Grede v. Fcstone, LLC

• Decision Date: 04 January 2013
• Docket Number: No. 09 C 136.,09 C 136.
• Citation: 485 B.R. 854
• Parties: Frederick J. GREDE, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust, Plaintiff, v. FCSTONE, LLC, Defendant.
• Court: U.S. District Court — Northern District of Illinois

485 B.R. 854

Frederick J. GREDE, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust, Plaintiff,

v.FCSTONE, LLC, Defendant.

No. 09 C 136.

United States District Court,

N.D. Illinois,

Eastern Division.

Jan. 4, 2013.

Chris C. Gair, Angela M. Allen, Christine L. Childers, Jeffrey Scott Eberhard, Michael H. Margolis, Vincent E. Lazar, Jenner & Block LLP, Chicago, IL, for Plaintiff.

Stephen Patrick Bedell, Geoffrey S. Goodman, Jill L. Nicholson, Joanne Lee, Robert S. Bressler, Thomas Kelly Anderson, Thomas Paul Krebs, William J. McKenna, Jr., Foley & Lardner, Chicago, IL, for Defendant.

MEMORANDUM OPINION AND ORDER

JAMES B. ZAGEL, District Judge.

I. INTRODUCTION

Sentinel Management Group, Inc. (“Sentinel”) filed under Chapter 11 of the Bankruptcy Code in August 2007. In September 2008, Plaintiff Liquidation Trustee filed adversary proceedings in the Bankruptcy Court for the Northern District of Illinois for avoidance and recovery of pre and post-petition transfers made by Sentinel to or for the benefit of certain customers. On October 29, 2008, I withdrew the reference to the Bankruptcy Court, finding that the adversary proceedings raised “significant open and unresolved issues” of non-bankruptcy law regarding the applicability of common law trust principles to statutory trusts, and the duty of futures commission merchants (“FCMs”) to cover customer segregation shortfalls under the Commodity Exchange Act (“CEA”) and its regulatory provisions. Grede v. Fortis Clearing Americas LLC, No. 09 C 138, 2009 WL 3518159, at *3–4 (N.D.Ill. Oct. 28, 2009).

The instant adversary proceeding was chosen as a “test case” (as least in part) to resolve common legal issues among the Trustee's actions. Here, the Trustee seeks to avoid or reduce the transfer of approximately $15.6 million to Defendant FCStone. He alleges five counts: 1) avoidance and recovery of post-petition transfers (11 U.S.C. §§ 549(a) and 550); 2) avoidance and recovery of preferential transfers (11 U.S.C. §§ 547(b) and 550); 3) declaratory judgment that cash and securities held by Sentinel in allegedly segregated bank accounts is property of the Debtor's estate; 4) unjust enrichment; and 5) disallowance or reduction of claims (11 U.S.C. § 502(d)).

A bench trial was held on October 1 through 17, 2012.¹ Pursuant to Fed.R.Civ.P. 52(a), my findings of fact and conclusions of law are laid out below.

II. FINDINGS OF FACT²Parties

1. The Sentinel Liquidation Trust (the “Trust”) is a liquidating trust created under the Fourth Amended Chapter 11 Plan of Liquidation (the “Plan”) for Sentinel. The effective date of the Plan was December 17, 2008. Plaintiff Frederick J. Grede was formerly the Chapter 11 trustee for Sentinel. On December 17, 2008, pursuant to the terms of the Plan, Grede was appointed Liquidation Trustee of the Trust (the “Trustee”).

2. Defendant FCStone is an Iowa limited liability company with its principal place of business in Chicago, Illinois. FCStone is a futures commission merchant (“FCM”). As an FCM, FCStone maintains accounts and clears trades for customers in the futures markets; FCStone acts as a financial intermediary between its customers and the futures markets.

Sentinel's Business

3. Sentinel was an Illinois corporation headquartered in Northbrook, Illinois. Sentinel managed investments for various clients, including FCMs, hedge funds, financial institutions, pension funds, and individuals.

4. Sentinel offered its customers several different portfolios as investment options. Sentinel represented to its customers that all of its portfolios met the dual objectives of low risk and high liquidity. Sentinel's marketing materials described the allowable investments in the three primary portfolios as follows:

• Treasury Only Portfolio—Direct obligations of the U.S. Treasury.

• 1.25 Portfolio—Obligations of the U.S. Treasury, short term commercial paper rated A1/P1, medium and long term debt rated AA or higher, bank time deposits and repurchase agreements collateralized by the above.

• Prime Portfolio—Short term commercial paper rated A1/P1, investment grade corporate bonds, bank time deposits, repurchase agreements collateralized by the above and other highly rated marketable securities.

5. Sentinel classified its customers into three distinct segments or “SEGs” based on their regulatory status and the source and nature of their investments. The SEGs were comprised as follows:

SEG 1: Comprised of FCMs' customer funds required to be invested in compliance with CFTC Rule 1.25 and held in compliance with CEA and CFTC segregation requirements;

SEG 2: Comprised of FCMs' foreign futures and foreign options customer funds required to be invested in compliance with CFTC Rule 1.25 and held in separate accounts in compliance with CFTC Rule 30.7;

SEG 3: Comprised of hedge funds, other public and private trading funds, individual investors and FCMs investing proprietary or “House” funds.

6. Within each SEG, Sentinel further divided its customers into 11 groups, each of which consisted of customers with the same risk and return goals. Each customer participating within a specific group held an indirect beneficial ownership interest based on its pro rata share of the value of the securities held in that group's portfolio. The breakdown of the 11 customer groups by SEG, and their investment guidelines, were as follows:

SEG 1: FCM customers trading on U.S. exchanges

Group 1: Rule 1.25—Overnight reverse-repo government securities only

Group 7: Rule 1.25—Government securities, corporate bonds, cash

Group 8: Rule 1.25—Direct obligations of the U.S. Treasury only

Group 9: Rule 1.25—Government securities (no agency), corporate bonds, cash

SEG 2: FCM customers trading foreign futures and options

Group 5: Rule 30.7—Cash only

Group 6: Rule 30.7—Government securities and cash

SEG 3: Hedge funds, trusts, individual investors, FCM proprietary or “House” funds

Group 2: Prime—Government, corporate, sovereign debt rated as “investment grade” by an NRSRO.

Group 3: TOP—Direct obligations of the U.S. Treasury only

Group 4: Prime

Group 10: Rule 1.25—Government securities, corporate bonds, cash

Group 11: Prime—Government, corporate, sovereign debt rated as “investment grade” by an NRSRO.³

7. Defendant FCStone was a Sentinel customer. Defendant's funds were invested in the SEG 1, Group 7 customer portfolio.

8. Sentinel also managed a “House” or “Street” portfolio comprised of securities that were managed on a proprietary basis on behalf of Sentinel and certain employees, insiders and investors.

9. Prior to 2004, Sentinel entered into Investment Advisory Agreements, and post 2004 entered into Investment Management Agreements (collectively, “Customer Agreements”), with each of its investing customers. The Customer Agreements governed the terms of Sentinel's relationship with its customers. The Customer Agreements appointed Sentinel as a discretionary investment adviser with respect to assets deposited by customers. The Customer Agreements specified that the client's assets in a particular program would be invested along with the assets of other Sentinel clients in the same program and that the client would own an indirect interest in the segregated portfolio of the relevant program.

10. Sentinel's customers did not own any particular securities and were entitled only to redemptions of cash. All of Sentinel's transactions with customers were cash transactions.

The Regulatory Framework that Governed Sentinel's Business

11. Sentinel was registered with the Securities and Exchange Commission (“SEC”) as an investment adviser and with the Commodity Futures Trading Commission (“CFTC”) as a futures commission merchant. FCM registration was necessary for Sentinel to provide its investment advisory services to FCMs investing funds of their commodity customers. Sentinel did not itself execute or clear futures transactions, as registered FCMS typically do.

12. The Commodity Exchange Act (CEA) and CFTC Rules promulgated thereunder required Sentinel to segregate commodity customers' funds from those of other customer groups and from Sentinel's own assets. The CEA and its related CFTC rule applied to Sentinel's SEG 1 FCM customers with respect to the funds of the FCMs' commodity customers.

13. 17 C.F.R. 275.206 (the “SEC Custody Rule”), a regulatory provision promulgated under the Investment Advisers Act (IAA,) required Sentinel to segregate its customers' assets from those of other customer groups and from Sentinel's own assets. The SEC Custody Rule applied to all of Sentinel's customers.

Sentinel's Account Structure at the Bank of New York and JP Morgan

14. Sentinel maintained several accounts at the Bank of New York (“BONY”) to process daily transactions related to securities trading and customer cash deposit and withdrawal activity. BONY also functioned as the custodian of securities held on behalf of Sentinel's customers.

15. Sentinel maintained several accounts at JP Morgan, which functioned as the custodian for customer cash.

16. Specifically, Sentinel maintained three segregated cash accounts at BONY that were held for Sentinel's customers in SEGs 1, 2 and 3. The three BONY cash accounts were the transactional accounts through which all of Sentinel's customer deposits and withdrawals were received and paid. Customer deposits and withdrawals were wired in and out of these accounts on a daily basis.

17. Sentinel also maintained a House cash account at BONY.

18. Sentinel established three segregated securities accounts at BONY to hold government and governmental securities for customers in SEGS 1, 2 and 3.

19. Sentinel established three segregated securities accounts at BONY to hold Depository Trust Company registered corporate securities (“DTC securities”) for customers in SEGs 1, 2 and 3.

20. The BONY account structure also included the SEN and SLM accounts. The SEN account was a lienable account that served as the central settlement account at BONY for...