La décision Sentinel donne la priorité à la protection des marchés des valeurs mobilières et des contrats à terme

On March 19, 2014, the U.S. Court of Appeals for the Seventh Circuit decided Grede v. FCStone, LLC, Nos. 13-1232, 13-1278 (7th Cir. Mar. 19, 2014), an opinion that reinforces the importance of the portability of investment accounts carrying commodity customer funds. The Seventh Circuit held that commodity futures customer funds must be protected in an insolvency situation, and that the release of customer funds to meet margin obligations should be upheld at all costs. The Court’s decision recognizes the choice made by Congress to prioritize the stability of the financial markets ahead of other creditors when an investment firm becomes insolvent, and has significant implications for companies in the securities and futures industry.

Foley & Lardner LLP (“Foley”) tried the FCStone case in the district court and successfully handled the appeal in the Seventh Circuit. Foley represents FCStone, LLC and numerous other defendants in Sentinel-related cases, and acts as lead counsel of a joint defense group comprised of several former futures commission merchant (“FCM”) customers of Sentinel Management Group (“Sentinel”). On August 17, 2007, Sentinel, an investment management firm with a portfolio of $1.5 billion, filed for bankruptcy. Shortly before and after filing, Sentinel transferred hundreds of millions of dollars to the customer segregated accounts of its futures customers. These pre- and post-petition transfers became the source of dispute between the bankruptcy Trustee and the customers, and hinged on whether the Trustee had the authority to avoid and claw back the transfers under the Bankruptcy Code.

Sentinel’s customers included institutional investors such as FCMs, whose investments of customer funds are required by the Commodity Exchange Act and CFTC regulations to be held in trust and segregated from other funds. FCMs like FCStone, LLC were in Sentinel’s SEG 1 group, and deposited cash in exchange for a pro rata share of the value of securities in their groups’ portfolios. Just before filing for bankruptcy protection, Sentinel partially settled its accounts with each of the SEG 1 customers in the amount of $22.5 million. Three days after filing the petition, Sentinel and numerous FCM customers (many represented by Foley) appeared in bankruptcy court and successfully sought authorization for Sentinel to distribute another $297 million to the SEG 1 customers. The bankruptcy court issued an order stating that the bank was “authorized” to distribute the funds. The funds were distributed the next day.

A year later, the Trustee filed a motion with the bankruptcy court to clarify or modify its previous order. The court declined to modify the order, but stated the order did not determine whether the post-petition transferred monies were property of the bankruptcy estate, and that it was not its intention to “authorize” the post-petition transfers.

In September 2008, the Trustee filed separate adversary proceedings against each of the SEG 1 Defendants, seeking clawback of approximately $297 million in post-petition transfers and $22.5 million in pre-petition transfers. The case against FCStone, LLC was chosen as a test case while all of the other cases were effectively stayed, and a district court bench trial was held in October 2012. The district court ruled in favor of the Trustee and ordered FCStone, LLC to return all pre- and post-petition transfers because the court believed the commingled customer funds were property of the bankruptcy estate, and the August 2007 transfer of those funds had not been properly authorized under the bankruptcy code. The district court also rejected FCStone, LLC’s argument that the pre-petition transfers were protected by Section 546(e) of the Bankruptcy Code.

FCStone, LLC appealed the district court’s judgment. After briefing and oral argument, the Seventh Circuit, in an opinion written by Judge Hamilton, reversed the lower court because the district court’s opinion faced “insurmountable legal obstacles.”

In reversing, the Seventh Circuit held that the bankruptcy court clearly authorized the $297 million post-petition transfer, determining that finality and clarity were especially important in situations such as here where stability of the financial markets is at stake. The Seventh Circuit noted that FCStone, LLC and Sentinel’s other FCM customers needed the August 2007 transfers within hours of the bankruptcy court authorizing the transfer in order to satisfy customer margin obligations; had Sentinel’s FCM customers not received the post-petition transfer, they might have been liable to meet those obligations and a number of the FCMs might have been placed in financial peril. Therefore, the Seventh Circuit held that the FCMs—and the connected futures market itself—relied on the essential bankruptcy court order authorizing transfer of the funds, and the bankruptcy court abused its discretion in trying to eradicate its authorization order after the fact and after the parties and the market relied on it to satisfy customer margin obligations.

This case underscores the importance of investors in insolvent firms to involve outside counsel at the onset of bankruptcy. As is clear from the opinion, it is vitally important for parties seeking authorization orders to use operative and understandable language both when applying to the bankruptcy court for such an order and in drafting the authorization order. As the Seventh Circuit ruled in FCStone, once an order is entered authorizing transfer of funds, and especially when a party relies on that order to carry out an important public policy such as satisfying customer margin obligations, funds transferred pursuant to such an order may not be clawed back.

The Court also found that Sentinel’s pre-petition transfer to its FCM customers was the exact kind of transfer protected by Section 546(e) of the Bankruptcy Code. As the Court noted, Congress enacted Section 546(e) “to prevent a large bankruptcy from triggering a wave of bankruptcies among securities businesses” by allowing parties to rely on the finality of securities transactions. By preventing such a rippling effect, the safe harbor was meant to “protect[] the market from systemic risk and allow[] parties in the securities industry to enter into transactions with greater confidence.” While noting that the protection in Section 546(e) may not seem equitable to Sentinel’s other customers who did not receive a pre-petition transfer, the Court explained that “Congress chose finality over equity for most pre-petition transfers in the securities industry” in order to protect certainty and liquidity in the marketplace. Transfers of customer funds such as those made to Sentinel’s FCM customers are clearly transfers that Congress intended to protect under Section 546(e) in order to guard against instability in the financial markets.

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