Refco: When Smart Money Isn't So Smart

A special bankruptcy examiner faults TH Lee's bad due diligence for the downfall of the recently public brokerage. And he's got the e-mail trail

by Matthew Goldstein
July 13, 2007

The titans of the private equity world fancy themselves smarter, shrewder, and more sophisticated than any one else on Wall Street. Investors have bought into the sentiment as they've scooped up the shares of the private equity firms that have gone public recently: Blackstone Group and Fortress Investment Group. But a recent report on the spectacular collapse of Refco—the once-dominant commodities broker that was laid waste by a massive accounting fraud—paints an unflattering portrait of the private equity firm that engineered Refco's August, 2004, leveraged buyout and its initial public offering a year later (see, 7/11/07, "Kill the Private-Equity Tax Break").

The 416-page report from Joshua Hochberg, a special examiner appointed by a U.S. bankruptcy judge to investigate the Refco collapse, finds fault with some of the due diligence done by Thomas H. Lee Partners in the months leading up to its $1.9 billion LBO of Refco. In particular, the examiner takes issue with TH Lee's handling of a tip from a "deep throat" source that "all was not well with Refco." Four months before the buyout was completed, the informant tried to warn the Boston-based private equity firm that Refco was "sloughing off" trading losses and hiding them in a foreign subsidiary.

But the ominous warning was dismissed by TH Lee's top brass, following a June 1, 2004, meeting with Phillip Bennett, Refco's then-chief executive. Hochberg says TH Lee executives left the heart-to-heart meeting, feeling satisfied that all was O.K. with the brokerage. The examiner notes that Scott Schoen, TH Lee's co-president, sent an e-mail to his colleagues, saying the meeting "went very well" and that "Phil was very constructive."

Fraud Should Have Been Detected

Little more than a year later, the same Bennett was being charged by federal prosecutors with orchestrating a multi-year scheme to use a series of circular loans to hide up to $750 million in noncollectible customer-trading losses. The alleged scheme came to light in October, 2005, just two months after Refco went public in an IPO underwritten by Bank of America, Credit Suisse, and Goldman Sachs.

Within a matter of days, Refco's stock crashed, the 36-year-old brokerage firm filed for bankruptcy, and Bennett was charged with multiple counts of securities fraud. The examiner concludes if TH Lee Partners had done a more exhaustive investigation into the May, 2004, tip, it "Should have detected the fraud."

Worse, it appears Schoen and his cronies went into that meeting with their minds made up that the tip had no merit. In another internal e-mail unearthed by the examiner, Schoen refers to the "script" for setting up the meeting with Bennett. Schoen writes, "We want to sign the deal and go forward. This allegation has been brought to us by someone we have known on Wall Street for a long time and we trust, but it is brought second hand. We don't believe it, but we owe it to ourselves, our fiduciary role with our LP's, and to Phil as our prospective partner to discuss it openly and directly and try to address it together."

How Much Did Deep Throat Know?

Schoen penned the late-night e-mail two days before the meeting with Bennett. The main recipient of the e-mail was the firm's founder and namesake, Thomas H. Lee. Schoen and several other TH Lee executives would later join Refco's board of directors after the LBO got approved. Several months after the Refco debacle, Lee left the firm he started and went out to launch a new venture.

To be fair, there's no indication in the examiner's report that the "deep throat" source, who admittedly hadn't worked at Refco for several years and refused to meet in person with TH Lee executives, knew anything about the alleged use of circular loans. It's not even clear whether the trading losses the tipster was referring to were some of the same losses Bennett allegedly was trying to hide. The examiner also does not recommend the filing of any civil damage claims against TH Lee—although he points out he wasn't empowered to investigate the private equity firm.

The examiner's main marching orders from the bankruptcy court were to investigate the role played by Refco's professional advisers—the lawyers and accountants—in either contributing to, or failing to detect, the fraud. On that score, Hochberg did reach some important conclusions, saying claims for damages could be brought against the law firm Mayer Brown Rowe & Maw and the auditing firms Grant Thornton and Ernst & Young.

Still, the examiner takes issue with TH Lee (referred to as THL) for not going the extra mile and doing the additional due diligence steps recommended to it by KPMG—the audit firm it had hired to review the transaction. Says Hochberg, "THL moved ahead with the LBO and did not conduct the additional diligence. THL also did not implement these procedures during the subsequent IPO due diligence, by which time four THL directors were serving on the Refco board and THL was the controlling shareholder."

Shareholders Take Aim

Ever since the Refco collapse, TH Lee has portrayed itself as a victim of the fraud allegedly masterminded by Bennett. The firm repeatedly has pointed out that it spent $10 million on pre-deal due diligence and lost $245 million when Refco went belly up. In the wake of the examiner's report, TH Lee continues to insist it was victimized by Refco's top managers, just like the individual investors who bought the brokerage's stock after the IPO. "The bankruptcy examiner's report further underscores the well-established fact that THL and others were the victims of a carefully concealed fraud," says a TH Lee spokesman.

But the image of TH Lee as a victim doesn't sit well with some, especially after the latest revelations in the examiner's report. In particular, the lawyer representing Refco's beleaguered shareholders in a pending class action says the new information will strengthen a claim for damages against TH Lee. John "Sean" Coffey, a partner with Bernstein Litowitz Berger & Grossmann, which is suing Refco's underwriters and TH Lee, says, the report is "devastating" for the private equity firm. He says the examiner's finding reveals that TH Lee gave the "appearance of doing due diligence" but didn't properly investigate Refco before the buyout and the IPO.

It's far too soon to say how the shareholder suit against TH Lee will turn out. But the examiner's report will no doubt raise questions about the kind of due diligence done by private equity firms. And with the corporate buyouts continuing at a record pace, that's something investors may want to keep in mind when private equity firms seek to unload companies they acquire in future IPOs.

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