Seventh Circuit denies trustee's claim to property transferred out of segregation and posted as collateral for a $312 million loan

On August 9, the U.S. Court of Appeals for the Seventh Circuit denied the claim of the liquidation trustee for the failed FCM, Sentinel Management Group, against the Bank of New York Mellon for more than $300 million that Sentinel had illegally removed from customer segregation accounts and posted as collateral for a loan from BNY.  app. ct. op.  The trustee, Frederick Grede, argued that BNY's lien on the funds should be voided and the funds returned for distribution to creditors because BNY was complicit in the breach of segregation.

Sentinel used the segregated funds to secure overnight loans that at one point exceeded $500 million.  The loan proceeds were used to finance, among other things, customer redemptions and Sentinel's proprietary trading.  Eventually, a BNY official began to question how Sentinel -- with a capitalization of roughly $3 million -- could post security worth 100 times that amount without using property to which others had a claim.  But he allowed himself to be fobbed off with a vague answer from his subordinates.

Both the District Court and the Court of Appeals showed the traditional reluctance -- embodied in the case law -- to impose a duty on a bank to supervise the propriety of its customers' actions.  The Court of Appeals noted that Sentinel could electronically desegregate funds without significant knowledge or involvement of BNY and that BNY's electronic system handled hundreds of thousands of transfers each day.  Neither the District Court nor the Court of Appeals was willing to consider BNY's conduct sufficiently egregious to void its lien, despite BNY's suspicions about the source of Sentinel's loan collateral.

The most disturbing aspect of this case -- detailed in the District Court's opinion (441 B.R. 864 (2010)) -- is that it portrays a deeply dysfunctional system.  Nobody was "minding the store" while Sentinel played fast and loose for several years with hundreds of millions dollars of customer funds:

• the NFA received monthly forms and annual audited financial statements that should have alerted it to Sentinel's irregular practices;

• the CFTC received the same information as the NFA but also did not detect Sentinel's scheme;

• independent auditors did not detect Sentinel's nefarious activities; 

• BNY did not follow up on its suspicions about the source of Sentinel's collateral; and

• Sentinel's customers -- many of whom were sophisticated FCM's -- entrusted large sums of money to Sentinel, which  offered the facially ridiculous claim that it had "constructed a fail-safe system that virtually eliminates risk from short term investing."

Every element in the system designed to protect customer funds failed.  This fact -- which will recur frequently in other situations we examine -- indicates that the system is due for a serious overhaul.