Inside Bawag's Refco Role

The Austrian bank once secretly controlled 47% of the brokerage.
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The Austrian bank Bawag was a partner in crime with former

Refco

(RFXCQ)

CEO Phillip Bennett in the nearly $1 billion accounting fraud that led to the collapse of the New York-based commodities brokerage, prosecutors said Monday.

Over the past six months, the obscure Austrian bank has emerged as a key player in the Refco scandal. In fact, prosecutors contend in a settlement reached Monday that Bawag once controlled 47% of the brokerage through a secret deal with Bennett.

By agreeing to pay a minimum of $675 million in a complicated settlement hammered out by federal prosecutors, Bawag won't face any criminal charges over its role in Bennett's alleged debt-hiding scheme. The total amount shelled out by Bawag eventually could exceed $700 million.

Refco's creditors in the brokerage's bankruptcy proceeding will get most of the money, collecting at least $506 million from the Austrian lender. Refco shareholders and the private equity firm Thomas H. Lee Partners, which lost $245 million when Refco went belly up last October, will split the rest. Refco shareholders are guaranteed a $108 million payout, according to a separate deal negotiated by lawyers with Bernstein Litowitz Berger & Grossman.

A 13-page nonprosecution agreement between Bawag and federal prosecutors in New York requires the Austrian bank to "accept and acknowledge'' responsibility for participating in Bennett's alleged five-year scheme to keep up to $1 billion in uncollectible debts off Refco's balance sheet. The deal also requires Bawag to cooperate with authorities and turn over documents that could prove useful to prosecutors in the ongoing criminal investigation.

Ultimately, the settlement is a small price to pay given the fact that Austria's fourth-largest lender secretly owned up to 47% of Refco and pocketed $952 million from the brokerage's 2004 leveraged buyout. Federal authorities say the secret deal provided Bawag with a strong incentive to aid Bennett in his scheme to burnish Refco's books and make the brokerage appear financially healthier than it really was.

The $1.9 billion leveraged buyout set the stage for Refco's successful $583 million IPO last August. But just two months later, the debt-hiding scheme would come to light, Bennett would be arrested and charged with securities fraud and Refco would file for bankruptcy.

"This office will vigorously pursue those who aid and abet their business associates in committing financial crimes and defrauding American investors, even those who act entirely from abroad,'' says U.S. attorney for the Southern District of New York Michael Garcia.

The nonprosecution agreement with Bawag, however, left the door open to the possibility that the U.S. government may still go after the bank for tax violations. People familiar with the matter say the bank may have violated federal tax law by concealing its full ownership stake in Refco.

Before the secret ownership agreement came to light, Bawag had claimed to own no more than 10% of Refco prior to the 2004 buyout.

TheStreet.com

, in articles last

November and

March, was the first to report that Bawag may have had a secret deal with Refco to boost its equity stake in the brokerage.

The

Securities and Exchange Commission

in a civil complaint filed in conjunction with the U.S. attorney's action, charged that Bawag aided Bennett's scheme by engaging in a series of year-end transactions that involved loans worth hundreds of millions of dollars. The SEC contends Bawag executives knew the purpose of the year-end transactions was to conceal Refco's bad debts.

"Bawag's conduct was especially egregious because the bank's former executives understood that the deceptive year-end transactions would help Phillip Bennett and Bawag cash out their ownership interests at the expense of innocent investors,'' says Scott Friestad, an associate director in the SEC's enforcement division.

The year-end transaction involved a series of short-term loans, beginning in 2000 and ending in 2005. The loan amounts ranged from $250 million to $300 million.

Prosecutors, meanwhile, allege that Refco helped Bawag engage in some of its own balance sheet deception. Prosecutors claim Bennett arranged for Bawag to shift up to $500 million in "worthless assets'' that the bank had incurred to accounts at Refco.

The worthless assets were part of the $1.2 billion in trading losses Bawag incurred from a series of bad investments from a hedge fund run by the son of a former bank CEO. Some of the losses were packaged into bonds sold by the Bawag through an entity called Liquid Opportunities-Plus Fund. A portion of the bond scheme was first reported by Bloomberg earlier this year.