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Refco Tax Firm Quit Prior to 2004 Buyout

Ernst & Young's exit led to the hiring of a much smaller firm.

The Wall Street professionals who brought



to public markets last year have long claimed they were blindsided by the problems that led to the brokerage's bankruptcy. But evidence continues to surface that suggests a healthier skepticism on their part might have spared investors a lot of pain.

Take a decision in early 2004 by the accountancy Ernst & Young to quit as Refco's tax preparation firm.

has learned that E&Y stopped working for Refco around the same time Thomas H. Lee Partners was engineering a $1.9 billion buyout of the brokerage in August 2004.

People familiar with the situation say E&Y stopped working for Refco after a dispute, the cause of which couldn't be determined. Some sources say it was over fees.

Whatever the issue, E&Y's departure sent Refco officials scrambling to find new accountants to work on the company's 2004 tax returns. Forced to make a quick hire, Refco settled upon Levine Jacobs & Co., a little-known Livingston, N.J., firm of 20 employees.

There's no indication of any wrongdoing by Levine Jacobs. The small firm has nevertheless been drawn into the accounting scandal that led to Refco's collapse last October, two months after its $585 million initial public offering. Federal prosecutors investigating the accounting fraud, which was allegedly orchestrated by former Refco CEO Phillip Bennett, have obtained tax records and other documents from Levine Jacobs, according to court records.

Prosecutors charged Bennett, the brokerage's former CEO, with hiding up to $750 million in uncollectible customer-trading losses in a private entity he controlled, Refco Group Holdings Inc. Prosecutors contend that Bennett's debt-hiding scheme was intended to make Refco appear financially healthier than it really was in a bid to attract private investors such as Thomas H. Lee Partners and pave the way for a lucrative IPO.

A receptionist for Levine Jacobs says the firm has no comment on the Refco investigation. A spokesman for E&Y also declined to comment.

A spokesman for Thomas H. Lee Partners says the firm was aware of the switch in tax preparers, looked into the situation and found nothing unusual. The spokesman says the buyout firm's own accountant, KPMG, did its own independent tax analysis and didn't find any substantive disagreements with Refco's firm.

"The fund did exhaustive due diligence and stands behind it,'' says a Thomas H. Lee Partners spokesman. "The fund was the victim of a carefully concealed fraud.''

Indeed, legal experts say there could be a perfectly innocent explanation for the switch in tax preparers. They note that preparing a company's tax returns does not involve the same kind of detailed analysis that is done in an audit, which embraces the entirety of a company's financial condition. Levine Jacobs didn't do any audit work for Refco.

But in the wake of the Refco accounting scandal and Bennett's subsequent indictment in November on securities fraud charges, the substitution of a small firm like Levine Jacobs for a Big Four audit firm in any context raises eyebrows, some say. That's especially so after the brokerage's IPO prospectus noted that Grant Thornton, Refco's auditor, had found "two significant deficiencies" in the brokerage's "internal controls over financial reporting'' in February 2005.

"Obviously, in hindsight, and with all of these other things, it looks like a red flag,'' says Donald Langevoort, a securities law professor at Georgetown University. "It's one of those things you'd want to inquire into.''

Langevoort says, however, that a change in tax preparation firms alone probably is not enough to set off alarm bells for an investor.

Prosecutors, as part of the ongoing investigation, are reviewing "tax returns and related materials'' prepared by Levine Jacobs for Refco and Refco Group Holdings -- the Bennett-controlled entity, according to court filings.

previously reported that one matter on which prosecutors are focusing concerns "tax issues'' involving Refco Group Holdings and Bank fur Arbeit und Wirtschaft, the Austrian bank that had once had a significant ownership interest in Refco.

Earlier this week, Refco's creditors filed a lawsuit alleging that Bawag aided and abetted the fraud at Refco. In the process, the creditors allege Bawag had a secret deal with Bennett that enabled it to pocket $1.3 billion of the proceeds from the 2004 buyout, an amount far in excess of its stated 10% ownership interest in Refco.

People familiar with Refco, meanwhile, say the pre-buyout investigation by Thomas H. Lee Partners also failed to uncover the secret deal that allegedly allowed Bawag to walk away from Refco with $1.3 billion.'s

own reporting uncovered a portion of that deal before the creditors filed their lawsuit by reviewing corporate records.

If nothing else, the switch in tax preparers raises new questions about the quality of the due diligence done by Thomas H. Lee Partners in advance of the buyout. The Boston-based buyout firm claims it began looking into buying Refco in the fall of 2003 and spent more than $10 million on experts to look under the brokerage's hood.

In a lawsuit filed last November against Bennett and other former Refco executives, Thomas H. Lee Partners, which lost nearly $250 million on the deal, claims it was duped by Refco and was the victim of "wrongful, unlawful and duplicitous conduct.''

The switch also raises a new round of questions for the three Wall Street investment firms --

Bank of America

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Credit Suisse

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Goldman Sachs

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-- that managed Refco's $585 million initial public offering last August.

The Boston-based buyout firm and the three investment firms all have been named as defendants in a putative class-action lawsuit filed by Refco's beleaguered shareholders. The lawsuit filed by Bernstein Litowitz Berger & Grossman claims the underwriters "utterly failed in their responsibilities to the investing public'' by failing to properly vet Refco's financial situation.

The tax preparer switch, of course, wasn't the only warning sign at Refco. Other signs of potential trouble afoot included the auditor's warning about the weaknesses in the firm's financial controls and a looming regulatory action against the brokerage over its role in a manipulative shorting scheme.

"You've got to ask why

E&Y left,'' says John Coffey, a partner with Bernstein Litowitz, the firm heading up the class-action suit. "Taken together with other issues, it could be a red flag. We'd be interested in what, if any, inquiry was made about that switch.''

Officials for the three investment banks either declined to comment or could not be reached for comment.