A recent federal district court decision in the Sentinel bankruptcy case raises troubling implications for the futures industry at a time when regulators and the industry are tackling how to enhance the protection of customer funds.
The decision, which was handed down on Jan. 4 by U.S. District Court Judge James Zagel, involves a case arising from the 2007 bankruptcy of Sentinel Management Group. Sentinel, a registered FCM and investment adviser, managed segregated funds investments for other FCMs. In its decision, the Court ordered one of Sentinel’s FCM customers, FCStone, to repay close to $15.6 million in customer segregated funds that had been returned to it within days of Sentinel’s bankruptcy filing in 2007. The Court effectively ruled that the funds had lost their statutory protection as customer segregated funds due to Sentinel’s alleged misconduct, and should instead be distributed “fairly” among Sentinel’s customers.
The decision is now on appeal, but if it stands, it could erode the protections afforded to segregated funds under the Commodity Exchange Act in a bankruptcy scenario. Among other things, it disregards the industry’s reliance on FCM and custodial books and records to identify CEA-protected segregated funds, effectively finding that such reliance is misplaced and constitutes a “tracing fiction” when Sentinel’s other customers were covered by competing regulatory trust protections.
The decision could also compromise future efforts to manage the bankruptcy of a futures commission merchant or a custodian by raising doubts about the finality of court-sanctioned transfers of segregated funds out of the failed entity. Furthermore, the decision makes the unprecedented finding that FCMs are liable as de facto guarantors of the solvency of their custodians.
This case is the first of 10 or more Sentinel-related cases against FCMs in which the trustee is seeking repayment of close to $300 million in segregated funds that had been restored to these FCMs. As a result, the outcome of the appeal could have a significant impact on all of these cases.
Although Sentinel registered as an FCM in the early 1980s, it did not have traditional futures customers. Instead, the company was formed for the purpose of managing the investment of segregated funds for other FCMs, which it referred to as the “Seg 1 customers.” It needed the FCM registration to be able to hold segregated funds of its FCM customers, and was subject to CEA and CFTC segregation requirements. Sentinel was also registered with the Securities and Exchange Commission as an investment adviser. This allowed it to expand its investment management services to other clients, such as hedge funds and FCMs investing their proprietary funds, which it referred to as the “Seg 3 customers.” Sentinel’s SEC registration also meant that it had to comply with the SEC’s investment adviser custody rule.
Sentinel offered its Seg 1 FCMs several different investment strategies, each to be operated in compliance with the investment restrictions established by the Commodity Futures Trading Commission’s Rule 1.25. Sentinel issued individual customer account statements on which it identified the customer’s pro rata interest in each security in the portfolio in which it participated.
Around 2003, Sentinel began entering into proprietary repo trades involving corporate debt securities, an activity that accelerated from 2004 to 2007. During the summer of 2007, as the credit crisis worsened, Sentinel’s counterparties began closing out positions, which required Sentinel to repurchase securities that, generally speaking, were highly illiquid. To meet those obligations, Sentinel drew on an overnight loan facility it had with Bank of New York, originally established to fund client redemptions.
In late June 2007, the BONY loan reached a high of $573.8 million. As security for its overnight loans, Sentinel transferred certain customer securities into an overnight lienable account at BONY. That included improper use of Seg 1 securities, in particular during July 2007, but after July 31, Sentinel primarily used Seg 3 securities to collateralize the loan.
On August 17, 2007, Sentinel filed for bankruptcy. Shortly before this event, the company sold its portfolio of Seg 1 FCM customer securities to Citadel Equity Fund for approximately $317 million and deposited the cash proceeds in the Seg 1 segregated cash account at BONY. Three days after filing for bankruptcy, Sentinel filed an emergency motion with the U.S. Bankruptcy Court in Chicago seeking an order to distribute the proceeds from the Citadel sale to the Seg 1 FCMs, including FCStone. Following a hearing that same day, the Bankruptcy Court issued an order authorizing BONY to release the Citadel sale proceeds to the FCMs, less a holdback of approximately $15.6 million. This distribution order specifically stated that the distribution to the Seg 1 FCMs was “authorized.” The next day, Aug. 21, BONY wired a total of approximately $297 million to the customer segregated deposit accounts of the Seg 1 FCMs. FCStone received close to $14.5 million from this distribution as a return of segregated funds.
In September 2008, the Trustee for the Sentinel estate filed cases against the Seg 1 FCMs, seeking, among other things, recovery of the August 2007 distributions. The Trustee selected FCStone as a “test case” for the cases against the Seg 1 FCMs. The bench trial was held before Judge Zagel on Oct. 1 through 17, 2012. The Court issued its memorandum opinion on Jan. 4, 2013 ordering FCStone to return approximately $15.6 million to the Sentinel estate. FC-Stone is appealing the decision.
Analysis of the Opinion
As a threshold matter, the Court was forced to grapple with the fact that the Bankruptcy Court had authorized the distribution of funds to the Seg 1 FCMs as a return of segregated customer funds. Indeed, the Bankruptcy Court had issued the authorization order at the behest of the CFTC, which argued that the distribution was necessary to avoid default on margin obligations and the potential failure of as many as a dozen FCMs. The Seg 1 FCMs argued that, under the law, a distribution that was authorized by the Bankruptcy Court cannot subsequently be “clawed back” or questioned by other creditors.
The Court gave short shrift to this argument, relying heavily on the Bankruptcy Court’s statement, more than a year later, that its authorization order was not intended to decide the question of whether the funds in question were the property of the Sentinel bankruptcy estate. The Bankruptcy Code, however, expressly prohibits the claw back of authorized distributions of estate property as well.
This ruling places all future distributions from troubled FCMs or custodians holding segregated funds on behalf of FCMs into grave doubt, as it indicates that a court order authorizing the distribution of such funds from the failed entity will not prevent the recipient FCMs from being dragged into creditor lawsuits and exposed to litigation damages years after the fact. It is not hard to imagine that a recipient FCM adversely impacted by a bankruptcy could well decide to “wave the white flag” itself instead of seeking capital infusions to stay in business if it cannot rely upon the certainty of a bankruptcy court order authorizing the return of the segregated funds to it.
The Court acknowledged that the customer segregated funds were trust property, but noted that other non-futures customers of Sentinel had suffered even more severe losses and were also protected by a trust under an SEC investment adviser custody rule, Rule 206(4)-2. In the Court’s view, considerations of fairness dictated that the funds distributed to the Seg 1 FCMs should be redistributed to the other customers so that all customers of Sentinel shared on an equal basis. The Court also ruled that FCStone was required to trace the customer funds in question, and that Sentinel’s wrongdoing made tracing impossible, especially in the face of competing regulatory trust claims. This aspect of the ruling essentially means that the custodian’s wrongdoing can nullify the trust protection normally afforded to customer funds by the CEA. It also means that the types of books and records relied upon to monitor and enforce segregation compliance cannot be used to identify statutorily protected segregated funds. This ruling poses the troubling question: what is the point of the statutory trust if it can be nullified by the wrongdoing that it is designed to protect against?
Finally, notwithstanding that the funds were transferred to an FCStone customer segregated deposit account, the Court concluded that FCStone was the recipient and beneficiary of the distributions in question, which were predicate findings to holding FCStone liable to repay the money. The Court ruled that because the funds transferred to FCStone were less than the amount of its total excess segregated funds (which FCStone maintained as a cushion against future customer defaults), FCStone could withdraw the transferred amount from customer segregation. The Court also ruled that, regardless of the amount of excess segregation, FCStone benefitted from the transfer because, as an FCM, it acted as a guarantor for its customers in the event of losses at Sentinel, thus making FCStone liable for the losses in question. This aspect of the ruling, if upheld on appeal, significantly recasts the risk relationship between custodians, FCMs and their customers to the profound detriment of FCMs, who are not in a position to monitor, much less control, the internal conduct or finances of their custodians.
Over the course of decades, Congress and the CFTC, working with the industry, have developed a comprehensive array of laws and regulations that are designed to confer sacrosanct trust protection on customer segregated funds and protect those funds from the claims of debtors and creditors alike. In the final analysis, what is most troubling is that the Court has imposed its view of “fairness” and its concerns for the plights of other creditors, in place of the legislative scheme that has been so carefully developed by those who best understand the unique attributes of the futures markets and the requirements of industry members.
Kathryn Trkla, Geoffrey Goodman and Stephen Bedell are partners at Foley & Lardner LLP. Foley is part of the joint defense group representing various FCM creditors in the Sentinel bankruptcy proceeding.