In re Mjk Clearing, Inc.

• Citation: 286 B.R. 109
• Decision Date: 22 November 2002
• Docket Number: Adversary No. 01-4275.,Adversary No. 01-4257.
• Parties: In re MJK CLEARING, INC., Debtor. Ferris, Baker Watts, Inc., Plaintiff, v. James P. Stephenson, Trustee, Defendant.
• Court: United States Bankruptcy Courts. Eighth Circuit. U.S. Bankruptcy Court — District of Minnesota

286 B.R. 109

In re MJK CLEARING, INC., Debtor.

Ferris, Baker Watts, Inc., Plaintiff, v. James P. Stephenson, Trustee, Defendant.

Adversary No. 01-4257.

Adversary No. 01-4275.

United States Bankruptcy Court, D. Minnesota.

November 22, 2002.

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Thomas E. Jamison, Minneapolis, MN, Charles S. Fax, Baltimore, MD, Richard A. Kirby, Washington, DC, for plaintiff.

Stephen M. Mertz, Ted R. Cheesebrough, Minneapolis, MN, for defendant.

Kenneth Caputo, Washington, DC, for Securities Investor Protection Corporation.

MEMORANDUM ORDER GRANTING SUMMARY JUDGMENT

ROBERT J. KRESSEL, Bankruptcy Judge.

This proceeding came on for hearing on the parties Motions for Summary Judgment. Thomas E. Jamison, Charles S. Fax and Richard A. Kirby appeared for the plaintiff. Stephen M. Mertz and Ted R. Cheesebrough appeared for the defendant. Kenneth Caputo appeared for the Securities Investor Protection Corporation.

This court has jurisdiction over this matter pursuant to the Securities Investors Protection Act of 1970 and in particular the Protective Decree entered against the debtor under 15 U.S.C. § 78eee(b), as well as under 15 U.S.C. §§ 78eee(b)(2), 78eee(b)(4), and 28 U.S.C. §§ 1331 and 1332.

THE PARTIES

The plaintiff, Ferris, Baker Watts is a Delaware corporation with its principal place of business in Washington, D.C., and is registered with the United States Securities and Exchange Commission as a securities broker-dealer. The debtor, formerly known as Miller Johnson & Kuehn, is a corporation organized under the laws of Minnesota with its principal place of business in Golden Valley, Minnesota. The debtor, until it suspended business activities on September 25, 2001, was engaged in the business of securities brokerage and trading.

FBW and MJK entered into a Master Securities Loan Agreement in January of 1999.¹ The agreement was amended on January 26, 1999. Pursuant to the MSLA, if one party borrowed securities from the other, the borrower would deposit with the lender cash or other collateral in an amount equal to at least one hundred percent of the market value of the loaned securities. The lender would pay the borrower a cash collateral fee for any cash given as collateral for loaned securities at a rate agreed between the parties, and would hold that collateral as security for the borrower's obligations with respect to the loan. Moreover, the MSLA provided that if the value of the securities increased in the market, the borrower would provide additional cash collateral to the lender. Conversely, if the value of the securities decreased, the stock lender would return the amount of the decrease. This process is known as "marking to market," which serves to equalize the value of the securities and the cash collateral. Finally, section 3.2 of the MSLA provided:

In addition to the rights and remedies given to Lender hereunder, Lender shall have all the rights and remedies of a secured party under the New York Uniform Commercial Code. It is understood that Lender may use or invest the Collateral, if such consists of cash, at its own risk, but that (unless Lender is a Broker-Dealer) Lender shall, during the term of any Loan hereunder, segregate Collateral from all securities or other assets in its possession. Lender may pledge, repledge, hypothecate, rehypothecate, lend, relend, sell or otherwise transfer the Collateral, or re-register Collateral evidenced by physical certificates in any name other than Borrower's only (a) if Lender is a Broker-Dealer or (b) in the event of a Default by Borrower.

The debtor's securities lending business involved transactions for one of three purposes: (1) loaning stock held by the debtor to raise capital; (2) borrowing stock to make deliveries; or (3) serving as a conduit/intermediary between parties. In this last type of transaction, the debtor would borrow securities from one party and loan those same securities to another party. In return, the debtor would receive cash collateral from the party to whom it loaned the securities, and the debtor would then post cash collateral with the party from which it borrowed securities as collateral for its own obligations.

All cash collateral received by MJK from any party to which it loaned securities was automatically reflected as a debit on MJK's account at the Depository Trust Company. Similarly, for every transaction in which MJK borrowed securities, MJK's DTC account reflected a credit representing the transfer of cash collateral out of the account. On any given day MJK's DTC account reflected numerous debits and credits that were the result of the plethora of securities transactions in which it participated. Each of these debits and credits were aggregated at the end of the day, providing a net amount for MJK's DTC account. As a consequence, any cash collateral posted by FBW or any other borrower of MJK was commingled with other cash collateral received by MJK from various securities transactions that day.

MJK'S DEMISE

Prior to September 2001, MJK entered into stock loan agreements with other broker-dealers one of which was Native Nations Securities, Inc. Pursuant to a MSLA with NNS, during 2000 and 2001 MJK entered into a series of stock loan transactions with respect to three securities: (1) various issues of bonds by Imperial Credit Industries, Inc.; (2) shares of common stock of GenesisIntermedia, Inc.; and (3) shares of common stock of Holiday RV Superstores, Inc. On or around July 17, 2001, MJK borrowed from NNS $64,000,000 face amount of bonds issued by ICII that MJK listed at a carrying value of $63,210,000. FBW claims that with respect to such bonds, there were no records of them trading on the market in the ensuing three months and there was no record that they had any market value. With respect to the GENI stock, as of July 2001, MJK had on account 6,611,700 shares valued by MJK at $18 per share for a total value of $119,010,600. FBW claims that the 6,611,700 shares of GENI stock represented nearly one-third of the outstanding stock of GENI and could not reasonably be liquidated at the value carried by MJK. Concerning the Holiday RV stock, MJK on or around July 17, 2001, MJK borrowed from NNS 4,000,000 shares that MJK valued at $4 per share for a total of $16,000,000. FBW claims that the 4,000,000 shares of RVEE represented more than 50% of the outstanding stock of RVEE and could not reasonably be liquidated at the value carried by MJK. FBW also claims that as of July 17, 2001, MJK held a stock-borrow receivable from NNS in the amount of $198,221,600 on ICII, GENI, and RVEE, but these stocks were worth no more than $17,600,000, thus causing MJK to be unsecured in an amount not less than $180,621,600.

MJK reported in its quarterly Focus Report to the SEC for the quarter ending June 30, 2001, that the company had net capital of $21,906,498, a net capital requirement of $6,311,774, and therefore excess net capital of $15,574,724. FBW alleges, however, that as of July 17, 2001, taking into account the net capital requirement of $6,311,774 and the amount of its unsecured receivable from NNS, which FBW alleges is not less than $180,621,600, MJK was in violation of its net capital requirement.²

As of August 31, 2001, MJK reported to the SEC that it had a net capital of $22,528, 817, a net capital requirement of $7,645,029, and resulting in excess net capital of $14,883,788. FBW alleges, however, that MJK was in violation of its regulatory net capital requirements and insolvent from at least July 17, 2001, through the present and at no time did MJK inform the SEC of its net capital violations or insolvency. FBW also alleges that MJK's net capital deficiencies was caused by their failure to obtain the return of cash collateral from NNS when the market value of ICII bonds declined.

Prior to September 11, 2001, GENI shares traded consistently in the range of $17 per share. Its price for the purpose of establishing the amount of collateral held by NNS was generally fixed at $18 per share throughout the several months preceding September 11, 2001. Likewise, the mark set for shares of GENI that MJK loaned to other broker-dealers was $18 per share, and throughout July and August of 2001, and continuing through September 11, 2001, MJK's stock loan positions in GENI, as reflected in MJK's books, were matched on most days, meaning that the value of the securities corresponded to the value of the collateral.

On September 11, 2001, securities trading in the United States was halted. Trading was resumed on September 17, 2001. By the close of trading on September 17, 2001, the price of GENI stock had declined to $16.20 per share. On September 18, 2001, MJK paid GENI marks received from other broker-dealers in the amount of $7,211,400. FBW states that on that same date, MJK should have marked the price of GENI stock in the same amount to NNS and should have demanded that NNS return $7,211,400 in cash collateral. FBW alleges that MJK's failure to make such a demand created a collateral imbalance on the books of MJK in the amount of $7,211,400. FBW alleges that these factors required MJK to take a special charge to its net capital as of September 18, 2001, but that MJK failed to take a special charge. Had MJK taken this special charge, FBW alleges, MJK would have disclosed that it lacked the minimum stated capital necessary to operate.

The price of GENI stock continued to decline to a closing price of $13.38 per share on September 19, 2001. On that date, MJK satisfied marks at $3 per share on the 7,211,400 shares of GENI stock that it had lent to other broker-dealers, resulting in MJK's return of collateral to those broker-dealers in the amount of $21,634,200. FBW alleges that MJK did not demand that NNS return a like amount of cash collateral to MJK, and that this created a further collateral imbalance on the books of MJK in the amount of...