Ten weeks ago, Refco Inc. (RFK) completed an initial public offering raising over $500 million for the firm. With operations in 14 countries worldwide, Refco is a financial services organization that specializes in derivatives (options and futures) and is among the leading active members in futures exchanges in Chicago, New York and in Europe, according to a Refco press release. What looked like a solid investment took a large downswing on Oct. 12. The NYSE finally halted trading on Refco stock after it lost over 60 percent in the week following the announcement, resulting in a net loss of over $1 billion to investors.

The Securities and Exchange Commision charged Refco’s CEO Phillip Bennet for fraudulently hiding the existence of hundreds of millions of dollars in transactions between Refco and a hedge firm controlled by Bennet. Bennet hid as much as $545 million of trading losses and uncollectable debts owed by customers, allowing them to show profits on their financial statements by avoiding large write-offs.

According to the Wall Street Journal, Refco’s auditor Grant Thornton issued a statement defending its auditing procedures and it wasn’t until late September that they had questions leading to this finding. Grant Thornton is not out of trouble, as investors are wondering why they didn’t find the fraud earlier with hundreds of millions at stake.

Additionally, the Wall Street Journal reported that the lead partner of Thornton’s audit of Refco also was Arthur Andersen’s lead partner for Refco before their collapse.

I do not believe that this fraud could have been prevented, but it could have been found much earlier before the IPO had a chance to hurt many outside investors. Goldman Sachs, Bank of America and Credit Suisse, the major underwriters of Refco’s IPO, all had the opportunity to look deeper into the debt on the balance sheet before submitting it to the SEC.

Section 404 of the Sarbanes-Oxley Act of 2002 is supposed to prevent such frauds from occurring by checking the internal controls of public companies. However, auditors don’t perform an internal control evaluation until the companies are required to file an annual report. Under the 1933 Act, auditors only have to attest to the accuracy of the financial statements, and not the internal controls.

Thus, I believe that had Grant Thornton checked for internal controls prior to the IPO, they would have found the relation between bad debts and Bennet’s hedge firm as a conflict of interest. Also, Thornton may not have acted illegally in any way, but that doesn’t mean they won’t have to pay heavy settlements. I don’t think they should have to pay anything, as the definition of fraud is the intentional misrepresentation of fact. Finding such frauds is not easy and could be downright impossible.

I believe change needs to take place. An amendment needs to be made to the Sarbanes-Oxley Act and the 1933 Act, requiring auditors to perform an internal control assessment before a company is allowed to go public.

The fraud itself may not have been avoidable, but the damage to investors was.

Stock Pick of the Week:

My pick of the week is eBay (EBAY). Although I feel the price/earnings ratio is high, I believe the upcoming holiday season will be very fortunate for eBay. Revenues, gross profit and net income have consistently increased each quarter for the last year, and they have loads of cash. Price: $38.40.

Jeffrey Lipsey is a senior in Business. His column appears on Thursdays. He can be reached at [email protected].