IN RE: SENTINEL MANAGEMENT GROUP, INC., Dеbtor. APPEAL OF: FREDERICK J. GREDE, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust.
Nos. 10-3787, 10-3990 & 11-1123
United States Court of Appeals For the Seventh Circuit
Argued September 8, 2011 — Decided August 26, 2013
Before MANION, ROVNER, and TINDER, Circuit Judges.
Appeals from the United States District Court for the Northern District of Illinois, Eastern Division. No. 1:08-cv-02582 — James B. Zagel, Judge.
I. Factual Background
Even though we find some inconsistencies in the thirty-nine-page opinion of the district court, its comprehensive review of the evidence still provides a useful starting point for our discussion. See Grede v. Bank of N. Y. Mellon, 441 B.R. 864 (N.D. Ill. 2010). The district court’s findings of fact, of course, “are entitled to great deference and shall not be set aside unless they are clearly erroneous.” Gaffney v. Riverboat Servs. of Ind., Inc., 451 F.3d 424, 447 (7th Cir. 2006). Nonetheless, we review the district court’s findings of law—including the district
Before filing for bankruptcy in August 2007, Sentinel was an investment manager that 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 caрital. Sentinel’s customers were not typical investors; most of them were futures commission merchants (FCMs), which operate in the commodity industry akin to the securities industry’s broker-dealers. In Sentinel’s hands, FCMs’ client money could, in compliance with industry regulations governing such funds, earn a decent return while maintaining the liquidity FCMs need. “Sentinel has constructed a fail-safe system that virtually eliminates risk from short term investing,” proclaimed Sentinel’s website in 2004.
To accept capital from its FCM customers, Sentinel had to register as a FCM, but it did not solicit or accept orders for futures contracts. Sentinel received a “no-action” letter from the Commodity Futures Trading Commission (CFTC) exempting it from certain requirements applicable to FCMs. But Sentinel reprеsented that it would maintain customer funds in segregated accounts as required under the Commodity Exchange Act,
Maintaining segregation serves as commodity customеrs’ primary legal protection against wrongdoing or insolvency by FCMs and their depositories, similar to depositors’ Federal Deposit Insurance Corporation protection, see
Sentinel pooled customer assets in various portfolios, depending on whether the customer assets were CFTC-regulated assets of FCMs or unregulated funds such as hedge funds or FCMs’ proprietary funds. But Sentinel handled “its and its customers’ assets as a single, undifferentiated pool of cash and securities.” Grede, 441 B.R. at 874. When customers wanted their capital back, Sentinel could sell securities or borrow the money. Sentinel’s borrowing practices, and in particular an overnight loan it maintained with the Bank of New York, is this appeal’s focal point. This arrangement allowed Sentinel to borrow large amounts of cash while pledging customers’ securities as collateral.
Under the new arrangement, Sentinel maintained three types of accounts at the Bank. First, clearing accounts allowed Sentinel tо buy or sell securities, including government, corporate, and foreign securities and securities traded with physical certificates. The Bank maintained the right to place a lien on the assets in clearing accounts. Second, Sentinel maintained an overnight loan account in conjunction with its secured line of credit. To borrow on the line of credit, Sentinel would call bank officials to confirm whether it had sufficient assets in lienable accounts to serve as collateral. A senior bank executive had to approve requests that put the line of credit above a predetermined “guidance line.” Third, Sentinel maintained segregated accounts that held assets that could not
Sentinel could independently transfer assets between accounts by issuing electronic desegregation instructions without significant bank knowledge or involvement. This system allowed for hundreds of thousands of trades worth trillions of dollars every day at the Bank. Sentinel maintained responsibility for keeping assets at appropriate levels of segregation. The Bank’s main concern was ensuring Sentinel had sufficient collateral in the lienable accounts to keep its overnight loan secured. In fact, at no point does it appear that the Bank was under-secured. If Sentinel sought to extend the line of credit beyond the value of the assets held in the lienable accounts, the Bank made sure Sentinel mоved enough collateral into the lienable accounts. Sentinel used cash from the overnight loan for customer redemptions or failed trades and provided collateral in the form of the customers’ redeemed securities. When customers redeemed investments, Sentinel could provide cash, via the loan, without waiting for the
But in 2001, and increasingly in 2004, Sentinel started using the loan tо fund its own proprietary repurchase arrangements with counterparties such as FIMAT USA and Cantor Fitzgerald & Co. Sentinel would finance most of a security’s purchase price by transferring ownership of the security to a counterparty, who would lend Sentinel an amount of cash equal to a percent of the asset’s market value. Sentinel used the overnight loan to cover the difference (known as a “haircut“) between the security’s cost and the repo loan. Sentinel had to buy the security back at some point for the amount loaned plus interest. By 2007, Sentinel held more than $2 billion in securities through repo arrangements. Meanwhile, Sentinel’s guidance line for the Bank loan grew from $30 million pre-May 2004, to $55 million in May 2004, tо $95 million in December 2004, to $175 million in June 2005, to $300 million in September 2006. The average loan balance from June 1, 2007, to August 13, 2007, was $369 million. The line topped out at $573 million at one point, while all along customer assets served as collateral. In 2004, Sentinel faced a segregation shortfall of about $150 million, and by July 2007, that figure reached nearly $1 billion.
During the summer of 2007, the cloud of a liquidity and credit crunch settled in. Repurchase lenders became nervous. The type of securities Sentinel held became a focus of the market as counterparties stopped accepting securities previ-
On June 1, a counterparty returned $100 million in physical securities, and as a result, the Bank loan jumped from $259.7 million to $353 million over the course of a day. To meet the Bank’s demands for collateral, Sentinel moved about $88 million in government securities from segregated accounts to the lienable account. There was no way to maintain segregation levels via the returned physical securities because Sentinel did not keep segregated accounts for physical securities. Sentinel’s segregation deficit grew to $644 million. On June 13, the Bank became suspicious, and a managing director emailed vаrious bank officials involved with the Sentinel account, asking how Sentinel had “so much collateral? With less than $20MM in capital I have to assume most of this collateral is for somebody else’s benefit. Do we really have rights on the whole $300MM??”1 After speaking to several bank officers, a Bank of New York client executive responded, “We have a clearing agreement which gives us a full lien on the box position outlined below.” The client executive testified that this was a well-advised and carefully worded statement, but both the managing director and the client executive knew Sentinel had
A similar transaction occurred on July 17, with a counterparty returning about $150 million in corporate securities. Sentinel transferred $84 million in corporate securities from a segregated account to a lienable account. The Bank loan settled at $496.9 million and Sentinel’s segregation shortfall grew to $935 million. At the month’s end, Sentinel briefly sent capital in the other direction. On July 30, Sentinel moved $248 million in corporate securities back into segregation from a lienable account and on July 31, $263 million in government securities back into segregation from a lienable account. Yet that same day, Sentinel moved $289 million in corporate securities from a segregated account to a lienable account. Sеntinel’s loan settled at $356 million and its segregation deficit at $700 million.
Plaintiff Frederick J. Grede was appointed Chapter 11 Trustee for Sentinel’s estate and, subsequent to the Chapter 11 plan’s confirmation, the Trustee of the Sentinel Liquidation Trust. The Bank filed a $312 million claim as the only secured creditоr. Grede filed an adversary proceeding against the Bank alleging that Sentinel fraudulently used customer assets to finance the loan to cover its house trading activity. Grede further alleged that the Bank knew about it and, as a result, acted inequitably and unlawfully. Grede brought claims of fraudulent transfer under the Bankruptcy Code and state law,
II. Analysis
In the district court, Grede advanced three arguments why the Bank of New York should be dislodged from its secured position. First, Grede argued that Sentinel acted with actual intent to hinder, delay, or defraud when it borrowed money from the Bank, and thus, the Bank’s lien should be avoided. Second, Grede argued that the Bank engaged in inequitable conduct when it allowed Sentinel to borrow money, and as a result, the Bank’s lien should be subordinated to the claims of unsecured creditors. Third, Grede argued that Sentinel’s contracts with the Bank violated the law on their face, so the Bank’s lien should be invalidated. We address each of Grede’s arguments in turn.
A. Fraudulent Transfer
At the conclusion of the bench trial, the district court acknowledged that Sentinel “was already insolvent at the time of the transfers” and had “miss[ed] creditor assets.” But the district court did not believe such behavior was enough to prove that Sentinel possessed the actual intent to hinder, delay, or defraud other creditors besides the Bank (including its FCM clients), as required to avoid a lien under
Consequently, we conclude that Sentinel’s transfers of segregated funds into its clearing accounts demonstrate an “actual intent to hinder, delay, or defraud” under
Similarly, in United States v. Davuluri, 239 F.3d 902, 906 (7th Cir. 2001), the defendant, Surya Davuluri, also appealed his conviction of mail and wire fraud under
Like Davuluri, Sentinel exposed its FCM clients to a substantial risk of loss of which they were unaware when it pledged funds that were supposed to remain segregated for the FCM clients as collateral for Sentinel’s overnight loans with the Bank of New York. Even though the district court found that Sentinel’s pledge was not an attempt “to drain its assets and make them unavailable to other creditors,” we held in Davaluri that someone who has the best intentions can still possess an actual intent to defraud. 239 F.3d at 906. Consequently, even if we assume that Sentinel had the best intentions for its FCM clients when it pledged the segregated funds,
Sentinel’s pledge of the segregated funds as collateral for its own loan becomes particularly egregious when viewed in light of the legal requirements imposed on Sentinel by the Commodity Exchange Act (CEA). Again, even if we assume that Sentinel eventually intended to replace the segregated funds and earn greater returns for their FCM clients, Sentinel knew that its pledge of the segregated funds violated the CEA. The CEA exists explicitly for the purpose of “ensur[ing] the financial integrity of all transactions” involving FCMs, “avoid[ing] systemic risk,” and “protect[ing] all market participants from ... misuses of customer аssets.”
The language of the CEA makes clear that Sentinel did more than just expose its FCM clients to a substantial risk of loss of which they were unaware; Sentinel, in an unlawful manner, exposed its FCM clients to a substantial risk of loss of which they were unaware. Thus, even if Sentinel did not intend to harm its FCM clients, Sentinel’s intentions were hardly innocent. For this reason, we find that Sentinel’s actions, as dеtermined by the factual findings of the district court, demonstrate an actual intent to hinder, delay, or defraud. As
B. Equitable Subordination
Courts will subordinate a claim under
“Equitable subordination means that a court has chosen to disregard an otherwise legally valid transaction.” Lifschultz, 132 F.3d at 347. In the past, our court—like other courts—has treaded very carefully before disregarding an otherwise legally valid transaction. See, e.g., Lifschultz, 132 F.3d at 347 (citing In re Mobile Steel Co., 563 F.2d 692, 701-02 (5th Cir. 1977)). Two fundamental concerns have motivated our hesitance to invoke the doctrine of equitable subordination: (1) the upsetting of a claimant’s legitimate expectations, and (2) the spawning of legal uncertainty that courts will refuse to honor otherwise binding agreements “on amorphous grounds of equity,” increasing everyone’s credit costs. Id.
Besides these two concerns, the difficulty of proving that a creditor has engaged in inequitable behavior has further increased our hesitance to apply the doctrine of equitable subordination. For example, the question of “‘whether a party has acted opportunistically,’” is quite subjective. Id. at 349 (quoting David A. Skeel, Jr., Markets, Courts, and the Brave New World of Bankruptcy Theory, 1993 Wis. L. Rev. 465, 506). There are simply no clear rules for determining whether underhanded behavior occurred. Id. (“Equitable subordination relies
Proving that an outside creditor behaved inequitably in anticipation of the debtor’s bankruptcy is much more difficult; the interests of an outside creditor are not necessarily aligned with the interests of the debtor (or with the interests of the debtor’s shareholders). As a result, courts have been particularly hesitant to invoke the doctrine of equitable subordination outsidе of cases involving insiders of closely held corporations. Lifschultz, 132 F.3d at 343. Some bankruptcy courts have even required wrongful conduct that rises to the level of “gross and egregious,” “tantamount to fraud, misrepresentation, overreaching or spoliation,” or “involving moral turpitude” before equitably subordinating an outside creditor’s claim. In re Granite Partners, L.P., 210 B.R. 508, 515 (Bankr. S.D.N.Y. 1997) (quotations and citation omitted). Consequently, it is not surprising that “[c]ases subordinating the claims of creditors that dealt at arm’s length with the debtor,” such as the case at hand, “are few and far between.” Kham, 908 F.2d at 1356.
In the past, our court has not directly addressed the degree of wrongful conduct sufficient to invoke the doctrine of equitable subordination against an outside creditor, so the
But in reaching the conclusion that the Bank’s behavior was neither egregious nor conscience-shocking, the district court relied upon factual findings that were internally inconsistent. Although we normally give great deference to the district court’s factual findings after a full bench trial, we cannot extend the same deference to internally inconsistent factual findings, which are, by dеfinition, clearly erroneous. See United States v. Sablotny, 21 F.3d 747, 751 (7th Cir. 1994) (“The district court’s factual findings ... are not internally inconsistent, and are thus not in clear error.“); see also Anderson v. City of Bessemer, N.C., 470 U.S. 564, 575 (1985) (“[W]hen a trial judge’s finding is based on his decision to credit the testimony of one of two or more witnesses ... that finding, if not internally inconsistent, can virtually never be clear error.“).
In particular, the district court appears to contradict itself regarding the extent of the Bank’s knowledge before Sentinel’s collapse. Approximately halfway through its opinion, the district court states, “[T]he evidence at trial revealed the Bank‘s knowledge that Sentinel insiders were using at least some of the loan proceeds for their own purposes.” Grede, 441 B.R. at 883. This statement indicates that the Bank of New York knew Sentinel was еngaging in wrongful conduct before its collapse.
The fact that the Bank knew Sentinel insiders were misusing the loan proceeds before Sentinel’s collapse renders other statements in the district court’s opinion equally рuzzling. For instance, at one point in the opinion, the district court concludes:
If BNYM should have been more diligent with regard to verifying the source of collateral, such a lack of care does not rise to the level of the egregious misconduct necessary for equitable subordination. The fact remains that BNYM had little reason to conduct such a verification and could rely on representations and warranties. Notwithstanding the evidence that demonstrates that at least one BNYM employee was suspicious, several of the facts that Trustee maintains support a finding of knowledge do not necessarily suggest that Sentinel was misusing customer assets.
Id. at 891 (emphasis added). Again, if the Bank knew that Sentinel insiders were misusing the loan proceeds, then how
These inconsistencies in the district court’s opinion regarding the extent of the Bank’s knowledge before Sentinel’s collapse lead to further inconsistencies regarding the mental state of Bank employees. If Bank employees knew that Sentinel insiders were misusing loan proceeds, then it certainly suggests that Bank employees (at the very least) turned a blind eye to the rest of Sentinel’s misconduct. And yet the district court concludes that Grede “failed to prove that BNYM was deliberately indifferent to Sentinel’s alleged fraud.” Id. at 887. Even if we were to accept the district court’s conclusion that Bank employees were not deliberately indifferent to Sentinel’s misconduct (which, of course, requires overlooking the inconsistencies regarding the extent of the employees’ knowledge), we run into further inconsistencies regarding the employees’ mental states. The district court’s opinion appears to waffle back and forth between characterizing their mental states as negligent and as reckless. Two excerpts from the opiniоn illustrate our point well. Toward the end of its discussion of equitable subordination, the district court remarks:
BNYM claims it did ongoing diligence, focused on Sentinel’s creditworthiness in an effort to ensure repayment and noticed nothing. But the question of whether Sentinel had the right to pledge the collateral certainly goes to the heart of
whether BNYM was adequately secured. Even if the Bank was solely concerned with protecting its own interests, a diligence process that excludes such a verification seems to be ineffective and reckless in light of the facts of which the Sentinel team at the bank was aware.
Id. at 892 (emphasis added). This statement indicates that the Bank employees were reckless in their failure to detect Sentinel’s misconduct. But only a few pages later, the district court suggests that the Bank employees’ failure to detect Sentinel’s misconduct did not rise to the level of recklessness:
The fact that they would have been better bankers if they had made a more rigorous inspection of Sentinel’s operations or its reporting is not enough to hold BNYM liable. If some degree of negligence were enough to establish inequitable conduct, the result might be different.
Id. at 894.
Because of these inconsistencies throughout the opinion, we are understandably dubious of the district court’s ultimate conclusion that the Bank’s conduct did “not rise to the level of egregious and conscience-shocking, and its claim should not be subordinated.” Id. at 898. Thus, before the district court can reach any conclusion regarding the nature of the Bank’s conduct, we believe that the district court must clarify two critical issues:
- What exactly did BNYM know before Sentinel’s collapse? Did BNYM know that Sentinel was engaged in
misconduct of any kind (including abuse of the loan proceeds)? - Was BNYM’s failure to investigate Sentinel before its collapse merely negligent? Or was it reckless? Or was it deliberately indifferent?
Once the district court clarifies these two points on remand, it can then revisit the ultimate issue of whether the Bank’s claim merits equitable subordination.
C. Voiding the Contracts
The district court dismissed under
The district court correctly dismissed this claim because the agreements were not the cause of Sentinel’s under-segregation. The contracts did not require either Sentinel or the Bank to do anything illegal, nor did they encourage either party to engage in illegal activity. The contracts’ provisions requiring Sentinel to release all third-party claims when funds were desegregated were not inherently unlawful because segregated funds could be deposited elsewhere “in the normal course of business” to settle trades.
Just because the parties to a contract have engaged in illegal behavior does not mean the contract itself is intrinsically illegal. Nor does “the defense of illegality ... come into play just because a party to a lawful contract ... commits unlawful acts to carry out his part of the bargain.” N. Ind. Pub. Serv. Co. v. Carbon Cnty. Coal Co., 799 F.2d 265, 273 (7th Cir. 1986) (citations omitted). Consequently, we agree with the district court that the defense of illegality is inapplicable to the contracts between Sentinel and the Bank of New York.
III. Conclusion
For the foregoing reasons, we AFFIRM the judgment of the district court with respect to Grede’s illegаl contract claim. However, we REVERSE the decision of the district court with respect to Grede’s fraudulent transfer and equitable subordination claims, and we REMAND the case back to the district court for further proceedings on these two claims that are consistent with this opinion. Circuit Rule 36 shall not apply on remand.