Refco’s significant warning was buried

145 PAGES OF RISKS

NEW YORK

• Refco investors can’t complain they weren’t warned, but they might claim any skepticism was swamped by a flood of information.

Commodities and futures brokerage Refco Inc. submitted hundreds of pages of regulatory filings before its August initial public offering, warning of dozens of problems it could face — from insurgent attacks disrupting foreign operations to computer hackers sabotaging its network. But the blur of boiler- plate warnings effectively distracted investors from the one thing they need worry about. On page 23 of its 145-page registration statement, the auditors warned they had found “significant deficiencies” in its accounting controls.

Just how significant those deficiencies were became clear after the company disclosed it was carrying US$430-million in bad debts from an entity controlled by Phillip Bennett, its then-chief executive officer. Mr. Bennett was charged with securities fraud and Refco collapsed into bankruptcy.

In the process, most shareholders’ equity has been wiped out. Refco shares were trading at US$1 on the Pink Sheets on Friday, well off the US$22 IPO price.

The Refco debacle throws a spotlight on how — in an effort to meet regulatory obligations and avoid lawsuits — U.S. companies have turned a critical part of their disclosures into an all-butuseless distraction, experts said.

“Risk factors are looked upon as boilerplate, ‘Have we covered all our bases just in case the worst case does happen?’ ” said Tom Taulli, an IPO analyst and founder of DealflowSearch.com, of Newport Beach, Calif. “If you read the risk factors and really relied on them, you would never do an investment. The irony of it is that risk factors are almost meant not to be read, or not to be relied on.”

Refco also warned in its filings it was not yet in compliance with the strict standards for financial controls set by the U.S. SarbanesOxley law, which was introduced in 2002 after a series of corporate scandals, including the collapse of Enron and WorldCom.

The lists of risk factors in IPO filings tend to lean heavily on the same ideas, such as the potential for a company to lose key customers or management. When it went public in August, 2004, Google Inc. also spelled out dozens of risks to investors, including that its top three executives “tend to operate the company collectively which could prevent key strategic decisions from being made in a timely manner.”

Yet in the case of such warnings, the risks are apparently theoretical. Google shares reached record highs on Friday and anyone who bought in its IPO has recorded big gains.

Experts said companies’ legal advisors tend to recommend long lists of risk factors to limit the chances management, underwriters or auditors will be sued by angry investors if a stock performs badly. If they are sued, the argument goes, at least they have the risk disclosure as a defence.

“They try to make it sound like there’s limits to what they can do and, really clever crooks, they can’t discover that,” said Paul Banos, an auditing expert and dean of the Dartmouth University’s Tuck School of Business, of Hanover, N.H. “But that’s not what juries say.”

Several law firms brought Refcorelated suits, which are seeking class-action status. In addition to naming the company and its management, the suits target Refco’s lead underwriters — Credit Suisse First Boston, part of Credit Suisse Group , Goldman Sachs Group Inc. and Banc of America Securities LLC, part of Bank of America Corp. — and auditor Grant Thornton LLP. CSFB, Goldman and Grant Thornton declined comment on the suits, while a Banc of America spokesman said the company would ”vigorously contest” any legal action.

The problem, experts said, is that after investors have seen similar risk factors from company after company, they tend not to take them seriously. That is what allowed many investors to read past the warning that Refco’s financial practices produced “more than a remote likelihood that a misstatement of the financial statements that is more than inconsequential will not be prevented.”

“Nobody who read that probably thought in a million years this is what that meant,” said Gregg Berman, a corporate finance partner at New York law firm Fulbright & Jaworski, referring to Refco’s subsequent meltdown.

But the lesson is, no matter how dull a task, investors must be disciplined about trying to make sense of the risk factors.