Grede v. FCStone, LLC

• Decision Date: 14 August 2017
• Docket Number: No. 16-1896 & 16-1916,16-1896 & 16-1916
• Citation: 867 F.3d 767
• Parties: Frederick J. GREDE, not Individually but as Liquidation Trustee of the Sentinel Liquidation Trust, Plaintiff–Appellant/Cross–Appellee, v. FCSTONE, LLC, Defendant–Appellee/Cross–Appellant.
• Court: U.S. Court of Appeals — Seventh Circuit

867 F.3d 767

Frederick J. GREDE, not Individually but as Liquidation Trustee of the Sentinel Liquidation Trust, Plaintiff–Appellant/Cross–Appellee,

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

No. 16-1896 & 16-1916

United States Court of Appeals, Seventh Circuit.

Argued June 7, 2017

Decided August 14, 2017

Rehearing and Rehearing En Banc Denied October 2, 2017^*

Catherine L. Steege, Attorney, JENNER & BLOCK LLP, Chicago, IL, for Trustee.

Vincent E. Lazar, Attorney, Catherine L. Steege, Attorney, Angela M. Allen, Attorney, Barry Levenstam, Attorney, JENNER & BLOCK LLP, for Plaintiff–Appellant and Cross–Appellee.

Stephen Bedell, Attorney, Robert Seth Bressler, Attorney, Geoffrey S. Goodman, Attorney, David B. Goroff, Attorney, Thomas P. Krebs, Attorney, William J. McKenna, Jr., Attorney, FOLEY & LARDNER LLP, Chicago, IL, for Defendant–Appellee and Cross–Appellant.

Charles Roe Mills, Esq., Attorney, STEPTOE & JOHNSON LLP, Washington, DC, for Amicus Curiae.

Before Ripple, Rovner, and Hamilton, Circuit Judges.

Hamilton, Circuit Judge.

The 2007 bankruptcy of Sentinel Management Group, Inc. has echoed through the courts for ten years now. This is our fifth appeal dealing with Sentinel. In a pair of cases decided in 2013 and 2016, we addressed the priority of a claim against the bankruptcy estate by the Bank of New York, Sentinel's largest (but no longer secured) creditor. In re Sentinel Management Group, Inc. , 728 F.3d 660 (7th Cir. 2013) ; Grede v. Bank of New York Mellon Corp. (In re Sentinel Management Group, Inc. ), 809 F.3d 958 (7th Cir. 2016). Earlier this year, we affirmed the convictions and sentence of Sentinel's former president and CEO, who was prosecuted for wire fraud and investment adviser fraud. United States v. Bloom , 846 F.3d 243 (7th Cir. 2017).

In Grede v. FCStone, LLC , 746 F.3d 244 (7th Cir. 2014) ( FCStone I ), the direct predecessor to this appeal, we considered among other issues a distribution of $297 million to a group of Sentinel customers a few days after Sentinel filed for bankruptcy protection in August 2007. Following a bench trial, the district court had allowed the trustee in bankruptcy to avoid this post-petition transfer under 11 U.S.C. § 549. We reversed, holding that relief under § 549 was unavailable to the trustee because the bankruptcy court had authorized the transfer. We rejected the trustee's reliance on an October 2008 "clarification" through which the bankruptcy judge indicated that he had not intended to foreclose a § 549 avoidance action. Later statements by the judge about his subjective intentions could not, we concluded, defeat the plain language of the order authorizing the transfer. We remanded for further proceedings, which led to these new appeals.

Despite our holding in FCStone I that "the bankruptcy court authorized the post-petition transfer" and that the trustee "therefore cannot avoid the transfer," 746 F.3d at 258, the trustee argued on remand that the bankruptcy judge's October 2008 "clarification" was entitled to preclusive effect. Since FCStone did not appeal that "clarification" when it was made, the trustee argued, FCStone should be bound by it and collaterally estopped from arguing that the post-petition transfer was authorized. The district court rejected the trustee's argument on this point, and we affirm on two independent grounds. First, pursuant to the mandate rule and the law-of-the-case doctrine, the collateral estoppel theory was unavailable to the trustee on remand. Second, even if the theory were available despite our unambiguous holding in FCStone I , the bankruptcy judge's "clarification" was not the sort of final ruling that could be entitled to preclusive effect.

On cross-appeal, FCStone raises an issue that lingered in the background but was not squarely presented during the previous appeal. The question concerns the proper distribution of nearly $25 million held in reserve under the confirmed bankruptcy plan. FCStone argues that these funds are trust property belonging to it and other creditors in its customer class who are protected by statutory trusts under the Commodity Exchange Act. The district court disagreed, treating the funds instead as property of the bankruptcy estate subject to pro rata distribution among all Sentinel customers and other unsecured creditors. On this cross-appeal, we reverse. Under the Bankruptcy Code, property held by the debtor in trust for others is by definition not property of the bankruptcy estate. Pursuant to the confirmed bankruptcy plan, FCStone and similarly situated customers preserved their right to recover their trust property. These creditors are entitled to the benefit of reasonable tracing conventions. Moreover, FCStone introduced essentially unrebutted evidence at trial showing that it can trace a portion of the reserve funds back to its investment. FCStone is entitled to recover its proportionate share of the reserve funds. The reserve funds should be distributed pro rata among FCStone and other members of its customer class.

I. Factual Overview and Procedural History

A. Sentinel's Collapse

We review the most salient facts of the case, drawing from the district court's findings after the earlier bench trial. More complete discussions of Sentinel's downfall and the criminal misconduct of senior executives are included in the district court's earlier opinion, Grede v. FCStone, LLC , 485 B.R. 854, 859–67 (N.D. Ill. 2013), and in our opinions in Bloom , 846 F.3d at 246–50, and FCStone I , 746 F.3d at 247–51.

In brief, Sentinel managed investments for futures commission merchants (FCMs) like FCStone, as well as for other classes of investors. FCMs act as financial intermediaries between investors and futures markets. They are regulated under the Commodity Exchange Act. Sentinel itself was an FCM and so was regulated under the Act.

Sentinel organized its customers in different tranches known as segments or "SEGs." Within each SEG, customers were further divided into investment groups based on their risk appetites and financial goals. As relevant to this appeal, FCM customer assets were held in SEG 1, with FCStone's customer assets placed in Group 7. SEG 3 contained assets belonging to hedge funds and other sophisticated investors, as well as FCM proprietary or "house" funds.

When customers invested funds with Sentinel, those funds were exchanged for securities and interest-bearing cash through a process that Sentinel called "allocation." Customers did not own securities outright but instead held indirect pro rata interests in the securities allocated to their group portfolios, as determined by their level of investment.

Both the SEG 1 and SEG 3 customers were entitled to special protections under federal law. FCM customers who invested their own clients' funds in SEG 1 were protected by the Commodity Exchange Act and regulations promulgated by the Commodity Futures Trading Commission (CFTC). SEG 1 and SEG 3 customers alike were protected by the Investment Advisers Act of 1940 and regulations promulgated by the Securities and Exchange Commission (SEC). Both regulatory regimes required Sentinel to hold customer funds in segregation, i.e., separate from funds belonging to other customer classes and separate from Sentinel's own or "house" funds. Both regimes also created statutory trusts in the customers' favor to protect their property from Sentinel and its other creditors.

Sentinel, unfortunately, did not honor the statutory trusts and comply with the segregation rules under the Commodity Exchange Act and the Investment Advisers Act. Instead, as the district court found, Sentinel routinely used hundreds of millions of dollars in securities it had allocated to customers as collateral to support Sentinel's own borrowing to pursue its leveraged trading strategy for its own benefit. It moved those securities out of segregation and into a lienable account at the Bank of New York, its main lender, putting customer property at risk for Sentinel's benefit. As Sentinel's leveraged trading increased, its outstanding debt ballooned, and it drew more and more on its customers' assets to support its borrowing habit.

During the summer of 2007, Sentinel's investment scheme collapsed. As credit markets tightened and liquidity dried up on Wall Street (this was the beginning of what would become the financial crisis of the late 2000s), the market value of many Sentinel assets dropped. Sentinel's trading partners began making demands that forced it to borrow more heavily and in turn to provide more collateral—which it did by using customers' property as collateral. In late June and July 2007, Sentinel moved $250 million worth of securities allocated to SEG 1 to the lienable Bank of New York account. Then, in late July, Sentinel swapped these securities with securities allocated to SEG 3 customers, resulting in a "massive shift of loss exposure" from SEG 1 to SEG 3. See Grede , 485 B.R. at 866.

That final manipulation proved fateful for SEG 3 customers in the looming bankruptcy. Sentinel's wheeling and dealing had bought it some time, but in the end the firm could not keep up with redemption requests and demands from the Bank of New York. On Monday, August 13, 2007, Sentinel advised its customers that it was halting all redemptions (i.e., payments to them from their accounts). On Thursday, August 16, Sentinel sold a large portfolio of securities then allocated to SEG 1 to a firm called Citadel, depositing the proceeds in a SEG 1 cash account at the Bank of New York. The next day, Sentinel filed for Chapter 11 bankruptcy protection.

B. Chapter 11 Proceedings

1. Early Litigation

On Monday, August 20, 2007, the first business day after it filed for bankruptcy, Sentinel (still under the control of its insiders) filed an emergency motion in the bankruptcy court seeking an order approving payment of the Citadel sale proceeds to SEG 1 customers. After emergency hearings, the bankruptcy court issued an order authorizing the Bank of New...