Jon Corzine, the former chairman of bankrupt MF Global Holdings Ltd., may face claims for breach of fiduciary duty and negligence for his role in the company’s downfall, according to a report by the trustee liquidating the firm’s brokerage.
“Liquidity had been a cause for concern before and throughout Mr. Corzine’s tenure at MF Global, yet systems and tools that would enable accurate real time monitoring of liquidity were never implemented,” James Giddens, the trustee for MF Global Inc., said in a 275-page report issued today on how the brokerage failed, leaving a $1.6 billion shortfall in what should have been protected customer accounts.
Giddens found that though a “liquidity asphyxiation” led directly to MF Global’s demise in the week leading up to Oct. 31, Corzine’s efforts to make the company more profitable resulted in liquidity problems much earlier. Corzine also instructed MF Global’s former assistant treasurer, Edith O’Brien, to make a $175 million transfer on Oct. 28 to pay down an overdraft balance with JPMorgan Chase & Co. (JPM) in London, even though there was a lack of information that day about the firm’s liquidity, Giddens said.
That transaction was one of many that left customers short when MF Global Holdings filed the eighth-largest U.S. bankruptcy. Before the filing, a $6.3 billion trade on its own behalf on bonds of some of Europe’s most indebted nations led to credit downgrades and margin calls.
The trustee’s report, which relies on interviews with more than 100 people and a forensic investigation by Ernst & Young LLP accountants, describes how company employees used alternative accounting methods for foreign customer accounts and loose wording in regulations to borrow more than prudent from customer funds -- resulting in a $1.6 billion shortfall to what customers of the former futures merchant are owed.
Giddens didn’t make specific recommendations on potential criminal liability, saying those are beyond the scope of the report. Corzine, the former co-chairman of Goldman Sachs Group Inc., told lawmakers in December that he “never gave any instruction to misuse customer funds.”
John Moscow, a former prosecutor in the office of Robert Morgenthau, now with Baker Hostetler LLP in New York, sees criminal implications in the actions of executives who, according to Giddens, tapped segregated customer accounts when they needed extra liquidity for proprietary trading, returning the money before the end of the day.
“The crime of wrongful taking has been completed, if there is an obligation to hold onto money for a customer, and the money is withdrawn to be used to cover other positions, and is then returned,” Moscow said.
While CFTC rules require regulatory compliance at all times, “some MFGI employees did not consider the transfers to have any regulatory implications,” as long as the funds were returned before the end of each day, Giddens said in his report.
Also facing claims are O’Brien and Henri Steenkamp, the firm’s chief financial officer. O’Brien invoked her constitutional right against self-incrimination at a congressional hearing in March, disappointing lawmakers seeking answers to questions about frantic money transfers during the company’s final days in October.
Giddens said he will pursue claims through litigation and negotiation, starting to sue within 60 days.
“I have determined there may be valid claims against individuals and entities,” Giddens said in the report. “In my capacity as trustee, I will make every effort to ensure that such claims result in the greatest possible returns to customers.”
Giddens also said he’s in discussions with JPMorgan Chase, MF Global’s largest lender and the repository of its customer accounts, regarding money transfers that may be “voidable or otherwise recoverable.” In the days leading up to MF Global’s collapse, the bank increased margin requirements, reduced intraday and overnight loans to the company and took other steps to limit its exposure to the company’s troubles.
Giddens said JPMorgan has returned about $89.2 million in customer property and $518.4 million in non-segregated unallocated MF Global Inc. assets. He may sue the New York-based bank if he can’t reach an agreement on further returns of money, he said.
Giddens found that any lawsuits against JPMorgan and other counterparties to transfers made in the bank’s final weeks may be complicated by the “safe harbor” provision of the bankruptcy code, which protects parties who claim they had no knowledge of fraud. JPMorgan may argue that it simply acted as a custodial bank for some intercompany transfers, Giddens said. Other companies that received MF Global customer funds in its final days may also qualify for safe harbor protections, his report found.
The same “safe harbor” rules likely apply to customers, the trustee said. That means that customers who took money out of their accounts before the collapse probably can’t be sued to recover money for distribution to all creditors, the trustee said.
Criminal cases would be hard to bring nonetheless, because prosecutors would have to prove MF Global managers “willfully” broke CFTC and SEC rules, said Peter Henning, a former Securities and Exchange Commission lawyer who teaches at Wayne State University in Detroit.
“I can see a civil enforcement act, but I think criminal is a stretch on this type of technical violation,” he said in an e-mail. “It does show that (like Icarus) MF Global intentionally flew close to the sun, willing to push the rules. And it also shows how odd the commodities rules are, because you can’t ‘‘temporarily borrow’’ funds like that in a securities firm.”
Mary Sedarat, a JPMorgan spokeswoman, and Reid Weingarten, a lawyer for O’Brien, declined to comment on Giddens’s report.
“The trustee’s report is consistent with Mr. Corzine’s congressional testimony that he did not direct or intend to direct the misuse of customer funds,” Steven Goldberg, a Corzine spokesman, said in an e-mail. “We simply do not agree with the trustee’s suggestion that Mr. Corzine was negligent or there is any other basis to sue him.”
Giddens found that “contrary to some public reports, the shortfall of customer property at MFGI was not caused by direct investment of customer funds in sovereign debt or even by losses on proprietary investments such as the sovereign debt,” but rather “the actions of management and other employees, along with lack of sufficient monitoring and systems,” which led to customer property being used to fund margin calls on the European sovereign debt investments.
The U.S. Commodity Futures Trading Commission, the company’s regulator, requires customer funds to be segregated. It also allows futures merchants to withdraw customer funds for their own use, within certain limits. They also can put the company’s own funds into customer accounts to keep them from being “under-segregated.”
Giddens found that MF Global employees looked at how they could use customer funds amid increasing liquidity troubles during the spring and summer, drawing on two sources of perceived “excess.”
There was a perceived $1 billion in what the company called “regulatory excess” -- an amount based on a so-called alternative accounting method the CFTC allowed for foreign customer accounts. The method, which differed from the accounting method for domestic accounts, allows less than the total amount of customer funds to be secured in segregated accounts, Giddens said in his report.
There was also a perceived excess at domestic accounts, which the company called “Firm Invested in Excess.” It was the amount which MF Global put into customer accounts that helped to keep the funds from becoming “under-segregated” by providing a cushion to prevent a shortfall in customer funds if there was a change in margin requirements from daily market movements.
As the company’s liquidity needs intensified, senior management looked to those excess amounts to fund its own trading, Giddens found. For example, on July 12, 2011, senior management proposed that the cash-starved proprietary securities business borrow $250 million on a regular overnight basis from the “Regulatory Excess.” After consulting with outside lawyers, the proposal was rejected on the grounds it would create a risk to customer funds.
Some of the “Regulatory Excess” was used for intraday funding of the firm’s proprietary activities, though, through what the company called an intraday “loan” from the Treasury Department in Chicago. As long as the funds were returned by the end of the trading day, “some MFGI employees” didn’t consider this a regulatory violation, Giddens wrote.
Some employees interpreted the wording of CFTC rules, which required that segregation calculations be done “as of the close of each business day,” to mean that customer funds could be used intraday, Giddens said. He didn’t identify the employees.
At the same time, MF Global changed how it funded customer withdrawals. In the spring and summer of 2011, it started drawing on foreign customer accounts, instead of money generated by its proprietary trading business. This wasn’t a problem before October, when typical withdrawals were less than $60 million a week -- an amount covered by the “Firm Invested in Excess.”
When credit downgrades and concerns about MF Global’s large sovereign debt portfolio sparked a run on the bank in late October, the rush of customer withdrawals and increases in collateral and margin requirements led to “liquidity asphyxiation,” Giddens wrote.
For example, on Oct. 26, Bank of New York Mellon Corp. (BK), which provided clearing services to MF Global, “drastically increased” its collateral requirement for overnight financing of an $85 million loan by the brokerage unit.
The bank also debited MF Global $500 million on Oct. 26 and $1 billion on Oct. 27, causing its transactions through the bank’s clearing system to be delayed as they required BNY Mellon’s approval. Giddens found there was no transaction or event tied to the debits and they were “arbitrary and were entered to artificially create a negative balance with the bank and delay transactions.”
Kevin Heine, a spokesman for Bank of New York Mellon, declined to comment.
In MF Global’s final days, several large transfers led to the shortfall in customer funds, Giddens said. On Oct. 26, $615 million was moved from customer accounts to fund proprietary trading. The money wasn’t returned by the end of the business day, throwing the company out of regulatory compliance, he said.
A $175 million transfer to clear an overdraft balance at JPMorgan Chase in London on Oct. 28 made matters worse, Giddens found.
In his conclusion, Giddens proposes measures that could prevent future disasters like MF Global, such as abolishing the alternative calculation method for foreign accounts and requiring that more than 100 percent of the value of customer funds be segregated as a “cushion” for customer funds.
He also suggests a rule by Congress that would make directors and officers of a company personally and civilly liable for any shortfall in customer funds without allowing them to defend themselves on the basis that they delegated essential duties.
The MF Global trustee indicated he may be hampered in his lawsuit by current limitations on his powers to recover customer money. He wants Congress to clarify a trustee’s rights to take the necessary actions in the future, he said.
“I am pleased the Trustee has shed light on the chaos between October 26 and Halloween,” said U.S. Senator Pat Roberts, a Republican from Kansas, in a statement today. He said that after all investigations into the brokerage’s failure are complete, he will work with regulators and customers to strengthen safeguards around customer accounts.
The brokerage customer shortfall consists of $900 million that should be in U.S. customers’ commodity and brokerage accounts, and about $700 million owed to customers who traded on foreign exchanges, which Giddens is seeking through U.K. proceedings.
Restoring all of customers’ money will depend on success in those proceedings, as well as through lawsuits and negotiations with other parties, Giddens said. He also needs to transfer non- segregated funds to customer accounts to erase the shortfall completely, he said.
The company’s general unsecured creditors have a “low” chance of getting substantial returns, he said.
Giddens is also talking with MF Global’s insurers about coverage for the lawsuits he may file against former managers, he said.
Giddens has been liquidating the former brokerage under the Securities Investor Protection Act to repay customers. At the same time, parent company MF Global Holdings (MFGLQ) is unwinding in bankruptcy to repay creditors. The parent’s trustee, Louis Freeh, is expected to issue his own report today on a separate probe into how the company failed.
In prior progress reports, the two trustees have disputed whether certain assets belong to customers or creditors. Distributions set in motion by Giddens so far are predicted to return about 80 percent of what U.S. customers are owed.
Firms buying MF Global customer claims in the debt market, based on what they think the customers will eventually be repaid, have been buying claims for as much as 95 cents on the dollar for U.S. accounts, while customers trading on foreign exchanges have been getting around 70 cents for selling their claims, according to a group, Commmodity Customer Coalition.
Giddens’s firm is charging $20.1 million for its work liquidating the defunct brokerage in the period from Oct. 31 to Feb. 29, with $17.1 million to be paid first and another $3 million subject to a second court order, according to a filing in U.S. Bankruptcy Court in Manhattan today.
MF Global Holdings’ Chapter 11 bankruptcy filing listed assets of $41 billion and debt of $39.7 billion.
The brokerage case is Securities Investor Protection Corp. v. MF Global Inc., 11-02790, U.S. District Court, Southern District of New York (Manhattan). The parent’s bankruptcy case is MF Global Holdings Ltd., 11-bk-15059, U.S. Bankruptcy Court, Southern District of New York (Manhattan).