Experts: No 'silver bullet' to protect investors in wake of Peregrine

Predicting the future(s)

George Ford
Published: July 29 2012 | 5:04 am - Updated: 31 March 2014 | 10:21 pm in
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Despite efforts to beef up fraud detection in the wake of the $215 million embezzlement at Peregrine Financial Group in Cedar Falls, legal experts say no silver bullet will ultimately protect investors.

The National Futures Association, a Chicago-based self-regulating industry organization, has begun electronic surveillance of customer segregated funds held by brokerages such as Peregrine to buy futures contracts for clients. The NFA was transitioning to the new system as brokerages were due for an audit.

Russell Wasendorf Sr., founder and chairman of the defunct Peregrine with offices in Cedar Falls and Chicago, allegedly created phony paper bank statements to avoid detection. Wasendorf reportedly had resisted electronic account confirmation since the NFA began the move from paper documentation to the web-based system in January.

"We have to get all the FCMs (futures commission merchants, or futures brokerages) to enroll in this program with Confirmation.com,  a third-party vendor," said Larry Dyekman, a spokesman for the National Futures Association. "The banks that hold their money on deposit also need to enroll in Confirmation.com.

"There is no rule at this point that says that the FCMs have to enroll. We're hopefully going to get a rule approved in August by the Commodity Futures Trading Commission that will allow us to check customer segregated accounts electronically 24/7 without getting permission from the FCMs."

While futures brokerages can delay enrolling, any bank that fails to provide electronic online access will not be considered an acceptable depository institution to hold customer segregated accounts.

Customer segregated accounts earmarked for futures trading are not insured by the Securities Investor Protection Corp. (SIPC)  or any other regulator because it's illegal for a brokerage to use those funds for any other purpose. That has led investors to believe that they are safer than traditional bank accounts.

Customer funds in a bank are guaranteed by the Federal Deposit Insurance Corp. up to $250,000 per account.

While in theory customer segregated accounts cannot be touched, the $215 million in missing funds at Peregrine Financial Group and more than $1 billion of clients' money that vanished at MF Global have illustrated the fallacy of that logic.

"Direct electronic access is not going to be an absolute cure-all," said Robert Miller, who will join the University of Iowa College of Law on Aug. 1. "This is a classic example of cops and robbers down through the ages. Every time the cops make an advance, the robbers come up with a counter strategy.

"It gets harder and harder for the robbers, but it never becomes impossible."

Miller, an associate professor on the faculty of the Villanova Law School since 2005, said a massive "police state" regulatory system might be able to detect more serious financial fraud, but the cost and time involved would be substantial.

"The Securities and Exchange Commission has 200 attorneys in Washington and 12,000 publicly traded companies to monitor — not counting investment advisers and mutual funds," Miller said. "If you feel the SEC should take a hard look at everybody, the first thing you would have to do is increase the SEC staff by a factor of 100 (to 20,000).

"The people at the SEC work very hard, they're not perfect, and they don't make near as much as most of the people in the private sector. Yes, some people tried to tip them off about Bernie Madoff (who took $20 billion from investors), but you have to understand that they get hundreds of tips every day, and most of them are complete nonsense."

Miller, a former mergers-and-acquisitions lawyer on Wall Street, said industry regulators such as the National Futures Association typically catch brokers selling inappropriate investments to clients.

"That's really what they should be looking for most of time," he said. "When you come into a futures shop, that's much more likely to be the problem that exists than a (Russell) Wasendorf creating fake documents."

Meir Statman, Glenn Kilmek Professor of Finance at Santa Clara University in Santa Clara, Calif., said investors looking to make "quick money" are attracted to the futures market, which trades in everything from corn and soybeans to frozen concentrated orange juice and crude oil.

"I have my students try investing in futures as part of a game in class where they don't waste their money, but they come to the conclusion that it's not as magical as it seems," said Statman, whose research focuses on investor behavior. "They get the point I'm trying to emphasize, which is in every trade there is an idiot.

"When a futures contract between traders goes up in price, it benefits one of them, but it harms the other. Knowing that it's a zero-sum game, meaning one person in the trade makes a dollar and the other person loses a dollar, we ask as scholars, 'Why do people continue to play it?'

"If you're a farmer and you need to hedge your wheat crop, that's one thing. I think engineers, lawyers and small businessmen do it because they either don't understand the nature of the game — there's an idiot in every trade and it might well be them — or  they understand that, but they always think the other guy is going to be the idiot."

Miller said investors need to diversify their holdings and avoid making investment decisions based on the reputation of a broker or CEO of a company. He points out that Wasendorf was considered a "pillar" of the Cedar Falls-Waterloo community and Madoff was a former president of the National Association of Securities Dealers.

"You hear about the Madoffs and the Wasendorfs, but you don't hear about the millions of people in the financial industry who work very hard every day and don't commit fraud," Miller said. "Unfortunately it gives people a very skewed perception.
 

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