Strategic Posturing Behind the Suit Against Corzine

Louis J. Freeh, the bankruptcy trustee for the failed futures firm MF Global, filed a lawsuit aimed at pinning its collapse squarely on Jon S. Corzine, the former chief executive, and two of his top lieutenants. And unlike in many other suits, Mr. Freeh has not named other groups like a company’s directors.

The tale Mr. Freeh weaves in the complaint presents Mr. Corzine and the other defendants, Bradley I. Abelow, the former chief operating officer, and Henri J. Steenkamp, the former chief financial officer, as having failed to properly manage risk at MF Global while recklessly trading in European sovereign debt. It is a picture of a headlong rush into failure. Mr. Freeh asserts that the three defendants breached their fiduciary duties by allowing MF Global to take on excessive risks.

The core of the case is that the three men did not properly “develop the appropriate controls, procedures and systems needed to transform” MF Global into a full-service investment bank. Not only that, but Mr. Corzine took personal control of MF Global’s proprietary trading “without ensuring that the Company had sufficient controls and adequate liquidity to properly manage the risks inherent in such trading.”

Mr. Corzine’s representatives have vehemently denied the accusations, and question why Mr. Freeh is taking such actions while court-order mediation is still proceeding.

But regardless of the merits of the case, Mr. Freeh is clearly making a tactical move with his lawsuit. Among the questions that arise in any corporate failure is this important one: Where were the directors, who are ultimately responsible for oversight of the company? In Mr. Freeh’s version of events, it turns out they were quite active in approving the risk limits and other acts by Mr. Corzine. But they were not the primary wrongdoers in this tale, and are not named as defendants. This seems to be part of his legal strategy in this suit. He appears to feel he has a better chance at overcoming the legal hurdles to holding executives liable for business decisions than members of MF Global’s board.

Mr. Freeh’s complaint is noteworthy for adopting an all-in strategy against Mr. Corzine, Mr. Abelow and Mr. Steenkamp. Strategically, Mr. Freeh may be hoping the directors will turn on Mr. Corzine and blame him for being a pied piper who led them to approve policies that turned out to be disastrous for MF Global. In corporate litigation, it is always helpful to have someone inside the boardroom pointing the finger at a wrongdoer to help show that these were not just ordinary business decisions that turned out badly.

It may be that Mr. Freeh will settle a claim against the directors later. But by suing Mr. Corzine first, the directors should get the message that they are bit players at best in Mr. Freeh’s account.

In addition, it is much easier under the law to hold officers liable for misdeeds than it is in the case of directors. Under Delaware law, where MF Global was incorporated, corporate directors cannot be sued to recover monetary damages for anything except a breach of the duty of loyalty, which usually requires showing that they gained improper benefits from their actions. To establish that directors are liable for failing to oversee the company and its risk management practices, Mr. Freeh would have to prove that “the directors demonstrated a conscious disregard for their responsibilities” and acted in bad faith.

This is an extremely high standard to meet, and Delaware courts regularly dismiss such claims. In a shareholder derivative case involving claims that Citigroup’s board failed to properly oversee the bank’s risk management before the financial crisis, for example, a Delaware court refused to find the board liable despite the bank’s near collapse and subsequent government bailout. Indeed, the court stated that under Delaware law “[t]o impose oversight liability on directors for failure to monitor ‘excessive’ risk would involve courts in conducting hindsight evaluations of decisions at the heart of the business judgment of directors.” The case against the Citigroup directors was dismissed because the plaintiffs could not show that the directors had acted in bad faith, but instead may have merely failed in their risk monitoring.

Mr. Freeh is keenly aware that Delaware law presents an almost insurmountable barrier to any suit against the directors. The board certainly looks foolhardy in trusting Mr. Corzine to take the risks that he did, but proving that they acted in bad faith would be quite difficult.

In contrast, Delaware law does not afford corporate officers the same level of protection. That means Mr. Freeh can seek to recover for a breach of the duty of due care by showing gross negligence on the part of the leaders of MF Global.

That is still a high standard, requiring something akin to proving recklessness by Mr. Corzine. But unlike a suit against the directors, which would probably be dismissed quickly, this claim has a reasonable chance of surviving a motion to dismiss that would allow it to proceed toward a trial. A public airing of MF Global’s plunge into bankruptcy is probably the last thing Mr. Corzine wants, so the settlement value of the case is higher.

Mr. Corzine was very careful to state in his Congressional testimony that he acted in good faith and that his actions were based on advice provide by others for policies that were ultimately approved by the directors. He will offer the business judgment rule, a cornerstone of Delaware corporate law, to argue that these were merely bad business decisions, which cannot create liability. Even Mr. Freeh admits that the MF Global directors signed off on much of the conduct, giving Mr. Corzine some cover for his management of the firm.

While Mr. Freeh has an uphill battle to win the case, Mr. Corzine’s more immediate problem may be the high costs of a potential trial. Because MF Global is in bankruptcy, he cannot look to the company to indemnify him for any settlement or even pay his legal expenses, something normally provided to corporate officers sued for their actions.

Instead, Mr. Corzine must rely on MF Global’s insurance – and it had two pretty hefty policies. At the time of the bankruptcy, MF Global had a “directors and officers” liability policy for $225 million and an “errors and omissions” liability policy for $150 million. The judge in the bankruptcy case has already authorized Mr. Corzine and other employees to draw up to $30 million from the policy to pay for their legal fees.

But this cap has probably been exceeded by now, given the numerous Congressional hearings about MF Global’s collapse and the criminal and regulatory investigations of the firm. The question is whether the bankruptcy court will allow Mr. Corzine and the other defendants to continue to draw on the insurance to pay for their mounting legal costs or seek to preserve the policy for payments to MF Global’s customers and claims holders.

Mr. Corzine’s biggest concern is not that he may lose the case, but that the mounting legal fees will take a significant bite out of the fortune he amassed from his days at Goldman Sachs. Mr. Freeh is clearly aiming straight at Mr. Corzine, and is not the type of opponent who can be sent packing with a quick settlement.