In re MF Global: Customer Responsible for Debit Balance on Account Liquidated by FCM without Notice | Practical Law

In re MF Global: Customer Responsible for Debit Balance on Account Liquidated by FCM without Notice | Practical Law

The US Bankruptcy Court for the Southern District of New York held, in In re MF Global Inc., that a customer was liable to the trustee of failed futures commission merchant MF Global for the debit balance of the customer's account where the customer agreement granted the FCM the right to declare the customer in default without making a margin call as well as the right to liquidate the customer's account without affording it prior notice.

In re MF Global: Customer Responsible for Debit Balance on Account Liquidated by FCM without Notice

by Practical Law Finance
Published on 16 Jul 2015 • USA (National/Federal)
The US Bankruptcy Court for the Southern District of New York held, in In re MF Global Inc., that a customer was liable to the trustee of failed futures commission merchant MF Global for the debit balance of the customer's account where the customer agreement granted the FCM the right to declare the customer in default without making a margin call as well as the right to liquidate the customer's account without affording it prior notice.
On June 2, 2015, the US Bankruptcy Court for the Southern District of New York held, in In re MF Global Inc., that a customer was liable to the trustee of a failed futures commission merchant (FCM) (MF Global) for the debit balance of the customer's account at the FCM where the customer agreement granted the FCM the right to declare the customer in default without making a margin call as well as the right to liquidate the customer's account without affording it prior notice (No. 11–02790 (MG), (Bankr. S.D.N.Y. June 2, 2015)).

Background

Charles Sonson (customer) opened an investment trading account with MF Global Inc. (MFGI), an FCM, on August 20, 2009, and executed a customer agreement which governed the relationship between the parties. The customer agreement granted MFGI various rights, including:
  • The right to declare customer in default under the customer agreement without making a margin call.
  • The right to liquidate customer's account without affording customer prior notice.
On May 6, 2010, a market disruption caused a rapid decline in prices for many major exchange-listed stocks, causing customer account to become undermargined, creating exposure for MFGI. Although not contractually obligated to do so, MFGI attempted to notify customer on May 6 to inform him that his account was below margin and that he needed to deposit $154,000 into his account to maintain his minimum margin balance. MFGI was unable to speak with customer on each attempt to contact him.
According to the MFGI trustee, customer failed to contact MFGI, and MFGI was forced to cover customer's debit to protect itself. Accordingly, MFGI began liquidating customer's customer account. By the following day, customer's customer account was fully liquidated and reflected a debit balance in the amount of $51,093.46. According to the MFGI trustee, the customer agreement provided that customer was "unconditionally obligated" to pay MFGI the amount of any debit balance in his account regardless of how it was incurred.
MFGI demanded that customer pay the debit balance, but customer refused to pay on the grounds that MFGI improperly liquidated his account. Rather than pay MFGI the debit balance, customer commenced a lawsuit against MFGI in the US District Court for the Northern District of Illinois on June 22, 2010. Customer sought damages for breach of contract, breach of the fiduciary duty of care and misrepresentations in violation of the Commodity Exchange Act (CEA). MFGI counterclaimed for breach of contract alleging that customer failed to pay MFGI the debit balance as well as fees and costs required under the terms of the customer agreement.
In its objection, the MFGI trustee argued that section 502(d) of the Bankruptcy Code requires the disallowance of any claim from a claimant from which property is recoverable unless the claimant pays the amount for which it is liable. According to the trustee, the debit balance of customer's account constituted property of the estate subject to turnover under section 542 of the Bankruptcy Code. The MFGI trustee asserted that customer refused to turn over any portion of the debit balance to MFGI or otherwise agree to a consensual resolution of the debit balance. Accordingly, the MFGI trustee argued that customer's claim should be disallowed unless and until he has paid or turned over the debit balance to the estate.

Outcome

Section 502(d) of the Bankruptcy Code

Under 502(d), a bankruptcy court is required "to disallow the claim of any claimant who is withholding property of the estate which may be recovered under" section 542(b) of the Bankruptcy Code. The purpose of section 502(d) is to prevent entities that hold estate property subject to turnover or avoidance from receiving a distribution of estate assets until that property is first returned to the estate.
The court determined that whether the trustee has made a prima facie showing that the debit balance of customer's account was subject to turnover for purposes of ruling on the objection required the court to resolve whether the debit balance constituted estate property.
The court held that:
  • Customer was liable to MFGI in the debit balance of his account.
  • The trustee met his burden of making a prima facie showing that the debit balance was subject to turnover under section 542.

MFGI Did Not Breach the Customer Agreement by Liquidating Customer's Account

The court held that MFGI did not breach the customer agreement by liquidating customer's account without notice. Rather, MFGI had the right to liquidate customer's undermargined account without notice, and that right was not waived or limited by MFGI's margin call.
The customer agreement included provisions:
  • Imposing on customer the obligation to maintain a certain amount of margin on deposit (margin provision).
  • Setting out MFGI's ability to declare a default and the remedies available upon an event of default (default provision). Specifically, the default provision provided that MFGI was authorized to declare (without the necessity for a call for additional capital) customer in default under the customer agreement and any other agreement. The default provision made clear that MFGI could declare customer in default without first making a margin call.
  • Affording MFGI remedies upon default (remedy provision). The remedy provision granted MFGI the right to sell, in the event of default (without prior notice to customer), any property in which customer had an interest held by or through MFGI or its affiliates. The remedy provision further provided that customer would thereafter be liable to MFGI for any remaining deficiencies, losses, costs or expenses sustained by MFGI.
The court determined that, while the default provision broadly authorized MFGI to declare customer in default, the customer agreement did not indicate whether MFGI was required to notify customer that he was in default before exercising its remedies upon default. The court noted that it was undisputed that MFGI made three attempts to advise customer that his account was below margin. Furthermore, customer admitted that he learned of the margin call by listening to a voice message from MFGI before his account was liquidated. The court therefore concluded that, to the extent that the customer agreement required MFGI to communicate to customer that he was in default, MFGI satisfied the requirement. By notifying customer of the margin call, MFGI communicated that his account was undermargined and in violation of the margin provisions of the customer agreement.
The court further noted that the remedy provision clearly provided that, upon default, MFGI could liquidate customer's account positions without notice. Furthermore, neither Illinois nor federal law requires an FCM to provide a customer prior notice before liquidating an undermargined account.
Next, the court, relying on First Am. Disc. Corp. v. Jacobs, rejected customer's alternative argument that the customer agreement or Illinois law incorporate a requirement that customer be afforded reasonable time to comply with a margin call (756 N.E.2d 273 (2001)).
The court next held that the manner of MFGI's liquidation of customer's account did not breach the customer agreement. The court rejected customer's argument that the debit account balance resulted from "the inconsistent and haphazard way" that MFGI liquidated the positions in his account. According to customer, MFGI could not make a reliable valuation of his account on May 6, 2010 because substantially all of the positions in his account were relatively illiquid. The court reasoned that the plain language of the customer agreement imposed no limitations on the manner in which MFGI liquidated the positions in customer's account. Additionally, neither Illinois nor federal law requires an FCM to liquidate a customer's account in any particular manner.

The Trustee Adequately Alleged that customer's Debit Account Balance is Subject to Turnover

Finally, the court found that the trustee adequately alleged that the debit balance of customer's account was subject to turnover under section 542(b). According to section 542(b), "an entity that owes a debt that is property of the estate and that is matured, payable on demand, or payable on order, shall pay such debt to, or on the order of, the trustee...."
The court held that:
  • The debit balance of customer's customer account with MFGI constituted a debt owed to MFGI pursuant to a prepetition contract.
  • The debt was "matured" within the meaning of section 542(b), because the trustee has established that customer was unconditionally obligated to pay MFGI the amount of this debit balance under the customer agreement.

Practical Implications

The case is a reminder that futures account agreements and futures and options account agreements often include one-sided margin provisions that grant extensive rights in posted customer collateral to the FCM. Customers need to be aware of these rights when entering into these types of agreements. These terms are often non-negotiable since these entities are gatekeepers to these markets and market participants cannot trade in certain products or enter into certain types of financial contracts without agreeing to these provisions.
However, market participants should be aware that certain key terms - such as notices and timing of collateral calls and posting - are subject to some limited negotiation, especially for high net worth, creditworthy customers.