Grede v. UBS Sec., LLC

• Decision Date: 20 March 2018
• Docket Number: No. 09 C 5880,09 C 5880
• Citation: 303 F.Supp.3d 638
• Parties: Frederick J. GREDE, not individually, but as Liquidation Trustee and Representative of the Estate of Sentinel Management Group, Plaintiff, v. UBS SECURITIES, LLC, Defendant.
• Court: U.S. District Court — Northern District of Illinois

303 F.Supp.3d 638

Frederick J. GREDE, not individually, but as Liquidation Trustee and Representative of the Estate of Sentinel Management Group, Plaintiff,

v.UBS SECURITIES, LLC, Defendant.

No. 09 C 5880

United States District Court, N.D. Illinois, Eastern Division.

Signed March 20, 2018

Angela M. Allen, Catherine L. Steege, Vincent E. Lazar, Jenner & Block LLP, Chris C. Gair, Jeffrey Scott Eberhard, Gair Law Group Ltd., Chicago, IL, for Plaintiff.

Stephen Patrick Bedell, Geoffrey S. Goodman, Robert S. Bressler, Thomas Paul Krebs, Peter James O'Meara, Foley & Lardner LLP, Michael K. Desmond, Figliulo & Silverman, Chicago, IL, for Defendant.

MEMORANDUM OPINION AND ORDER

REBECCA R. PALLMEYER, United States District JudgeThe short-term cash management firm Sentinel Management Group, Inc. collapsed and filed for bankruptcy in August 2007 at the outset of the financial crisis. Required by federal law to segregate its clients' funds and invest in only the highest grade government securities, Sentinel instead pledged the securities in its clients' accounts as collateral for loans from the Bank of New York—which Sentinel then used to buy even more securities on its own "House" account for the benefit of corporate insiders. As credit markets tightened in the summer of 2007, Sentinel found itself unable to both repay the Bank’s loan and return its clients' money on demand. All told, Sentinel cost its investors more than $600 million. See United States v. Bloom , 846 F.3d 243, 245–46 (7th Cir. 2017) (affirming Sentinel CEO Eric Bloom’s convictions on nineteen counts of wire fraud and investment advisor fraud). Dozens of lawsuits were filed in the wake of Sentinel’s failure. Many are ongoing to this day.

Defendant UBS Securities, LLC is a former customer of Sentinel. In March 2007, Sentinel transferred $108 million to UBS, which included $14.4 million characterized as "cumulative interest." (UBS Securities, LLC’s Memorandum in Support of its Motion for Summary Judgment [97] ("UBS’s Opening Br."), 1.) The Plaintiff in this case, Frederick J. Grede, is the Liquidation Trustee for the Sentinel Liquidation Trust. The Trustee claims that Sentinel acted with actual "intent to hinder, delay, and defraud" its other creditors when making the pre-petition transfer to UBS, and argues that the cumulative interest payment represents "false profits." (Complaint [1] in No. 09-BR-521, 18–19) (citing 11 U.S.C. § 548(a)(1)(A) ). Accordingly, the Trustee seeks to avoid the transfer and return the $14.4 million to the Liquidation Trust. UBS has moved for summary judgment, arguing that the Trustee has alleged only a "general scheme to defraud," and not fraudulent intent with respect to the specific transfer at issue. (UBS’s Opening Br. 2.) UBS asserts that the cumulative interest was "neither ‘false’ nor ‘profits,’ " but rather the proceeds of Sentinel’s legitimate investment activity—which Sentinel properly paid to UBS in fulfillment of its legal and contractual obligations. (Id. )

For the reasons stated below, the Defendant’s motion for summary judgment [96] is granted.

FACTUAL BACKGROUND

1. Overview of Sentinel’s Business and Bankruptcy

Sentinel Management Group, Inc. was an Illinois corporation that provided cash-management services for institutional investors, hedge funds, and individuals. (UBS Securities LLC’s Local Rule 56.1 Statement of Uncontested Material Facts [98] ("UBS SoF"), ¶ 3.) Its primary business consisted of making safe, short-term investments of the excess cash held by other investment firms called futures commission merchants ("FCMs")—brokers that execute trades in the futures and options markets and that are regulated by the Commodity Futures Trading Commission ("CFTC"). (Id. ) Although Sentinel did not itself execute futures or options trades, it too was registered as an FCM with the CFTC as a prerequisite for managing the funds of typical FCMs. (Id. ); see also Bloom , 846 F.3d at 246 (describing Sentinel’s business model as "unique" and operating "like a mutual fund, pa[ying] a return based on profits and losses.") Importantly, this meant that Sentinel was governed by the same securities law and regulations as its clients. (UBS’s SoF ¶ 4.) These regulations required Sentinel to maintain its clients' funds in segregated accounts, and limited Sentinel’s use of those funds to "investments [in] certain high-quality government and corporate securities" such as U.S. Treasury bills. (Id. at ¶¶ 9–10) (citing 7 U.S.C. § 6d(b) and 17 C.F.R. § 1.25 ).

Sentinel offered a variety of investment programs to account for different investment objectives and to comply with various regulations, but ultimately pooled all of its clients' assets into one of three distinct groups. (UBS’s SoF ¶ 10) Sentinel called these groups SEG 1, SEG 2, and SEG 3. (Id. ) When advertising its investment options to potential customers, Sentinel referred to the SEG 1 group as the "125 Portfolio" (named after CFTC Rule 1.25) and the SEG 3 group as the "Prime Portfolio." Bloom , 846 F.3d at 247. SEG 1 was more conservative and intended for FCMs investing their own customers' funds, while SEG 3 offered a higher rate of return at slightly greater risk and was open to Sentinel’s non-FCM clients: hedge funds, individuals, and FCMs investing their proprietary, non-customer funds.¹ Id. Clients who invested money into one or more SEGs were promised "an undivided, pro-rata beneficial interest in the pool of securities" purchased using the funds within each SEG. (UBS’s SoF ¶ 12.) This meant that Sentinel’s investors did not own specific securities outright, but saw their funds "exchanged for securities and interest-bearing cash through a process that Sentinel called ‘allocation’ " and instead held indirect shares of their respective SEG based on their level of investment. Grede v. FCStone, LLC , 867 F.3d 767, 771 (7th Cir. 2017) (" FCStone II ").

In addition to making trades for its clients, Sentinel also traded on its own "House" account for the benefit of corporate insiders, which included the chairman, Philip Bloom; the CEO, Eric Bloom (Philip’s son); and the vice president of trading, Charles Mosley. (Trustee’s Statement of Additional Material Facts in Opposition to UBS’s SoF [112] ("Trustee’s SoAF"), ¶ 4.) Sentinel’s House account was not constrained by the laws and regulations that governed the grade and risk of investments within the customer SEGs. Bloom , 846 F.3d at 247. Federal law, federal regulations, and Sentinel’s client agreements did, however, require all client funds to be segregated from each other as well from Sentinel’s House funds. (UBS’s SoF ¶ 9) (citing 7 U.S.C. §§ 6d(a) and 6d(b) ; 17 C.F.R. §§ 1.3(gg), 1.20, 1.25, and 1.26(a) ).

As has been well documented in more than a dozen published and unpublished opinions dating back to 2009, Sentinel failed to abide by these rules.²

In 1997, Sentinel opened up a line of credit—called the "overnight loan"—with the Bank of New York for the purpose of providing liquidity for customer redemptions and failed trades. In re Sentinel Management Group, Inc., 728 F.3d 660, 663–64 (7th Cir. 2013) (" BONY I "); (Trustee’s SoAF ¶ 11). Although Sentinel at certain points held well over $1 billion in customer assets, it kept very little cash on hand—never more than $3 million. BONY I , 728 F.3d at 663 ; (Trustee’s SoAF ¶ 12). This overnight loan from the Bank of New York allowed Sentinel to pay its redeeming clients in cash immediately, rather than after waiting for specific securities to sell. BONY I , 728 F.3d at 664 ; (see also Expert Report of Frances M. McCloskey ("McCloskey Rep."), ¶¶ 64–67, Ex. 2 to UBS Securities, LLC’s Response to Trustee’s SoAF [121-2] ("UBS’s Resp. to Trustee’s SoAF").) As acknowledged by the Seventh Circuit, the original overnight loan 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." BONY I , 728 F.3d at 664.

Sentinel maintained two types of accounts with the Bank of New York to facilitate this arrangement: segregated accounts and non-segregated accounts. Nine segregated accounts held different asset classes—cash, government securities, and DTC (corporate) securities³ —for each of SEGs 1, 2, and 3. (Trustee’s SoAF ¶ 8.) The four non-segregated accounts included Sentinel’s House cash account, as well as several clearing accounts through which Sentinel bought, sold, and transferred securities. (Id. at ¶ 9.) Sentinel also maintained six additional segregated accounts for holding clients' cash at JP Morgan, which will be discussed further below. (Id. at ¶ 10.)

Sentinel’s primary clearing accounts at the Bank of New York were called the "SEN account" and the "SLM account." (Id. at ¶ 9.) These two accounts operated together to clear transactions and to secure the overnight loan from the Bank. (McCloskey Rep. ¶¶ 64–67.) The SEN account was the clearing account and only held securities or cash during the day. Every evening, Sentinel would zero out the SEN account and transfer securities to the night-time SLM account to secure the overnight loan. At some point, however, Sentinel began securing the overnight loan using the assets in all of the non-segregated accounts, not just the overnight SLM account.⁴ BONY I , 728 F.3d at 663.

Sentinel’s actual use of the overnight loan and its customers' funds bore little resemblance to their purported uses. Bloom , 846 F.3d at 248. Instead of merely facilitating day-to-day liquidity, Sentinel used the overnight loan to purchase "risky securities that did not comply with customers' investment portfolio guidelines." Grede v. FCStone, LLC , 746 F.3d 244, 248 (7th Cir. 2014) (" FCStone I "). Most importantly, beginning in 2001 and increasingly by 2004, Sentinel’s management started using the proceeds of the overnight loan "to fund its own proprietary repurchase arrangements." BONY I , 728 F.3d at 664. Repurchase arrangements, or "repos," are...