Grede v. Fcstone, LLC

• Decision Date: 19 May 2014
• Docket Number: Nos. 13–1232,13–1278.,s. 13–1232
• Citation: 746 F.3d 244
• Parties: Frederick J. GREDE, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust, Assignee of certain claims, Plaintiff–Appellee, Cross–Appellant, v. FCSTONE, LLC, Defendant–Appellant, Cross–Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

746 F.3d 244

Frederick J. GREDE, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust, Assignee of certain claims, Plaintiff–Appellee, Cross–Appellant,

v.FCSTONE, LLC, Defendant–Appellant, Cross–Appellee.

Nos. 13–1232, 13–1278.

United States Court of Appeals, Seventh Circuit.

Argued Dec. 10, 2013.

Decided March 19, 2014.

Rehearing and Rehearing En Banc Denied May 19, 2014.^*

Catherine L. Steege, Attorney, Jenner & Block LLP, Chicago, IL, for Plaintiff–Appellee, Cross–Appellant.

Stephen Bedell, Attorney, Foley & Lardner LLP, Chicago, IL, for Defendant–Appellant, Cross–Appellee.

Before MANION, ROVNER, and HAMILTON, Circuit Judges.

HAMILTON, Circuit Judge.

Sentinel Management Group, Inc., was an investment management firm that filed for Chapter 11 bankruptcy protection on August 17, 2007. Sentinel was caught in the midst of the credit crunch that heralded the beginning of the financial crisis of 2008–09. The crunch Sentinel faced was much worse because, it is now clear, Sentinel managers invaded for their own use the assets that Sentinel was legally required to hold in trust for its customers.

These appeals focus on two transfers of assets. In the days and even the hours just before the bankruptcy filing, Sentinel shifted assets around to increase dramatically the assets available to pay one group of its customers at the expense of another group. Then, on the first business day after the bankruptcy filing, Sentinel obtained the permission of the bankruptcy court to have its bank distribute more than $300 million from Sentinel accounts to the favored group of customers. As a result of these pre-petition and post-petition transfers, the customers in the favored pool have recovered a good portion of their assets from Sentinel, while those in the disfavored pool are likely to receive much less. For the benefit of the disfavored pool of customers, Sentinel's trustee in bankruptcy has sought to avoid both transfers under 11 U.S.C. §§ 547 and 549. Both transfers benefitted defendant FCStone, LLC, one of the customers in the favored pool, and both transfers to FCStone have been litigated as a test case. After a trial, the district court allowed the trustee to avoid both transfers. FCStone has appealed.

This case seems to be unprecedented, or at least unusual, in one important respect. Sentinel's managers violated federal commodities and securities law by invading not just one but two statutory trusts for customer assets, one under the Commodity Exchange Act and the other under the Investment Advisors Act. Those federal statutes, their accompanying regulations, and the two federal agencies charged with enforcing them were not enough to stop Sentinel managers from removing securities from customer trust accounts and using them for their own gain. (Federal criminal charges are pending against two senior executives of Sentinel.) Two groups of customers (not to mention the rest of Sentinel's creditors) have been wronged, large amounts of money are at stake, and there are insufficient funds in the estate to make Sentinel's customers whole. Under these circumstances, there are no easy answers, and the courts face hard choices in applying bankruptcy law to the wreckage and the survivors.

The district court resolved the conflict between the two groups of wronged customers in an equitable way. The court “avoided” (a technical term meaning set aside) both the pre-petition and post-petition transfers so as to share the available assets as fairly as possible between the two groups who are similarly situated, apart from Sentinel's choices to favor one group over the other. Grede v. FCStone, LLC, 485 B.R. 854 (N.D.Ill.2013). As we explain below, however, our review persuades us that there are insurmountable legal obstacles to the avoidance relief ordered by the district court. We therefore reverse as to both transfers.

With respect to the pre-petition transfer, the bankruptcy code provides for avoidance (sometimes also called a “clawback”) of so-called preferential transfers made by an insolvent debtor in the 90 days before filing a bankruptcy petition. 11 U.S.C. § 547(b). The code has a broad exception from avoidance or clawback, however, for payments made to settle securities transactions. See 11 U.S.C. § 546(e). In this case, Sentinel's pre-petitiontransfer fell within the securities exception in § 546(e) and therefore may not be avoided.

The post-petition transfer of $300 million was authorized by the bankruptcy court. That authorization means that the post-petition transfer cannot be avoided under the express terms of 11 U.S.C. § 549. Although we do not reach all of the parties' arguments under § 549, in an effort to provide guidance to the district court for future related cases, we briefly discuss at the end of this opinion whether the post-petition transfer involved property of the bankruptcy estate.

I. Factual Background

The details of Sentinel's illegal practices and eventual collapse have been described well in the district court's findings in this case, Grede v. FCStone, LLC, 485 B.R. 854 (N.D.Ill.2013), and by our court in a related case, In re Sentinel Mgmt. Grp., Inc., 728 F.3d 660 (7th Cir.2013), so we set out only the facts most relevant to these appeals.

Sentinel was an investment management firm that specialized in short-term cash management. Its customers included hedge funds, individuals, financial institutions, and futures commission merchants, known in the business as FCMs. Sentinel promised to invest its customers' cash in safe securities that would nevertheless yield good returns with high liquidity. Under the terms of Sentinel's investment agreement, a customer would deposit cash with Sentinel, which then used the cash to purchase securities that satisfied the requirements of the customer's investment portfolio. Customers did not acquire rights to specific securities under the contract, but rather received a pro rata share of the value of the securities in their investment pool. Sentinel prepared daily statements for customers that indicated which securities were in their respective pools and the customers' proportional shares of the securities' value.

Sentinel classified all customers into segments depending on the type of customer and the regulations that applied to that customer. Sentinel then divided each segment into groups based on the type of investment portfolio each customer had selected. In all, Sentinel had three segments divided into eleven groups. For our purposes, we focus on two segments: Segment 1, which consisted of FCMs' customers' funds, and Segment 3, which contained funds belonging to hedge funds, other public and private funds, individual investors, and FCMs investing their own “house” funds. FCStone's funds were in Segment 1.

Both Segment 1 and Segment 3 accounts were subject to federal regulations requiring Sentinel to hold its customers' funds in segregation, meaning separate from the funds of other customers and Sentinel's own assets. Customer funds could not be used, for example, as collateral for Sentinel's own borrowing. The FCMs in Segment 1 were protected by the Commodity Exchange Act and related CFTC regulations, while Segment 3 customers were protected by the Investment Advisors Act and related SEC regulations. Both sets of regulations created statutory trusts requiring Sentinel to hold customers' property in trust and to treat it as belonging to those customers rather than to Sentinel. See 7 U.S.C. § 6d(a)-(b) (statutory trust under the CEA); 17 C.F.R. § 275.206 (statutory trust under the IAA).

Unfortunately for Sentinel's customers, their investment agreements with Sentinel and the federal regulations bore little relation to what Sentinel actually did with their money. Rather than investing each segment's cash in securities for the segment, Sentinel lumped all available cash together without regard to its source and used it to purchase a wide array of securities, including many risky securities that did not comply with customers' investment portfolio guidelines. Risky securities were used in “repo” transactions or assigned to a house securities pool.¹ At the end of each day, Sentinel would assign securities to groups from its general pool of securities and would issue misleading customer statements listing the securities that were supposedly held in the customer's group account. Sentinel's “house” securities bought in part with customers' money did not appear on customer statements.

Sentinel also allocated a misleading sort of “interest income” to its customers on a daily basis. Under the terms of their agreements with Sentinel, customers were entitled to a pro rata share of the interest accrued by securities in their respective pools. However, Sentinel instead would calculate the interest earned by all securities, including those belonging to other Segments and the house pool. Sentinel would then guesstimate the yield its customers expected to receive on their group's securities portfolio, add a little extra so that the rate of return seemed highly competitive, and report the customer's pro rata share of that amount, minus fees, on the customer's statement.

Sentinel funded its securities purchases using not only the customer cash in the segment accounts but also cash from repo transactions and money loaned to it by the Bank of New York (BONY), the bank where Sentinel housed the majority of its client accounts. BONY required Sentinel to move securities into a lienable account to serve as collateral for the loan. If Sentinel were to move Segment 1 or Segment 3 customer assets into a lienable account, meaning that BONY had a lien on those customer assets to secure its loans to Sentinel, then Sentinel would be violating the trust requirements of federal laws meant to protect Segment 1 and Segment 3 customers from precisely such a risk.

Originally, the BONY loan was meant to provide overnight liquidity. As Sentinel expanded its...