Lee could face suits over role in scandal-plagued Refco's IPO

By Steven Syre
Globe Columnist
October 18, 2005

The accounting scandal at futures brokerage Refco Inc. has clobbered lots of investors, none more so than the Thomas H. Lee Co. and its private-equity clients. Here's the simple math for the Lee funds that own 38 percent of the company: Their 48.9 million Refco shares were worth $28.56 each on Oct. 7, just before news of the company's fiasco developed. Those shares last traded five days ago at $7.90. That works out to a decline of just about $1 billion.

But Lee has another Refco stock problem, one with implications that aren't so easy to pencil out. What about the $170 million of Refco stock that Lee funds sold into the market as part of the company's larger initial public offering over the summer? Refco's financial statements, included in documents supporting that IPO, are now disowned by the company itself.

That potential liability won't turn out to be anything like $170 million and does not come close to qualifying as Lee's biggest Refco headache. But it's still a big-ticket issue and poses legal questions that are extremely rare in the world of private equity.

Refco was considered one of Lee's great investing triumphs as recently as two weeks ago. The firm's funds had invested $507 million in Refco to buy a controlling interest in the business just a year ago. The shares Lee sold in the IPO, added to the increased value of the stock it continued to hold, amounted to a fast 200 percent return.

Fortunes changed quickly when Refco discovered a $430 million debt to the company was owed by an entity connected to its chief executive, Phillip Bennett, a fact that appeared to have been obscured by briefly shifting the obligation to a hedge fund client on several timely occasions.

Bennett was suspended and soon charged with securities fraud. He paid back the entire debt a week ago, but Refco warned investors they could not rely on company financial statements dating back three years. Refco shares went into a free fall as the accounting scandal unfolded.

The Refco story has been a gift to securities class-action lawyers, who are sure to press fraud and other claims against Refco and any available deep pocket. Among the likely lawsuits: claims for rescission from owners of Refco shares.

Rescission in the Refco case would require sellers of IPO shares take back the stock at a price identical to that of the initial offering, $22 per share, or nearly three times its most recent trading price.

Investors who bought their shares at the IPO or very soon after the offering -- and continue to hold them -- would have a very strong case for rescission, assuming the company financial statements backing the stock sale turn out to be fraudulent, according to attorneys who specialize in securities law and have no connection to the Refco case.

Those investors would not have to prove that Lee representatives, including four who sat on the Refco board, were aware of the fraudulent financial statements to demand that Lee funds take back the shares they sold into the IPO, the lawyers said.

Here's the catch: How many shareholders really qualify under those standards? The group of investors who bought IPO stock and still own it may be small enough to fit into a phone booth. Refco sold 26.5 million shares in its IPO. Nearly 80 million Refco shares changed hands last week alone.

Investors who have recently purchased Refco stock in the open market could sue the Lee funds as IPO sellers and seek damages. But the securities lawyers said those investors would be required to meet much higher legal standards, and their odds for success would be very remote.

Regardless of Lee's eventual exposure, no private-equity firm wants to be tied up in lawsuits challenging the honesty of an IPO in which it was directly involved. Public stock offerings are a key strategy that private-equity firms use to sell out of investments and return cash to their investors.

Despite the Refco meltdown, Lee funds have produced spectacular returns for investors. Lee funds have returned $6 billion in cash to investors over the past two years and the prime fund that put its money into Refco, Thomas H. Lee Equity Fund V, is generating annual returns over 30 percent, even if that one bad investment is written down to be considered worthless. That fund ranks among the top 10 percent of comparable private-equity portfolios.

The Refco punch hasn't decked Lee's performance. But the headlines this month and the claims in lawsuits to follow leave bruises just the same.

Labels: Phillip Bennett, Refco