On January 4, 2013, the US District Court for the Northern District of Illinois issued an opinion in an adversary proceeding relating to the Chapter 11 bankruptcy case of Sentinel Management Group, Inc., in which it held that certain prepetition payments made by Sentinel, a futures commission merchant (FCM), to its customers were not protected from avoidance action by the safe harbor of section 546(e) of the Bankruptcy Code. Under section 546(e), payments made by or to an FCM in connection with a securities contract, commodity contract or forward contract are exempt from avoidance under the Bankruptcy Code. However, in this case, the Court found that the connection between the payment and the contract was too attenuated for the safe harbor to apply. The case is currently under appeal to the US Court of Appeals for the Seventh Circuit.

Sentinel was a corporation that managed investments for clients such as FCMs, hedge funds, financial institutions, pension funds and individuals. Sentinel offered several different portfolios as investment options and classified its customers into three segments or "SEGs" based on the customers' regulatory status and the types of investments the customer invested in. Sentinel was registered with the SEC as an investment adviser and with the CFTC as an FCM. While FCMs typically execute and clear futures transactions, Sentinel registered as an FCM only so that it could provide its investment advisory services to FCMs that invested funds of their commodity customers pledged to these FCMs as collateral under commodities trades (customer funds). Sentinel represented to its customers and to regulators that all of its customer funds were properly held in segregation. In fact, Sentinel treated its own and its customers' assets as a single, undifferentiated pool of cash and securities.

Sentinel maintained customer fund accounts at Bank of New York (BONY) and had an arrangement under which BONY would cover Sentinel's collateral haircuts associated with its repurchase agreements (repos), subject to reimbursement by Sentinel. As the credit markets contracted in the summer of 2007, Sentinel's repo counterparties began closing out positions in Sentinel's repo portfolio, returning securities Sentinel had loaned them and demanding cash in return. Unable to meet its repayment obligations, Sentinel drew more heavily on its BONY coverage. Sentinel provided BONY with additional collateral for the loan by using cash and securities from its customer accounts.

On August 16, 2007, BONY notified Sentinel that it planned to liquidate Sentinel's collateral. The same day, Sentinel sold a portfolio of securities to Citadel Investment Group, LLC. The next day, before filing for bankruptcy, Sentinel distributed the proceeds from the Citadel sale to customers in two SEG 1 investment groups. On August 20, 2007, Sentinel obtained a court order allowing it to distribute additional sale proceeds to SEG 1 customers. As a result, FCStone, LLC, an FCM invested in SEG 1, received a total of approximately $15.6 million in both prepetition and postpetition payments. In contrast, customers in SEG 3 received no prepetition payments from Sentinel and were left with a small pool of assets to recover from in the bankruptcy case.

In September 2008, the liquidation trustee filed various adversary proceedings for avoidance and recovery of prepetition and postpetition transfers made by Sentinel to or for the benefit of certain SEG 1 customers. The adversary proceeding against FCStone was chosen as a test case to resolve common legal issues among the adversary proceedings. In the test case, the trustee sought to avoid or reduce the transfer of approximately $15.6 million to FCStone.

The key litigated issues before the Court were whether:

The Court ruled, among other things, that the transfers to FCStone were:

After the Court determined that the prepetition portion of the transfer to FCStone was an unlawful preference, FCStone's defense was that this transfer was protected by the settlement payment safe harbor provisions of section 546(e) of the Bankruptcy Code (§ 546(e), Bankruptcy Code) for payments made in settlement of a securities agreement. Section 546(e) protects from avoidance margin payments and settlement payments made by or to (or for the benefit of) certain types of financial parties and transfers made in connection with securities contracts, commodity contracts or forward contracts. The purpose of this safe harbor is to prevent disruptions to the capital markets that might occur if long-term trades could be unraveled later by preferences and other avoidance actions.

FCStone argued that the transfer was:

The trustee argued that the transfer was not:

The Court sided with the trustee, holding that regardless of whether the distribution fit under the literal interpretation of the section 546(e) safe harbor, it was inconceivable that it had been congressional intent for the safe harbor provisions to apply to the circumstances presented in the case. The Court based its conclusion on two factors:

The safe harbor is meant to shield legitimate securities and commodities transactions from avoidance to prevent a damaging ripple effect throughout the capital markets. The Court reasoned that where the debtor is a financial institution selling securities on behalf of third party customers, the section 546(e) safe harbor would serve not to shield the actual exchange between debtor and buyer, but to favor certain customers over others. The Court opined that allowing this could destabilize the financial system by making it impossible to predict how losses would be allocated when an FCM or investment adviser goes bankrupt.

While the 546(e) safe harbor protects settlement payments made to FCMs in connection with a securities contract, commodity contract or forward contract, as this case illustrates, if the connection between the payment and the contract is too attenuated, as here, the safe harbor does not apply. Under the Court's ruling, these payments are subject to avoidance under the Bankruptcy Code and to the bankruptcy claims process.

Although the precise scope of the Court's exception is unclear, it appears to apply to situations in which the debtor's business involves trading on behalf of third parties where the debtor distributes proceeds from an unrelated transaction to its customers. FCStone's appeal to the Seventh Circuit will be of great importance in determining the proper scope of the safe harbor as it relates to FCMs.

The question remains whether the ruling would have been different had the funds disbursed to the FCM customers been tied more directly to the IAA. It is also unclear why FCStone did not attempt to rely on the language contained in 546(e) protecting from avoidance the return of margin payments (customer funds) by an FCM to a customer in connection with a commodity contract, but rather attempted to rely on the less-applicable securities agreement language.

The Court expressed a willingness to examine the facts and circumstances of the transaction to see if it aligned with the congressional intent behind the 546(e) safe harbor. However this decision stands in contrast to broader views of the safe harbor adopted by other courts, such as the US Court of Appeals for the Second Circuit and the US Bankruptcy Court for the Southern District of New York (see Legal Update, Second Circuit Holds that "Settlement Payment" Safe Harbor Insulates Early Redemptions of Enron Commercial Paper from Fraudulent Transfer and Preference Attack and Official Comm. of Unsecured Creditors of Quebecor World (USA), Inc. v. American United Life Ins. Co. (In re Quebecor World (USA) Inc.), 453 BR 201 (Bankr. S.D.N.Y. 2011)).

While the ruling could cause certain commodities customers to consider conducting commodity futures trades on exchanges located in other jurisdictions where courts have interpreted the safe harbor more broadly, the precedential value of this case may be limited because:

For more information on the section 546(e) safe harbor, see Practice Note, Fraudulent Conveyances in Bankruptcy: Overview: Settlement Payment Defense.

For information on repos, see Practice Note, Repos: Overview (US).

For information on Dodd-Frank rules addressing the treatment of customer funds by FCMs, see Practice Note, The Dodd-Frank Act: Derivatives Margin Collateral Rules: Investment of Customer Funds and Cleared Swaps Customer Collateral.