Court Says Broker Fraud Protected by Bankruptcy’s Safe Harbor

By | March 20, 2014

Bankruptcy law’s “safe harbor,” which prevents customers of defunct brokerages from being sued, applies even when the broker was engaged in fraud and violated multiple securities laws, the U.S. Court of Appeals in Chicago ruled.

The 31-page opinion by U.S. Circuit Judge David F. Hamilton reversed a decision from January 2013 by U.S. District Judge James B. Zagel. Zagel said the safe harbor of Section 546(e) of the Bankruptcy Code shouldn’t be employed because it was “inconceivable” that Congress wanted the statute invoked when the broker was benefiting some customers by defrauding others.

The case before the Chicago appeals court involved liquidated money manager Sentinel Management Group Inc. A registered futures commission merchant, Northbrook, Illinois- based Sentinel was required to keep investments in two different segregated accounts for two different types of customers. Each account was governed by different federal statutes and different regulatory schemes. Sentinel improperly moved customers’ deposits from one account to the other.

Shortly before bankruptcy, Sentinel began giving preferred treatment to one group of customers at the expense of the other. Immediately after bankruptcy, although before the trustee was appointed to oust management, Sentinel prevailed on the bankruptcy judge to pay out $300 million to the group of favored customers, Hamilton said.

After his appointment, trustee Frederick Grede started a test case against futures commission merchant FCStone LLC to recover $15.6 million, representing money received from Sentinel just before and after the bankruptcy filing in August 2007.

Zagel took the lawsuit out of bankruptcy court and ruled in January 2013 that the safe harbor shouldn’t apply. His ruling in favor of the trustee was set aside yesterday by Hamilton.

Hamilton conceded that Sentinel violated numerous securities laws and said the case presented “hard choices in applying bankruptcy law to the wreckage.” He said the safe harbor presented “insurmountable obstacles” to the trustee’s efforts to take back money paid to the preferred group and even out losses between the two sets of customers.

With regard to payments FCStone received before bankruptcy, Hamilton said the “powerful and equitable purposes” Zagel employed were “directly contrary” to the “broad language” of the safe harbor, which precludes suing to recover payments made in connection with securities accounts.

Although he said he hoped his opinion wouldn’t be “understood as applying wooden textualism to the issue,” Hamilton said he could see “no persuasive reason” to depart from the statute’s “deliberately broad text.”

In response to Zagel’s conclusion that Congress couldn’t have meant to protect transactions of the sort at issue, Hamilton said that “Congress chose finality over equity” with regard to taking back pre-bankruptcy transfers.

As for the post-bankruptcy transfers, Hamilton said they were authorized by the bankruptcy judge under Section 549 of the Bankruptcy Code. Because there was no appeal, the post- bankruptcy payments couldn’t be taken back because they were court authorized.

Hamilton said the appeal involved so-called preference suits to recover payments within 90 days before bankruptcy. He pointed out that the safe harbor has an exception allowing suits to recover transfers within two years before bankruptcy that were the result of actual fraud. Hamilton said the safe harbor has no exception for preference suits.

“We’re studying the opinion,” attorney Catherine Steege, who argued the case for Grede, said by phone today. “We are obviously disappointed and the trustee is considering his options.”

For details on Zagel’s opinion, click here for the Jan. 8, 2013, Bloomberg bankruptcy report.

Sentinel voluntarily asked for a trustee four business days after its Chapter 11 filing in August 2007. Its Chapter 11 plan was implemented in December 2008 and created trusts that sued on behalf of creditors.

Customers who had claims of their own against third parties had the right under the plan to assign the claims to the trustee to prosecute collectively. Almost all did. The plan called for the trustee to allocate lawsuit recoveries between customers and those who assigned him their claims.

The appeal is Grede v. FCStone LLC, 13-1232, U.S. Court of Appeals for the Seventh Circuit (Chicago).

The district court case is Grede v. FCStone LLC, 09- cv-00136, U.S. District Court, Northern District of Illinois (Chicago). The Chapter 11 case is In re Sentinel Management Group Inc., 07-bk-14987, U.S. Bankruptcy Court, Northern District of Illinois (Chicago).

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