MF Global failed on Oct. 31, 2011, producing the eighth-largest bankruptcy in U.S. history and the largest commodity brokerage collapse of all time. While this is not the first time a major brokerage firm has failed, what sets MF Global apart is the fact that $1.2 billion in customer funds were missing at the time of the failure, and still remain missing three months later. This shortfall affects approximately 38,000 futures brokerage accounts, a large percentage of which were held by individuals and entities in the agricultural sector.

The Commodity Exchange Act and Commodity Futures Trading Commission (CFTC) regulations require funds in customer futures and options brokerage accounts to be segregated from all other money, securities or other property owned or controlled by the brokerage firm. The funds from all customers can be commingled in a single account, but they must be separately accounted for, and must be treated as belonging to the customer.

These segregated funds may be invested in U.S. government securities, U.S. agency obligations, municipal securities, certificates of deposit issued by Federal Deposit Insurance Corporation-insured banks, commercial paper and corporate notes or bonds guaranteed by the federal government’s Temporary Liquidity Guarantee Program, or money market mutual funds. Effective Feb. 17, customer funds can no longer be invested in sovereign debt, due in large part to concerns about the creditworthiness of a number of foreign countries. In addition, there will be new limits on the percentages that can be invested in certain of these categories in an effort to encourage diversification.

The reason why customer funds are segregated is to put them out of reach and prevent them from being diverted to other uses by the brokerage firm. Similarly, the investment restrictions on segregated funds are designed to ensure that they are not exposed to loss from poor or risky investments. Many observers have described segregated funds as “sacrosanct,” never to be touched by the brokerage firm entrusted with those funds for anything except meeting margin calls or other financial obligations of the customers who own those funds. Any other use of segregated funds is a violation of both the Commodity Exchange Act and CFTC regulations. Exactly what happened at MF Global – whether the firm tapped the segregated funds account to meet its own financial needs, or the funds were improperly invested in financial instruments that suffered steep losses, or any of the other possible explanations being pursued by investigators – is still an open question. However, the fact that these funds are missing has caused severe financial distress for former MF Global customers.

The Federal Bankruptcy Code, the Commodity Exchange Act and CFTC regulations all recognize the important status of segregated funds, and grant special treatment to futures/options brokerage accounts held by public customers. When a bankruptcy occurs, all customer accounts of that brokerage firm are to be transferred in their entirety, including all assets specifically identified with a particular customer account. Any assets that remain after these customer accounts have been transferred – including assets in accounts owned or controlled by the brokerage firm, such as “proprietary” and “house” trading accounts – are then to be liquidated and divided among the remaining creditors, along with any other assets owned by the firm.