Caught in the Ruins of Refco

A local hedge fund ensnared in the scandal says it was dupedThe wreckage from the rapid collapse of Refco, which until two weeks ago had been one of the world’s biggest commodities and futures brokers, has entangled a New Jersey financial firm.

The worst fallout has rained down on Refco’s shareholders, who watched $2 billion in equity disappear overnight. Refco’s stock plunged from a price of $28.56 to 65¢ a share the day after the firm filed for Chapter 11 bankruptcy last week. Behind the debacle was a $430 million accounting fraud allegedly orchestrated by Phillip Bennett, the Manhattan brokerage’s former CEO.

But some chunks of debris have also dented the Liberty Corner family of investment firms in Summit. One firm in the group, a hedge fund called Liberty Corner Capital Strategies, took part in a series of borrowing and lending deals with Refco that prosecutors say Bennett used to shift more than $300 million in bad debts off the company’s books.

The transactions allegedly helped Refco burnish its quarterly balance sheet and pump up its financial fitness for a $583 million initial offering of its stock that was completed in August. One exchange that took place in February and March was the basis for the criminal securities fraud charge that was lodged against Bennett in federal court in Manhattan two weeks ago.

The case has forced Liberty Corner, which normally operates in a very private financial realm, to mount a public defense of its reputation. Kevin Marino, a Newark attorney who represents Liberty Corner, says the firm was an innocent dupe in the transactions. He says it had no idea that one of the Refco units involved in the transactions—Refco Group Holdings—was secretly controlled by Bennett rather than the company.

Marino has been spending much of the last two weeks on damage-control duty—rushing to cooperate with regulators and prosecutors and talking to reporters in an effort to keep the toxic publicity surrounding Refco from poisoning Liberty Corner’s business relationships.

“We’ve been beside ourselves with this,” he says. “It’s created a firestorm and it’s sullied our reputation and it’s cast us in a negative light and there is just no basis for it.”

His efforts paid off last week when federal prosecutors authorized him to issue a public statement saying that neither Liberty Corner Capital Strategies, nor its owner, William (“Terry”) Pigott was a target of their probe.

Pigott launched the hedge fund in 1999 and had built up a business using large blocks of capital to exploit small pricing discrepancies in securities markets. Its specialty was playing off the pricing of U.S. Treasury bills against Eurodollars. Most of its clients are institutional investors and wealthy individuals. Marino describes the firm’s investments as conservative but highly leveraged. He says it has had up to $400 billion in assets under management.

Before starting Liberty Corner, Pigott managed a bond investment portfolio at Daiwa Securities. He has kept a low profile since the scandal first broke while Marino has run interference for the firm.

John Tortorella, a lawyer with Marino’s firm, says Pigott and Bennett had not been friends or even business associates before the this year’s transactions. Pigott “had never spoken to [Bennett], had never met him,” Tortorella says.

Marino says the February financial arrangement that prosecutors have focused on was just another fixed-income arbitrage deal of the type Liberty Corner routinely handled. Liberty Corner borrowed $335 million from one Refco unit at 2.50% and loaned that same amount to another Refco unit, Refco Group Holdings, at 3.25%. Marino says the 10-day transaction netted Liberty Corner a fee of $90,000.

“There’s no way anyone at Liberty could have known this was a bad loan or anything approaching a bad loan.” Marino says. “We were never told there was $430 million of bad debt, we were never told there was an attempt to conceal debt for Mr. Bennett.”

Marino says Bennett had guaranteed that Refco would repay Liberty Corner’s $335 million loan to Refco Group Holdings even though the unit wasn’t actually under Refco’s control. Papers for the transactions were drawn up by Mayer, Brown, Refco’s Chicago law firm, and checked over by Liberty Corner’s lawyers before they were processed.

Mayer, Brown says its lawyers were also in the dark about any impropriety.

The origin of the debt was more than $400 million in trading losses Refco racked up during the 1990s. Rather than show them on its books and take a writedown against income, Bennett agreed to take them on himself and try to collect them. The receivables were transferred to Refco Group Holdings, a company Bennett personally controlled even though it sounded like just another Refco subsidiary.

But Refco still carried on its books a $430 million debt that Refco Group Holdings owed it. This was the entry the Liberty Corner transactions were allegedly designed to hide.

The fallout is far from over. There were reports last week that Refco insiders, principally Bennett and Tone Grant, his predecessor as the firm’s CEO, had collected more than $1 billion in payments from the firm in the year before its public stock offering.

Refco also agreed last week to sell its commodities brokerage and futures unit, which wasn’t included in the parent firm’s bankruptcy filing but has been weakened by customer defections, to an investor group led by J.C. Flowers & Co., a Manhattan money-management firm.

Meanwhile, a tsunami of litigation is already building. Four class action suits have been filed against Refco; its accountants Grant Thornton; and Credit Suisse First Boston, Goldman, Sachs and Bank of America Securities, the underwriters of its August stock offering.

With Refco already in bankruptcy proceedings, the plaintiffs are likely to turn their attention to whether the underwriters or accountants were negligent in not uncovering the bad debts on Refco’s books.

Summit in recent years has become the home base for a cluster of hedge funds. Their managers often live nearby and like the convenience of the town’s easy rail access to Manhattan.

In fact the downtown building where Liberty Corner has its offices—47 Maple Street—was also home to Beacon Hill Asset Management, a firm that ran into trouble two years ago for allegedly concealing a $300 million drop in the market value of two hedge funds it managed. Its four principals agreed last year to pay $4.4 million in fines, restitution and interest to settle a civil lawsuit the Securities and Exchange Commission had brought against them.

This past summer a Flemington firm called Majestic Capital was caught up in an investigation into $440 million missing from Bayou Management, a Connecticut hedge fund. Investigators traced some $100 million of the funds to Majestic Capital after Karl Johnson, who runs the firm from his home, allegedly sought to deposit the money. Johnson has denied any wrongdoing.

E-mail to wquinn@njbiz.com

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