In re Sentinel Mgmt. Grp., Inc.

• Decision Date: 30 September 2013
• Docket Number: 10–3990,Nos. 10–3787,11–1123.,s. 10–3787
• Citation: 728 F.3d 660
• Parties: In re SENTINEL MANAGEMENT GROUP, INC., Debtor. Appeal of Frederick J. Grede, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust.
• Court: U.S. Court of Appeals — Seventh Circuit

728 F.3d 660

In re SENTINEL MANAGEMENT GROUP, INC., Debtor. Appeal of Frederick J. Grede, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust.

Nos. 10–3787, 10–3990, 11–1123.

United States Court of Appeals, Seventh Circuit.

Argued Sept. 8, 2011.

Decided Aug. 26, 2013.

Rehearing and Rehearing En Banc^* Denied Sept. 30, 2013.

Chris C. Gair (submitted), Gair Law Group, Ltd., Catherine L. Steege, Attorneys, Jenner & Block LLP, Chicago, IL, for Frederick J. Grede.

Jeffery W. Sarles, Attorney, Mayer Brown LLP, Chicago, IL, for Bank of New York Mellon Corporation.

Martin B. White, Attorney, Commodity Futures Trading Commission, Washington, DC, for Commodity Futures Trading Commission Amicus Curiae.

Before MANION, ROVNER, and TINDER, Circuit Judges.

TINDER, Circuit Judge.

The collapse of investment manager Sentinel Management Group, Inc., in the summer of 2007 left its customers in a lurch. Instead of maintaining customer assets in segregated accounts as required by law, Sentinel had pledged hundreds of millions of dollars in customer assets to secure an overnight loan at the Bank of New York, now Bank of New York Mellon. This left the Bank in a secured position on Sentinel's $312 million loan but its customers out millions. Once Sentinel filed for bankruptcy, Sentinel's Liquidation Trustee, Frederick J. Grede, brought a variety of claims against the Bank—including fraudulent transfer, equitable subordination, and illegal contract—to dislodge the Bank's secured position. After extensive proceedings, including a seventeen-day bench trial, the district court rejected all of the Trustee's claims. Although we appreciate the district court's painstaking efforts, we cannot agree with its conclusion that Sentinel's failure to keep client funds properly segregated was insufficient to show an actual intent to hinder, delay, or defraud. We also find significant inconsistencies in both the factual and legal findings of the district court with respect to the equitable subordination claim. For these reasons, we reverse the judgment of the district court with respect to Grede's fraudulent transfer and equitable subordination claims.

I. Factual Background

Even though we find some inconsistencies in the thirty-nine-page opinion of the district court, its comprehensive review of the evidence still provides a useful starting point for our discussion. See Grede v. Bank of N.Y. Mellon, 441 B.R. 864 (N.D.Ill.2010). The district court's findings of fact, of course, “are entitled to great deference and shall not be set aside unless they are clearly erroneous.” Gaffney v. Riverboat Servs. of Ind., Inc., 451 F.3d 424, 447 (7th Cir.2006). Nonetheless, we review the district court's findings of law—including the district court's determination of actual intent to hinder, delay, or defraud—de novo. Johnson v. West, 218 F.3d 725, 729 (7th Cir.2000).

Before filing for bankruptcy in August 2007, Sentinel was an investment manager that marketed itself to its customers as providing a safe place to put their excess capital, assuring solid short-term returns, but also promising ready access to the capital. Sentinel's customers were not typical investors; most of them were futures commission merchants (FCMs), which operate in the commodity industry akin to the securities industry's broker-dealers. In Sentinel's hands, FCMs' client money could, in compliance with industry regulations governing such funds, earn a decent return while maintaining the liquidity FCMs need. “Sentinel has constructed a fail-safe system that virtually eliminates risk from short term investing,” proclaimed Sentinel's website in 2004.

To accept capital from its FCM customers, Sentinel had to register as a FCM, but it did not solicit or accept orders for futures contracts. Sentinel received a no-action” letter from the Commodity Futures Trading Commission (CFTC) exempting it from certain requirements applicable to FCMs. But Sentinelrepresented that it would maintain customer funds in segregated accounts as required under the Commodity Exchange Act, 7 U.S.C. § 1 et seq. Maintaining segregation meant that at all times a customer's accounts held assets equal to the amount Sentinel owed the customer, and that Sentinel treated and dealt with the assets “as belonging to such customer.” 7 U.S.C. § 6d(a)(2) (“Such money, securities, and property shall be separately accounted for and shall not be commingled with the funds of such commission merchant or be used to margin or guarantee the trades or contracts, or to secure or extend the credit, of any customer or person other than the one for whom the same are held ...”).

Maintaining segregation serves as commodity customers' primary legal protection against wrongdoing or insolvency by FCMs and their depositories, similar to depositors' Federal Deposit Insurance Corporation protection, see12 U.S.C. § 1811 et seq., or securities investors' Securities Investor Protection Corporation protection, see15 U.S.C. § 78aaa et seq. Sentinel also served other investors such as hedge funds and commodity pools, and as early as 2005, began maintaining a house account for its own trading activity to benefit Sentinel insiders. In 2006, Sentinel represented that non-FCM entities made up about one-third of its customer base. By 2007, Sentinel held about $1.5 billion in customer assets but maintained only $3 million or less in net capital.

Sentinel pooled customer assets in various portfolios, depending on whether the customer assets were CFTC-regulated assets of FCMs or unregulated funds such as hedge funds or FCMs' proprietary funds. But Sentinel handled “its and its customers' assets as a single, undifferentiated pool of cash and securities.” Grede, 441 B.R. at 874. When customers wanted their capital back, Sentinel could sell securities or borrow the money. Sentinel's borrowing practices, and in particular an overnight loan it maintained with the Bank of New York, is this appeal's focal point. This arrangement allowed Sentinel to borrow large amounts of cash while pledging customers' securities as collateral.

Sentinel's relationship with the Bank began in 1997 in the Bank's institutional-custody division but within months moved to the clearing division (technically dubbed broker-dealer services) because Sentinel actively traded securities and frequently financed transaction settlements. Under the old arrangement, for each segregated account, Sentinel had a cash account for customer deposits and withdrawals. Assets could not leave segregation without a corresponding transfer from a cash account. But the risks of overdrafts prompted a switch to an environment where securities would be bought and sold from clearing accounts lienable by the Bank. In an email, one bank official said in reference to Sentinel's original arrangement that “THIS ACCOUNT IS AN ACCIDENT WAITING TO HAPPEN.... I AM NOTIFYING YOU THAT I NO LONGER FEEL COMFORTABLE CLEARING THESE TRANSACTIONS AND REQUEST AN IMMEDIATE RESPONSE FROM YOU. THANK YOU.”

Under the new arrangement, Sentinel maintained three types of accounts at the Bank. First, clearing accounts allowed Sentinel to buy or sell securities, including government, corporate, and foreign securities and securities traded with physical certificates. The Bank maintained the right to place a lien on the assets in clearing accounts. Second, Sentinel maintained an overnight loan account in conjunction with its secured line of credit. To borrow on the line of credit, Sentinel would call bank officials to confirm whether it had sufficient assets in lienable accounts to serve as collateral. A senior bank executive had to approve requests that put the line of credit above a predetermined “guidance line.” Third, Sentinel maintained segregated accounts that held assets that could not be subject to any bank lien. These included accounts (corresponding with the lienable clearing accounts) for government, corporate, and foreign securities but no corresponding segregated account for physical securities. To receive FCM funds in the segregated accounts, the Bank countersigned letters acknowledging that the funds belonged to the customers and that the accounts would “not be subject to your lien or offset for, and on account of, any indebtedness now or hereafter owing us to you....” The agreement between Sentinel and the Bank provided that the “Bank will not have, and will not assert, any claim or lien against Securities held in a Segregated Account nor will Bank grant any third party ... any interest in such Securities.”

Sentinel could independently transfer assets between accounts by issuing electronic desegregation instructions without significant bank knowledge or involvement. This system allowed for hundreds of thousands of trades worth trillions of dollars every day at the Bank. Sentinel maintained responsibility for keeping assets at appropriate levels of segregation. The Bank's main concern was ensuring Sentinel had sufficient collateral in the lienable accounts to keep its overnight loan secured. In fact, at no point does it appear that the Bank was under-secured. If Sentinel sought to extend the line of credit beyond the value of the assets held in the lienable accounts, the Bank made sure Sentinel moved enough collateral into the lienable accounts. Sentinel used cash from the overnight loan for customer redemptions or failed trades and provided collateral in the form of the customers' redeemed securities. When customers redeemed investments, Sentinel could provide cash, via the loan, without waiting for the securities to sell. This arrangement did not violate segregation requirements. When a customer cashed out, the amount needed in segregation dropped by the amount lent by the Bank via the line of credit. The line of credit was in turn secured by assets moved out of customers' segregated accounts and into clearing accounts.

But in 2001, and increasingly in 2004, Sentinel started using the loan to fund...