Frederick J. GREDE, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust, Assignee of certain claims, Plaintiff-Appellee, Cross-Appellant, v. FCSTONE, LLC, Defendant-Appellant, Cross-Appellee.
Nos. 13-1232, 13-1278
United States Court of Appeals, Seventh Circuit.
Decided March 19, 2014.
Rehearing and Rehearing En Banc Denied May 19, 2014.
746 F.3d 244
Argued Dec. 10, 2013. * Judge Flaum took no part in the consideration of petition for rehearing.
Catherine L. Steege, Attorney, Jenner & Block LLP, Chicago, IL, for Plaintiff-Appellee, Cross-Appellant.
Stephen Bedell, Attorney, Foley & Lardner LLP, Chicago, IL, for Defendant-Appellant, Cross-Appellee.
Before MANION, ROVNER, and HAMILTON, Circuit Judges.
Sentinel Management Group, Inc., was an investment management firm that filed for Chapter 11 bankruptcy protection on August 17, 2007. Sentinel was caught in the midst of the credit crunch that heralded the beginning of the financial crisis of 2008-09. The crunch Sentinel faced was much worse because, it is now clear, Sentinel managers invaded for their own use the assets that Sentinel was legally required to hold in trust for its customers.
These appeals focus on two transfers of assets. In the days and even the hours just before the bankruptcy filing, Sentinel shifted assets around to increase dramatically the assets available to pay one group of its customers at the expense of another group. Then, on the first business day after the bankruptcy filing, Sentinel obtained the permission of the bankruptcy court to have its bank distribute more than $300 million from Sentinel accounts to the favored group of customers. As a result of these pre-petition and post-petition transfers, the customers in the favored pool have recovered a good portion of their assets from Sentinel, while those in the disfavored pool are likely to receive much less. For the benefit of the disfavored pool of customers, Sentinel‘s trustee in bankruptcy has sought to avoid both transfers under
This case seems to be unprecedented, or at least unusual, in one important respect. Sentinel‘s managers violated federal commodities and securities law by invading not just one but two statutory trusts for customer assets, one under the
The district court resolved the conflict between the two groups of wronged customers in an equitable way. The court “avoided” (a technical term meaning set aside) both the pre-petition and post-petition transfers so as to share the available assets as fairly as possible between the two groups who are similarly situated, apart from Sentinel‘s choices to favor one group over the other. Grede v. FCStone, LLC, 485 B.R. 854 (N.D.Ill.2013). As we explain below, however, our review persuades us that there are insurmountable legal obstacles to the avoidance relief ordered by the district court. We therefore reverse as to both transfers.
With respect to the pre-petition transfer, the bankruptcy code provides for avoidance (sometimes also called a “clawback“) of so-called preferential transfers made by an insolvent debtor in the 90 days before filing a bankruptcy petition.
The post-petition transfer of $300 million was authorized by the bankruptcy court. That authorization means that the post-petition transfer cannot be avoided under the express terms of
I. Factual Background
The details of Sentinel‘s illegal practices and eventual collapse have been described well in the district court‘s findings in this case, Grede v. FCStone, LLC, 485 B.R. 854 (N.D.Ill.2013), and by our court in a related case, In re Sentinel Mgmt. Grp., Inc., 728 F.3d 660 (7th Cir.2013), so we set out only the facts most relevant to these appeals.
Sentinel was an investment management firm that specialized in short-term cash management. Its customers included hedge funds, individuals, financial institutions, and futures commission merchants, known in the business as FCMs. Sentinel promised to invest its customers’ cash in safe securities that would nevertheless yield good returns with high liquidity. Under the terms of Sentinel‘s investment agreement, a customer would deposit cash with Sentinel, which then used the cash to purchase securities that satisfied the requirements of the customer‘s investment portfolio. Customers did not acquire rights to specific securities under the contract, but rather received a pro rata share of the value of the securities in their investment pool. Sentinel prepared daily statements for customers that indicated which securities were in their respective pools and the customers’ proportional shares of the securities’ value.
Sentinel classified all customers into segments depending on the type of customer and the regulations that applied to that customer. Sentinel then divided each segment into groups based on the type of investment portfolio each customer had selected. In all, Sentinel had three segments divided into eleven groups. For our purposes, we focus on two segments: Segment 1, which consisted of FCMs’ customers’ funds, and Segment 3, which contained funds belonging to hedge funds, other public and private funds, individual investors, and FCMs investing their own “house” funds. FCStone‘s funds were in Segment 1.
Both Segment 1 and Segment 3 accounts were subject to federal regulations requiring Sentinel to hold its customers’ funds in segregation, meaning separate from the funds of other customers and Sentinel‘s own assets. Customer funds could not be used, for example, as collateral for Sentinel‘s own borrowing. The FCMs in Segment 1 were protected by the
Unfortunately for Sentinel‘s customers, their investment agreements with Sentinel and the federal regulations bore little relation to what Sentinel actually did with their money. Rather than investing each segment‘s cash in securities for the segment, Sentinel lumped all available cash
Sentinel also allocated a misleading sort of “interest income” to its customers on a daily basis. Under the terms of their agreements with Sentinel, customers were entitled to a pro rata share of the interest accrued by securities in their respective pools. However, Sentinel instead would calculate the interest earned by all securities, including those belonging to other Segments and the house pool. Sentinel would then guesstimate the yield its customers expected to receive on their group‘s securities portfolio, add a little extra so that the rate of return seemed highly competitive, and report the customer‘s pro rata share of that amount, minus fees, on the customer‘s statement.
Sentinel funded its securities purchases using not only the customer cash in the segment accounts but also cash from repo transactions and money loaned to it by the Bank of New York (BONY), the bank where Sentinel housed the majority of its client accounts. BONY required Sentinel to move securities into a lienable account to serve as collateral for the loan. If Sentinel were to move Segment 1 or Segment 3 customer assets into a lienable account, meaning that BONY had a lien on those customer assets to secure its loans to Sentinel, then Sentinel would be violating the trust requirements of federal laws meant to protect Segment 1 and Segment 3 customers from precisely such a risk.
Originally, the BONY loan was meant to provide overnight liquidity. As Sentinel expanded its leveraged trading operations, though, it used the BONY loan to cover the fees those trades required. Sentinel‘s BONY loan ballooned, growing from around $55 million in 2004 to an average of $369 million in the summer of 2007. As the loan grew, Sentinel began using securities that were assigned to customers as collateral for its own borrowing, moving them out of their segregated accounts and into the lienable account overnight. This meant that securities that were supposed to be held in trust for customers were instead being used for Sentinel‘s financial gain and were subject to attachment by BONY, a flagrant violation of both SEC and CFTC requirements.
Sentinel‘s illegal behavior left customer accounts in both Segment 1 and Segment 3 chronically underfunded, but customers were none the wiser. The securities that were serving as collateral for the BONY loan continued to appear on customer statements as if they were being held in segregated accounts for their benefit even though Sentinel was routinely removing them from those accounts.
The music came to a crashing halt in the summer of 2007 as the subprime mortgage industry collapsed and credit markets tightened. Many of Sentinel‘s repo counter-parties began returning the high-risk, illiquid physical securities that Sentinel
BONY soon notified Sentinel that it would no longer accept physical securities as collateral. It began pressuring Sentinel to pay down its gigantic loan balance. In response, Sentinel moved $166 million worth of still-valuable corporate securities out of Segment 1, where they were held in trust, to a lienable account as collateral for the BONY loan, again violating federal segregation requirements and exposing Segment 1 customer assets to the risk of attachment by BONY. Sentinel also sold a large number of Segment 1 and Segment 3 securities to pay down the loan, again treating customer securities as if they belonged to Sentinel itself and using them for its own financial gain. On August 16, 2007, BONY asked Sentinel to repay its loan in full immediately. The following day, BONY told Sentinel that due to the failure to repay the loan, it would begin liquidating the loan‘s collateral in a few days. Sentinel filed for bankruptcy protection that same day.2
Sentinel took several actions as it approached bankruptcy that dramatically improved the situation of the Segment 1 customers and worsened that of the Segment 3 customers. On July 30 and 31, 2007, Sentinel returned $264 million worth of securities to Segment 1 from a lienable account where they had been placed in violation of segregation requirements. Sentinel then moved $290 million worth of securities from the Segment 3 trust into the same lienable account. This virtually emptied the Segment 3 trust and once again violated federal securities laws. Then, even after informing its customers on August 13 that it would no longer honor requests for redemption, Sentinel nevertheless paid out full and partial redemptions to some Segment 1 customers. Sentinel also distributed cash to two Segment 1 groups that constituted the full value of those accounts. Finally, on Friday, August 17, mere hours before filing for bankruptcy, Sentinel distributed $22.5 million in cash to two additional Segment 1 groups, one of which included FCStone. FCStone received $1.1 million in that distribution, which is the pre-petition transfer at issue in these appeals.
After filing for bankruptcy protection, Sentinel again acted to protect the Segment 1 customers at the expense of its other customers and creditors. On Thursday, August 16, Sentinel had sold a portfolio of Segment 1 securities to a company called Citadel and deposited the proceeds of more than $300 million in a Segment 1 cash account. Sentinel filed for bankruptcy the next day, on Friday, August 17.
On Monday, August 20, while still controlled by insiders, Sentinel filed an emergency motion with the bankruptcy court seeking an order allowing BONY to distribute the Citadel sale proceeds to the Segment 1 customers. The SEC, CFTC, and at least one Segment 3 customer appeared at an emergency bankruptcy court hearing. They expressed concerns that Sentinel might have been commingling
The bankruptcy court later appointed Frederick Grede as trustee of the Sentinel bankruptcy estate. The trustee filed adversary proceedings in the bankruptcy court seeking to avoid Sentinel‘s pre- and post-petition transfers to FCStone and others. The district court withdrew the reference to the bankruptcy court because it found the proceedings raised significant and unresolved issues of non-bankruptcy law. Grede v. Fortis Clearing Americas LLC, No. 09-C-138, 2009 WL 3518159, at *3-4 (N.D.Ill. Oct. 28, 2009). The current case against FCStone was selected as a test case to resolve common issues among the trustee‘s adversary proceedings against other FCMs who received pre-petition and post-petition transfers. (We do not discuss the other FCMs further.) The trustee sought to avoid Sentinel‘s pre-petition transfer to FCStone under
The district court held that the trustee could avoid the pre- and post-petition transfers. Grede, 485 B.R. 854. The court examined the post-petition transfer first, focusing on whether the transfer involved property of the estate and was authorized by the bankruptcy court, see
The district court also concluded that the bankruptcy court did not authorize the post-petition transfer of the Citadel sale proceeds within the meaning of
Turning to the pre-petition transfer, the court held that the transfer was not a “settlement payment” and was not made “in connection with a securities contract” within the meaning of
FCStone appeals the rulings avoiding both the pre- and post-petition transfers. It contends that the transfers did not involve property of the estate, that the pre-petition transfer fell within
II. Analysis
These appeals present many questions, but we find that just two are decisive. First, we conclude that the trustee cannot avoid the pre-petition transfer because
A. The Pre-Petition Transfer
In general, a bankruptcy trustee can avoid a transfer that (1) was made to or for the benefit of a creditor, (2) was for or on account of an antecedent debt, (3) was made while the debtor was insolvent, (4) was made on or within 90 days before the date of the filing of the petition, and (5) allowed the creditor to receive more than it otherwise would have through the bankruptcy.
The trustee‘s power to avoid transfers made on or within 90 days before a bankruptcy filing means that many financial transactions are not really final until those 90 days have passed. In securities and financial markets, however, such uncertainty can have especially high costs. In
Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment, as defined in section 101, 741, or 761 of this title, or settlement payment, as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or se
curities clearing agency, in connection with a securities contract, as defined in section 741(7), commodity contract, as defined in section 761(4), or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A) of this title.
(Emphasis added.)
The purpose of this safe harbor was “to ensure that honest investors will not be liable if it turns out that a leveraged buyout (LBO) or other standard business transaction technically rendered a firm insolvent.” Peterson v. Somers Dublin Ltd., 729 F.3d 741, 748 (7th Cir.2013); see also Peter S. Kim, Navigating the Safe Harbors: Two Bright Line Rules to Assist Courts in Applying the Stockbroker Defense and the Good Faith Defense, 2008 Colum. Bus. L.Rev. 657, 663-64. Otherwise, one firm‘s bankruptcy could cause a domino effect as its clients could similarly default on their obligations, which in turn would trigger further bankruptcies, and so on. By preventing one large bankruptcy from rippling through the securities industry in this way, the
We agree with FCStone that Sentinel‘s pre-petition transfer fell within
Section
The statute defines a settlement payment in a broad if rather circular manner as “a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade.”
The pre-petition transfer was also made “in connection with a securities contract,” which is an independent basis for applying the safe harbor of
The district court came to different conclusions based not on the text of
We understand the district court‘s powerful and equitable purpose, but its reasoning runs directly contrary to the broad language of
As important as the statutory text is, we hope we are not understood as applying a wooden textualism to the issue. We also do not see any persuasive reason to depart from the deliberately broad text of
By enacting
B. The Post-Petition Transfer
A bankruptcy trustee can avoid a transfer of property of the estate that occurs after the commencement of the case if it was not authorized under the bankruptcy code or by the bankruptcy court.
As discussed above, on the first business day after the bankruptcy petition was filed, Sentinel asked the bankruptcy court for an emergency order allowing BONY to disburse funds to Segment 1 customers, including FCStone. Sentinel claimed that the funds belonged to the Segment 1 customers and were not property of the estate because they were the proceeds of the sale of Segment 1 securities to Citadel. The SEC cautioned, and the CFTC conceded, that there was evidence that Sentinel had commingled Segment 1 and Segment 3 funds and that Sentinel had sold Segment 3 securities to Citadel. The SEC opposed the order on that basis. Despite these concerns, the bankruptcy judge approved the transfer, which was carried out very quickly.
A trustee may not avoid a transfer of property of the estate under
The trustee argues and the district court held that although the bankruptcy court allowed BONY to disburse the funds to Sentinel‘s customers, including FCStone, the bankruptcy court did not authorize the transfer within the meaning of
We conclude that the post-petition transfer was clearly authorized by the bankruptcy court. That court‘s later “clarification” of its order ran contrary to the plain language of its order. We also are not persuaded that the bankruptcy court order actually authorizing the transfer somehow managed not to authorize the transfer within the meaning of
For starters, we do not think that the bankruptcy court must first decide that the property at issue belongs to the estate in order to authorize the transfer within the meaning of
For instance, if a bankruptcy trustee wishes to disburse funds that do not belong to the estate, nothing prevents it from asking the bankruptcy court, out of an abundance of caution, to issue a comfort order authorizing the disbursement of admittedly non-estate funds. It cannot be the case that requesting the court‘s authorization would somehow subject that transfer to additional scrutiny (and potential clawback) that would not apply if the trustee had simply disbursed the funds to their owners, as he would have been perfectly entitled to do. See In re Kmart Corp., No. 02 B 02474, 2006 WL 952042, at *7 (Bankr.N.D.Ill. April 11, 2006) (
Whether the property belonged to the estate or not, in the absence of reversal, the authorization order ended any discussion about its original ownership, and the disputed property cannot later be clawed back by the trustee. See Vogel v. Russell Transfer, Inc., 852 F.2d 797, 800-01 (4th Cir.1988)
The text of the order did not reserve the trustee‘s right to avoid the transfer. Such a reservation would be illogical if the order authorized the transfer under
Unfortunately for the trustee and the interests he represents, however, the order did not preserve such a right to avoid the transfer. In negotiations about the order, the parties agreed to reserve a five percent “holdback” to cover any unanticipated claims that might arise. The order then stated that it was “without prejudice to all rights, defenses, claim [sic] and/or causes of action, if any, of the Debtor or any such third parties (including Citadel) against any Distributee, with respect to the Holdback and/or with respect to any claim for priority under Section 761-767, or other applicable law.” (Sections
The trustee‘s reading is not correct. The placement of “with respect to” twice in the sentence divided the sentence into two parts: (1) the holdback, and (2) claims for priority under sections 761-767 or other applicable law. The use of “and/or” between the holdback claims and the priority claims, but not between priority claims under sections 761-767 and “other applicable law,” also indicates that “other applicable law” modifies only the types of priority claims that can be brought. It follows that the sentence should be read to protect the debtor‘s rights against distributees (1) with respect to the five percent holdback contemplated in the order, and (2) with respect to claims for priority under
The trustee contends that we should interpret the order in light of the transcript of the hearing leading to the order authorizing the transfer. In gener
In this case, FCStone and other parties needed BONY to release the money within hours of the order being issued so that they could in turn pay their obligations to their own customers. Requiring FCStone to pore through the court record before deciding whether the transfer was authorized and whether it could transfer the money on to its own customers without risk of having to return the money to Sentinel would have effectively nullified the emergency order. The amounts were large enough that if FCStone could not transfer the money to meet its obligations to its customers, it would have been insolvent itself. So, finding the text of the order unambiguous, we do not base our decision on the transcript of the hearing where the order was approved.6
The trustee also argues that we should defer to the bankruptcy court‘s later interpretation of its order. The district court deferred to the bankruptcy court‘s later interpretation of the order, citing In re Resource Tech. Corp., 624 F.3d 376, 386 (7th Cir.2010), which in turn cited In re Airadigm Communications, Inc., 547 F.3d 763, 768 (7th Cir.2008), for the broad proposition that we will leave the interpretation of a bankruptcy court‘s order to that court‘s discretion. At the same time, we have raised concerns about such deference to an issuing court‘s interpretation, especially when the issue affects reliance interests and the interests of non-parties, rather than just issues such as case management. See In re Trans Union Corp. Privacy Litigation, 741 F.3d 811, 816 (7th Cir.2014). “Litigants as well as third parties must be able to rely on the clear meaning of court orders setting out their substantive rights and obligations, and appellate courts should interpret those orders in the same manner.” Id. These concerns are particularly acute in a situation like the bankruptcy court‘s order authorizing payments to non-parties.
Too much deference to a bankruptcy court‘s much-later interpretation would undermine the ability of parties and non-parties to rely on a court order and creates the risk that interpretation of an order becomes a means to rewrite it after unintended consequences have given rise to regrets. When the order here was issued,
If we were to conclude now that the authorized transfer was not authorized after all, FCStone would face the resulting liquidity crunch now. The losses would fall not on its clients and creditors of 2007 but on its later clients and creditors, meaning that losses would fall quite differently than they would have in 2007. In other words, the bankruptcy court‘s later interpretation of its order would change the allocation of the loss stemming from Sentinel‘s bankruptcy, shifting it away from one group of FCStone customers and onto another. FCStone, the other FCMs, their customers, and all other affected parties have strong reliance interests in not allowing the bankruptcy court or the trustee to rewrite history in this way.7
The situation might be different if the bankruptcy court had clarified its order before parties and others had relied on the order‘s plain meaning to their detriment. However, deferring to the bankruptcy court‘s clarification made so long after the fact, when the money has already been disbursed to the FCMs and distributed to their customers, would upset the strong and reasonable reliance interests of those parties.
In this case, the text of the original order was sufficiently clear to find that the bankruptcy court‘s clarification, to the effect that the authorized transfer was not actually authorized for purposes of
We conclude, then, that the bankruptcy court authorized the post-petition transfer within the meaning of
Both the Segment 1 and Segment 3 funds were subject to statutory trusts. Segment 1 was protected by the
Between these two options, we think the district court had the better answer and that Cunningham and its progeny provide useful insight for resolving the competing trust claims in this case. (We do not think that Begier applies here because it involved a floating trust.) That would suggest that the Cunningham requirement that claimants trace their assets to establish their trusts (without the benefit of tracing conventions) would apply here as well. See Cunningham, 265 U.S. at 11. FCStone rightly notes, though, that Cunningham did not involve statutory trusts, and we too find the difference significant. Where Congress has acted to establish a trust for certain customers to strengthen their confidence in capital markets, the trust may be more robust than one imposed by a court‘s equitable powers. The congressional protection indicates a national interest in protecting those customers. In short, we agree with the district court‘s discussion of this problem. See Grede, 485 B.R. at 874-78.
A new rule may be in order for competing statutory trust claimants that splits the difference between the harsh consequences of failing to trace under Cunningham, and the lax tracing requirements under Begier. One such rule might be to require trust claimants to trace without the benefit of tracing conventions, but to place trust claimants who fail to trace in a class ahead of at least unsecured creditors, giving them priority in bankruptcy proceedings. Again, we are not required to resolve the issue today, both because we reverse on other grounds and because the Sentinel bankruptcy plan (which treats all creditors as a single class of unsecured creditors) has been approved and the time to appeal it has run out.
C. The Trustee‘s Cross-Appeal
The trustee cross-appealed for reinstatement of his unjust enrichment claim if we reversed the district court, and for prejudgment interest. We agree with the district court that the trustee‘s unjust enrichment claim is preempted by federal bankruptcy law. To allow an unjust enrichment claim in this context would allow the trustee or a creditor to make an end run around the bankruptcy code‘s allocation of assets and losses, frustrating the administration of the bankruptcy estate under federal bankruptcy law. See Contemporary Industries Corp. v. Frost, 564 F.3d 981, 988 (8th Cir.2009); Pertuso v. Ford Motor Credit Co., 233 F.3d 417, 426 (6th Cir.2000). We therefore will not reinstate the trustee‘s unjust enrichment claim. We also do not award the trustee pre-judgment interest because he is not the prevailing party. See, e.g., In re Oil Spill by the Amoco Cadiz Off Coast of France on Mar. 16, 1978, 954 F.2d 1279, 1331 (7th Cir.1992).
The judgment of the district court is REVERSED and the case is remanded to the district court for further proceedings consistent with this opinion.