Of all the major operational risk incidents that were seen in 2012, one of the most concerning was that involving Peregrine Financial Group, a financial firm that operated for over 20 years in relative obscurity in Cedar Falls, Iowa. Its founder, Russell Wassendorf Senior, following a suicide attempt and business failure a few months earlier, pleaded guilty and has now been sentenced to 50 years in prison, for four counts of: embezzling clients out of more than $100 million, commission of mail fraud, and two counts of lying to federal regulators. This disturbing episode highlighted once again -- following the Madoff and MF Global episodes -- two underlying risks: the need to protect client assets and that of fraudulent investment schemes paying investors returns from their own money or subsequent investors’ money.
For the investors, the sorry episode read like Madoff redux. Wasendorf's company, the Peregrine Group, known to most of its clients as PFGBest, developed a reputation in its formative years for pioneering new electronic trading platforms and reliable customer service. One can still find on its website a steady accumulation of top futures broker awards, even through 2012, and a long list of customer testimonials.
Wassendorf, like Madoff, became an industry acolyte and was sought out to take on industry guardianship roles. He served most significantly, on the National Futures Association’s, the self-regulated watchdog of the Futures Industry, Advisory Committee. He invested in the sort of outward signs of success and swagger that likely filled those around him, including clients, with confidence: a spectacular head-quarters, private jets and so on. Wassendorf maintained sole ownership of the company throughout its history and retained close control over back-office oversight functions.
According to his own admissions, he allowed no one else at the firm to communicate with regulators, auditors and banks. He was thus able to ensure that only he knew about the various steps in his fictitious scheme, for example, maintenance of a fictitious banks address to which all bank document requests were sent and intercepted (by him), as well as falsification of bank statements and confirmations. As with Madoff, the auditor was a one-person shop based at the accountant’s home. We have read this story before. Like Madoff, Wassendorf’s firm employed a small army of sales people who worked to introduce new accounts and new money to the firm. Also like Madoff, the lies finally caught up with him but only after a very long run.
One can easily understand why investors were misled. Most of the investors appear to have been retail, small-order clients, attracted to the PFGBest platform by the offer of low-cost, high-speed execution and the opportunity to speculate to obtain high returns. PFG’s salesmen, many of whom had had disciplinary issues with the regulators, were no doubt persuasive. Unfortunately for these customers, customer segregated accounts earmarked for futures trading are not insured, in contrast to normal brokerage accounts. Of course, investors would have been told that any cash in a customer segregated account is safe from harm, as implied by the term, client segregated. Investors may even have been led to believe that their money in such accounts was actually safer than at banks since funds there can be co-mingled with their own assets. However, such safety was at best an illusion.
Yet there were red flags that were missed: the legion of client complaints (one can still find clients complaints dating back to 2009 on Futures trading industry websites, alleging, for example, an inability to access or find funds deposited only days earlier); the no-name audit firm; the employment of multiple introducing brokers with extensive regulatory disciplinary records; and a final judgment in a client’s lawsuit against Peregrine in October 2009, which agreed that un-authorized trades had led to losses of $500,000 in one client’s account. Finally, the National Futures Association in February 2012 charged Peregrine with failure to supervise and prevent fraudulent tactics by their third party solicitors. This followed a settlement between the CFTC and Peregrine back in 2000 for violations in 1998 and 1999 relating to bookkeeping and under-capitalization of accounts. At that time Peregrine paid a fine of $90, 000 and was required to make some temporary book keeping changes.
In February 2012, again, despite the serious nature of the allegations and the pattern of bad, even ruinous behavior exhibited, the NFA accepted Peregrine’s offer to immediately settle the complaint for $70,000, without any admission of denial of the complaints. Peregrine also agreed to hire a full-time Anti-Money Laundering Officer. This had not been done by the time of the firm’s collapse.
Andrew Waxman writes on operational risk in capital markets and financial services. Andrew is a consultant in IBM's US financial risk services and compliance group. The views expressed her are those of his own. As an operational risk manager, Andrew has worked at some of the ... View Full Bio