Refco’s swan dive into a financial breakdown this week demonstrates the severity with which markets handle accounting fraud these days. Just two months after its IPO, the company, one of America's largest futures and commodity brokers, announced that debt owed to it by its CEO hadn’t been properly booked on its balance sheet. The CEO paid back the loan with interest shortly after the announcement, but within days the company’s stock price plummeted so low that the company had to halt operations due to a liquidity shortage. Struck from sticker shock at the sight of the $430 million price tag for this “hidden” debt, investors gave as much consideration to hanging on to their shares of Refco as one does to old mayonnaise when cleaning out the fridge.

The knee-jerk reaction of the shareholders begs an important question: if the loan got paid back, then why did shareholders keep running away?

In today’s environment of hyper-regulation, and with the forensic accounting industry seemingly on steroids, whispers of accounting troubles affecting one or two line items too often lead to screams of horrible errors infesting multiple years of entire financial statements. The debt itself wasn’t the bad part in Refco's case. Sure, the investors that paid $22 per share at the IPO (18 times Refco’s earnings) would have paid less if they knew that the debt existed. That’s why there are standards of disclosure that accounting gurus have written to make sure financial statements are as transparent as possible. But the principle of the thing was what really mattered. Insider deals such as this one between the firm’s and the CEO’s piggy banks demonstrate a tendency to put management interests ahead of shareholders’. When news of this undisclosed debt came out, the one thing occupying investors’ minds was: what else is wrong?

And, speak of the devil – a quick peek back in time shows that Refco had already had its fair share of problems prior to last week’s scandal announcement. Jack Ciesielski summarizes a few of them in his accounting blog:

“[T]here certainly were ample warnings that not all was well in the house of Refco. Count ‘em: there was the SEC investigation of the CEO of the securities subsidiary; last October’s departure of the CFO, and a two-month search for a replacement; and a [suspiciously low] level of infrastructure spending for a firm that [was supposedly] expanding its derivatives trading business.”

The company had also already publicly announced that it was attempting to fix its internal controls (meaning the procedures by which the company polices its own accountants), which were deemed a significant deficiency. They also admitted they had a lack of formalized policies for closing their books.

Not so rosy a picture for the investors that poured $583 million into the company's coffers to get in on the IPO.

Still, it took the CEO’s bad debt announcement to start the wave of panicked. Perhaps the past events were too vague to be alarming. Perhaps last week evoked an all-too-strong parallel with other scandals of the decade (Enron, WorldCom, Adelphia) by revealing yet again the omission of bad stuff from a company's balance sheet. In any case, at the end the signal was as clear as a gameshow’s flashing applause sign. Except here the gameshow was Wall Street, and Refco’s sign was reading “Sell it, Stupid”.

We live in a hot time for accounting scandals, and everyone’s ears are pricked for more financial statement drama. Refco was just another squirt of fuel into the fire. It will be interesting to see how attitudes change and how investors’ reactions to these kinds of announcements will temper over time. After all, Enron took six weeks to file for bankruptcy after its announcement. Refco took 8 days. Mayonnaise can go bad only so fast.

Posted by Michelle Smith on October 18, 2005 09:37 PM