies represented here this morning; in addition to
two Federal prosecutors' offices, as well as the SIPA trustee.
One of my first challenges was to understand what documents
the Chapter 11 trustee and the estates controlled so I could
make some arrangements and ensure that the investigators could
access the information they needed without compromising any of
the privileges that I have a fiduciary responsibility to
protect.
So we looked at thousands of materials. My team and I,
which consists of lawyers, financial experts, and
investigators, determined what the materials were over which we
had authority and jurisdiction. We reviewed thousands of pages,
and we then set in place a process that would quickly produce
the documents to the investigators. We did a limited waiver of
the existing privileges that may appertain to the Chapter 11
trustee, and I was happy to say that ultimately all those
issues were resolved, and the process of producing evidence to
the investigators has gone forward expeditiously.
We are very sensitive, of course, to the fact that many
customers have lost huge amounts of money and collateral that
was entrusted to, in this case, the subsidiary MF Global Inc.
We have scrubbed our own cash collateral upon direction by the
bankruptcy judge to make sure that none of the cash collateral
in the estate is in any way related to or would be part of the
customer accounts. And we concluded, with no disagreement from
Mr. Giddens and his staff, that the cash collateral that the
estates now possess does not include misappropriated or
misdirected customer funds.
Let me also talk and I am pleased to be able to talk about
the subject of bonuses. This was raised very appropriately,
Senator Tester, by you and your colleagues. The source of this
was, as you know, a media report, and I do not have control
over what is in the media, no more than anybody in this room
does. But I want to make it very clear it was never my
intention to pay any bonuses. I never had a plan in place to
pay any bonuses to senior executives. I read the story with a
lot of surprise. There had been no discussions between myself
and my staff about bonuses to senior executives. And bonuses
are not part of my consideration now, and they have not been in
the past. So I want to be as clear as I can about that.
My responsibility as trustee is to maintain the people that
I need right now to help administer a cost-efficient and well-
administered estate. So there are 15 employees. These are
noninsider employees who worry about tax, who worry about
financing, unwinding transactions. They are all working at this
point on salaries. The three senior executives who have been, I
believe, before the Senate are working also on salaries.
If I have to negotiate with any of the employees, the
noninsiders, the 15 employees, to stay onboard because there is
a $22 million tax refund that I need to get for the estate,
they have the expertise and the experience, you know, I will
set fair and competitive salaries with them. If they do not
agree with that, then that is not going to work out.
I want to remain transparent, as I must in this bankruptcy
process. Everything I do is subject to review not just by the
trustee but the bankruptcy court. All of our fees, all of our
expenses have to be reviewed there. So I want to conduct the
Chapter 11 debtor estates with full transparency and
cooperation.
In closing, I just want to say I have worked very
cooperatively with Mr. Giddens. Our staffs are in sometimes
daily contact. We meet on a regular basis. There will be times
when our interests diverge, just as the interests of other
parties in this very complex and, I think, long-running
bankruptcy will occur. But we have some very clear and
immediate common goals, which is to get as many assets back to
the estates as possible. And then ultimately courts in England,
perhaps the bankruptcy court in New York will ultimately make
decisions about how those assets are distributed. But sharing
the information, getting the assets, returning them is a very
common critical need.
From the perspective of the SIPA trustee, I very much
endorse the six very important considerations that he sets
forth, particularly on the international cooperation. We have a
lot of assets, we believe, that are in the U.K., but the U.K.
has a separate administrator. There is a separate court system.
We do not have privity as the holdings company to challenge and
file some of the claims and the subsidiary Inc. will do. But it
is a very difficult task to get facts and retrieve assets
overseas, so some restrictions about how segregation should be
mandated for U.S. investors overseas I think is a key one from
the point of view of the Chapter 11 trustee, and I would just
emphasize that.
Thank you very much.
Chairman Johnson. Thank you.
Commissioner Sommers, please proceed.
STATEMENT OF JILL E. SOMMERS, COMMISSIONER, COMMODITY FUTURES
TRADING COMMISSION
Ms. Sommers. Good morning, Chairman Johnson, Ranking Member
Shelby, and Members of the Committee. Thank you for inviting me
today to discuss the collapse of MF Global, lessons learned,
and policy implications.
On November 9th of 2011, the Commission voted to make me
the Senior Commissioner with respect to MF Global Matters. This
authorizes me to exercise the executive and administrative
functions of the Commission solely with respect to the pending
enforcement investigation, the bankruptcy proceedings, and
other actions to locate or recover customer funds or determine
the reasons for the shortfalls in the customer accounts. While
I am happy to be here today to testify, the scope of my
election as Senior Commissioner for MF Global Matters does not
extent to the market-wide policy implications arising from MF
Global's failure. Chairman Gensler remains in charge of
directing Commission staff to develop recommendations for
enhancing Commission and designated self-regulatory
organization programs that are related to the protection of
customer funds and has instructed staff to do so.
My focus has been on making sure that the Commission is
doing everything it can to facilitate the recovery of customer
funds and to bring those responsible for any violations of the
Commodity Exchange Act or Commission regulations to justice.
Towards those ends, over the past 5\1/2\ months Commission
staff has conducted a thorough analysis of the books and
records of MF Global and continues to work closely with the
trustee in the SIPA bankruptcy.
We are also engaging in a comprehensive and ongoing
enforcement investigation. It is imperative that the
Commission, the industry, and the Congress identify and assess
the causes for the collapse and shortfall in customer funds and
to take corrective action where possible. We must do everything
in our power to restore confidence in the futures markets so
that producers, processors, and other end users of commodities
can once again hedge their price risks without fear of their
funds being lost or frozen.
Section 4d of the CEA and Commission regulations require
that an FCM holding customer funds treat such funds as
belonging to the customer at all times. FCMs are prohibited
from using a customer's funds to margin or guarantee the trades
or contracts of another customer or of the FCM. And the FCM
must maintain sufficient funds in segregated accounts to cover
the net liquidating equity of each of its customers at any
given point in time.
Our regulations also require an FCM to hold customer funds
deposited for trading futures and options listed on foreign
boards of trade in separate accounts known as ``Part 30 secured
accounts.'' The Part 30 rules provide for an alternative
calculation of the amount of funds required to be segregated
that does not afford the same protections as the net
liquidating equity calculation that is used for Section 4d
funds. This is something that I think should be changed.
The Act and the Commission regulations establish a
regulatory structure where frontline financial regulation is
performed by designated self-regulatory organizations. The
Chicago Mercantile Exchange and the National Futures
Association are the two primary futures market DSROs. FCMs are
subject to CFTC-approved minimum financial and reporting
requirements that are enforced in the first instance by the
DSROs. Many FCMs are also registered with the SEC as broker-
dealers. These duly registered broker-dealer FCMs are subject
to the jurisdiction of both the CFTC and the SEC.
To ensure that all activities of a broker-dealer/FCM are
properly reviewed, futures and securities regulators, including
SROs, coordinate their regulatory oversight. This coordination
includes periodic meetings of the Inter-Market Financial
Surveillance Group.
MF Global was duly registered BD-FCM and, therefore, was
subject to the jurisdiction of both the CFTC and the SEC. The
CME was the DSRO for MF Global's futures markets activities and
had primary responsibility for overseeing the FCM's compliance
with capital, segregation, and financial reporting obligations
required by the CFTC.
Prior to the bankruptcy, the futures and securities
regulators shared information and examination results regarding
MF Global. In August of 2011, MF Global filed revised financial
statements and regulatory notices with the CFTC as a result of
additional capital charges that FINRA and the SEC required the
broker-dealer to take on with regard to certain repo-to-
maturity transactions on foreign sovereign debt. At
approximately the same time, the SEC staff contacted CFTC staff
to inform us of the capital charges. The CFTC staff also
consulted with CME, FINRA, and CBOE regarding the imposition
and rationale for these additional capital charges.
Commission staff consulted with domestic and foreign
regulators during the period of October 24th through October
31st, as well as in the critical hours leading up to the
bankruptcy filing. At the direction of Chairman Gensler,
commission staff continues to review customer fund protection
provisions of the Commodity Exchange Act and our Commission
regulations to identify possible improvements.
While the staff has not yet proposed amendments to the
Commission, it is expected that they will make recommendations
in several areas. At a minimum, I believe that changes should
be made to our Part 30 rules so that customer funds held for
trading on foreign markets are subject to the same net
liquidating equity calculations as Section 4d funds, that more
information be provided to customers regarding how their funds
are held and invested, and that more frequent reporting be
provided to regulators and that FCMs' internal controls for the
handling of customer funds be strengthened.
I understand the severe hardship that MF Global's
bankruptcy has caused for thousands of customers who have not
yet been made whole. These customers may have correctly
understood the risks associated with trading futures and
options, but they never anticipated that their segregated
accounts were at risk of suffering losses that were not
associated with their trading. The shortfall in customer funds
was a shock to the market from which we have not yet recovered.
I believe the Commission can make improvements to our
regulatory oversight of FCMs and DSROs to help restore
confidence in the futures markets, and I will help the
Commission and Congress to implement the rules necessary to
enhance our ability to protect market users and to foster open,
competitive, and financially sound markets.
Thank you.
Chairman Johnson. Thank you.
Mr. Cook, please proceed.
STATEMENT OF ROBERT COOK, DIRECTOR, DIVISION OF TRADING AND
MARKETS, SECURITIES AND EXCHANGE COMMISSION
Mr. Cook. Chairman Johnson, Ranking Member Shelby, and
Members of the Committee, good morning. My name is Robert Cook,
and I am the Director of the Division of Trading and Markets at
the Securities and Exchange Commission. Thank you for the
opportunity to testify on behalf of the Commission concerning
the lessons learned and policy implications of the collapse of
MF Global.
The bankruptcy of MF Global has resulted in serious
hardship for many of its customers, who have experienced
significant delays and uncertainty with respect to their
ability to access their own assets. More broadly, the failure
of MF Global and the shortfall in customer assets highlight the
need for financial firms and for regulators to remain vigilant
in ensuring that customer assets are appropriately protected.
SEC rules are designed to protect customer property by
prohibiting broker-dealers from using customer funds and
securities to support their proprietary positions or expenses.
Broker-dealers that hold securities or cash for customers must
maintain physical possession or control over securities that
customers have paid for in full and cannot use these securities
to support the firm's own business activities. Further, when
broker-dealers extend credit to allow customers to buy
securities on margin, the rules strictly limit how much of
those securities the broker-dealer can pledge to finance the
credit it has extended to customers.
The rules also protect cash held for customers or derived
from customer securities by requiring the broker-dealer to
maintain a reserve in a bank account for the exclusive benefit
of customers in an amount that exceeds the net amounts owed to
customers. These funds cannot be invested in any instrument
that is not guaranteed by the full faith and credit of the U.S.
Government.
Together with applicable SEC capital requirements and
protections under the Securities Investor Protection Act, this
regime is designed to ensure that if a broker-dealer fails,
customer securities and funds will be available to be returned
to those customers. The preferred method of returning
securities customer assets in a SIPA liquidation is to transfer
those assets to another broker-dealer. On December 9th, the
bankruptcy court approved the initial sale and transfer of
substantially all securities custody accounts to a solvent
broker-dealer. This sale and transfer applied to approximately
318 accounts held for nonaffiliated securities customers. The
trustee has reported that since the transfer, nearly all former
MF Global securities customers have received 60 percent or more
of their account value; 194 customers have received the
entirety of their account balances. We understand that those
194 customers include anyone entitled to SIPA protection with a
net equity claim of up to $1.25 million.
Generally, the rules governing protection of customer funds
and securities have worked reasonably well over time, but we
are considering whether there are ways that they can be
strengthened. For example, the SEC has proposed to clarify and
strengthen the rules governing audits of broker-dealers,
including an auditor's examination of the effectiveness of
broker-dealer controls relating to the custody of customer
assets. The SEC also continues to work with the self-regulatory
organizations, or SROs, to strengthen broker-dealer financial
responsibility requirements.
For example, in June of last year, the SEC approved a FINRA
rule requiring the establishment of registration,
qualification, examination, and continuing education
requirements for certain operations--or ``back office''--
personnel, including those who handle customer assets. This
rule should help ensure that those responsible for these
operations are fully versed in their legal obligations,
including those relating to the segregation and protection of
customer assets.
In February of this year, a modernization task force formed
by SIPC issued 15 recommendations to the SIPC Board, including
proposed statutory changes. The SEC staff is evaluating these
recommendations as well, several of which are directed to the
scope and dollar limit of protection for individual customers
in a SIPC liquidation.
The SEC is also engaged in a number of efforts, both
domestic and international, to share more and better data and
qualitative assessments of firms and markets and to do so in a
timely way. Some of these efforts involve improved coordination
with the SROs, including establishing more frequent meetings
with certain SROs with financial oversight responsibilities.
Thank you again for the opportunity to testify on this
important subject, and I look forward to answering any
questions you may have.
Chairman Johnson. Thank you.
Mr. Ketchum, please proceed.
STATEMENT OF RICHARD G. KETCHUM, CHAIRMAN AND CHIEF EXECUTIVE
OFFICER, FINANCIAL INDUSTRY REGULATORY AUTHORITY
Mr. Ketchum. Chairman Johnson, Ranking Member Shelby, and
Members of the Committee, thank you for the opportunity to
testify today. My name is Richard Ketchum, Chairman and CEO of
the Financial Industry Regulatory Authority, or FINRA.
When a firm like MF Global fails, there is always value in
reviewing the events leading to that failure and examining
where rules and processes might be improved. Clearly the
continued impact of MF Global's failure on customers who cannot
access their funds is of great concern, and every possible step
should be taken to restore those accounts as quickly as
possible.
With respect to oversight of MF Global's financial and
operational compliance, FINRA shared oversight responsibilities
with the SEC, of course, and the Chicago Board Options
Exchange, which was the designated examining authority, or DEA,
for MF Global. When FINRA is not the DEA for one of its
regulated broker-dealers, we work closely with the DEA and
routinely analyze the firm's FOCUS report filings and annual
audited financial statements as part of our ongoing oversight
of the firm.
While that monitoring focuses on a broad range of issues,
it is particularly relevant to note that our financial
surveillance team placed a heightened focus on exposure to
European sovereign debt, and during April and May of 2010, we
began surveying firms as to their positions in those
instruments.
In a review of MF Global's audited financial statements
filed with FINRA on May 31 of last year, our staff raised
questions about a footnote disclosure regarding the firm's
repo-to-maturity, or RTM, portfolio. During discussions with
the firm, FINRA learned that a significant portion of that
portfolio was collateralized by approximately $7.6 billion in
European sovereign debt. According to U.S. GAAP, RTMs are
afforded sale treatment and, therefore, not recognized on the
balance sheet. Notwithstanding that accounting position, the
firm remained subject to credit risk throughout the life of the
repo.
Beginning in mid-June, FINRA, along with the CBOE, had
discussions with the firm regarding the proper treatment of the
RTM portfolio. Our view was that while recording the repos as
sales was consistent with GAAP, they should not be treated as
such for purposes of the capital rule given the market and
credit risk those positions carried. As such, we asserted that
capital needed to be reserved against that position.
FINRA and the CBOE also had discussions with the SEC about
our concerns. The SEC agreed with our assertion that the firm
should be holding capital against these positions. The firm
fought this interpretation throughout the summer, appealing
directly to the SEC, before eventually conceding in late
August.
MF Global infused additional capital and made regulatory
filings on August 31st and September 1st that notified
regulators of the identified capital deficiency and the change
in net capital treatment of the RTM portfolio.
Following this, FINRA added MF Global to alert reporting, a
heightened monitoring process whereby we require firms to
provide weekly information, including net capital and reserve
formula computations.
During the week of October 24th, as MF Global's equity
price declined and its credit rating was cut, FINRA increased
the level of surveillance over the firm. At the end of that
week, FINRA was on-site at the firm, with the SEC, as it became
clear that MF Global was unlikely to continue to be a viable
stand-alone business. Our primary goal was to gain an
understanding of the custodial locations for customer
securities and to work closely with potential acquirers in
hopes of avoiding SIPC liquidation. As has been widely
reported, the discrepancy discovered in the segregated funds on
the futures side of the firm ended those discussions.
While FINRA believes that the financial securities rules of
the SEC combined with SIPC create a good structure for
protecting customer funds, firm failures provide an important
opportunity for review and analysis of where improvements may
be warranted.
FINRA has identified changes that can be made to better
protect customers and their funds through both our own
rulemaking process and also in terms of our coordination with
our regulatory counterparts.
Most recently, FINRA and the Chicago Mercantile Exchange
established regular coordination calls so that our respective
staffs can share information about the approximately 50 firms
that are both broker-dealers and FCMs. In addition, we have
initiated a series of briefings on select firms for domestic
and international regulators of securities and futures. Our
next briefing will be in June, and we have expanded the list of
the regulators and SROs included in the event.
We have also continued our work on rulemaking efforts aimed
at enhancing financial surveillance. Starting in October,
FINRA-regulated firms must file additional financial and
operational reports that capture more granular detail about a
firm's revenues and expenses. And last week, FINRA's board
approved an additional report that would inform the assessment
of off-balance-sheet activities on firms' net capital,
leverage, and liquidity.
FINRA shares your commitment to reviewing MF Global's
collapse. We will continue to review our own rules and
procedures and reach out to our fellow regulators to identify
areas where current processes may be enhanced.
Again, thank you for the opportunity to share our views. I
would be happy to answer any questions you may have.
Chairman Johnson. Thank you.
Mr. Duffy, please proceed.
STATEMENT OF TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME GROUP
INC.
Mr. Duffy. Chairman Johnson, Members of the Committee,
thank you for the opportunity to testify respecting lessons
learned from the collapse of MF Global. I have previously
testified respecting MF Global's misuse of segregated customer
funds and CME's efforts on behalf of customers. Today I will
summarize our efforts in the industry's to restore customer
confidence.
The shortfall in customer segregated funds was limited to
the funds under MF Global's control. The customers' funds held
in segregation by CME's clearinghouse to cover futures
positions were complete. Our ability to transfer the positions
and the collateral of our customers was undone by a provision
in the Bankruptcy Code requiring pro rata loss sharing among
all customers. We believe that Congress can help protect
customers whose collateral is safeguarded at a clearinghouse.
It can do that by changing the Bankruptcy Code to permit
clearinghouses to transfer fully collateralized customers to
other clearing members despite a failure of their clearing
member.
The industry is united in its search for solutions that
will restore confidence in regulated futures and derivatives
markets. Obviously, changes in the Bankruptcy Code are not easy
or quick, and it is constructive to look at a wide range of
actions that can be implemented without legislation.
CME Group, along with other exchanges and the National
Futures Association, has proposed four forms of intensified
reporting to prevent misuse of customer funds. The Futures
Industry Association, on behalf of its members, also proposed
enhanced reporting and greater transparency. CME Group is
already implementing proposals which will include:
One, mandatory daily reporting of segregation statements by
all FCMs;
Two, additional surprise reviews of customers' segregated
accounts;
Three, a requirement that the FCM's CEO or CFO sign all
payouts of customer segregated funds exceeding 25 percent of
excess segregated fund amounts, plus immediate notification to
CME;
And, four, a bimonthly report reflecting how segregated
funds are invested and where they are held.
CME has also challenged the industry and the Commission to
consider whether other solutions will better serve the
interests of customers and the industry. In addition to the
proposed amendment of the Bankruptcy Code, CME is working with
its clearing members to find a structure that will protect
their collateral against fellow customer and fraud risks. We
are committed to finding a solution that will provide strong
protection for the segregated funds of futures and swap
customers from a legal, operational, and cost/benefit
perspective without destroying the industry's business model.
In addition to these regulatory initiatives, we also
recently launched the CME Group Family Farmer and Rancher
Protection Fund. This fund is designed to protect family
farmers, family ranchers, and their cooperatives in the event
of shortfalls in segregated funds. We hope these steps will
give additional confidence to U.S. futures markets after the
actions and failure of MF Global. The misconduct of MF Global,
however, should not serve as a reason to undermine the current
system of frontline auditing and regulating by clearinghouses
and exchanges.
Some critics suggest that the current regulatory system is
compromised by conflicts of interest. There are no conflicts of
interest in CME's duties to the CFTC, to its customers, and its
shareholders. CME's duty to its shareholders requires that it
diligently keep its markets fair and open by vigorously
regulating all market participants.
Federal law mandates an organizational structure that
eliminates conflicts of interest. The current regulatory model
has served the futures industry, its customers, and the public
very well. We look forward to working with the Congress and the
regulators to enhance customer protections and foster
confidence in our markets.
I thank you for your time this afternoon.
Chairman Johnson. Thank you. I would like to thank all of
our witnesses for their testimony. As we begin questions, I
will ask the clerk to put 5 minutes on the clock for each
Member.
Judge Freeh, just to be clear, given that $1.6 billion of
customer funds have yet to be recovered due to mismanagement or
possible illegal transfers by MF Global, can you commit to us
today that your office will not be seeking bonuses for any
former or current MF Global employee?
Mr. Freeh. Yes, Senator.
Chairman Johnson. Mr. Giddens, if some type of SIPC-like
insurance coverage had been in place for commodities accounts,
how would that have impacted the transfer of client positions
to other FCMs as well as the claims distribution process for
former customers of MF Global? Do you believe that Congress
should study and revisit the idea of extending to commodities
accounts an insurance coverage similar to that provided for
securities accounts under the securities Investor Protection
Act?
Mr. Giddens. Senator, yes. SIPC proceedings, which govern
the liquidation of broker-dealers, contain essential and well-
established procedures for contemplating and facilitating
transfers of accounts to other solvent broker-dealers and
provide mechanisms for the prompt payment of customer claims.
All of this is greatly facilitated because there is the
financial support of the SIPA fund, which has in the case of
SIPA several billion dollars of assets and the ability to
assess the industry for additional funds.
Those funds would assist if it were necessary to cover
shortfalls to enable a trustee to transfer accounts to other
solvent--by analogy, to other solvent FCMs. I think as Mr.
Duffy was alluding to, there are problems here because under
the statute you have to distribute equally on a pro rata basis.
So, yes, I believe that if you had a fund which would give
you more flexibility as a trustee, you could more rapidly
transfer accounts and at least have that available in your
arsenal of things to move things along.
Chairman Johnson. Commissioner Sommers, could you describe
any legal actions or other efforts the CFTC is taking to
recover the more than $700 million of U.S. customer funds being
held in the U.K.? How has the work of the CFTC in this area
been coordinated with Mr. Giddens' efforts to protect U.S.
customers subject to CFTC Regulation 30.7?
Ms. Sommers. Thank you, Senator. The CFTC does not have the
authority to bring an action in the U.K. court proceeding, but
we are, as we are in the United States, working very closely
with Mr. Giddens and his staff, the law firm that he has hired
to represent the bankruptcy in the U.K. in front of the English
court, and we will continue to monitor all of the different
actions that happen in that proceeding.
Chairman Johnson. Mr. Giddens, do you have anything to add?
Mr. Giddens. Just to confirm that we do confer frequently
with the CFTC about the strategy in the U.K. and the nature of
the legal issues. Equally, we have, to the extent we can,
shared information with Judge Freeh regarding that proceeding.
Our view, of course, is that all of those funds in the U.K. are
segregated assets that belong to the 30.7 customers of the
broker-dealer.
Chairman Johnson. Mr. Duffy, do you have any views on the
FIA recommendations offered last month to better protect
segregated customer accounts? Also, would it be valuable for
SROs and the CFTC to receive daily electronic backup
documentation on these accounts directly from exchanges,
clearinghouses, and custodial banks in order to confirm that
the self-reporting of seg funds by FCMs is accurate?
Mr. Duffy. Let me take the latter first. As far as the
daily reporting from the SRO and the CFTC to the exchanges, I
am a big believer, Senator, in transparency and real-time
reporting, so it is kind of hard to argue with that. The
reality is what are the practicalities of getting that done.
Even if we were to have it on a real-time basis, if people were
having multiple books or doing nefarious activities, it would
still be very difficult to detect what happened in the MF
Global situation. So as much as I support real-time tie-outs, I
think there is a lot of information that still needs to go into
that.
As far as the FIA's recommendations on the signoffs and
some of the things that they have proposed, yes, the CME Group
is very supportive of their recommendations.
Chairman Johnson. I note that Senator Shelby has
temporarily left the Committee hearing to attend an
Appropriations hearing, and he will be back. Senator Corker.
Senator Corker. Thank you, Mr. Chairman, and I thank all of
you for your testimony.
I sit through most of these hearings, and today it almost
gives you a headache to think about all the various regulators
involved in one entity, and we created that, you all did, and
so I am not criticizing that. But it does seem like there are a
lot of silos and various areas that each of you look at that do
not overlap properly. And what I would like to do is ask Mr.
Giddens and Judge Freeh: What happened? What happened to the
customer accounts? How did the money end up in places that it
was not supposed to end up? We have talked about everything but
that here today.
Mr. Giddens. Our analysis of what happened and where the
money went I think is substantially concluded. That is the
first phase of the process. Because of the liquidity crisis in
the last week, something like $105 billion in cash went out of
the firm to banks, depositories, some to commodities customers,
some to securities customers in what on the surface appear to
be ordinary commercial transactions. A great deal of this was
caused by customers leaving the firm and asking that their
assets be transferred out of the firm. Also, the firm had to
scurry around to find additional collateral. Additional
collateral was required with respect to the repo-to-market
transactions which went from something like $200 million to
maybe $900 million additional collateral required.
In these firms, cash is moved around from various accounts
on a daily basis, and it is possible that if mistakes are made
and you say we have excess in one category, we can use that
category to move it to another, and with so much happening in
the last week and so many volumes of transactions, that is
where we think the--what accounts for the mistakes.
So we can trace where the cash and securities in the firm
went, and that we have done. The second more complex phase,
which we are also aggressively pursuing, is to get as much of
that back if we have an appropriate legal theory to do that,
and we have done that. We have had some success to date, and we
will continue to pursue that with a goal of getting back as
much of the property as we can.
Senator Corker. Let me ask you this question. We kind of
all get the picture of what happened. A lot of money was moving
around quickly. The firm was in a desperate state. With all of
that occurring, regardless of, you know, the umpteen million
regulators that look at this, the fact is--how do you keep that
from--how do you keep at the end money going out of a customer
account inappropriately to some other place? I mean, how can
even a regulator at that instant keep that from happening?
Mr. Giddens. Given the fact that so-called operational
personnel can move funds and have authority to do it, it is
almost not possible to build a foolproof system which would--
the checks that you have or the reporting requirements and also
the totaling up on a daily basis of what the segregation
requirements should be, if there are substantial mistakes in
that, it permits someone to say theoretically I have an excess
in the commodities funds; therefore, I can transfer that to the
securities accounts, or vice versa.
We had an example shortly--after I was appointed, I had a
call from MF Global itself saying we have wrongly transferred
$220 million from the securities accounts to the commodities
accounts, and we would like to reverse that. How that was done
or who authorized it or whatever, you know, we cannot say. But,
clearly, there were mistakes being made, and part of this--as I
say, the process is that most people do not realize that
relatively low-level operational people in any given time have
the authority to transfer hundreds of millions of dollars----
Senator Corker. Was there an investment committee? Is there
personal recourse to the executives when these kinds of things
happen? Is there a way to deal with them on a personal basis
against their personal assets? And, second, was there any kind
of investment committee or internal controls that existed there
to keep this kind of thing from happening within the firm? And
if not, are there other firms, to your knowledge, that have
these same problems?
Mr. Giddens. On the personal liability, I think there are--
my own personal view and the view of people working with me is
that there are discrepancies so that seniors and higher-ups who
do not directly authorize the young vice president to move
money are probably--it is very difficult to suggest that they
are personally liable. And that is one of the reasons I
suggested that we look at that and begin to consider saying it
is not enough when you are managing the firm, determining the
investments and the overall strategy, if you in effect create
the liquidity crisis, that you will bear some responsibility if
there are shortfalls in customer property. I think it is
certainly----
Senator Corker. I know I am running out of time. Were there
internal controls or an investment committee? Was there any
discipline within the firm that kept one person from making a
big bet and the company going haywire?
Mr. Giddens. My understanding was there was an investment
committee. There were risk officers at the firm. There were
examples of where recommendations were not taken by the risk
officer, and under perfectly legitimate corporate structures,
senior officers could choose to ignore that.
Our view of MF Global from our analysis of its operations
was that the firm was poorly capitalized and had liquidity
crises, highly leveraged before Mr. Corzine came to the firm,
and, in fact, those problems continued. They certainly went
through the motions of having operational supervision and risk
supervision and the like. How effective that was I think is
demonstrated by the ultimate failure of the firm.
Senator Corker. Mr. Chairman, thank you for the time.
Chairman Johnson. Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman. Thank you all
for your testimony.
Mr. Giddens and Mr. Freeh, let me ask you, I just heard
your response to Senator Corker's last question that MF Global
was poorly capitalized and had a liquidity crisis, that it was
highly leveraged. Was that in essence the harbinger of its
doom?
Mr. Giddens. That was certainly a large contributing
factor, so that if they had a crisis, there was not much of a
cushion to fall back on. I think also it would be the nature of
their investments in risky European sovereign debt of countries
such as, I believe, Italy, Spain, and Ireland, with the result
that since those were purchased on margin, the margin amounts
and the collateral put up had to be continually increased. So
that toward the end, as I recall, something in the neighborhood
of $200 to $300 million in margin became closer to $900 million
in margin that had to be put up. So all of that created much
more severe strains on the firm.
Mr. Freeh. Senator, also, in addition to that, a critical
factor was really the inability of its IT and technology system
to just keep pace with the trades and to even record them. In
the last few days, there are many nonrecorded trades. Even now,
to reconstruct what happened there is very difficult. The IT
system and the technology, you know, was not equipped for the
frenetic pace of trading in the last several days, and that
combined with the miscalculation using the most generous term
at this point, subject to investigation, of what was segregated
and what was not segregated, and the inability to control and
track the trades in the accounts was just a perfect storm for
the disaster that occurred.
Senator Menendez. So you clearly had between poor
capitalization, liquidity crisis, highly leveraged, and
inferior technology, a structural problem at MF Global.
Let me ask you this: Has it been part of your effort and
review to determine what individuals at what level--I am trying
to think here of structure more than individuals, but what
individuals created the set of decisions that created the
challenge that we have?
Mr. Freeh. Yes, Senator. That is a subject both of my
investigation and Mr. Giddens. We are looking to determine the
available causes of action, including fraud, lack of fiduciary
responsibility.
Senator Menendez. And where are you in that investigation
at this point?
Mr. Freeh. We are just beginning it, sir.
Senator Menendez. Just beginning it. So you cannot identify
at this point the responsible parties?
Mr. Freeh. I could not do that fairly at this point.
Senator Menendez. Let me ask you this, Mr. Giddens. You
suggested in response, I think, in earlier testimony that
director liability might be a preventative measure. Isn't there
director liability here now?
Mr. Giddens. There well may be, and we are looking at that.
If there were breaches of fiduciary duty that are actionable,
we will pursue them.
Senator Menendez. Ms. Sommers, on December 11th, the CFTC
finalized a rule prohibiting the investor of customer funds in
foreign sovereign debt securities. If the rule had been
finalized before the collapse of MF Global or not overturned in
2005, does the CFTC believe that MF Global would have avoided
collapse?
Ms. Sommers. No, sir.
Senator Menendez. OK.
Ms. Sommers. The investments under 1.25 are the permissible
investments that the FCM can use to invest customer funds that
are in segregation, but they cannot be used by the FCM
themselves to invest it for the FCM's own gain.
Senator Menendez. What is the likelihood of--my
understanding is you have identified where the money is. What
is the likelihood of recovering it on behalf of all of those
individuals whose money is abroad?
Mr. Giddens. With respect to the $700 million that was
represented to the U.S. customers as being segregated for them,
our position is that under U.K. law, that money should be
treated as segregated customer funds. And I think we are
reasonably confident of a positive outcome from the U.K.
courts, but there is no guarantee of that.
Senator Menendez. One final question. Mr. Duffy, clearly
what a company does in the first instance is the challenge. We
would expect them to do the right thing, both legally and
substantively and ethically. But in the absence of that, is
there anything in this experience that says to you, heading
CME, that there is something structural that needs to be
changed to be able to at least mitigate the extent? My
understanding is that there was a $700 million--some-odd
instance in which they would have--reporting would have
indicated that funds were commingled. That could not be stopped
because it already was done. But might it have mitigated going
to $1.6 billion.
Mr. Duffy. Again, the number of $1.6 billion, you would
have to ask Mr. Giddens where that came from. Our number is
significantly lower, and we are referring to the U.S. number
around $700 million as missing. And anything that we could have
gained by the experience, I think that we have done everything
as a DSRO. We have reviewed all of our practices going back
looking through the whole forensic analysis of MF Global, and
we feel very strongly that we did all the things that were
appropriate.
I think Mr. Giddens said something that was very important
just a moment ago. He said that the company has a liquidity
crisis, and their increases went from $200 to $900 million on
their margin calls. That money had to come from somewhere, and
if there was a liquidity crisis, where was that money coming
from? So I think that is a very important point in this hearing
today. So that is one of the things I have learned.
As far as going forward, I think that the CME is--without a
doubt, that is the biggest part of what we do as a DSRO, is to
protect the integrity of our markets and our clients.
Senator Menendez. So there is nothing structurally that you
have learned from this?
Mr. Duffy. I do not believe there is anything structurally
wrong with the process sir.
Senator Menendez. Thank you, Mr. Chairman.
Chairman Johnson. Senator Johanns.
Senator Johanns. Let me just say thank you for being here.
Mr. Giddens or Judge Freeh, either one of you maybe would
be equipped to answer this. I am trying to get a perspective
here just in terms of time. You said, I think, Mr. Giddens,
when former Senator Corzine came on board, there were problems
with this firm. They had liquidity problems and that sort of
thing. As I understand it, that would have been in the scope of
$200 million at that point in time? Is that what you found?
Mr. Giddens. No, Senator. I was just alluding to the fact
that the evidence we see is that from 2008 on, MF Global was
either losing money in an operating sense or was highly
leveraged. And so it was a firm which had financial
difficulties when Mr. Corzine came in, and that is simply to
say that--the liquidity crisis was certainly not as severe as
it was in the final weeks, in October of 2011.
Senator Johanns. That is what I was trying to get at here.
Everything I have heard through hearings like this and reading
testimony, et cetera, was that in the final weeks of MF Global,
the sky fell in. Now, my understanding--and to me it seems so
basic, you know, even having been a lawyer where you maintain a
trust account, somebody gives you money, you put it in a trust
account. You are not authorized to say, gosh, kind of a rough
month this month, clients are not paying their bills or
whatever, so I will just borrow money out of the trust account.
But that is, in effect, what they did here, right?
Mr. Giddens. The analogy is good, but what they can do
perfectly legally through fancy footwork and accounting each
day is look at funds that are theoretically in a so-called
trust account and say we now have excess, because money is
moving in and out daily among--as we have a chart in here to
indicate--between the broker-dealer, the FCM accounts, the
segregated accounts, to European subsidiaries, to banks,
depositories. So it is all very fluid. So the concept that
there is a frozen trust account that you cannot touch is not
the way it operates in the real world. And it operates in such
a sense, if you do a calculation and somebody in Chicago says,
well, we have calculated with have $200 million excess so we
can now use that as collateral and transfer that to the broker-
dealer account equally, as in the example I gave, a transfer
was made from the broker-dealer segregated fund on the last day
of $220 million maybe on the assumption that they had excess.
But the rules of the regulators and the way this worked and
maybe the way it has to work is that the money is really not
frozen and can easily be moved around.
There could be much stricter safeguards, some of the things
Mr. Duffy was talking about in terms of making people
responsible at the top, which I was talking about, and others,
so it is not so easy for some $85,000-a-year vice president to
say I have seen the calculations and, therefore, I will move
$200 million from one way to the other.
Senator Johanns. Did you come across any indication that
the firm was actually using that approach in a way that you
personally would regard or you would offer an opinion that that
was deceptive, it was done in a way to deceive people who were
supposed to be paying attention to this or regulating this?
Mr. Giddens. I really have no personal opinion about that.
Senator Johanns. Let me ask a question then about that. You
are going into this time of a personal investigation, I think
is what you said, Judge Freeh, and you are going to start
trying to uncover who did what and when and that sort of thing.
So what are your options? If you see evidence that that
practice was done in a deceptive way, just describe for the
Committee the three or four things that could happen to the
principals here.
Mr. Freeh. Yes. In addition to the regulators and the
criminal investigators conducting simultaneous and in some ways
very similar investigations and that is why we are cooperating
with them to the ultimate extent possible, making available
records, witnesses, waiving privileges where we can do so. But
in our own investigation and our own mandate, myself as the
Chapter 11 trustee and Mr. Giddens as the SIPA trustee, is to
look for causes of action, and at this point nothing is off the
table. So we not only look at employees and directors of the
holding company as well as the subsidiary that Mr. Giddens is
the trustee for, but third parties, including financial
institutions, who had different collateral requirements, which
changed particularly in the last several days.
So at this point, literally everything is on the table,
both, you know, individual persons as well as institutions, and
what we will do, maybe separately but maybe simultaneously, is
make legal determinations with our lawyers about whether a
viable cause of action exists and whether it is efficient to
pursue that cause of action.
In my own case, representing the debtors, we may have a
cause of action that would cost $10 million, but the
institution or the individual has no assets, so I would have to
weigh that in terms of wasting assets in the estate.
Senator Johanns. Thank you.
Thank you, Mr. Chairman.
Chairman Johnson. Senator Tester.
Senator Tester. Yes, thank you, Mr. Chairman, and I
appreciate you holding this hearing. It is not a surprise to
especially Mr. Giddens. I mean, we saw Montanans' funds used to
hedge wiped away because of the lack of MF Global's ability to
segregate funds and keep them segregated. I think this is the
eighth large bankruptcy in U.S. history, and correct me if I am
wrong, the first time segregated funds have gone missing, so to
speak.
I will probably get back around to Senator Corker's
question because I think it is a good one, and I am not sure
there is an answer to it, but we will probably do it anyway.
First of all, I want to thank all of you for testifying. I
very, very much appreciate your time here today.
Mr. Freeh, you have got an incredible resume, one that I am
sure you are proud of, one that is very, very good. And in
going back to the question that the Chairman asked, the very
first question where he did talk about bonuses, I just want to
clarify because in your statement today you said bonuses are
not part of consideration now or in the past. I thought you
told the Chairman nor in the future. Is that correct?
Mr. Freeh. I did, sir.
Senator Tester. Well, thank you. And the questions that
have been asked kind of add some credence to this. You say that
there are about 15 employees that you have hired--and correct
me if I am wrong--plus three senior executives. Is that
correct?
Mr. Freeh. Yes, sir. The 15 employees remain. They were
prepetition operators. They run, as I mentioned, tax activities
and, you know, they are the worker bees so to speak.
Senator Tester. Not folks, so to speak, who would be part
of the problem.
Mr. Freeh. Well, we do not know at this point, but of
course, we are not considering them insiders. We are
considering them employees.
Senator Tester. How about the three senior executives?
Would they be considered insiders?
Mr. Freeh. Yes, they are insiders.
Senator Tester. OK. So in the previous question that
Senator Johanns asked, you said you are looking about who did
what when and a potential cause of action. When you negotiate
their salaries, how are you going to do it when, in fact, you
are looking at them as being part of the problem, part of the
so-called crooks?
Mr. Freeh. Well, we have not made any determinations, of
course, in that regard. The salaries are set, Senator. We are
not negotiating salaries.
Senator Tester. Who sets them?
Mr. Freeh. Well, they were set at the time of the petition
reverting back to their base salaries. So each employee,
including the three insiders, had base salaries which have been
continued.
Senator Tester. OK. All right. So the point I am trying to
get at here--and I think I heard the answer--is, I mean, I do
not really want to give any benefits whatsoever to anybody who
caused this debacle, and ``debacle'' is not a tough enough
word. Are you confident that that is the case?
Mr. Freeh. I am confident that is the case. What I did say
to the Chairman with respect to the 15 noninsiders--for
instance, the group that is working now to get a very important
and valuable tax refund back to the estate--you know, I need to
maintain them or else the alternative would be to go out and
hire, you know, an accounting firm at three or four times the
cost. So that is the balance that I am conducting, but it is on
that noninsider level, and there are only, as I said, 15
critical people that I have to balance a fair and competitive
salary for.
Senator Tester. OK. Mr. Duffy, in your testimony you
described the futures market as mostly professional, and yet
Mr. Giddens suggests in his testimony that 78 percent of MF
Global's claimants--I suspect some farmers and ranchers--would
be seeking a return of less than $100,000. And this really is
the question: Why should farmers and ranchers trust CME in the
future to regulate and be able to protect their money?
Mr. Duffy. I think there are several reasons, sir, but
first and foremost and really important is the $5.5 to $6
billion, roughly, of segregated funds that MF Global was
holding, CME Group held $2.5 billion of those segregated funds.
When MF Global collapsed and filed for bankruptcy, CME still
held $2.5 billion of those customer funds. Our customers were
made whole at the clearinghouse level. There were monies that
were transferred out at the firm level, not the clearinghouse
level.
With respect to what Mr. Giddens said about the $100,000
clients, there are many clients that have significantly higher
balances than that. But one of the reasons why we came up with
the Farmer & Rancher Protection program is there is roughly
36,000 accounts at MF Global of which 20,000-some-odd have
$25,000 or $50,000 or less. So it goes a lot smaller. A lot of
those are bona fide hedgers and ranchers. If, in fact, MF
Global happened today, under our program every farmer and
rancher would have been made 100 percent whole.
Senator Tester. But it was not, and so what about those
folks who are not made whole now, the little guys?
Mr. Duffy. Again, we cannot do things--looking back, it
would be considered a moral hazard. There was $158 billion of
segregated funds in the futures industry, and that would be a
detriment to CME or anybody else to try to guarantee that type
of number.
Senator Tester. OK. Mr. Giddens--it might just be for a
second, Mr. Chairman. Mr. Giddens, there have been a lot of
questions here today about a half a dozen regulators and maybe
more, about what happened, what transpired, things have been
talked about, poorly capitalized, liquidity problems when Mr.
Corzine came on board. And we see something happen in the
eighth largest bankruptcy that has ever happened where
segregated funds were compromised.
Does this kind of stuff just happen or--as a policy maker,
you always look to say what went wrong, what could we have done
better, who screwed up. Are you to a point where you can say
that? And I do not want you throwing anybody under the bus,
just be honest. Are you at a point where you can say this is
where the system failed, this was a regulator that either did
not do their job or did do their job, or if you have got a
cagey enough accountant and you can juggle the books good
enough, you can get away with just about anything? Because it
appears to me that--unless there is something else out there,
and tell me what it is.
Mr. Giddens. I think that the evidence indicates that in
most of the cases the individuals complied with--speaking of
FCMs generally, complied with the regulations. The regulators
looked at the materials. The materials were filed. But all of
the failures of either broker-dealers or FCMs are for the most
part caused either by fraud or by financial mismanagement. And
in those percentages where this occurs, as I think was the case
here, you can by hindsight look at it and say there are some
things that could have been done--more frequent reporting, also
I think the imposition on seniors in the firm, such as the CEO
and the CFO, to say if there is a shortfall in customer funds,
you may be liable, personally liable, and, therefore, that
should incentive you to have internal systems which assure you
that you have enough funds. And perhaps one of the ways to do
that, as is done with any kind of a normal repo or so is have
excess collateral, so why not have a requirement that there be
excess segregation?
So I think there are specific things that can be done to
ameliorate the situation. I do not think it was just a
happenstance circumstance. I think there is often a case in
many bankruptcies from Enron on out where a firm is in
financial trouble, and the normal controls are ignored, and
people act in desperation to try to avoid these kind of
problems.
I think the regulators and the reports and things required
do serve a valuable purpose, but I think they can be improved.
Senator Tester. Thank you. Thank you all for your
testimony.
Chairman Johnson. Senator Moran.
Senator Moran. Chairman, thank you.
Commissioner Sommers, I want to focus on CFTC. What was the
conflict of interest that Chairman Gensler caused to recuse
himself 5 days after the filing of the bankruptcy?
Ms. Sommers. I am not familiar with the specifics or what
he was thinking when he decided to recuse himself.
Senator Moran. There was not a discussion among the
Commissioners?
Ms. Sommers. There was not a discussion.
Senator Moran. But then there was a vote, I assume, that
selected you to be the lead on MF Global?
Ms. Sommers. Yes, sir. The other three Commissioners voted.
Senator Moran. But no discussion about why Chairman Gensler
was no longer going to act in that capacity?
Ms. Sommers. No, sir.
Senator Moran. Prior to the bankruptcy of MF Global,
looking back it seems clear that MF Global was under financial
stress. You can look at stock prices, the New York Fed
reaction. Did the CFTC take any action to enhance its
surveillance or to encourage others to enhance its surveillance
prior to the filing of bankruptcy?
Ms. Sommers. In the week leading up to the bankruptcy
filing, we had people on the ground at MF Global. Our staff in
Chicago was there on the ground. But the numbers and what we
look at are whether or not the firm is capitalized and whether
they have the money to meet their segregated obligations to
their customers. And the data that was provided to us from MF
Global showed that they were in compliance up until the very
last few days.
Senator Moran. When you say you had CFTC personnel on the
ground, was that an increase in personnel on the ground? Did
you detect that there might be something wrong and reacted or
not?
Ms. Sommers. We actually had people at MF Global's offices
in Chicago and New York, and that is not typical.
Senator Moran. And when did that occur?
Ms. Sommers. The week prior.
Senator Moran. The week prior.
Ms. Sommers. Yes.
Senator Moran. When over 99 percent of MF Global's accounts
were commodity accounts, did CFTC have an opportunity to
prevent SIPA from taking over the bankruptcy? And why was MF
Global Holding, the holding company, why was it allowed to file
Chapter 11? Both of those instances seem to have preferred the
general creditors over the segregated account holders. Did CFTC
have a role in altering the decisions that were made that
allowed those two things to happen, the kind of--SIPA's
involvement, in my view to the detriment of the segregated
account holders, and the holding company-wide bankruptcy
filing. Both those worked to the detriment, it seems to me, to
the segregated account holders. Did the CFTC have a role to
play in those decisions?
Ms. Sommers. Although I was not privy to the conversations
that led up to MF Global being placed into a SIPC bankruptcy
proceeding, it is my understanding that when that is done and
the SEC has the ability to place an entity that they believe is
either in financial distress or is approaching financial
distress, they have the ability to refer them to SIPC.
We do not have that same authority if an entity is a stand-
alone FCM versus a broker-dealer FCM. But it is my
understanding that even though the entity was a joint broker-
dealer FCM and placed into a SIPA proceeding, that all of the
Commission's regulations, Part 190, bankruptcy rules and
regulations, those all apply, just as they would if it were
just a stand-alone FCM and those, you know, were not in----
Senator Moran. Commissioner, is what you are telling me
then that my understanding that--or my suggestion that those
segregated account holders were harmed by that decision is not
true?
Ms. Sommers. My understanding is that it is not true.
Senator Moran. Did that discussion occur prior to the
filing of bankruptcy? Was CFTC engaged in this conversation
about how this bankruptcy was going to occur?
Ms. Sommers. The Commission was informed that MF Global was
going to be placed into a SIPA liquidation. We were not
involved in whether or not that decision should be made.
Senator Moran. Who at CFTC was handling the decisions
related to enhanced supervision and the kind of bankruptcy or
the bankruptcy proceedings--who at CFTC was handling those
decisions prior to the bankruptcy?
Ms. Sommers. Up until November 3rd, Chairman Gensler was
directing those decisions.
Senator Moran. And since you have told me you do not know
what his conflict of interest was that caused him to recuse
himself 5 days after the bankruptcy, you do not have an opinion
as to whether that same conflict of interest would have accrued
prior to the filing of bankruptcy. Do you know if something
happened between the filing of bankruptcy and the 5 days later
when he recused himself that created a conflict of interest? Or
is it the same conflict of interest that was there prior to
bankruptcy and subsequent to bankruptcy?
Ms. Sommers. I do not know.
Senator Moran. Thank you.
Mr. Chairman, thank you.
Chairman Johnson. Senator Shelby.
Senator Shelby. Thank you. I apologize for missing part of
your testimony, but I have a conflict, as others do. We had a
markup in the Appropriations Committee, and you should not be
absent from that, as you can recall. I hope some of these
questions have not been asked, but if they have, I was not here
to hear them.
I will first go to you, Commissioner Sommers. During the
week leading up to the bankruptcy--picking up on some of
Senator Moran's questions, during the week leading up to the
bankruptcy of MF Global, did Chairman Gensler ever, ever
indicate to you that he was concerned about customer assets at
MF Global?
Ms. Sommers. My recollection, Senator, is that Chairman
Gensler had concerns regarding the financial condition of the
company, and that is why staff were sent.
Senator Shelby. How many times do you recall--or do you
have a record of it that you could furnish to the Committee if
you do not recall yourself right at the moment--did Chairman
Gensler brief you and other Commissioners at the CFTC's
meetings on the management of the crisis? Because that had to
be a concern for the CFTC, because this was not business as
usual.
Ms. Sommers. Right. Over the weekend prior to the filing of
the bankruptcy, I recall receiving two emails from the
Chairman, and then we held a closed meeting----
Senator Shelby. And what was the substance of those emails?
Ms. Sommers. Just informing us that he was on----
Senator Shelby. That there was a problem?
Ms. Sommers. No. Informing us that he had been on
conference calls with domestic and foreign regulators regarding
the potential sale of MF Global to another financial
institution.
Senator Shelby. Did he indicate great concern at that time?
Ms. Sommers. Not at that time, no.
Senator Shelby. OK. Mr. Duffy, I will direct this question
to you and also to Commissioner Sommers. What authorities does
the Chicago Mercantile Exchange, CME, have to protect customer
segregated accounts at a futures commission merchant during an
emergency situation? And, Commissioner Sommers, following up on
that question to Mr. Duffy, what authorities does the CFTC have
to protect customer segregated accounts at a futures commission
merchant during an emergency situation?
Mr. Duffy, you first.
Mr. Duffy. Well, first and foremost, we make sure that they
are in segregated compliance, and these are reports that we----
Senator Shelby. That there will be--answer that again, if
you would, just for the record.
Mr. Duffy. I am sorry?
Senator Shelby. What did you say, they will be--there
should be segregated----
Mr. Duffy. We get segregated reports.
Senator Shelby. OK.
Mr. Duffy. From MF Global, as we were getting them all
along on a daily basis since they were acquired at Refco. So
they were on a daily seg report voluntarily anyway. So we were
getting these reports on a daily basis. There was a day lag and
then you've got to tie them out over a several-day period. So
these are some of the things that we do to have authorities to
make sure they are in compliance. If they go out of compliance
of segregation, it is a violation of CME's rules and then of
the CFTC's rules.
Senator Shelby. Were some of those reports you were
getting, as you look back, were they misleading or were they a
little more than that or what?
Mr. Duffy. The latter, sir. They were a little more than
that. We were told on one report given to us on a Thursday that
they had $200 million in excess seg. After they had announced
that the money was missing on Sunday evening----
Senator Shelby. Was that true?
Mr. Duffy. It was then true that they gave us the right
report saying they were 200 deficit. They gave it to us on the
following Monday. So they definitely--from the prior Thursday.
So the reports were definitely inaccurate.
Senator Shelby. So that is misleading you, right?
Mr. Duffy. It was very misleading to us, sir. Yes, sir.
Senator Shelby. OK. Commissioner Sommers, a question to
you, the same thing.
Ms. Sommers. We have never had this type of situation in
the past, but if we were ever in a situation where we believed
that a company was in a situation where they could not meet
their obligations, the Commission could seek legal action to
have a receiver appointed in an emergency situation.
Senator Shelby. I will direct the same question to both of
you. In the area of protection of customer segregated accounts,
Commissioner Sommers and Mr. Duffy, both of your organizations,
as I understand it, had staff on-site at MF Global's Chicago
offices the weekend before the firm's bankruptcy filing. What
steps did your agency--I will start with you, Commissioner
Sommers--take to protect customer assets prior to learning that
customer assets were missing? And what date and time did staff
in your agencies first learn that there was a possible or
probable shortfall in the customer segregated accounts? And
after you learned of the missing consumer assets, what specific
steps did each of your agencies take to ensure that customer
funds were not improperly transferred over the weekend? That is
when it seems there was more than a little mischief done.
Commissioner Sommers, you first.
Ms. Sommers. So the first question with regard to what our
staff was doing, although the Commission and the DSRO receive
daily segregation reports, those reports only list the amount
of money that the FCM owes to customers, what their obligation
would be there. Our staff was in the process of trying to get
supporting documentation from MF Global to be able to make sure
that they actually had that money in the bank.
Senator Shelby. You had that conversation you testified to
earlier, either personally or some communication by email, from
Chairman Gensler that obviously there was more than a little
concern at your office regarding MF Global. Is that right?
Ms. Sommers. Well, I think that----
Senator Shelby. You did not think everything was OK at MF
Global after you talked to or you read the emails of Chairman
Gensler, did you?
Ms. Sommers. I think in the beginning the reason why he
sent staff to the offices of MF Global is so that we could
receive the supporting documentation to make sure, to do the
tie-back of the segregated accounts and to make sure that that
money was there.
Senator Shelby. Because there was concern at your agency
about MF Global.
Ms. Sommers. Right.
Senator Shelby. Where the money was coming from and what
money they had and so forth.
Ms. Sommers. Right. So----
Senator Shelby. Is that correct?
Ms. Sommers. That is true, and the documentation and the
data that they provided to us showed us that they were in
compliance. So over the weekend----
Senator Shelby. But that was not true, was it?
Ms. Sommers. That was not true.
Senator Shelby. Did you have a suspicion at that time it
was not true?
Ms. Sommers. I do not believe that staff had suspicion that
they were not in compliance. Over the weekend, the staff was in
the process of filing all of the documents that we would need
to file in order to make a transfer possible, so customers from
MF Global, if there was a financial institution that would
purchase the FCM, that those customer accounts could be
transferred with our approval. So we were drafting those
documents in order to make that transfer of customer positions
possible. We were not informed--the Commission was not informed
until Monday morning of October 31st that there was a shortfall
in customer segregation----
Senator Shelby. But were you ever concerned that there
might be some things wrong at MF Global? Obviously, something
had to come up on your radar.
Ms. Sommers. Absolutely. We were concerned but never--I do
not believe I ever thought that one of the concerns should be
that there would be a shortfall in customer segregation.
Senator Shelby. Mr. Duffy, do you have any comments on
that?
Mr. Duffy. I will echo Commissioner Sommers for the most
part, and my recollection of what happened was we also had
people on the round tying out, validating the reports against
bank records and everything else, and we got through Friday
into Saturday, and we still had people on the ground. And then
we were told that there was an accounting error, as we
referenced in my earlier testimony last year, of $900 million.
And so everybody was trying to put the company----
Senator Shelby. An accounting error of 900----
Mr. Duffy. Yes, I found that pretty staggering myself.
Senator Shelby. How much, $900 million?
Mr. Duffy. $900 million, yes. So some people felt it was
too big, it had to be an accounting error. There were others of
us that thought it was too big and it could not be an
accounting error. So I was in the latter camp.
Senator Shelby. Well, did that send a lot of anxiety
through your organization?
Mr. Duffy. It sent a lot of anxiety, but I think people
felt fairly confident that there was no way that it was not an
accounting error, and the company was going to be whole and
segregation----
Senator Shelby. Were the people wrong that thought that?
Mr. Duffy. People were dead wrong, sir.
Senator Shelby. Dead wrong.
Mr. Duffy. Dead wrong.
Senator Shelby. Mr. Giddens, you are the MF Global trustee,
right?
Mr. Giddens. Yes, sir.
Senator Shelby. And as trustee, just for the record, what
is your portfolio? What are you supposed to do as the trustee
for MF Global, Inc.?
Mr. Giddens. Well, I am appointed the equivalent of a
Chapter 7 liquidating trustee, and I have the same powers as a
Chapter 7 trustee for the FCM and also for the broker-dealer.
Senator Shelby. OK.
Mr. Giddens. My job is to marshal the assets of the broker-
dealer estate and to pay them out as required by law. They are
a sacrosanct property, which is really not part of the estate,
which belongs to customers--the commodities customers' funds
and also the securities customers' funds. And there are very
detailed provisions of both the CFTC Act and also the SIPA Act
which governs how you calculate those claims and pay them out.
The big distinction and the big difference and the reason
that, as Mr. Cook of the SEC has pointed out, some of the
securities customers have been paid in full is the existence of
the resources of the SIPA fund which provides up to an
additional $500,000 to cover losses in an account.
Senator Shelby. Is that $500,000 per account?
Mr. Giddens. Yes, sir.
Senator Shelby. OK.
Mr. Giddens. Yes, $250,000----
Senator Shelby. What is the average account?
Mr. Giddens. The average securities account----
Senator Shelby. At MF Global.
Mr. Giddens. At MF Global, probably--just doing the
calculation in my head, it was probably $1 million or more.
Senator Shelby. OK.
Mr. Giddens. The commodities accounts, I think as we
indicated, 75 percent were less than $100,000 and probably 93
percent of the commodities accounts were less than $1 million.
Now, in both cases there were significant numbers of
commodities customers and securities customers who in the last
weeks transferred their accounts from MF Global to other
solvent firms.
Senator Shelby. And why did they do this? Was there concern
in the marketplace about MF Global at that time?
Mr. Giddens. Absolutely. Its credit had been downgraded
and----
Senator Shelby. And do you know of your own account, of
your own knowledge, that that concern in the marketplace
extended to Chicago, to the Commodity Futures Trading, or to
the SEC, or to the CME?
Mr. Giddens. Certainly it was in the major newspapers
that----
Senator Shelby. Yes, everywhere.
Mr. Giddens. ----the firm was experiencing trouble. Whether
anyone suspected that there was a shortfall in segregation, I
do not know that. But I do know that because of downgrading and
rating and losses, many of the larger accounts left the firm.
Senator Shelby. People were leaving ship, weren't they?
Mr. Giddens. Absolutely.
Senator Shelby. OK. Your written testimony, Mr. Giddens,
provides an overview of large cash movements at MF Global
during October 2011. Were there any large transfers--you talked
about some of the others, alluded to them--from MF Global's
customer segregated accounts to the firm's own accounts while
multiple regulators were on-site at MF Global starting on
October the 27th?
Mr. Giddens. The answer is yes. There were billions of
transfers in and out of the firm and from the various accounts.
Senator Shelby. And the regulators were on-site there.
Mr. Giddens. Yes, sir.
Senator Shelby. OK. Were there any subsequent large
transfers out of MF Global's own accounts to pay
counterparties?
Mr. Giddens. Certainly during the period of October 27th
through October 31st, yes.
Senator Shelby. OK. Mr. Giddens, you recently announced
that you would pursue litigation in the United Kingdom to
recover approximately $700 million of customer funds. What is
your best guess or your judgment for how long it will take for
MF Global customers to recover, if they do, the $700 million
that is trapped in the U.K.? And will it take weeks, months, or
years and so forth? Just your judgment.
Mr. Giddens. The petition to commence the case is due to be
filed shortly. How quickly and how the court determines how the
litigation is held, what discovery is required and the like, is
unknown at this time. We will try to expeditiously get a
decision from the court.
We had a similar situation in the Lehman case in which our
position was that funds that were with the Lehman U.K. broker-
dealer were segregated customer funds--these happened to be
securities funds, and that was opposed by the English
regulators. And that process, because of appeals to three
courts, took almost in excess of 2 years until there was a
final decision. I hope that will not be the case here.
Senator Shelby. What is your best judgment on how long it
will take to recover the remaining $900 million in customer
funds?
Mr. Giddens. We have recovered through closeouts with some
parties some portion of that already.
Senator Shelby. How much have you recovered of the $900
million, roughly? You can correct the record, but just give
your judgment.
Mr. Giddens. I believe about in excess of $500 million. But
I am not sure.
Senator Shelby. OK. But you will furnish the correct----
Mr. Giddens. We will happily supply supplemental
information on that.
Senator Shelby. Commissioner Sommers, I would like to come
back to you. In an attempt to justify his MF Global recusal,
Mr. Gensler stated that he did not want his relationship with
the MF Global CEO Jon Corzine to ``be a distraction.'' Did Mr.
Gensler, Chairman Gensler, ever express any concern that his
relationship with Mr. Corzine would be a distraction from any
previous matter involving MF Global, including matters related
to CFTC Rule 1.25 dealing with investment of customer
segregated funds?
Ms. Sommers. Not that I am aware of.
Senator Shelby. You do not recall?
Ms. Sommers. No.
Senator Shelby. Have you searched your records and your
emails and everything else?
Ms. Sommers. We have.
Senator Shelby. OK. Mr. Gensler also stated, and I will
quote him, that he ``will not participate in any enforcement-
related matters involving MF Global and any matter directly
related thereto.'' Those are his words. This language appears
from reading it to prohibit him from participating in any of
the CFTC's efforts to develop recommendations based on lessons
learned from the collapse of MF Global. Do you agree or
disagree?
Ms. Sommers. Senator, we, my staff----
Senator Shelby. In other words, he cannot have it both
ways. He is either in the game or out of the game. He is saying
here he is out of the game as Chairman. Is that correct? Is
that the way you read the language?
Ms. Sommers. We have sought direction from the General
Counsel of the agency on my delegation, and we are told that my
delegation does not go toward the policy recommendations, that
the Chairman would be handling them.
Senator Shelby. I know my time is moving on, but I have
another question that I need to ask Mr. Giddens as trustee.
On April 4th, Mr. Giddens, you provided an update on your
investigation of JPMorgan Chase, which is MF Global's largest
creditor, regarding the MF Global funds in its possession. You
stated that you and JPMorgan--and these are your words--``are
presently engaged in substantive discussions regarding the
resolution of claims.''
Is it your expectation that some of these funds will be
returned from JPMorgan Chase to MF Global customers? And when
can MF Global customers expect a resolution of claims against
JPMorgan, if they can?
Mr. Giddens. I believe that we have a solid basis for
seeking a recovery of some of the funds that were transferred
to JPMorgan. As to how that decision ultimately will be made,
if we do not reach a consensual conclusion, it will probably
have to be resolved by bankruptcy Judge John Glenn, and how
long that will take is difficult to predict. But we would not
be exchanging information and engaging in really confidential
discussions about legal arguments unless we thought we had a
good prospect of recovering something from them.
Senator Shelby. Mr. Chairman, could I ask Mr. Freeh one
quick question, if I could?
Chairman Johnson. Yes.
Senator Shelby. Mr. Freeh, you are the trustee of MF Global
Holdings. Is that correct?
Mr. Freeh. Yes, sir.
Senator Shelby. So is it your responsibility to protect the
corpus of assets of what is left of MF Global Holdings?
Mr. Freeh. Yes, MF Global and the other debtors that are in
Chapter 11, of which I am the trustee, exactly, to get the
assets and get them back to the creditors if possible.
Senator Shelby. OK. Thank you, Mr. Chairman.
Chairman Johnson. I would like to thank our witnesses for
their testimony today. It is important that Congress continues
to evaluate the lessons learned from the collapse of MF Global
and to discuss the important issues raised at today's hearing.
I look forward to working with my colleagues to help ensure
that we can better protect customer accounts and improve future
regulatory coordination.
This hearing is adjourned.
[Whereupon, at 11:51 a.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN TIM JOHNSON
Today's hearing will examine the lessons learned from the collapse
of MF Global. The misuse of customer accounts by one of the world's
largest commodities and derivatives brokers has shaken confidence in
our markets and deserves a thoughtful discussion of how to better
protect farmers, ranchers and investors going forward.
But before we get to these important issues, I would like to
express my deep concern that almost 6 months after MF Global's
bankruptcy, thousands of former customers--including hundreds of South
Dakotans--still have not recovered the $1.6 billion removed from what
should have been protected customer accounts. I know that the trustees,
regulators, as well as the FBI and Justice Department, continue to
investigate what happened in the final chaotic days of MF Global, but
these customer funds must be returned without further delay to their
rightful owners and those individuals and executives responsible for
transferring these funds must be held accountable to the full extent of
the law. Lastly, it is not acceptable for MF Global executives to be
given bonuses when customers have not recovered funds improperly taken
from them by MF Global--and I thank Senator Tester for his leadership
on this issue.
Since the collapse of MF Global in October 2011, my staff has
worked closely with Senator Shelby's staff in conducting extensive
interviews and due diligence with the regulators, self-regulatory
organizations and other parties involved in overseeing MF Global and
its bankruptcy. We have also coordinated with the Senate Agriculture
Committee--which has primary jurisdiction over matters involving
commodities--in holding a series of bipartisan briefings for all Senate
staff with representatives of many of the organizations before us today
to help our constituents impacted by the firm's downfall.
As investigators seek to recover MF Global customer funds and hold
accountable those responsible for any wrongdoing, this Committee will
focus our attention on preventing future abuses and the other critical
public policy issues raised by the collapse of MF Global.
Today's hearing provides a unique opportunity to ask an important
set of questions: how can we strengthen protections for customer
accounts at futures commission merchants or broker dealers, including
those firms that hold U.S. customer funds abroad? Given the size of the
shortfall in MF Global's customer accounts, what should Congress
understand about the idea of extending to commodity accounts similar
insurance protections that are currently available to securities
accounts under the Securities Investor Protection Act? And how we can
continue to improve regulatory oversight and coordination for large,
complex global financial institutions?
MF Global may also provide some early lessons about the Wall Street
Reform Act since it is the first collapse of a major financial
institution since the law's passage. For example, the story of MF
Global teaches us that effective customer protection and market
oversight demands that we fully fund our regulatory cops on the beat.
In hindsight, there is little doubt that the regulators responsible for
monitoring MF Global should have taken additional steps. But
shortchanging the CFTC or SEC of much needed funding will only force
them to delegate even more authority to self-regulatory organizations
in a way that could impair effective market surveillance. When funding
cuts prevent regulators from inspecting firms or assigning necessary
staff to monitor crises, the American people and market confidence pay
the price.
Additionally, a key pillar of the Wall Street reform bill was to
end ``too big to fail''--and if MF Global demonstrates anything, it is
that those who take risky bets that bring down their companies are now
free to fail and will not receive any more taxpayer bailouts.
______
PREPARED STATEMENT OF JAMES W. GIDDENS
Trustee, Securities Investor Protection Act Liquidation of MF Global
Inc.
April 24, 2012
Chairman Johnson, Ranking Member Shelby, and Members of the
Committee, thank you for inviting me to testify today. My name is James
Giddens. I am the court-appointed Trustee for the Securities Investor
Protection Act (SIPA) liquidation of the failed broker-dealer, MF
Global Inc. I am also the Trustee for the liquidation of the failed
broker-dealer, Lehman Brothers Inc., and have extensive experience in
broker-dealer liquidations. As a SIPA Trustee, I have all the powers
and duties of a trustee liquidating a futures commission merchant under
Chapter 7 of the Bankruptcy Code.
Considerations
I would like to provide to this Committee some considerations on
topics that may merit further study and input from regulators, industry
experts, and members of the public. My comments are based on my
experiences as Trustee generally, as well as my discussions with former
MF Global customers, a group that includes thousands of America's
farmers and ranchers, many of whom are undoubtedly your constituents. I
understand the frustrations of the many former MF Global customers. My
goal is to return as much money to customers as possible, as quickly as
possible. All of us hope to avert a repeat of the MF Global
catastrophe, or, at a minimum, alleviate its consequences, and with
this goal in mind, I offer the following topics for consideration:
Strict liability for the senior officers and directors of a
commodities broker.
Establishment of a commodities customer protection fund.
Suitability requirements for commodities customers.
Segregation requirements in excess of 100 percent of
customer funds; notice requirements for the withdrawal of
``excess'' segregated funds.
Complete segregation of 30.7 ``secured'' funds and
elimination of alternative calculation.
Improved international cooperation.
Strict Liability for Senior Officers and Directors
The failure of MF Global Inc. was in part due to a failure to
maintain integrated systems for tracking liquidity and the movement of
funds, a lack of supervision of key treasury functions, fragmentation
of responsibility, and inattention to the details of maintaining the
segregation of customer funds at senior levels of the company. Because
regulations require futures commission merchants (FCMs) to segregate
customer funds at all times, it may be appropriate to impose civil
fines in the event of a regulatory shortfall on the officers and
directors who are responsible for signing the firm's financial
statements.
Consideration should be given to requiring the chief executive
officer, the chief financial officer, the chief compliance officer, and
the general counsel of an FCM to certify not only their company's
financial statements but also their compliance with customer
segregation requirements on a frequent and continuing basis.
Consideration should also be given to making the officers responsible
for establishing and overseeing a company's internal controls and
procedures and certifying that they have done so. Where there is a
shortfall in customer funds, Congress should consider making the
officers and directors of the company accountable and personally and
civilly liable for their certifications without any requirement of
proving intent and without permitting them to defend on the basis that
they delegated these essential duties and responsibilities to others.
Commodities Customer Protection Fund
The liquidation of MF Global Inc. would have played out differently
had there been even a modest protection fund for commodities customers.
The statistics we have gathered in the claims process demonstrate that
the accounts of more than two-thirds of the customers who filed claims
represent only 3 percent of the total amount that MF Global was
required to segregate for commodities customers, or no more than $200
million in total. Of the commodities customer claims received by my
office, 78 percent seek a return of less than $100,000. Thus, a fund
limited to protecting these smaller accounts--representing many farmers
and ranchers--could be of relatively modest size but would suffice to
make these customers whole very quickly even in a case with a shortfall
the size of MF Global's. With such a fund in existence, three-quarters
of MF Global's commodities customers would not have been subject to any
loss and could have been made whole within days of the bankruptcy
filing.
A protective fund of this nature could be modestly funded and
maintained at a minimal cost until such time as necessary to advance
funds to customers, thereby allowing them to resume trading with little
or no delay. The fund could be replenished by industry assessments when
needed to satisfy claims in FCM failures.
Suitability Requirements for Commodities Customers
MF Global's commodities customers included farmers, ranchers, and
members of the general public. Commodities trading is clearly an
important part of the economy that, among other things, assists our
vital agricultural base in hedging risk and funding itself. However, my
staff and I have heard from many claimants across the spectrum of day
traders and others who appear to have invested their retirement
accounts and life savings in products in the U.S. and abroad that they
may not have fully understood. We have heard from some former MF Global
customers who have said they did not understand the account statements
they received from MF Global even when it was in business.
Under current regulations, commodities customers are not subject to
suitability requirements, such as those that the Securities and
Exchange Commission has approved and are applicable to securities
customers. Suitability requirements could help ensure that there is
reasonable basis to believe that a transaction or investment strategy
is suitable for a commodities customer, based on information about that
customer obtained through reasonable diligence by the FCM.
Segregation Requirements In Excess of 100 percent of Customer Funds;
Notice Requirements for Withdrawal of Residual Balances
Consideration should be given to requiring an FCM to segregate an
amount in excess of 100 percent of customer funds. Requiring FCMs to
post proprietary funds beyond the margin provided by customers could
help ensure that there is a sufficient cushion at all times for
commodities customers. Consideration should also be given to
implementing specific review and sign-off requirements by the CFO or
other senior officers whenever an FCM seeks to withdraw even what are
believed to be residual or excess segregated funds from a segregated
(or secured) account when the withdrawal exceeds a certain dollar
amount or percentage of either the account or the calculated excess.
Complete Segregation of 30.7 Funds
Under current rules, FCMs are not required to calculate ``secured''
amounts for customer funds held for trading on foreign exchanges per
Commodities Futures Trading Commission Rule 30.7 (30.7 funds) the same
way that they must calculate ``segregated'' amounts for customer funds
held for trading on U.S. exchanges per section 4d of the Commodity
Exchange Act (4d funds). Specifically, the rules allow a FCM to
calculate the ``secured'' amount according to one of two methods:
A. Net Liquidating Equity Method: the net liquidating value of the
net equity of all customer accounts plus the market value of
any securities held in customer accounts; or
B. Alternative Method: a risk-based measurement based on margin
required, plus or minus the unrealized gain or loss on futures
positions, plus long option value, minus short option value.
In the case of MF Global, reliance on the Alternative Method in the
time period leading up to the liquidation resulted in substantially
fewer funds being segregated than under the Net Liquidating Equity
Method. This allowed the FCM to believe that it was in regulatory
compliance, with hundreds of millions of dollars to spare, even when
the amount in segregation was actually in or perilously close to being
in deficit. If FCMs were required to compute the secured amount under
the Net Liquidating Equity Method, it could help ensure that all
customer funds are properly segregated at all times and eliminate a
difference in treatment among customers of which most customers are
unaware.
International Cooperation
The collapse of MF Global, like the collapse of Lehman Brothers,
has revealed significant gaps between protections afforded customers in
U.S. and foreign countries, such as the United Kingdom, arising largely
from differences in insolvency laws and the absence of clear legal
precedent. Though there may not be a one-size-fits-all solution for
these issues, customers would benefit from greater harmonization of
rules governing the segregation of customer funds and treatment of
omnibus accounts. A jurisdiction outside the United States should only
be approved as a location for the deposit of U.S. customer segregated
funds if there are adequate assurances that other Governments and firms
themselves are requiring and effecting segregation consistent with the
representations made by a U.S. broker to its customers.
When a company like MF Global or Lehman Brothers fails, it is
important that property segregated in one country for customers in
another country is returned to the trustee or administrator in the
country where the customer resides. In my experience, however, these
tend to be the last issues to be resolved, which often require
protracted litigation. In the case of MF Global, I have been engaged in
active discussions since November with the administrators for the
estate of MF Global U.K. Ltd. concerning the return of approximately
$700 million of segregated customer property. I have filed a client
claim in that proceeding seeking the return of all such segregated
property, and have engaged in an exchange of information with the
British administrators regarding this claim. That process has shown
that there is a dispute as to whether the customer property that is the
subject of my claim was or should have been segregated under English
law. I believe that is in the best interests of MF Global Inc.'s former
commodities customers that this dispute be resolved by the court, and
the British administrators, at my request, have agreed to seek
direction from the English court on these issues. Though I will press
to have this litigated as expeditiously as possible, adjudication and
resolution will likely take significant time and expenditure of
resources, all the while holding up the possibility of substantial
distributions to 30.7 customers in the United States.
Update on Trustee's Investigation
As Trustee, my statutory mandate as the customers' advocate is to
preserve and recover MF Global Inc. customer assets so that they can be
returned to the rightful owners and to maximize the estate for all
stakeholders.
As part of my statutorily mandated duty, I am investigating the
extent of and reasons for any shortfall in customer funds. This
includes a deliberate, thorough, and independent investigation of the
complex cash movements made by MF Global Inc. prior to its liquidation.
My investigative team consists of counsel experienced in broker-dealer
liquidations and expert consultants and forensic accountants from both
Deloitte & Touche and Ernst & Young. All efforts are conducted under
the supervision of the Bankruptcy Court and are coordinated with the
United States Department of Justice, the CFTC, the SEC, and SIPC.
On February 6, 2011, I issued a preliminary report on the status of
my investigation, which preliminarily determined that MF Global Inc.
had a shortfall in commodities customer segregated funds beginning on
Wednesday, October 26, 2011, and that the shortfall continued to grow
in size until the bankruptcy filing on Monday, October 31, 2011. As
detailed in the preliminary report, my office has traced substantially
all of the cash transactions made in and out of MF Global Inc. in the
last week before bankruptcy, totaling more than $105 billion. At the
request of the Committee, I have attached as an appendix a timeline of
key events leading up to MF Global's bankruptcy filing based on my
investigation.
My investigation has included thorough review of the actions of
JPMorgan Chase, N.A., regarding JPMorgan's activities in connection
with MF Global. JPMorgan has cooperated with my investigation, which
has included witness interviews and review of extensive documentation
by my staff, including attorneys and forensic accountants from Ernst &
Young. My office and JPMorgan are presently engaged in substantive
discussions regarding the resolution of claims.
I also believe, based on my investigation of conduct, allocation of
responsibilities and reporting with respect to the segregated customer
accounts, that there may be claims against certain responsible
individuals at MF Global Inc. and MF Global Holdings Ltd. for, among
other things, breach of fiduciary duties owed to both MF Global Inc.
and its customers, and violations of the segregation requirements of
the Commodity Exchange Act. I may pursue these legal actions separately
or in conjunction with commodities customers.
As I move forward with my investigation, I will continue to provide
updates to the Court and public on my findings and conclusions.
Status of Customer Distributions
My office has distributed nearly $4 billion to former MF Global
Inc. retail commodities customers with U.S. futures positions via three
bulk transfers:
Within days of the bankruptcy, I received court approval
for the transfer of 10,000 commodities customer accounts with
three million open positions, along with approximately $1.5
billion in collateral associated with those positions at the
time of the bankruptcy. These open positions had a notional
value of $100 billion. A serious disruption in markets was
avoided by the transfer.
A transfer of 60 percent of the cash attributable to
approximately 15,000 customer commodity accounts with cash only
in the accounts, totaling approximately $500 million, was
completed in November.
In December and January, a third transfer occurred that
moved approximately $2 billion to restore 72 percent of U.S.
segregated customer property to all former MF Global Inc.
retail commodities customers with U.S. futures positions.
My office has received 26,778 total commodities claims and has
received over 4,500 additional general creditor claims that were likely
misfiled, which will be treated as commodities claims. I expect that
the total number of unique claims from former commodities customers
(accounting for duplicates and amendments) will be approximately
23,000.
My office has determined and issued letters of determination for
nearly 22,000 commodities claims, which is over 90 percent of the
expected total claims.
In addition to the completed distributions, I have filed a motion
with the Bankruptcy Court seeking authority for a distribution of up to
approximately $600 million of customer property held as segregated by
MF Global Inc. for its former commodities futures customers who traded
on U.S. exchanges (4d funds); up to approximately $50 million of
customer property associated with commodity transactions in foreign
markets (30.7 funds); and up to approximately $35 million of customer
property to a domestic delivery class, which we have identified as
consisting of physical customer property that has been or will be
reduced to cash in any manner.
I have also received Court approval to sell and transfer
approximately 318 active retail securities accounts, which is
substantially all of the securities accounts at MF Global Inc. Nearly
all securities customers have received 60 percent or more of their
account value and already 194 of former MF Global Inc. securities
customers have received the entirety of their account balances because
of a SIPC guarantee.
Conclusion
My office has made every effort to communicate directly and
frequently with customers. Our Web site includes updates, court
filings, and claims information, including a section addressing the
common questions being asked by customers in calls or other
communications to my staff. My staff and I are answering customer calls
and emails and holding meetings with customer groups and counsel. I
have established special hotlines for customers to call with questions
about their claims determinations, the treatment of their physical
property, or tax issues.
If your constituents have any questions, I encourage them to visit
MFGlobalTrustee.com, email my staff at [email protected].
I fully understand the frustration of many former MF Global Inc.
customers, some of whom you have heard from directly. When a broker-
dealer fails under the unprecedented circumstances surrounding MF
Global's demise, the liquidation is necessarily complex. My office has
been working tirelessly with speed and diligence to identify ways to
return assets to customers to the full extent of our ability under the
applicable provisions of SIPA, the Bankruptcy Code, and CFTC
regulations.
Thank you Chairman Johnson, Ranking Member Shelby, and other
Members of the Committee for the opportunity to testify before you and
to submit this testimony for the full record of the hearing.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
PREPARED STATEMENT OF LOUIS J. FREEH
Trustee, MF Global Holdings Ltd.
April 24, 2012
Chairman Johnson, Ranking Member Shelby, and distinguished Members
of the Committee, my name is Louis J. Freeh and I am appearing before
you today in my capacity as the Chapter 11 Trustee of MF Global
Holdings Ltd. and five of its subsidiaries.
On October 31, 2011, MF Global Holdings Ltd. and MF Global Finance
USA Inc., referred to generally as ``Finco'', filed for bankruptcy
under Chapter 11 of the Bankruptcy Code. Upon the commencement of the
bankruptcy cases, the debtors operated as debtors-in-possession.
Shortly thereafter, on November 7, 2011, the Office of the United
States Trustee formed a creditors' committee representing the unsecured
creditor constituency of the Chapter 11 debtor entities. Without any
possibility of rehabilitation, the debtors and the creditors committee
jointly filed a motion to appoint a Chapter 11 Trustee. That motion was
approved by the Court, and I was named as the Chapter 11 Trustee. My
appointment was approved by the Bankruptcy Court effective as of
November 28, 2011.
On December 19, 2011, three additional MF Global entities that are
each indirect subsidiaries of the Chapter 11 parent filed for
bankruptcy. I was subsequently appointed the Chapter 11 Trustee of
those entities as well. In addition, on March 2, 2012, MF Global
Holdings USA Inc., a direct subsidiary of the parent holding company
debtor, filed for bankruptcy protection. On March 8, 2012, I was also
appointed Chapter 11 Trustee of that estate. As is evident from this
brief timeline, we are in the early stages of this bankruptcy
proceeding, and there is still much information to be learned about the
facts and circumstances that led to the collapse of MF Global.
My duties as a Chapter 11 Trustee are set forth in Section 1106 of
the Bankruptcy Code and include the obligation to investigate the acts,
conduct, assets, liabilities and financial condition of the debtor,
among other things. Unlike the SIPA Trustee, who is charged primarily
with the return to customers of their investment property, the
responsibility of the Chapter 11 Trustee is to maximize the value of
the estate for the benefit of its creditors.
Upon my appointment on November 28, 2011, I began to assemble a
team of legal advisors and financial consultants with extensive
experience in bankruptcy matters, as it was widely believed that these
proceedings were likely to be among the most complex bankruptcy matters
in recent memory. We immediately began to assess the Debtors' state of
affairs. Investigations into the collapse of MF Global were already
being conducted by the CME, the SEC, the CFTC, and the SIPA Trustee,
and at least two Federal prosecutors' offices.. Customers of MF Global
Inc., the U.S. broker dealer, had already commenced litigation against
certain officers and directors of the broker dealer as well as those of
the parent holding company debtor.
Even before the commencement of my appointment, the Debtors were
faced with a number of expansive requests for documents and information
and my team immediately immersed itself in a process that had already
been unfolding for several weeks, in an effort to learn what documents
were in my possession, how records were maintained, and where files
were kept. All of this was critical to our ability to fulfill our
obligations as Chapter 11 Trustee.
These difficulties were exacerbated by the fact that what had once
been operated as one large MF Global worldwide organization suddenly
became fragmented, virtually overnight. Separate proceedings were
commenced for individual MF Global entities, most notably the SIPA
proceeding here in the U.S. and the U.K. administration (the U.K.
equivalent of a U.S. bankruptcy proceeding) of the U.K. broker dealer,
which proceed independently from one another. The MF Global entities
suddenly found themselves without access to global systems previously
utilized by the entire group of companies, because certain entity-wide
systems such as accounting and email systems were owned and controlled
by individual MF Global companies.
With these difficulties, the Chapter 11 debtors had been able to
assemble some materials before my appointment. I needed, however, to
ascertain what documents, files, information, and materials were the
property of the Chapter 11 parent, versus property of the SIPA estate,
the U.K. broker dealer estate, or perhaps jointly owned by a Chapter 11
debtor and another estate. My advisory team was required to review
thousands of pages of emails, documents and other files to determine
(1) what those materials said, (2) whether the materials were
responsive to any request by any governmental agency or the SIPA
Trustee, and (3) whether any protectable corporate privilege existed. I
then needed to implement a process to produce as quickly as we could
documents requested as part of the investigations, but also in a manner
that did not unnecessarily result in a broad waiver of any existing
privilege. To do otherwise at this very early stage potentially could
have been contrary to my obligations as Chapter 11 Trustee. Ultimately,
these issues were resolved and the process moved forward expeditiously.
Although none of the entities for which I serve as Chapter 11
Trustee are regulated entities, the concerns of customers are
nonetheless important to me and my advisors. With a backdrop of
allegations of missing customer funds, the Bankruptcy Judge, the
Honorable Martin Glenn, directed that my team perform an analysis of
the approximately $25 million held in a cash collateral account owned
by Finco to determine whether that cash included misappropriated MF
Global Inc. customer property. Thereafter, my advisors poured through
account data and transaction documents covering more than $3.5 billion
in cash transfers, including transfers from accounts held by MF Global
Inc. My advisors interviewed and met with employees of MF Global Inc.
and advisors retained by the SIPA Trustee in order to ensure that an
appropriate investigation had been conducted in preparing the report.
Upon completing the analysis, which was shared with the SIPA Trustee,
we concluded with no disagreement from the opinion of the SIPA Trustee
that the cash collateral account did not include misappropriated or
misdirected customer funds.
There has been a great deal of publicity regarding the shortfall in
customer property. Without in any way diminishing the importance of the
SIPA Trustee's obligation to locate and recover customer property, the
Bankruptcy Code requires me to attempt to recover for the benefit of
the creditors of the Chapter 11 estates monies that were obtained by
the parent from third party lenders and investors and routed to the
U.S. broker dealer or elsewhere. In particular, and by way of example,
during the month of October, 2011, in excess of $1 billion in cash was
transferred from MF Global Holdings Ltd. and Finco to MF Global Inc. In
addition, a substantial portion of the net proceeds from the $650
million of MF Global bonds sold in 2011 to investors by MF Global
Holdings Ltd. had been transferred to MF Global Inc. Just as the SIPA
Trustee is analyzing and investigating the whereabouts of funds and
property entrusted by customers to the U.S. broker dealer, so too my
team must investigate the whereabouts of funds loaned to the U.S.
broker dealer for which the Chapter 11 estates remain liable to
creditors and investors.
In furtherance of my duty to investigate the affairs of the Chapter
11 debtors for which I serve as Trustee, my advisors and I meet
regularly with our creditors committee as well as with representatives
of the SIPA Trustee and the representatives of the foreign affiliates.
These meetings are important for each of the estates to gather and
share information with one another to facilitate a timely investigation
of the facts and circumstances leading up to the bankruptcy and to
determine where the assets of the various estates may be located.
The representatives of the SIPA Trustee and my advisors often speak
daily, have engaged in information sharing calls at least weekly, and
are currently discussing coordinated efforts to assist one another in
the administration of our respective estates. I have found this
cooperation to be invaluable, if not essential, to my ability to
satisfy my fiduciary obligations as a Chapter 11 Trustee. I strongly
believe that the interests of all of the various estates are best
served by cooperating and sharing information to uncover precisely what
led to the collapse of MF Global. No one estate has all of the
information, but together, the puzzle pieces can be put together.
To be clear, the trustees and foreign administrators can and likely
will assert different legal arguments to support their claims to
property located throughout the world. The bankruptcy court and perhaps
other courts will make those legal determinations. But the ultimate
legal disputes that may arise should not serve as a barrier to sharing
the critical facts to tell the world what led to the collapse.
Notwithstanding that we are operating under the supervision of the
court, however, it is clear even at this early stage that the
competing, and perhaps at times conflicting, obligations and duties of
the two Trustees and various foreign administrators has and will
continue to have the effect of extending the length of time necessary
for all of the estates to conduct their investigations; to determine
the value and location of assets; and ultimately to make distributions
to customers and/or creditors.
At the present time, the Chapter 11 debtors employ approximately 15
nonexecutive individuals, most of whom had been employed by one of the
debtors prior to the commencement of the bankruptcy cases. They, along
with the remaining senior executives, continue to provide invaluable
support in reconciling the debtors' books and records, closing open
trades at the unregulated entities, the preparation of tax returns, and
assisting in understanding the many complex prepetition transactions
between and among the various MF Global entities.
In conversations about retaining these individuals and the
knowledge they possess, I've discussed at various times the possibility
of establishing a retention program. To be clear, no formal program was
ever created for senior executives, nor was any motion ever filed with
the court for approval in connection with any retention program for
senior executives.
As we continue our investigation, we will be filing a report with
the Bankruptcy Court on or before June 4, 2012. Mindful of this
impending deadline, we have filed with the Bankruptcy Court a motion
seeking authority to issue subpoenas for the production of documents
and examination of witnesses on a shortened timetable. That motion will
be heard on April 25, 2012. We remain hopeful that parties will be
cooperative during this investigation, but a formal process will be
utilized as necessary.
It is important to note that the transparency of the bankruptcy
process mandates that the work performed by the Chapter 11 Trustee is
closely monitored by the Office of the United States Trustee and
supervised by the United States Bankruptcy Court.
I fully intend to fulfill my legal obligations as Chapter 11
Trustee as timely and transparently as I can responsibly do so,
recognizing that all of my, and my professionals, actions must be
consistent with the duties and obligations set forth in the Bankruptcy
Code.
______
PREPARED STATEMENT OF JILL E. SOMMERS
Commissioner, Commodity Futures Trading Commission
April 24, 2012
Good morning Chairman Johnson, Ranking Member Shelby, and Members
of the Committee. Thank you for inviting me today to discuss the
collapse of MF Global, lessons learned, and policy implications. Over
the past 5\1/2\ months the Commodity Futures Trading Commission has
conducted a thorough analysis of the books and records of MF Global and
continues to work closely with the Trustee in the SIPA bankruptcy
proceeding to recover customer funds. We are also engaging in a
comprehensive and ongoing enforcement investigation. It is imperative
that the Commission, the industry, and the Congress identify and assess
the causes for the collapse and shortfall in customer funds and to take
corrective action where possible. Chairman Gensler has directed
Commission staff to develop recommendations for enhancing Commission
and designated self-regulatory organization (DSRO) programs related to
the protection of customer funds, which could include changes to
Commission rules governing futures commission merchants (FCMs),
enhanced Commission oversight of DSROs, and possible statutory changes,
among other things. We must do everything in our power to restore
confidence in the futures markets so that producers, processors and
other end users of commodities can once again hedge their price risks
without fear of their funds being frozen or lost.
On November 9, 2011, the Commission voted to make me the Senior
Commissioner with respect to MF Global Matters. This authorizes me to
exercise the executive and administrative functions of the Commission
solely with respect to the pending enforcement investigation, the
bankruptcy proceedings, and other actions to locate or recover customer
funds or determine the reasons for shortfalls in the customer accounts.
While Mr. Giddens and Mr. Freeh are here to discuss the bankruptcy
proceedings, I would like to provide some background on why the claims
of MF Global's commodity customers are in a Securities Investment
Protection Act proceeding.
SIPA Proceedings
Under the Securities Investors Protection Act of 1970 (SIPA), the
Securities and Exchange Commission (SEC) has the authority to refer an
entity registered as a broker-dealer (BD) to the Securities Investors
Protection Corporation (SIPC) if there is reason to believe that the BD
is in or is approaching financial difficulty. SIPC may initiate a
liquidation proceeding to protect customers of an insolvent BD when
certain statutory criteria are met. When a BD is also a registered FCM,
as MF Global was, there is one dually registered entity and the entire
entity gets placed into liquidation. Because there is one entity, it is
not possible to initiate a SIPA liquidation for the BD and a separate
bankruptcy proceeding for the FCM. It is important to note, however,
that when a dually registered BD-FCM is placed into a SIPA liquidation
proceeding, the relevant provisions and protections of the Bankruptcy
Code, the Commodity Exchange Act (CEA or Act) and the Commission's
regulations apply to the claims of commodity customers just as they
would if the entity were solely an FCM and in a non-SIPA bankruptcy
Proceeding.
Current Protections for Customer Funds
Section 4d of the CEA and Commission regulations require an FCM
holding customer funds to treat such funds as belonging to the customer
at all times and to segregate from its own funds any money, securities
or property deposited by its customers to margin, guarantee, or secure
futures or options positions entered into on Commission designated
contract markets (Section 4d funds). FCMs are prohibited from using a
customer's funds to margin or guarantee the trades or contracts of
another customer, or of the FCM. The FCM may, however, commingle the
funds of one futures customer with funds belonging to other futures
customers in a single account or accounts. The FCM is required to
maintain sufficient funds in segregated accounts to cover the net
liquidating equity (i.e., total account balances due) of each of its
customers at any given point in time.
The Act and regulations also require an FCM to hold in separate
accounts (designated as ``Part 30 secured accounts'') customer funds
deposited for trading futures and options listed on foreign boards of
trade. The FCM may commingle the foreign futures funds deposited by one
customer with the funds deposited by other foreign futures customers.
An FCM may not, however, commingle Section 4d funds with Part 30
secured account funds. Under Part 30, an FCM must hold funds sufficient
to meet the margin required on open futures and option positions, plus
any unrealized gains, or minus any unrealized losses, on the open
positions. The FCM is not required to hold in Part 30 secured accounts
funds sufficient to cover the net liquidating equity of each foreign
futures customer as it must for Section 4d accounts.
When a customer opens a trading account with an FCM, Commission
regulations require the FCM to provide the customer with a risk
disclosure statement that generally centers on market risk, market
volatility, and leverage. Disclosures concerning how customer funds can
be invested by an FCM are not currently mandated, but Commission
Regulation 1.25 lists permitted investments and establishes a general
prudential standard that requires that any investment of customer funds
be ``consistent with the objectives of preserving principal and
maintaining liquidity.'' Section 4d and Commission Regulation 1.25
require that the value of customer segregated accounts remain intact at
all times.
Commission Regulation 1.20 requires that accounts holding
segregated funds be titled specifically to identify the contents of the
account as separate from the ownership of the FCM. In addition, FCMs
must obtain letters from their depositories acknowledging that the
depositories cannot exercise any right of offset to such accounts for
obligations of the FCM. Regulation 1.20 depositories cannot hold,
dispose of, or use customer funds for anyone other than the customer
who deposited such funds.
Commission Regulation 1.12 requires FCMS to notify the Commission
immediately of any deficiency in segregated and secured customer
accounts. FCMs must also notify the Commission of instances of
significant margin calls (such as a margin call to a customer, which if
not satisfied, would put fellow customers at risk if an adequate buffer
or ``excess segregation'' was not in segregated accounts).
Customers are required to post margin to support their futures and
option positions. Generally, a customer deposits more than the minimum
initial margin required for the positions established. The additional
funds provide a buffer so a customer can place trades without positing
additional margin and lessen the likelihood of repeated margin calls or
having positions liquidated if margin calls are not met on a timely
basis. In addition to customers depositing additional margin, in
practice, FCMs typically maintain significant amounts of their own
capital as ``excess segregated funds.'' By doing this, one customer's
deficit due to market moves or unmet margin calls is covered by the
FCM's buffer and does not result in one customer's funds being exposed
to the credit risk of another customer. FCMs are not obligated to
provide excess segregated funds, but given the legal obligation to have
sufficient funds in segregated accounts at all times to cover all
liabilities to customers, FCMs generally find it wise to have a buffer.
A customer may withdraw excess margin funds or use such funds as
the customer deems appropriate. This would include using the funds for
nonfutures related transactions with the FCM. If the excess funds held
by the FCM are used in a manner directed by the customer such that the
funds are not maintained in a segregated or secured account, the funds
would not have the protections afforded customer funds under the
Bankruptcy Code and Part 190 of the Commission's regulations.
FCMs are also free to withdraw excess funds in Section 4d accounts
deposited by and belonging to the FCM. At no time, however, may an FCM
withdraw funds belonging to customers from a Section 4d account, use
those funds for its own purposes, and replace them at a later date.
Oversight of FCMs
FCMs are subject to CFTC-approved minimum financial and reporting
requirements that are enforced in the first instance by a DSRO, for
example, the Chicago Mercantile Exchange (CME), or the National Futures
Association (NFA). DSROs also conduct periodic compliance examinations
on a risk-based cycle every 9 to 15 months. The requirements of DSRO
examinations are contained in Financial and Segregation Interpretations
4-1 and 4-2, which are specified as application guidance to Core
Principle 11 (Financial Integrity) for designated contract markets. The
Commission has proposed codifying the essential components of these
interpretations into an amended Commission Regulation 1.52.
An examination of segregation compliance is mandatory in each
examination (certain other components need not be included in every
examination). This examination includes a review of the depository
acknowledgement letters and the account titles of segregated accounts
(unless unchanged from the prior examination), verifying account
balances, and ensuring that investment of customers funds is done in
accordance with Commission Regulation 1.25.
Commission Regulation 1.10 requires FCMs to file monthly unaudited
financial reports with the Commission and the DSRO. These reports
include the FCM's segregation, secured and net capital schedules, and
any ``further material information as may be necessary to make the
required statements and schedules not misleading.'' Each financial
report must be filed with an oath or attestation, and for a
corporation, the oath must be by the Chief Executive Officer or the
Chief Financial Officer.
Commission Regulation 1.16 requires FCMs to file annual certified
financial reports with the Commission and the DSRO. The audits require,
among other things, that if a new auditor is hired, the new auditor is
required to notify the Commission of certain disagreements with
statements made in reports prepared by prior auditors. Auditors also
must test internal controls to identify, and report to the Commission,
any ``material inadequacy'' that could reasonably be expected to:
inhibit a registrant from completing transactions or promptly
discharging responsibilities to customers or other creditors; result in
material financial loss; result in material misstatement of financial
statements or schedules; or result in violation of the Commission's
segregation, secured amount, record keeping or financial reporting
requirements.
Coordination Among Regulators for Dually Registered BD-FCMs
The Act and Commission regulations establish a regulatory structure
where frontline financial regulation is performed by the DSROs. As
mentioned, the CME and the NFA are the two primary futures market
DSROs. Generally speaking, the CME has primary financial surveillance
responsibilities over FCMs that are clearing members of the CME, and
NFA has primary financial surveillance responsibilities over other
FCMS, including nonclearing FCMs and retail foreign exchange dealers.
Many FCMs are also registered with the SEC as BDs. These dually
registered BD-FCMs are subject to the jurisdiction of both the CFTC and
the SEC. The CFTC focuses primarily on the futures activities of dual-
registrants, while the SEC focuses primarily on their securities
activities.
To better ensure that all activities of a BD-FCM are properly
reviewed, futures and securities regulators, including self-regulatory
organizations (SROs), coordinate their oversight efforts. This
coordination includes periodic meetings of the Inter-Market Financial
Surveillance Group (IFSG), which is comprised of the CFTC, the SEC, and
futures and securities markets SROs. The IFSG generally meets two to
three times each year to discuss emerging regulatory issues, including
rule amendments that impact financial or operational requirements for
FCMs and BDs, and changes to business operations. The IFSG meetings
also provide a platform for securities and futures regulators to
discuss upcoming examination priorities.
Futures and securities SROs also share information regarding dual-
registrants as part of the examination program. For example, prior to
conducting an examination of a dually registered BD-FCM, the futures
market DSRO will contact the securities market SRO for the purpose of
obtaining an understanding of any issues or concerns that the
securities SRO may have with the firm, either as a result of a current
event or as part of the securities SRO's previous examination. The
information obtained by the futures market DSRO would be used in
setting the scope of its examination of the FCM. The futures and
securities SROs also share their examination reports of dually
registered entities.
MF Global was a dually registered BD-FCM, and therefore was subject
to the jurisdiction of both the CFTC and the SEC. The CME was the DSRO
for MF Global's futures market activities, and had primary
responsibility for overseeing the FCM's compliance with the capital,
segregation and financial reporting obligations required by the CFTC.
The Chicago Board Options Exchange (CBOE) and the Financial Industry
Regulatory Authority (FINRA) were the SROs for MF Global's securities
market activities, and had primary responsibility for overseeing the
BD's compliance with securities regulations.
Prior to the bankruptcy, the futures and securities regulators
shared information and examination results as described above. In
August 2011, MF Global filed revised financial statements and
regulatory notices with the CFTC as a result of additional capital
charges that FINRA and the SEC required the BD to take on certain repo
to maturity transactions on foreign sovereign debt, which was activity
overseen by the SEC and FINRA. At approximately the same time, SEC
staff contacted CFTC staff to inform them of the capital charges. CFTC
staff also consulted with the CME, FINRA, and the CBOE regarding the
imposition and rationale for the additional securities capital charges.
The additional capital charges caused MF Global to fall below CFTC
minimum capital requirements, which the firm immediately addressed by
contributing additional capital to the FCM.
Commission staff also consulted with FINRA and the CME during the
period of October 24 through October 31, 2011. During these calls
futures regulators and securities regulators provided information on
the status of MF Global from their regulatory perspectives. These
discussions focused on various issues, including the impact of the
credit rating downgrades and reported losses of $186 million for the
quarter ending September 30, 2011. The purpose of these discussions
included sharing information regarding the firm's financial condition
and potential liquidity issues and sources of funding, and the fact
that the reported earnings and credit rating downgrade did not appear
to cause a significant number of futures customers to seek to transfer
their accounts during the early part of the week of October 24, 2011.
Commission staff also participated on calls with the Joint Audit
Committee, a committee comprised of futures exchanges and clearing
organizations, commencing on October 27, 2011. The exchanges informed
Commission staff that MF Global was meeting all of its financial
obligations to the respective clearing organizations and that the
futures markets had not imposed additional margin or capital
requirements on MF Global. The exchanges indicated that some customers
were now transferring their accounts out of MF Global.
Commission staff also consulted with the SEC and FINRA in the hours
leading up to the bankruptcy filing on October 31, 2011, when, as it
acknowledged, MF Global was in violation of Section 4d of the Act and
Commission regulations for failing to maintain sufficient funds in
segregation to cover the account equities of each customer.
Strengthening Protections for Segregated Customer Assets
In the aftermath of MF Global, Commission staff is reviewing the
customer funds protection provisions of the CEA and Commission
regulations to identify possible improvements to the protection of
customer funds. As part of this process, staff held a 2-day public
roundtable on February 29 and March 1, 2012, to solicit input on
potential areas of regulatory reform and to identify possible
enhancements to FCM internal controls surrounding the handling of
customer funds. Panelists at the roundtable represented a broad and
diverse cross-section of the futures industry, including academics,
consumer groups, agricultural and energy interests, managed funds and
pension plans, FCMs, derivatives clearing organizations, securities
regulators, futures and securities SROs, and industry trade
associations.
The roundtable provided a forum for Commission staff to obtain
information and views on a range of issues. Day one of the roundtable
focused on the advisability and practicality of implementing the legal
segregation with operational commingling model as the segregation model
for collateral posted by futures customers (the Commission has already
approved this model for swaps); alternative models for the custody of
customer collateral; FCM controls over the disbursement of customer
funds deposited for trading on U.S. futures markets; increasing
transparency surrounding an FCM's holding and investment of customer
funds; and lessons learned from commodity brokerage bankruptcy
proceedings. Day two of the roundtable focused primarily on the
protection of customer funds deposited with FCMs for trading on foreign
futures markets; particular issues associated with dually registered
BD-FCMs; and enhancing the self-regulatory structure.
Commission staff has also held discussions on enhancing customer
protections with representatives of the Futures Industry Association
(FIA) and the two primary futures market DSROs, the NFA and the CME.
Staff is taking into consideration the recommendations that FIA issued
in its document titled, ``Initial Recommendations for Customer Funds
Protection,'' and in its publication of frequently asked questions
regarding the protection of customer funds. The CME and the NFA have
also implemented certain improvements in their capacity as DSROs and
are considering others.
While Commission staff has not yet proposed amendments to
Commission regulations, it is expected that staff will make
recommendations in several areas, including rules requiring FCMs to
establish certain internal controls and other requirements related to
their handling of customer funds, rules requiring greater transparency
and reporting regarding the investment and holding of customer funds,
and amending the requirements governing Part 30 secured accounts.
Regulatory Coordination for Complex Global Financial Institutions
Many FCMs intermediate futures transactions for customers trading
on both U.S. and foreign markets, and also provide services as
securities BDs. The Commission and futures SROs have historically
focused their resources and oversight efforts on such FCMs' futures
activities, including the firms' compliance with minimum capital
requirements and the requirements to segregate customer funds for
trading on U.S. and non-U.S. futures markets.
The recent bankruptcies of Refco, Lehman Brothers, and MF Global
highlight the challenges presented by large FCMs that operate with
affiliated entities in multiple jurisdictions. Many of these entities
have lines of business that are subject to multiple U.S. and non-U.S.
regulatory authorities, which requires coordination among regulators to
ensure effective and complete financial oversight.
Staff currently is reviewing and revising its oversight programs to
better address the risks presented by large, complex financial
institutions. Staff plans to focus greater attention on assessing such
entities' liquidity and operational risks. Staff also plans to increase
its review of such firms' internal controls over the handling of
customer funds. Staff is also reviewing Commission regulations to
assess whether to require firms to provide notice of, or seek approval
for, new lines of business or operations prior to implementation.
Furthermore, any efforts by regulators to effectively oversee the
unwinding of a dually regulated BD-FCM require significant coordination
between futures regulators and securities regulators, including SROs.
It is imperative that regulators coordinate their efforts and take
steps to ensure that the actions taken by one regulator do not
materially impact the ability of other regulators to effectively wind
down the business of a firm and minimize the impact on the regulated
financial markets.
SIPC Insurance
SIPC insurance provides financial assistance to securities
customers in the event that a failed BD owes customers cash or
securities that are missing from customer accounts. SIPC coverage is
limited to $500,000 per customer, including up to $250,000 for cash.
The use of an insurance-type fund comparable to SIPC coverage has
been debated in the futures industry for many years. Issues that have
been identified include the significant costs of establishing and
maintaining such a fund for commodity customers. Unlike the securities
markets, which have a significant amount of retail participation,
futures customers are predominantly institutional in nature. Such
institutional customers often have substantial account balances with
FCMs that would require significant insurance pay-outs in the event of
an FCM failure. Commission staff is considering the feasibility of
establishing insurance-type protection, however, or other comparable
protections, for futures customers as it conducts a broader assessment
of the enhancement of protections afforded customer funds.
Ongoing Investigations
Commission staff has cooperated with, and shared information with,
the SIPA Trustee since MF Global filed for bankruptcy. One of the areas
where Commission staff has shared information with the Trustee is the
analysis of the movement of customer funds out of segregated accounts
during the period prior to the bankruptcy filing to identify potential
improper withdrawals or distributions. Staff continues to provide
assistance to the Trustee in his efforts to recover customer funds,
including funds held for customers trading on foreign markets.
The Commission's Division of Enforcement is also actively engaged
in the investigation concerning the shortfall of customer funds. Staff
is speaking with witnesses and reviewing documents and other
information. They are proceeding as expeditiously as they can. As the
Committee will understand, I cannot disclose any specific details of
the investigation because they are nonpublic, and because I do not want
to prejudice any potential enforcement action. In general, however,
depending on the specific facts and circumstances, a shortfall in
customer segregated funds could amount to a violation of the CEA and
Commission regulations including those that: (1) govern segregated
funds; (2) prevent theft of customer money; (3) require our registrants
to properly supervise accounts; (4) prevent making false statements;
and (5) prohibit deceptive schemes. Depending on the specific facts and
circumstances, the Commission could file an enforcement action against
corporate entities and/or individuals who have violated the CEA or
regulations. In addition, depending on the specific facts and
circumstances, individuals could also be liable if they are ``control
persons'' of a company that violated the law. A ``control person''
generally refers to management. Depending on the specific facts and
circumstances, an enforcement action could be filed against individuals
who ``aid and abet'' violations by companies. Finally, Commission
regulations impose obligations on accountants who audit FCMs and on the
banks that hold customer segregated funds for FCMs. My mention of these
particular provisions does not in any way limit the Division's
investigation or the relief we can seek, nor does it indicate that the
Division has reached any conclusions.
Generally, the Commission has the authority to, among other things,
seek and impose civil monetary penalties, require a defendant to
disgorge ill-gotten gains, obtain restitution for customers and obtain
other injunctive relief. In terms of civil monetary penalties, the
Commission can seek the greater of three times the defendant's gain, or
a set amount, which is currently $140,000 per violation. Civil monetary
penalties are paid to the U.S. Treasury, while restitution is paid to
victims who suffered losses.
The Commission is a civil enforcement agency, so we cannot seek
imprisonment as a sanction in an enforcement action. However, a willful
violation of the CEA, or our regulations, is a Federal crime, which can
be prosecuted by a United States Attorney. We do not have any say in
whether or not the criminal authorities prosecute, and I understand
that they have a higher burden of proof than we have.
Conclusion
I understand the severe hardship that MF Global's bankruptcy has
caused for thousands of customers who have not yet been made whole.
These customers may have correctly understood the risks associated with
trading futures and options, but never anticipated that their
segregated accounts were at risk of suffering losses not associated
with trading. The shortfall in customer funds was a shock to the
markets from which we have not yet recovered.
I believe the Commission can make improvements to our regulatory
oversight of FCMs and DSROs to help restore confidence in the futures
markets, and I will work with the Commission and Congress to implement
the rules necessary to enhance our ability to protect market users and
to foster open, competitive, and financially sound markets.
______
PREPARED STATEMENT OF ROBERT COOK
Director, Division of Trading and Markets, Securities and Exchange
Commission
April 24, 2012
Chairman Johnson, Ranking Member Shelby, Members of the Committee,
my name is Robert Cook, and I am the Director of the Division of
Trading and Markets at the Securities and Exchange Commission (SEC).
Thank you for the opportunity to testify on behalf of the SEC
concerning the collapse of MF Global.
The bankruptcy of MF Global has resulted in serious hardship for
many of its customers, who have experienced significant delays and
uncertainty with respect to their ability to access their own assets.
More broadly, the firm's collapse and the apparent shortfall in
customer assets highlight the need for financial firms and regulators
to remain vigilant in ensuring that customer assets are appropriately
protected and made readily available to customers whenever they may be
needed.
To that end, the SEC and its staff are working with the trustee,
our fellow financial regulators, and other authorities to facilitate
the orderly liquidation of MF Global and the return of MF Global
customer assets. While the examination and review of the causes and
implications of the collapse of MF Global are ongoing, my testimony
provides an overview of the regulation of MF Global's SEC-registered
broker-dealer subsidiary prior to the bankruptcy, the key events
leading up to the bankruptcy, the status of approximately 318
securities accounts in the liquidation proceedings, and the securities
customer protection regime. My testimony also describes some
implications of MF Global's bankruptcy for market oversight, as well as
a summary of recent efforts by the SEC to promote sharing of
information among regulators, a proposal by the SEC to further
strengthen the rules that affect the protection of customer assets, and
self-regulatory organization (SRO) initiatives to enhance the financial
responsibility regime for broker-dealers.
Regulation of MF Global Prior to Its Bankruptcy
MF Global Holdings Ltd. (together with its subsidiaries, ``MF
Global'') was a publicly traded holding company that conducted
financial activities through a number of subsidiaries located in
various countries. MF Global Inc. (MFGI), an indirect subsidiary of the
holding company, was dually registered with the Commodity Futures
Trading Commission (CFTC) as a futures commission merchant (FCM) and
with the SEC as a broker-dealer. As of October 31, 2011, MFGI had
approximately 36,000 futures customers \1\ and approximately 318
custodial accounts for nonaffiliated securities customers. \2\ MFGI
also was authorized by the Federal Reserve Bank of New York to act as a
primary dealer in the U.S. Treasury markets. Another affiliate, MF
Global U.K. Limited, was regulated by the U.K. Financial Services
Authority (FSA). There was no consolidated supervisor of MF Global at
the holding company level.
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\1\ See, ``Expedited Motion to Approve Further Transactions and
Distributions for MF Global Inc. United States Commodity Futures
Customers'' (Nov. 29, 2011).
\2\ In his motion seeking authorization to sell and transfer
substantially all customer securities accounts held by MFGI, the
trustee identified approximately 330 securities accounts that were
custodial accounts that had positive net equity on October 31, 2011,
excluding accounts of affiliates and firm insiders. See, Motion of
James W. Giddens, Trustee for the Liquidation of MF Global Inc., for an
Order Authorizing the Sale, Transfer, and Assignment of Certain
Customer Securities Accounts (Nov. 30, 2011) (Trustee Securities
Account Transfer Motion). A subsequent status update filed by the
trustee with the U.S. Bankruptcy Court for the Southern District of New
York indicated that the court's order applied to the sale and transfer
of ``approximately 318 active retail securities accounts.'' See,
Trustee's Preliminary Report on Status of his Investigation and Interim
Status Report on Claims Process and Account Transfers (Feb. 6, 2012)
(Trustee Interim Status Report).
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The ``frontline'' supervisory function for the securities
activities of broker-dealers is performed by the SROs, including the
Financial Industry Regulatory Authority (FINRA) and the various
securities exchanges. When a broker-dealer is a member of multiple
SROs, one SRO functions as the ``designated examining authority'' (DEA)
responsible in the first instance for examining the securities
component of the firm's financial and operational programs, including
its compliance with the SEC's capital and customer protection
requirements. In the case of MFGI, the DEA was the Chicago Board
Options Exchange (CBOE), although FINRA was also closely involved in
the oversight of MFGI's broker-dealer activities. The futures
activities of financial firms, including related segregation
requirements, are overseen by the CFTC and the futures SROs, including
the National Futures Association and the Chicago Mercantile Exchange.
The SEC oversees the regulatory functions of securities SROs and
regularly communicates and coordinates with them on examinations and
other matters. In its SRO role, CBOE conducted examinations of MFGI for
compliance with financial responsibility rules. FINRA conducted
examinations for compliance with other rules, such as sales practice
requirements. In addition, the SEC's national examination program
conducts its own risk-based examinations of SEC-registered broker-
dealers. Unlike some other regulators of financial firms, the SEC does
not have an ``on site'' presence at any broker-dealer and generally
does not have examination staff dedicated solely to particular broker-
dealers.
Key Events Leading up to the Bankruptcy
Although the investigation of the causes of MFGI's collapse is
ongoing, we can highlight our current understanding of several key
events leading up to its failure. \3\
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\3\ The events described in this testimony, other than those that
are a matter of public record, are based on SEC staff's current
recollection and information, including information from third parties
that is currently unconfirmed. SEC staff's knowledge of the facts
surrounding the bankruptcy of MF Global continues to develop, and
accordingly the description of events herein is subject to change.
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Capital Treatment of Repo-to-Maturity Transactions
During 2010, MFGI started acquiring significant proprietary
positions in European sovereign debt, which were financed using an
instrument called a ``repo-to-maturity'' (RTM). \4\ As of March 31,
2011, MFGI had accumulated several billion dollars of European
sovereign debt positions using RTM transactions. \5\
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\4\ An RTM is a form of a repurchase agreement. A repurchase
agreement generally involves the sale of securities--here, European
sovereign bonds--coupled with an agreement to repurchase the securities
at a later date at a fixed price. In an RTM transaction, the repurchase
date is the same date as the maturity date for the securities that were
sold.
\5\ See, MF Global Inc., Financial and Operational Combined
Uniform Single (FOCUS) Report: Information Required of All Brokers and
Dealers Pursuant to Rule 17a-5, Part III (Form X-17A-5 Part III) (Mar.
31, 2011), Statement of Financial Condition, Note 4.
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In the summer of 2011, based on an analysis of MFGI's financial
statements, FINRA and CBOE staffs questioned MFGI about whether the
firm was properly recognizing its RTM positions for purposes of its
regulatory net capital computations. The SEC's net capital rules (which
are similar to those of the CFTC in important respects) require broker-
dealers, including MFGI, to maintain certain minimum amounts of liquid
capital based on their business activities. After consulting with SEC
staff, SRO staff informed MFGI that under the SEC's rules it must take
capital charges for the European sovereign positions as if they were on
the firm's balance sheet, notwithstanding the fact that the bonds had
been ``sold'' pursuant to the RTM transactions.
In August 2011, representatives of MFGI contacted SEC staff in
Washington, DC, to request a meeting to present the firm's view that
the RTM positions should be subject to lesser capital charges than
those determined by staff from the SROs and SEC. On August 15, 2011,
SEC staff met with representatives of MF Global, including its Chief
Executive Officer, Jon S. Corzine, to discuss this issue. After further
consultations among the regulators, FINRA staff informed MFGI on or
around August 24 that the regulators' collective view that a capital
charge was required for the RTM positions had not changed.
Following the resolution of that issue, the regulators also
discussed with MFGI: (1) whether MFGI needed to provide a formal net
capital deficiency notice under SEC Rule 17a-11, which generally
requires broker-dealers to provide a ``hindsight notice'' of any
deficiency in their compliance with the SEC's financial responsibility
rules; and (2) whether MFGI needed to restate and refile its monthly
``FOCUS'' report (containing capital and certain other financial
information) for July 2011, which could result in the net capital
deficiency becoming public. \6\ Pursuant to Rule 17a-11, once the
deficiency was identified, the firm was required to file the
``hindsight notice'' and, on August 25, it did so. After consulting
with SEC staff, SRO staff also required the firm to file an amended
FOCUS report for July 2011. On August 31, MFGI amended its FOCUS report
for July 2011 to reflect the required capital charges, reporting a
``hindsight'' capital deficiency of approximately $150 million as of
July 31, 2011. At the holding company level, MF Global disclosed the
net capital issue regarding the RTM positions at MFGI in an amendment
to MF Global's public filings on September 1. \7\
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\6\ FOCUS reports are filed by broker-dealers with their DEA
pursuant to SEC Rule 17a-5.
\7\ See, MF Global Holdings Ltd., Amendment No. 1 to the Quarterly
Report for the Period Ended June 30, 2011 (Form 10Q/A) (Sept. 1, 2011).
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Bankruptcy of MF Global
During the week of October 17, 2011, press reports noted that
regulators had directed MF Global to increase capital at MFGI due to
concerns about MFGI's capital treatment of its RTM positions. On
Tuesday, October 25, 2011, MF Global announced quarterly earnings,
reporting a net loss of $192 million for the three months ending
September 30, 2011. Its stock price declined almost 50 percent that day
and continued to decline over the week. During this same week, certain
credit rating agencies downgraded the firm's credit rating or put it on
negative watch. MF Global informed SEC staff during this week that
certain counterparties and customers were reducing their exposures to
MFGI, and MFGI was undertaking significant efforts to reduce the size
of its balance sheet.
SEC staff commenced a continuous on-site presence at MFGI's New
York office beginning on October 27 to monitor the firm's condition,
and to engage with senior management regarding the steps that were
being taken by the firm. On Friday, October 28, MF Global management
reported on developments to Chairman Mary Schapiro and SEC staff,
including myself. According to the firm, it was in discussions with
various parties regarding potential strategic transactions, such as the
sale of the firm, the sale of the RTM positions, and the sale of the
firm's customer business. We continued to receive updates from our on-
site staff and from calls with firm management on Saturday and Sunday,
and we continued to consult closely with other regulators, including
the CFTC, FINRA and the FSA. By Sunday afternoon, MF Global reported
that the firm was close to concluding a strategic transaction with a
potential purchaser of the customer business of MFGI, which could
provide customers with continued access to their accounts. SEC staff
worked closely with the CFTC and FSA to review and comment on the key
transaction terms to determine that they provided adequate customer
protection. However, MF Global subsequently reported in the early
morning hours of Monday, October 31, that MFGI had identified a
significant deficiency in its segregated accounts for futures
customers, and that the acquisition negotiations had terminated.
At that point, after considering MFGI's financial condition and
available alternatives, SEC staff determined, in consultation with the
CFTC, that the safest and most prudent course of action to protect
customer accounts and assets was to initiate a liquidation proceeding
under the Securities Investor Protection Act (SIPA). \8\ A referral was
made to the Securities Investor Protection Corporation (SIPC) early in
the morning on Monday, October 31. On that same day, the U.S. District
Court for the Southern District of New York entered an order granting
the application of SIPC to commence a liquidation of MFGI under SIPA
and appointing James W. Giddens as trustee for the liquidation. The
case was then removed to the U.S. Bankruptcy Court for the Southern
District of New York (Bankruptcy Court). Also on October 31, MF Global
Holdings Ltd. separately filed a voluntary bankruptcy petition in the
Bankruptcy Court, and MF Global U.K. Limited entered administration
proceedings in the United Kingdom.
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\8\ SEC-CFTC Statement on MF Global, Oct. 31, 2011, available at
http://sec.gov/news/press/2011/2011-230.htm.
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MFGI Liquidation and the Impact on Securities Customers
The preferred method of returning securities customer assets in a
SIPA liquidation generally is to transfer those assets in bulk to
another solvent broker-dealer. This approach typically provides
customers with access to their securities and funds more quickly than
the claims process. Accordingly, shortly after the initiation of the
SIPA proceeding, the trustee solicited from other broker-dealers
interest in taking over MFGI's securities customer accounts. Based on
the available expressions of interest, on November 30, 2011, the
trustee filed an expedited motion seeking authorization to sell and
transfer substantially all securities custody accounts to another
broker-dealer. This sale and transfer applied to approximately 318
accounts held for nonaffiliated securities customers of MFGI. The
transaction was approved by the Bankruptcy Court on December 9, 2011.
Securities customers are able to trade their securities and use
their funds upon completion of the transfer of their accounts.
Moreover, each customer is given the option of maintaining the
customer's securities account at the receiving broker-dealer or moving
the account to a different broker-dealer selected by the customer.
According to the trustee, of all former MFGI securities customers,
nearly all have received 60 percent or more of their account value, and
194 have received the entirety of their account balances, after giving
effect to the protection afforded by SIPC (up to $500,000). \9\
Customers who do not ultimately receive 100 percent of their net equity
through this initial transfer may be able to receive additional funds,
up to the aggregate amount of their net equity, if the trustee
determines that there is customer property available for that purpose.
Although the claims submission deadline was January 31, 2012, for
former MFGI commodities customers and former MFGI securities customers
seeking the maximum protection under SIPA, securities customers and all
general claimants may still submit claims to the trustee through June
2, 2012.
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\9\ See, Trustee Interim Status Report, supra note 2.
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Throughout this process, SEC staff has been working closely with
the trustee and SIPC, seeking to expedite the return of assets to
customers of MFGI. To that end, SEC staff has been in frequent
communication with the trustee with respect to the status of the
transfers and claims made by securities customers.
Securities Customer Protection Regime
MFGI acted as a ``carrying'' firm for a small number of securities
customers, meaning that it held their funds and securities. MFGI also
had additional securities customers for which it executed purchases and
sales of securities but did not hold funds and securities--rather, such
securities were held at other custodians that settled transactions
executed through MFGI on a ``delivery versus payment'' basis.
As a broker-dealer registered with the SEC, MFGI was subject to the
SEC's customer protection rule. This rule requires that each broker-
dealer that holds securities or cash for customers take two primary
steps to safeguard customer property. These steps are designed to
protect customer property by prohibiting broker-dealers from using
customer funds and securities to support their proprietary positions or
expenses. Together with the applicable SEC capital requirements, this
regime also is meant to make it more likely that, if the broker-dealer
fails, segregated securities and funds will be readily available to be
returned to the customers.
The first step required under the customer protection rule is that
the broker-dealer must maintain physical possession or control over
securities that customers have paid for in full. This means that if a
customer has fully paid for his or her securities, they cannot be used
by the broker-dealer in its business--for example, they cannot be
pledged as collateral to finance the firm's own trades or to raise
funds for the firm to invest. Further, if a customer has a margin loan,
the customer protection rule strictly limits the amount of securities
that can be used by the broker-dealer for financing purposes. The goal
in both cases is to require broker-dealers to hold customer securities
in a manner that allows those securities to be readily available to
customers, either on demand or upon the liquidation of the firm.
The second step required under the customer protection rule is that
the broker-dealer must maintain a reserve in an account at a bank for
the benefit of customers in an amount that exceeds the net funds
attributable to customer positions. These funds cannot be invested in
any instrument that is not guaranteed, as to principal and interest, by
the full faith and credit of the U.S. Government. The amount owed to
customers must be computed pursuant to a prescribed formula, normally
on a weekly basis. A broker-dealer cannot make a withdrawal from the
reserve account until the next computation, and then only if the
computation indicates that there is an excess amount in reserve--
greater than what is required to be maintained under the rule. In
essence, this requirement complements the protection afforded to
securities held at a broker-dealer by requiring the firm to maintain a
reserve of funds or U.S. Government guaranteed securities equal to its
net cash obligations attributable to customer positions.
A broker-dealer that complies with the customer protection rule--
isolating customer funds and securities through these steps and
separating them from the firm's proprietary business--should be in a
position to return all the securities and funds it owes to customers if
it falls into financial difficulty. If a broker-dealer cannot return
all the securities and funds owed to customers, SIPC has the
responsibility to institute a proceeding under SIPA to liquidate the
broker-dealer. Under SIPA, all securities customers share pro rata in
the available securities customer property before any other types of
creditors of the broker-dealer. If the available securities customer
property is insufficient to return 100 percent of the amount owed to
securities customers, SIPC may advance up to $500,000 per customer (of
which $250,000 can be used to make up a cash shortfall).
Implications for Market Oversight
While our near term focus has been on working with SIPC and the
trustee to facilitate the return of securities and funds to customers
of MFGI, the SEC will continue to strive to identify further
enhancements to its customer protection regime that may be appropriate.
The events leading up to the bankruptcy of MF Global and its
aftermath reinforce the importance of close and ongoing coordination
and information sharing among regulators and other interested parties.
In this case, these parties included not only the SEC and CFTC and
other Federal regulators, but also the SROs, the FSA, SIPC, and,
following the bankruptcy filing, the trustee.
Protection of Customer Assets
While our experience with addressing MF Global's failure highlights
the importance of domestic and international regulatory coordination,
it also underscores the paramount importance of the rules governing
protection of customer assets and the controls that are crucial for
compliance with those rules. In general, the rules governing protection
of customer funds and securities that apply to registered broker-
dealers, described above, have worked well over time, but we are
considering whether there are ways that they could be strengthened. In
particular, in June 2011, the SEC proposed rule changes that are meant
to clarify and strengthen the rules governing audits of broker-dealers,
including an auditor's examination of broker-dealer controls relating
to the custody of customer assets, as well as to enhance the SEC's
oversight of broker-dealers that hold customer securities and funds.
Specifically, the proposal would:
Enhance the current requirement that a broker-dealer
undergo an annual audit by a public accounting firm registered
with the Public Company Accounting Oversight Board by
strengthening the standards that govern the auditor's
examination of the broker-dealer's compliance, and internal
controls over compliance, with SEC net capital and custody
requirements.
Require that broker-dealers that maintain custody of
customer assets file with the SEC a new ``Form Custody'' every
quarter. This form would contain more detailed information
about how broker-dealers maintain custody of customer assets in
order to further facilitate verification by examiners that
customer assets are being properly protected.
SEC staff has evaluated comments received in response to this
proposal and is working to finalize a recommendation to the Commission.
More broadly, the staff is evaluating other possible rule changes
to the financial responsibility requirements, including some previously
considered by the Commission that could strengthen customer protection.
For example, one change under consideration would be to limit, for
purposes of the customer reserve fund required by Rule 15c3-3, the
amount of cash a broker-dealer could maintain in any one bank, as a
percentage of capital of the broker-dealer or the bank.
The SEC also continues to work with the SROs to help strengthen
broker-dealer financial responsibility requirements. For example, in
June 2011, the SEC approved a FINRA rule filing to establish
registration, qualification, examination, and continuing education
requirements for certain operations--or ``back office''--personnel,
including those who handle customer assets. This rule should help to
better ensure that those responsible for operations functions are fully
versed in all the relevant rules and their obligations, including those
relating to the segregation and protection of customer assets. In
addition, in February 2012, the SEC approved a FINRA proposal to
require each member firm to file certain additional financial or
operational schedules or reports to supplement existing requirements to
file FOCUS reports with FINRA pursuant to SEC Rule 17a-5. This rule
allows FINRA to receive more granular data pertinent to income and
expense items, and therefore to better identify firms that warrant
heightened scrutiny and to evaluate industry-wide trends.
In February of this year, the SIPC Modernization Task Force, which
was established by SIPC for the purpose of undertaking a comprehensive
review of its operations and policies and to propose reforms to
modernize SIPA and SIPC, issued a number of recommendations, including
proposed statutory changes. SEC staff is evaluating these
recommendations, several of which are directed to the scope and dollar
limit of protection for individual customers in SIPC liquidations.
Although SIPC has not itself yet responded to the recommendations, we
look forward to discussing them with SIPC as part of our review.
Finally, with regard to accounting standards, in March 2012, the
Chairman of the Financial Accounting Standards Board (FASB) added a
project to the FASB's agenda to reconsider the accounting and
disclosure requirements for repurchase agreements and similar
transactions. The FASB Chairman cited the need to revisit the
accounting requirements to address application issues as a result of
changes in the marketplace and to ensure that investors obtain useful
information about these transactions. As part of the project, the FASB
is expected to reconsider the accounting and disclosures requirements
related to RTM transactions. There is ongoing communication between SEC
staff and the FASB regarding their standard-setting efforts.
Regulatory Cooperation
Given the pace of developments in the financial markets generally
and, in particular, how quickly the financial condition of a financial
firm that is in distress can deteriorate, the SEC is engaged in a
number of efforts--both domestic and international--to share more and
better data and qualitative assessments of firms and markets, and to do
so in a timely way. Some of these efforts involve coordination with the
SROs, in recognition of their importance as ``frontline'' supervisors.
For example, examination staff in the SEC's Office of Compliance
Inspections and Examinations (OCIE) recently initiated quarterly
meetings with FINRA and CBOE and semi-annual meetings with the Chicago
Stock Exchange (CHX), in each case in respect of the SRO's capacity as
a DEA. Further, OCIE recently has sought to enhance its inter-regulator
Summit of Securities Regulators, increasing the frequency with which it
convenes and expanding the group of regulators such that it now
includes FINRA, CBOE, CHX, the Municipal Securities Rulemaking Board,
the North American Securities Administrators Association, the Federal
Reserve Board, various Federal Reserve Banks, and the CFTC. The first
meeting of the expanded group will take place this month and will
provide an opportunity for this diverse gathering of regulators to
discuss issues and concerns regarding registrants, current regulatory
developments, and to identify common risks and collaboration
opportunities. In addition to these recent initiatives, the Commission
has been a key participant in the Intermarket Surveillance Group (ISG)
since its formation in the 1980s. The ISG provides a critical venue for
sharing investigative information and surveillance data among domestic
and foreign market centers, market regulators, and exchanges, including
both securities and futures exchanges.
For many years, the SEC has been engaged in numerous and ongoing
efforts to increase cooperation and the flow of information relevant to
market oversight among international regulators, through various means,
including cooperative arrangements, such as memoranda of understanding
(MOU), informal and formal bilateral discussions, and participation in
multilateral organizations. \10\
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\10\ A list of supervisory MOUs is available at: http://
www.sec.gov/about/offices/oia/oia_cooparrangements.shtml.
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In the international sphere, the SEC works closely with both
banking and securities regulators through various venues, including the
Financial Stability Board, IOSCO, the Council of Securities Regulators
of the Americas, the Cross-border Crisis Management Working Group, and
the Senior Supervisors Group. The SEC also has ongoing bilateral
dialogues with key international regulatory counterparts, including the
United Kingdom, India, China, Korea, and Turkey. Furthermore, the SEC
participates alongside the Department of the Treasury and the Federal
Reserve Board in the Financial Markets Regulatory Dialogue with the
European Union.
Conclusion
The SEC and its staff are working with our fellow financial
regulators and other authorities to facilitate the identification and
return of customer assets. We also are engaged in ongoing efforts to
increase the exchange among regulators of information that is relevant
to oversight of markets and market intermediaries, and are considering
measures to further strengthen the existing customer protection regime.
I would be pleased to answer any questions you may have.
______
PREPARED STATEMENT OF RICHARD G. KETCHUM
Chairman and Chief Executive Officer, Financial Industry Regulatory
Authority
April 24, 2012
Chairman Johnson, Ranking Member Shelby, and Members of the
Committee, I am Richard Ketchum, Chairman and CEO of the Financial
Industry Regulatory Authority, or FINRA. On behalf of FINRA, I would
like to thank you for the opportunity to testify today.
When a firm like MF Global fails, there is always value in
reviewing the events leading to that failure and examining where rules
and processes might be improved. I commend the Committee for having
this hearing to do just that. Clearly the continued impact of MF
Global's failure on customers who cannot access their funds is of great
concern, and every possible step should be taken to restore those
accounts as quickly as possible.
Like many other financial firms today, MF Global's operations
included multiple business lines, engaging multiple regulatory schemes
and crossing national boundaries. We and the other regulators here
today will explain our roles in overseeing the various parts of the
firm. We all share the goal of restoring funds to customers. While
FINRA's role in that process is limited at this stage, we are committed
to continuing to provide assistance wherever we can.
FINRA
FINRA is the largest independent regulator for all securities firms
doing business in the United States, and, through its comprehensive
regulatory oversight programs, regulates both the firms and
professionals that sell securities in the United States and the U.S.
securities markets. FINRA oversees approximately 4,500 brokerage firms,
163,000 branch offices and 630,000 registered securities
representatives. FINRA touches virtually every aspect of the securities
business--from registering industry participants to examining
securities firms; writing rules and enforcing those rules and the
Federal securities laws; informing and educating the investing public;
providing trade reporting and other industry utilities and
administering the largest dispute resolution forum for investors and
registered firms.
In 2011, FINRA brought 1,488 disciplinary actions, collected fines
totaling more than $63 million and ordered the payment of almost $19
million in restitution to harmed investors. FINRA expelled 21 firms
from the securities industry, barred 329 individuals and suspended 475
from association with FINRA-regulated firms. Last year, FINRA conducted
approximately 2,400 cycle examinations and nearly 6,800 cause
examinations.
One of our regulatory programs that is particularly relevant to
today's hearing is our financial and operational surveillance. Through
this program, FINRA reviews FOCUS (Financial and Operational Combined
Uniform Single) reports that broker-dealers file on a monthly basis as
required by the Securities and Exchange Commission (SEC). These reports
detail a firm's financial and operational conditions and allow FINRA to
closely monitor a firm's net capital position and profitability for
signs of potential problems.
FINRA's activities are overseen by the SEC, which approves all
FINRA rules and has oversight authority over FINRA operations.
Oversight of MF Global
Like many financial firms today that operate simultaneously in
multiple channels, MF Global was not solely a broker-dealer, but also a
futures commission merchant or FCM. As such, multiple Government
regulators and self-regulatory organizations (SROs), including FINRA,
had a role in overseeing various parts of the firm's operations.
With respect to oversight of MF Global's financial and operational
compliance, which is most relevant to today's hearing, FINRA shared
oversight responsibilities with the Chicago Board Options Exchange
(CBOE) and the SEC, especially in terms of the firm's compliance with
the net capital rule. For broker-dealers that are members of multiple
SROs, the SEC assigns a Designated Examining Authority, or DEA, to
examine the firm's financial and operational programs, including the
firm's compliance with the Commission's net capital and customer
protection rules. For MF Global, that DEA was the CBOE. As such, CBOE
conducted the regular examinations of the firm for capital compliance.
There are two primary SEC rules for which financial examinations
evaluate compliance, the net capital and customer protection rules. The
primary purpose of the SEC's net capital rule, 15c3-1, is to protect
customers and creditors of a registered broker-dealer from monetary
losses and delays that can occur if that broker-dealer fails. It
requires firms to maintain sufficient liquid assets to satisfy customer
and creditor claims. It accomplishes this by requiring brokerage firms
to maintain net capital in excess of certain minimum amounts. A firm's
net capital takes into account net worth, reduced by illiquid assets
and various deductions to account for market and credit risk. This
amount is measured against the minimum amount of net capital a firm is
required to maintain, which depends on its size and business. The net
capital rule is intended to provide an extra buffer of protection,
beyond rules requiring segregation of customer funds, so that if a firm
cannot continue business and needs to liquidate, resources will be
available for them to do so.
The SEC's customer protection rule, 15c3-3, has two components,
reserve formula computation and possession or control, and was designed
to ensure the safety of customers' assets. The objective of the reserve
formula computation is to protect the customer funds in the event the
broker-dealer becomes financially insolvent. Possession or control
requires that the broker-dealer obtain prompt possession or control of
customers' fully paid for and excess margin securities, ensure that
customers' assets held by a broker-dealer are properly safeguarded
against unauthorized use and separate firm and customer related
business.
Fewer than 20 FINRA-regulated broker-dealers have a DEA other than
FINRA, but in those cases, we work closely and cooperatively with the
DEA when questions or issues arise. Even when we are not the DEA for
one of our regulated broker-dealers, FINRA monitors and analyzes the
firm's FOCUS report filings and annual audited financial statements as
part of our ongoing oversight of the firm. That was the case with MF
Global.
While that monitoring focuses on a broad range of issues, it is
particularly relevant to note that our financial surveillance team
placed a heightened focus on exposure to European sovereign debt
beginning in spring 2010. During April and May, our staff began
surveying firms as to their positions in European sovereign debt as
part of our ongoing monitoring of regulated firms.
In response to our outreach on this issue, MF Global indicated in
late September 2010 that the firm did not have any such positions. We
later learned that the firm began entering into transactions that
carried European debt exposure prior to that inquiry. While the firm's
response was consistent with GAAP accounting rules that repo-to-
maturity (RTM) transactions are treated as a sale for accounting
purposes, the lack of a complete response delayed us in detecting the
firm's exposure.
MF Global's Exposure to European Sovereign Debt
In a routine review of MF Global's audited financial statements
filed with FINRA on May 31, 2011, our staff raised questions about a
footnote disclosure regarding the firm's RTM portfolio. RTMs are
essentially transactions whereby the maturity date of a firm's bond
position held in its inventory matches the maturity date of the repo.
During the course of discussions with the firm, FINRA learned that a
significant portion of that portfolio was collateralized by
approximately $7.6 billion in European sovereign debt. According to
U.S. GAAP, RTMs are afforded sale treatment and therefore not
recognized on the balance sheet. Notwithstanding that accounting
position, the firm remained subject to market and credit risk
throughout the life of the repo.
Beginning in mid-June, FINRA had detailed discussions with the
firm, in which CBOE also participated, regarding the proper treatment
of the RTM portfolio and we asserted that not enough capital was
reserved against the RTM. While the SEC has issued guidance clarifying
that RTMs collateralized by U.S. Treasury debt do not require capital
to be reserved, there is no such relief for RTMs collateralized by debt
of non-U.S. Governments. We researched whether the firm retained
default risk on the positions, and concluded that it did. Our view was
that while recording the RTMs as sales was consistent with GAAP, they
should not be treated as such for purposes of the capital rule given
the market and credit risk those positions carried. As a result, we
asserted that capital needed to be reserved against the RTM.
FINRA and CBOE also had discussions with the SEC about our concerns
that the firm was not holding capital against its RTM portfolio. The
SEC agreed with our assertion that the firm should be holding capital
against the positions. The firm fought this interpretation throughout
the summer, appealing directly to the SEC, before eventually conceding
in late August 2011.
The firm infused additional capital and filed an amended July FOCUS
report on August 31 to report a $150 million capital deficiency in
July. The firm also provided notification, pursuant to SEC Rule 17a-11,
of its capital deficiency to the SEC, CBOE and FINRA as well as to the
Commodity Futures Trading Commission (CFTC), pursuant to CFTC Rule
1.12. The net capital deficiency in the amended July FOCUS report was
reported on the CFTC's Web site. In addition, on September 1, the firm
amended its Form 10-Q filing with the SEC to identify the change in net
capital treatment of the RTM portfolio.
In September, FINRA added MF Global to ``alert reporting,'' a
heightened monitoring process whereby we require firms to provide
weekly information on net capital, inventory, profit and loss as well
as reserve formula computations.
On October 19, the Intermarket Financial Surveillance Group (IFSG),
which is comprised of securities and futures regulators and self-
regulatory organizations, had its annual meeting. The IFSG was
established in 1989 in order to enhance the coordination and monitoring
efforts of both securities and commodities regulators. Through an
information sharing agreement, SROs provide each other with financial
surveillance data and related information on an as-needed basis. In
addition, SRO representatives meet annually to discuss relevant capital
and customer protection issues. Exposure to European sovereign debt was
one of the topics at the October meeting and FINRA raised MF Global's
positions during the discussions.
During the week of October 24, as MF Global's equity price declined
and its credit rating was cut, FINRA increased the level of
surveillance over the firm. We requested detailed information about the
firm's balance sheet and liquidity; we received updates about the loss
of lending counterparties and customers; and we spoke to clearing
organizations about the margin required to settle trades. At the end of
that week, FINRA was on site at the firm, with the SEC, as it became
clear that MF Global was unlikely to continue to be a viable standalone
business. Our primary goal was to gain an understanding of the
custodial locations for customer securities and to work closely with
potential acquirers in hopes of avoiding SIPC liquidation. As has been
widely reported, the discrepancy discovered in the segregated funds on
the futures side of the firm ended those discussions.
MF Global Bankruptcy and Liquidation Proceeding
On October 31, 2011, MF Global Holdings, Ltd. and MF Global, Inc.
filed for bankruptcy and entered into SIPC liquidation. Since that
time, FINRA has provided assistance as requested by the SEC and the
trustee.
On November 4, 2011, FINRA assisted the trustee in alerting broker-
dealer firms via email that the trustee was accepting proposals for the
transfer of approximately 450 customer securities accounts of MF Global
to another member of SIPC.
We have also assisted the trustee by providing information about
other broker-dealers to which MF Global securities customer accounts
may be transferred.
Increased Regulatory Coordination and New Rulemaking Efforts to Better
Protect Customers and Their Funds
Both prior to and since the failure of MF Global, FINRA has worked
to identify changes that can be made to better protect customers and
their funds, through both our own rulemaking process, and also in terms
of our coordination with our regulatory counterparts. I will highlight
a few of the efforts that FINRA has been involved in over the past
several months.
First, FINRA and the Chicago Mercantile Exchange have established
regular coordination calls so that our respective staffs can share
information about the approximately 50 firms that are both broker-
dealers and futures commission merchants, and therefore are subject to
the oversight of both entities. Through these calls, our staffs will
have regular opportunities to discuss routine oversight issues as well
as to highlight for one another any concerns or situations that warrant
heightened monitoring. The goal for these calls is to enhance
coordination between our organizations and ensure that each is aware of
issues identified by the other, as early as possible. In addition,
FINRA is currently in discussions with the CFTC regarding possible
information sharing arrangements that could further enhance oversight
of dual broker-dealer/futures commission merchant firms.
Another example of enhanced coordination among regulators is a
series of ``supervisory colleges'' that we initiated last fall. Based
on the model that international regulators have used in overseeing
large global banking institutions, we hosted an in-depth briefing on
select nonbank investment firms and invited staff from both domestic
and international regulators of securities and futures to participate.
During the event, regulators were able to exchange information and
engage in a dialogue with the firms' senior executive management--and
each other--to gain a more comprehensive understanding of each
institution's business strategy, legal and regulatory structure,
corporate governance, and risk drivers. We plan to host a second such
event in June and have expanded the list of regulators and SROs
included in the event.
In addition to coordinating with other regulators, FINRA has
continued its work on two rulemaking efforts that are aimed at
enhancing financial surveillance and expediting the return of customer
funds and securities in the event of liquidation.
In late February, FINRA implemented a new rule that requires FINRA-
regulated firms to file additional financial or operational schedules
or reports as we deem necessary to supplement the FOCUS report. The
rule provides FINRA with the framework to request more specific
information that we determine is necessary or appropriate for the
protection of investors or in the public interest. Under this rule, the
SEC has approved the adoption of one such report--the Supplemental
Statement of Income--which enables FINRA to capture more granular
detail about a firm's revenue and expenses, including a breakdown of
commission revenues by product, a breakdown of principal trading gains
and losses by security type as well as detailed components of fee and
interest revenues among other things.
Also pursuant to this rule, last week, the FINRA Board approved a
proposal to adopt a second supplemental FOCUS report to capture
information that is not otherwise reported on certain firms' balance
sheets. If approved by the SEC, all carrying and clearing firms would
be required to file this information with FINRA on a quarterly basis.
Captured in this report would be, among other data, gross exposures in
financing transactions, such as reverse repos, repos, repos to maturity
and other transactions that are otherwise netted under GAAP. This
additional information will permit FINRA to more effectively assess on
an ongoing basis the potential impact that off-balance sheet activities
may have on such firms' net capital, leverage and liquidity, and their
ability to fulfill their customer protection obligations.
FINRA has also proposed a new rule that would expedite the
liquidation of a firm and most importantly, the transfer of customer
assets, should a firm need to cease operations. FINRA is currently
reviewing comments submitted on this proposal and will make adjustments
as warranted before submitting a final proposal to the SEC for review.
Conclusion
FINRA will continue to work with our fellow regulators and Congress
as the liquidation process for MF Global proceeds, and as we implement
the measures identified to date which could improve oversight of
similar firms and coordination between regulators. We share your
commitment to reviewing the events involved in the firm's collapse,
relevant rules and coordination with other regulators to continue to
identify potential policy or procedural adjustments that may be
warranted.
We realize that it is critical to continually evaluate the customer
protection regime to ensure that it is designed as well as it can be to
ensure prompt restoration of customer funds in the event of a firm
collapse. To that end, we would be glad to participate in a broader
review, in coordination with the SEC, CFTC, self-regulatory
organizations and others to provide an overall assessment of where
current rules and processes may need enhancements.
Again, I appreciate the opportunity to testify today. I would be
happy to answer any questions you may have.
______
PREPARED STATEMENT OF TERRENCE A. DUFFY
Executive Chairman, CME Group Inc.
April 24, 2012
Chairman Johnson, Senator Shelby, Members of the Committee, thank
you for the opportunity to testify respecting some lessons learned from
the collapse of futures commission merchant (FCM) and broker-dealer
(BD) MF Global, Inc. (MFG) and possible policy responses to protect
customers. I am Terry Duffy, Executive Chairman of CME Group (CME Group
or CME), which is the world's largest and most diverse derivatives
marketplace. CME Group includes four separate exchanges--Chicago
Mercantile Exchange Inc. the Board of Trade of the City of Chicago,
Inc., the New York Mercantile Exchange, Inc. and the Commodity
Exchange, Inc. (together ``CME Group Exchanges''). The CME Group
Exchanges offer the widest range of benchmark products available across
all major asset classes, including futures and options based on
interest rates, equity indexes, foreign exchange, energy, metals,
agricultural commodities, and alternative investment products. CME also
includes CME Clearing, a derivatives clearing organization and one of
the largest central counterparty clearing services in the world; it
provides clearing and settlement services for exchange-traded
contracts, as well as for over-the-counter (OTC) derivatives
transactions through CME Clearing and CME ClearPort'.
I have previously testified respecting MF Global's misuse of
segregated customer funds and CME Group's efforts on behalf of
customers. Today, I will summarize CME Group's and the industry's
efforts to restore customer confidence, and our suggestions for
strengthening customer protection and confidence going forward. I will
also explain why the current system of front line auditing and
regulation by clearing houses and exchanges should not be abandoned as
a result of the misconduct of MF Global, and why you can be confident
in the robust regulation that the SRO system provides.
Introduction
On October 31, the Securities Investor Protection Corporation
(SIPC) filed a petition with a Federal District Court in New York to
place MFG into bankruptcy. Unlike in prior bankruptcies of CME member
firms, our clearing house was unable to transfer all customer positions
and property to another firm due to missing customer funds in
segregated customer accounts under the control of the FCM. Indeed, this
may be the first time in the industry's history that public customer
will suffer ultimate losses with respect to their accounts for U.S.
futures exchange trading. \1\
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\1\ As recent examples, in both Refco and Lehman, which had large
FCM operations, while nonfutures customers were significantly impacted
by the bankruptcy proceedings, the regulated commodity customer
accounts were transferred to new FCMs without any disruption. We had no
reason to believe this situation would be any different at MFG until
the segregation shortfall at MFG was discovered.
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The shortfall in customer segregated funds occurred only in regard
to funds under MFG's control. The customers' funds held in segregation
at the clearing level at CME and other U.S. clearinghouses were intact.
However, the clearinghouses were not able to avoid market disruptions
by immediately transferring those customer positions and any related
collateral because of limitations under the Bankruptcy Code. We believe
that Congress can help protect customers whose collateral is
safeguarded at clearing houses by changing the bankruptcy code to
permit a clearing house that holds full collateral for a failed
clearing member's customers to immediately transfer customer positions,
along with the required collateral for those positions, to other
clearing members.
The industry is united in its search for solutions that will
restore confidence in the safety of funds invested in regulated futures
and derivatives markets. Obviously, changes in the Bankruptcy Code are
not the only answer, and it is constructive to look at a wide range of
changes that can be implemented without legislation. In order to
evaluate the proposals, it is necessary to begin with an understanding
of the current system for protecting customer property and positions. A
bit of background information regarding the clearing model in the
futures industry, including the role and obligations of FCMs and
derivatives clearing houses is my starting point.
The Futures Commission Merchant
An FCM is an individual or organization that (i) solicits or
accepts orders to buy or sell futures contracts or options on futures
contracts and (ii) accepts money or other assets from customers to
support such orders. As such, FCMs are agents or intermediaries for
their customers. Among other things, the Commodity Exchange Act (CEA),
which is the main statute governing the FCM's legal obligations,
expressly states that all money and other property of any customer
received to margin or guarantee a derivative contract cleared though a
derivatives clearing organization belongs to the customer and may not
be commingled with the FCM's own trading accounts.
With respect to ensuring that such customer collateral received by
the FCM is segregated, the CEA, applicable regulations of the Commodity
Futures Trading Commission (CFTC) and our clearing house rules require
that money and other customer property must be separately accounted for
and may not be commingled with the funds of the FCM or be used to
margin, secure, or guarantee any trades or contracts of any person
other than the person for whom the same are held. Additionally, CME
Clearing has rules on its books directly addressing FCMs' obligations
in this regard.
In practice, an FCM maintains a number of customer segregated
accounts at custodians approved by the CFTC. As a customer establishes
positions, the FCM transfers collateral from one of its customer
segregated accounts to a customer segregated account maintained and
controlled by the clearing house. In many cases, the FCM collects
margin from its customers in excess of what is required by the clearing
house to support the customer positions cleared through the clearing
house; this ``excess margin'' is often held in the customer segregated
accounts controlled by the FCM. The FCM also typically holds some of
its own funds in the customer segregated accounts, in order to ensure
that the accounts never fall below the required segregated amount. All
assets in the customer segregated accounts are subject to various CFTC
and clearing house rules, including limitations on permissible
investment of these funds under CFTC Regulation 1.25. Different rules
apply to the assets of customers who also trade on foreign exchanges.
Derivatives Clearing Houses
A clearing house acts as the seller to every buyer and buyer to
every seller of every cleared contract. For futures contracts, it pays
winners and collects from losers twice each day so that debt is
eliminated from the system and systemic risk is minimized. When a firm
fails to pay its losses, the clearing house must still pay the other
firms that have profitable positions opposite the failed firm's trades.
The Guaranty Fund is one of the principal means to make such payments
possible.
Each clearing member contributes assets and agrees to pay an
assessment, based on its risk profile, for the sole purpose of covering
any loss suffered by the clearing house when it makes good on its
commitment to honor its contracts despite the default of another
clearing member. This guaranty is designed to protect against the
systemic risk that could arise if the default of one clearing member
were to lead to the failure of other clearing members. It is worth
noting that the assets in and committed to the Guaranty Fund do not
belong to CME Group, they belong to the clearing members who have
contributed them.
Nearly 65 different U.S. FCMs hold approximately $155 billion in
U.S. customer collateral and nearly $40 billion in collateral held for
trading on foreign exchanges--much of which is not placed with
regulated clearing houses. As of March 2011, the total amount of
customer funds held by the top 30 FCMs was more than $163 billion. No
clearing house, however large, could effectively or economically
guarantee all such funds and all such activity. Some have suggested
that a Government insurance program similar to the equities markets'
SIPC be established for futures markets. SIPC is designed to protect
retail brokerage accounts up to $500,000, so even under SIPC, many
larger securities accounts are not insured. While there are some
smaller retail futures customers, many futures customers carry tens of
millions or even more in their FCM accounts. The futures markets are
mostly professional markets with very different risk profiles from the
securities markets. Given the size and scope of the majority of the
accounts in this business, a Government insurance scheme may be a cost
prohibitive and/or ineffective solution. Nevertheless, an insurance
scheme is certainly an idea that should be explored, and CME will work
closely with regulators and industry participants to find solutions
that can help prevent a repeat episode of such magnitude and retain, or
in some cases restore, the confidence of market users.
Industry Proposals To Protect Customers
On March 12th, a special committee composed of representatives from
the futures industry's regulatory organizations, including CME, offered
four recommendations to strengthen current safeguards for customer
segregated funds held at the firm level. CME Group is already
implementing these proposals, which will include:
Requiring all Futures Commission Merchants (FCM) to file
daily segregation reports.
Performing more frequent periodic spot checks to monitor
FCM compliance with segregation requirements.
Requiring a principal of the FCM to approve any
disbursement of customer segregated funds not made for the
benefit of customers and that exceeds 25 percent of the firm's
excess segregated funds.
Requiring all FCMs to file bimonthly Segregation Investment
Detail Reports, reflecting how customer segregated funds are
invested and where those funds are held.
In addition, in order to enhance intra-regulator coordination, we
have recently established routine communications with FINRA for all of
our common firms--the firm coordinators/relationship managers will
reach out to each other to have these communications. We believe this
will allow the coordinators on both sides to get to know one another
better and to increase the sharing of information.
On February 29th, the Futures Industry Association proposed initial
recommendations for enhancing the protection of customer funds. http://
www.futuresindustry.org/downloads/Initial_Recommendations_for_Customer
_Funds_Protection.pdf The specific recommendations include:
Establishing a reporting requirement for the daily
computation made by each FCM of customer funds on deposit in
segregated accounts;
Requiring FCMs to file twice-monthly reports on the
investment of customer funds;
Requiring FCMs to assure the appropriate separation of
duties among individuals working at FCMs who are responsible
for compliance with the rules protecting customer funds;
Requiring FCMs to document their policies and procedures in
several critical areas, including the valuation of securities
held in segregated accounts, the selection of banks, custodians
and other depositories for customer funds, and the maintenance
and withdrawal of ``residual interest,'' which consists of the
excess funds deposited by firms in the customer segregated
accounts.
CME has also challenged the industry and the Commission to consider
whether other solutions will better serve the interests of customers
and the industry. In addition to the proposed amendment of the
Bankruptcy Code, CME is working with its clearing members and certain
customers to find a structure that will protect their collateral
against fellow customer and fraud risks. We are committed to finding a
solution that will provide stronger protection for futures and swaps
customers' segregated funds, from a legal, operational, and cost-
benefit perspective without destroying the industry's business model.
In addition to these regulatory initiatives, we also recently
launched the CME Group Family Farmer and Rancher Protection Fund to
protect family farmers, family ranchers and their cooperatives against
losses of up to $25,000 per participant in the event of shortfalls in
segregated funds. Farming and ranching cooperatives also will be
eligible for up to $100,000 per cooperative.
These steps, we hope, will help to rebuild the confidence in U.S.
futures markets that was so badly shaken by the actions and failure of
MF Global. While we think these initiatives are important to rebuilding
that confidence, the misconduct of MF Global should not serve as a
reason to undermine the current system of front line auditing and
regulation by clearing houses and exchanges.
``Self-Regulation'' Is a Misnomer: Both the CFTC and Clearing Houses
Play Key Regulatory Roles
Some critics suggest that the current regulatory framework is
somehow to blame for MF Global's misconduct. As further detailed in the
discussion below, ``self-regulation'' in the context of futures markets
regulation is a misnomer, because the regulatory structure of the
modern U.S. futures industry is in fact a comprehensive network of
regulatory organizations that work together to ensure the effective
regulation of all industry participants.
The CEA establishes the Federal statutory framework that regulates
the trading and clearing of futures and futures options in the United
States, and following the recent passage of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, its scope has been expanded to
include the over-the-counter swaps market as well. The CEA is
administered by the CFTC, which establishes regulations governing the
conduct and responsibilities of market participants, exchanges and
clearing houses.
CME was the designated self-regulatory organization (DSRO) for MFG.
As MFG's DSRO, CME was responsible for conducting periodic audits of
MFG's FCM-arm and worked with the other regulatory bodies of which the
firm is a member. CME conducted audits of MFG pursuant to standards and
procedures established by the Joint Audit Committee (JAC) \2\ and
reported such results to the CFTC.
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\2\ The JAC is a representative committee of U.S. futures
exchanges and regulatory organizations which participate in a joint
audit and financial surveillance program that has been approved and is
overseen by the CFTC. The purpose of the joint program is to coordinate
among the participants numerous audit and financial surveillance
procedures over registered futures industry entities.
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CME conducted audits of MFG, and all firms for which it was the
DSRO, at least once every 9-15 months. The last audit of MFG was based
on the firm's records for the close of business on January 31, 2011.
This regulatory audit began subsequent to this audit date, and the
audit was completed with a report date of August 4, 2011.
Some critics have suggested that the failure of MFG demonstrates
that the current system of front line auditing and regulation by
clearing houses and exchanges is deficient because of conflicts of
interest. However, there is no conflict of interest between the CME
Group's duties as a DRSO and its duties to its shareholders--both
require that it diligently keep its markets fair and open by vigorously
regulating all market participants.
Federal law mandates an organizational structure that eliminates
conflicts of interest. In addition, we have very compelling incentives
to ensure that our regulatory programs operate effectively. We have
established a robust set of safeguards designed to ensure these
functions operate free from conflicts of interest or inappropriate
influence. The CFTC conducts its own surveillance of the markets and
market participants and actively enforces compliance with the CEA and
Commission regulations. In addition to the CFTC's oversight of the
markets, exchanges separately establish and enforce rules governing the
activity of all market participants in their markets. Further, the
National Futures Association (NFA), the registered futures association
for the industry, establishes rules and has regulatory authority with
respect to every firm and individual who conducts futures trading
business with public customers. The CFTC, in turn, oversees the
effectiveness of the exchanges, clearing houses and the NFA in
fulfilling their respective regulatory responsibilities.
The futures industry is a very highly regulated industry with
several layers of oversight. The industry's current regulatory
structure is not that of a single entity governed by its members
regulating its members, but rather a structure in which exchanges, most
of which are public companies, regulate the activity of all
participants in their markets--members as well as nonmembers--
complemented with further oversight by the NFA and CFTC.
CME Group Regulation
As discussed above, no one has a greater interest than CME Group in
ensuring that its industry-leading markets are perceived as--and in
fact are--safe, open and fair. CME Group does so by vigorously
regulating the users of our markets. There is substantial evidence that
such private regulation has served the markets and market participants
very well. We have established a robust set of safeguards designed to
ensure these functions operate free from conflicts of interest or
inappropriate influence:
Our ability to attract and retain business fundamentally
depends on our customers' confidence in the integrity of our
markets, and exceeding our customers' expectations in that
regard is one of the cornerstones of our business model.
Ensuring that our markets are defined by effective and
appropriately balanced regulation is a competitive advantage
that draws institutional, commercial and individual customers
to CME Group.
As a public company, it is only by performing our
regulatory functions well that we avoid the severe reputational
repercussions and associated impacts to shareholder value that
would arise if lax regulation or improper conflicts were to
compromise our commitment to fair, transparent and financially
sound markets.
CME Group's own capital is first at risk if a failed
clearing firm's capital and collateral posted to CME is
insufficient to cover a default at the clearing house, giving
us the strongest possible economic incentive to ensure robust
oversight of our clearing firms' compliance with our rules and
CFTC regulations.
In addition to strong economic and reputational self-
interest, CME Group is subject to robust regulatory oversight,
as further detailed in the next section, creating powerful
regulatory incentives for CME Group to effectively regulate its
markets.
The MF Global Bankruptcy
The MF Global bankruptcy was not a failure of exchange or
Government-sponsored regulation. Our Audit and other regulatory teams
performed their responsibilities in regard to MF Global consistent with
the highest professional standards. One hundred percent of the customer
segregated collateral posted to CME and held at the clearing level,
amounting to $2.5 billion, was fully accounted for. The well-publicized
shortfall in U.S. customer segregated funds came from funds held at the
FCM level, not funds held at the clearing level.
MF Global's unlawful transfers of customer segregated funds were a
very serious violation of the CEA and exchange rules. Unfortunately, no
regulator, whether an exchange sponsored regulator or otherwise, can
always detect and stop an individual who is intent on breaking the law.
Regulators can seek to establish appropriate rules, monitor compliance
with the rules to deter misconduct and correct infractions, and in
cases where a rule is broken, deter future misconduct by taking
vigorous action against persons liable for breaches of the rules.
Nor were there was no conflict of interest with respect to CME
Group's regulation of MF Global. Indeed, in 2008 and 2009, CME Group
fined MF Global $400,000 and $495,000, respectively, for supervision
failures and other violations of trading practices rules, clearly
indicating that CME Group's regulators actively monitored and enforced
compliance with the rules by MF Global, just as we do with every other
market participant.
Notwithstanding the fact that MF Global's misconduct was the cause
of the shortfall in customer segregated funds, CME Group's efforts in
the wake of these events speak to the level of our commitment to
ensuring our customers' confidence in our markets:
We made an unprecedented guarantee of $550 million to the
SIPC Trustee in order to accelerate the distribution of funds
to customers.
CME Trust pledged virtually all of its capital--$50
million--to cover CME Group customer losses due to MF Global's
misuse of customer funds.
And, as noted above, CME Group recently launched the CME
Group Family Farmer and Rancher Protection Fund to protect
family farmers, family ranchers and their cooperatives against
losses of up to $25,000 per participant in the event of
shortfalls in segregated funds. Farming and ranching
cooperatives also will be eligible for up to $100,000 per
cooperative.
No other exchange or clearing house has taken such actions.
Government Oversight
Regulation at CME Group is subject to active Government oversight,
primarily by the CFTC.
CME Group's exchanges are registered as designated contract
markets (DCMs) with the CFTC, and our clearing house is
likewise registered as a derivatives clearing organization
(DCO).
In order to achieve registered status, we are required to
fulfill substantial regulatory obligations codified in the
CEA's 23 core principles for DCMs and 18 core principles for
DCOs. These include core principles requiring that we establish
structures and enforce rules to minimize conflicts of interest
in our decision making processes and that we have appropriate
procedures for resolving potential conflicts.
The CFTC's Division of Market Oversight actively oversees
DCM compliance with core principles and its Division of
Clearing and Risk oversees DCO compliance. Exchanges and
clearing houses are continually subject to both formal and
informal reviews of how effectively we fulfill our regulatory
mandates. In the event CME Group's exchanges or clearing house
were to fail to comply with the core principles, the company
could face significant sanctions, reputational exposure and
even compromise the registration status which allows us to
operate our markets.
With respect to regulatory coordination, the CFTC and SEC
allow the SROs on the futures side and securities side to
coordinate their financial surveillance. We are signors to an
agreement under the Intermarket Financial Surveillance Group
(IFSG). This agreement allows the ``experts'' to focus on their
piece of the puzzle, as well as to share information on common
firms where we have concerns. The IFSG also meets once or twice
per year to share information on regulatory developments and
common firms. As noted above, we have recently established
routine communications with FINRA for all of our common firms--
the firm coordinators/relationship managers will reach out to
each other to have these communications. We believe this will
allow the coordinators on both sides to get to know one another
better and to increase the sharing of information.
Enforcement
CME Group's effectiveness and assertiveness in regulating its
markets is also reflected in the results of our surveillance and
enforcement programs.
In 2011, CME Group's exchanges opened approximately 700
regulatory inquiries, in addition to conducting proactive
regular surveillance, and took 138 formal disciplinary actions
against market participants.
Two of those recent actions, resulting in $850,000 in fines
and remedial actions, were taken against one of our most active
proprietary trading firms for failing to properly supervise and
test its deployment of automated trading systems. In another
recently resolved matter, 18 brokers and locals in a particular
market on the trading floor were fined more than $600,000 and
subject to trading suspensions for engaging in noncompetitive
trades that disadvantaged other market participants.
Direct regulation by the exchange offers our regulators unique
proximity to the markets, market participants and the broader resources
of the exchange. This fosters the development of expertise that not
only makes our regulatory staff more effective, but also assists
Federal regulators in our common objective of preserving the integrity
of the markets.
Most of our interaction with Federal agencies occurs with
the CFTC, and its Division of Enforcement publishes a report of
its activity for each fiscal year. Its most recent full report,
for FY2010, noted that it took 57 enforcement actions. \3\ In
30 percent of those actions, CME Group either referred the
matter to the CFTC or provided assistance to the CFTC.
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\3\ The CFTC recently released statistics for FY2011, which noted
the filing of 99 enforcement actions and the opening of more than 450
investigations, but the full report is not yet available.
Excluding enforcement actions outside of CME Group's
regulatory purview, such as fraud in the FX cash markets, the
percentage of CFTC actions in which CME Group referred the
matter to the CFTC and/or provided assistance to the CFTC was
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68 percent.
Another example of how exchange-sponsored regulation and
Federal regulation work together is a 2011 matter in which CME
Group regulators initially acted to bar a party engaged in
illegal practices from our markets and then referred the matter
to the CFTC and Department of Justice. Both the CFTC and DOJ
took enforcement action, and in December 2011, he was convicted
in criminal court and sentenced to 44 months in prison and
ordered to pay restitution of approximately $369,000 after
having pled guilty to wire fraud.
Last week, the CFTC acknowledged and thanked the NYMEX for
its assistance in the recent Optiver market manipulation
matter. ``NYMEX's proactive surveillance program detected the
subject trading by Optiver in the Crude Oil, New York Harbor
Gasoline, and Heating Oil contracts and contributed to the
cessation of the activity alleged in the complaint. NYMEX also
provided the CFTC with important information from the NYMEX's
own investigation of this matter, as well as other
assistance.'' \4\
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\4\ http://www.cftc.gov/PressRoom/PressReleases/pr6239-12
Exchange-sponsored regulation often allows for more expedient
identification of potential issues given our knowledge of and proximity
to the markets, as well as the ability to react more quickly and
flexibly to potential market and regulatory issues; in certain matters,
that speed can make all the difference between having the ability to
freeze or recoup misappropriated money and losing it forever to
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wrongdoers.
For example, in a series of three separate recent cases
resolved in 2011, the CME Group exchanges were able to quickly
identify suspicious activity in our markets involving off-shore
parties seeking to misappropriate money from other unwitting
market participants. We promptly referred those matters to the
CFTC which subsequently filed suit against the parties in
Federal court. Our ability to quickly detect this activity and
assist the CFTC in its subsequent investigatory efforts
resulted in fines and restitution of more than $3.5 million
and, by quickly freezing funds, prevented $7.2 million more
from being stolen.
Conclusion
The protection of the interests of customers and restoration of
public confidence following the failure and unlawful actions by MF
Global continue to be CME Group's highest priority. We look forward to
working with Congress and the regulators to enhance customer
protections and foster confidence in our markets.