October 17, 2005
Refco's IPO Due Diligence
One of the troubling aspects of Refco’s implosion is that Refco just went through the IPO process. Outside of an ex post government or internal probe, a company receives no greater scrutiny than from an IPO due diligence investigation. The investigation is performed in the months leading up to the IPO by the lead underwriters and their attorneys and involves a close examination of all aspects of the company and its business. The primary purpose of the investigation is to ensure the registration statement is accurate and complete in all material respects. This obviously was not the end result with Refco. And its unlikely that the due diligence team failed to ask the right questions. SEC regulations require that all transactions between the company and an executive officer in excess of $60,000 be disclosed in the prospectus (See Regulation S-K, Item 404). Hence, a standard part of the due diligence process is to repeatedly ask about related party transactions so that the required disclosure can be made. Clearly, the $430 million loan to the CEO should have been disclosed. Refco illustrates the difficulty of detecting fraud when it is perpetrated by senior management (here, the CEO). Notwithstanding that Sarbanes-Oxley has outlawed loans to executives, mandated increased internal controls, and ramped up auditing requirements through creation of the Public Company Accounting Oversight Board, nobody involved in Refco’s IPO due diligence detected the fraud.
Additionally, this situation further underscores the absurdity of the AICPA's efforts to greatly limit the role of auditors in the due diligence process, as I discussed in an earlier post. At the end of the day, as was the case here, for many types of financial fraud the auditor is in the best position to catch it. Hence, auditors should remain an integral part of the due diligence process.
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And the auditors weren't looking for it. They must look for and disclose related party transactions. They must give the Underwriters a comfort letter. A thief covering his tracks won't be caught by auditors. Let's just face it. The securities laws are blunt instruments at best and it is likely that they are not cost effective.
Posted by: Robert Schwartz | Oct 17, 2005 7:41:17 PM