Grede v. MBF Clearing Corp.

• Decision Date: 05 January 2018
• Docket Number: No. 09 C 5214,09 C 5214
• Parties: FREDERICK J. GREDE, not individually but as Liquidation Trustee for the Sentinel Liquidation Trust, Plaintiff, v. MBF CLEARING CORPORATION, Defendant.
• Court: U.S. District Court — Northern District of Illinois

FREDERICK J. GREDE, not individuallybut as Liquidation Trustee for the Sentinel Liquidation Trust, Plaintiff, v. MBF CLEARING CORPORATION, Defendant.

No. 09 C 5214

UNITED STATES DISTRICT COURT NORTHERN DISTRICT OF ILLINOIS EASTERN DIVISION

January 5, 2018

Judge Rebecca R. Pallmeyer

MEMORANDUM OPINION AND ORDER

This case is one of many disputes that arose in the wake of Sentinel Management Group, Inc.'s collapse nearly ten years ago. Sentinel was an investment management firm based in Northbrook, Illinois, that, until its demise, was in the business of managing short-term cash for its clients—mostly other financial institutions. Under federal law and the terms of its contracts, Sentinel was required to hold its clients' assets in segregated accounts. Instead, Sentinel pledged the securities in its clients' accounts as collateral for loans from the Bank of New York ("BONY"), which Sentinel then used to buy even more securities on its own "house" account for the benefit of corporate insiders. When credit markets tightened, Sentinel took out more and more loans from BONY to cover the cost of client redemptions—all the while lying to its clients and frantically shifting around funds to mask the shortfalls. By the time Sentinel filed for Chapter 11 bankruptcy on August 17, 2007, it had lost more than $600 million of its clients' money. See United States v. Bloom, 846 F.3d 243, 245-46 (7th Cir. 2017) (affirming the convictions of Sentinel CEO Eric Bloom for nineteen counts of wire fraud and investment advisor fraud).

Defendant MBF Clearing Corp. is a Delaware corporation with its principal place of business in New York City. MBF had been investing with Sentinel since 2003. Between August 7 and August 9, 2007—the eve of Sentinel's bankruptcy—MBF withdrew all of its funds from Sentinel. (Amended Complaint [82], ¶¶ 108-10.) Plaintiff Frederick J. Grede, the Liquidation Trustee for the Sentinel Liquidation trust, has filed a number of avoidance actions seeking recovery of dispersed funds, including, here, the funds recovered by MBF days before Sentinel's Chapter 11 filing.

The Trustee's original Complaint sought the return of $81.4 million in pre-petition transfers made to MBF as an avoidable preference under 11 U.S.C. § 547. (Complaint, Ex. A to Memorandum in Law in Support of MBF Clearing Corp.'s Motion to Withdraw the Reference [1-4] ("First Complaint"), ¶ 1.) MBF filed a motion for judgment on the pleadings [63] in 2014, but Judge Zagel of this court held the motion under advisement for several years. On June 1, 2017, this court reinstated and granted the Defendant's years-old motion without prejudice in light of the Seventh Circuit's decision to dismiss similar preference claims in a related "test case," Grede v. FCStone, LLC, 746 F.3d 244 (7th Cir. 2014) ("FCStone I"). The court granted the Trustee leave to amend his complaint, however, and the Trustee now pursues a new legal theory. This Amended Complaint seeks the return of a smaller sum, $32.7 million, under the theory that this smaller sum was an actual fraudulent conveyance under 11 U.S.C. § 548(a)(1)(A). (Amended Complaint ¶ 1.) Additionally, the Amended Complaint seeks the return of an undisclosed amount of "false profits in the form of purported 'interest'" that the Trustee also alleges were fraudulently transferred to MBF just before Sentinel's bankruptcy. (Id. at ¶ 111.)

MBF has moved to dismiss the Amended Complaint on two grounds. First, MBF urges that the statute of limitations on a fraudulent conveyance claim has expired, and asserts that the Trustee's Amended Complaint does not "relate back" to the original, or, alternatively, that the Trustee's amendments run afoul of the equitable doctrine of laches. (Memorandum of Law in Support of MBF Clearing Corp.'s Motion to Dismiss the Amended Complaint [85] ("Def.'s MTD"), 1.) MBF's other argument for dismissal rests on a second Seventh Circuit decision in the FCStone test case: Grede v. FCStone, LLC, 867 F.3d 767 (7th Cir. 2017) ("FCStone II").Based on the holding in FCStone II, MBF claims that the Trustee is collaterally estopped from arguing that the funds returned to MBF were a part of the bankrupt estate—a necessary component of a fraudulent transfer action. (MBF Clearing Corp.'s Reply Brief in Support of its Motion to Dismiss the Amended Complaint [91] ("Def.'s Reply"), 1-2.)

For the reasons explained here, the Defendant's Motion to Dismiss is denied.

FACTUAL BACKGROUND

The details of Sentinel's business have been well documented in more than a dozen published and unpublished opinions dating back to 2009, so a brief overview is all that is required here.¹ Sentinel Management Group, Inc. was an Illinois corporation that provided cash-management services for institutional investors, hedge funds, and individuals. (Amended Complaint ¶ 10.) Sentinel "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." In re Sentinel Management Group, Inc., 728 F.3d 660 (7th Cir. 2013) ("BONY I"). Its primary business was in handling short-term investments for futures commission merchants ("FCMs")—entities that trade in the futures and options markets and that are regulated by the Commodity Futures Trading Commission ("CFTC"). See Bloom, 846 F.3d at 246. As described by Judge Hamilton in a related criminal case stemming from Sentinel's bankruptcy:

Sentinel's business model was unusual and perhaps unique. It was registered with the CFTC as an FCM, but it did not trade in futures or options. Instead, Sentinel invested funds for other FCMs and, like a mutual fund, paid a return based on profits and losses. Sentinel was the only company that the CFTC permitted to operate in this manner.

Id. As an FCM itself, Sentinel was governed by the same securities laws and regulations as its clients. These regulations limited Sentinel's investments to "the highest grade securities andsimilar highly liquid investments"—such as U.S. Treasury bills—and required Sentinel to maintain its clients' funds in segregated accounts. (Amended Complaint ¶¶ 12-26) (citing 17 C.F.R. § 1.25 and 7 U.S.C. § 6d(b)). Sentinel's clients could also demand the return of their investments at any time.

Sentinel offered a variety of investment programs, but ultimately pooled all of its clients' assets into one of three segregated custodial accounts at the Bank of New York. Sentinel called these accounts SEG 1, SEG 2, and SEG 3. (Amended Complaint ¶ 11.) Sentinel also set up a single, non-segregated clearing account at BONY, through which all purchases and sales of government securities were processed on a daily basis before being posted to the appropriate permanent, segregated account. (Id. at ¶¶ 33-34.) MBF's funds were assigned to SEG 1 and SEG 2 throughout its relationship with Sentinel. In addition to making trades for its clients, Sentinel traded on its own "house" account for the benefit of corporate insiders including the chairman, Philip Bloom; the CEO, Eric Bloom; and the vice-president of trading, Charles Mosley. (Id. at ¶ 15.) Federal law, federal regulations, and Sentinel's client agreements all required client funds to be kept separate from each other as well as from Sentinel. (Id. at ¶ 16.) As has been well established, Sentinel failed to do this:

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.

FCStone II, 867 F.3d at 772; see also Bloom, 846 F.3d at 246-50.

Sentinel was also supposed to allocate the interest income on its clients' securities on a daily basis, but failed to meet this obligation. Instead of paying its clients their actual earnings, Sentinel calculated interest based on the total pool of securities, regardless of who owned or controlled them at the time. (Amended Complaint ¶ 47.) "Sentinel then allocated to customers approximations of what Sentinel thought customers expected to earn." (Id.) This yield manipulation was sometimes used to inflate Sentinel's claimed returns in order to draw in new customers, and was at other times understated so that Sentinel's managers could pocket the difference themselves, or try to pay off the daily interest on the BONY loan. (Id. at ¶¶ 48, 81.) In the case of SEG 1, the interest reported to those customers "was in the aggregate overstated by millions of dollars" and reflected interest that should have been attributed to other SEGs. (Id. at ¶ 82.) In effect, "Sentinel treated all of the more than $3 billion in securities it controlled as part of a single undifferentiated pool." (Id. at ¶ 77.) Sentinel's daily allocations of specific securities to segregated accounts were "solely for the purpose of reporting to customers," and, more often than not, "complete fabrication[s]" since Sentinel had already pledged those same securities as collateral for BONY's ever-increasing loan. (Id. at ¶¶ 77-78.)

By August 2007, "Sentinel no longer slouched toward bankruptcy; it careened." Bloom, 846 F.3d at 249. Credit markets tightened and clients started redeeming funds at an...