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Grede v. FCStone, LLC

United States Court of Appeals, Seventh Circuit

August 14, 2017

Frederick J. Grede, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust, Plaintiff-Appellant / Cross-Appellee,
FCStone, LLC, Defendant-Appellee / Cross-Appellant.

          Argued June 7, 2017

         Appeals from the United States District Court for the Northern District of Illinois, Eastern Division. No. 09 C136 - James B. Zagel, Judge.

          Before Ripple, Rovner, and Hamilton, Circuit Judges.

          Hamilton, Circuit Judge.

         The 2007 bankruptcy of Sentinel Management Group, Inc. has echoed through the courts for ten years now. This is our fifth appeal dealing with Sentinel. In a pair of cases decided in 2013 and 2016, we addressed the priority of a claim against the bankruptcy estate by the Bank of New York, Sentinel's largest (but no longer secured) creditor. In re Sentinel Management Group, Inc., 728 F.3d 660 (7th Cir. 2013); Grede v. Bank of New York Mellon Corp. (In re Sentinel Management Group, Inc.), 809 F.3d 958 (7th Cir. 2016). Earlier this year, we affirmed the convictions and sentence of Sentinel's former president and CEO, who was prosecuted for wire fraud and investment adviser fraud. United States v. Bloom, 846 F.3d 243 (7th Cir. 2017).

         In Grede v. FCStone, LLC, 746 F.3d 244 (7th Cir. 2014) (FCStone I), the direct predecessor to this appeal, we considered among other issues a distribution of $297 million to a group of Sentinel customers a few days after Sentinel filed for bankruptcy protection in August 2007. Following a bench trial, the district court had allowed the trustee in bankruptcy to avoid this post-petition transfer under 11 U.S.C. § 549. We reversed, holding that relief under § 549 was unavailable to the trustee because the bankruptcy court had authorized the transfer. We rejected the trustee's reliance on an October 2008 "clarification" through which the bankruptcy judge indicated that he had not intended to foreclose a § 549 avoidance action. Later statements by the judge about his subjective intentions could not, we concluded, defeat the plain language of the order authorizing the transfer. We remanded for further proceedings, which led to these new appeals.

         Despite our holding in FCStone I that "the bankruptcy court authorized the post-petition transfer" and that the trustee "therefore cannot avoid the transfer, " 746 F.3d at 258, the trustee argued on remand that the bankruptcy judge's October 2008 "clarification" was entitled to preclusive effect. Since FCStone did not appeal that "clarification" when it was made, the trustee argued, FCStone should be bound by it and collaterally estopped from arguing that the post-petition transfer was authorized. The district court rejected the trustee's argument on this point, and we affirm on two independent grounds. First, pursuant to the mandate rule and the law-of-the-case doctrine, the collateral estoppel theory was unavailable to the trustee on remand. Second, even if the theory were available despite our unambiguous holding in FCStone I, the bankruptcy judge's "clarification" was not the sort of final ruling that could be entitled to preclusive effect.

         On cross-appeal, FCStone raises an issue that lingered in the background but was not squarely presented during the previous appeal. The question concerns the proper distribution of nearly $25 million held in reserve under the confirmed bankruptcy plan. FCStone argues that these funds are trust property belonging to it and other creditors in its customer class who are protected by statutory trusts under the Commodity Exchange Act. The district court disagreed, treating the funds instead as property of the bankruptcy estate subject to pro rata distribution among all Sentinel customers and other unsecured creditors. On this cross-appeal, we reverse. Under the Bankruptcy Code, property held by the debtor in trust for others is by definition not property of the bankruptcy estate. Pursuant to the confirmed bankruptcy plan, FCStone and similarly situated customers preserved their right to recover their trust property. These creditors are entitled to the benefit of reasonable tracing conventions. Moreover, FCStone introduced essentially unrebutted evidence at trial showing that it can trace a portion of the reserve funds back to its investment. FCStone is entitled to recover its proportionate share of the reserve funds. The reserve funds should be distributed pro rata among FCStone and other members of its customer class.

         I. Factual Overview and Procedural History

         A. Sentinel's Collapse

         We review the most salient facts of the case, drawing from the district court's findings after the earlier bench trial. More complete discussions of Sentinel's downfall and the criminal misconduct of senior executives are included in the district court's earlier opinion, Grede v. FCStone, LLC, 485 B.R. 854, 859-67 (N.D. Ill. 2013), and in our opinions in Bloom, 846 F.3d at 246-50, and FCStone I, 746 F.3d at 247-51.

         In brief, Sentinel managed investments for futures commission merchants (FCMs) like FCStone, as well as for other classes of investors. FCMs act as financial intermediaries between investors and futures markets. They are regulated under the Commodity Exchange Act. Sentinel itself was an FCM and so was regulated under the Act.

         Sentinel organized its customers in different tranches known as segments or "SEGs." Within each SEG, customers were further divided into investment groups based on their risk appetites and financial goals. As relevant to this appeal, FCM customer assets were held in SEG 1, with FCStone's customer assets placed in Group 7. SEG 3 contained assets belonging to hedge funds and other sophisticated investors, as well as FCM proprietary or "house" funds.

         When customers invested funds with Sentinel, those funds were exchanged for securities and interest-bearing cash through a process that Sentinel called "allocation." Customers did not own securities outright but instead held indirect pro rata interests in the securities allocated to their group portfolios, as determined by their level of investment.

         Both the SEG 1 and SEG 3 customers were entitled to special protections under federal law. FCM customers who invested their own clients' funds in SEG 1 were protected by the Commodity Exchange Act and regulations promulgated by the Commodity Futures Trading Commission (CFTC). SEG 1 and SEG 3 customers alike were protected by the Investment Advisers Act of 1940 and regulations promulgated by the Securities and Exchange Commission (SEC). Both regulatory regimes required Sentinel to hold customer funds in segregation, i.e., separate from funds belonging to other customer classes and separate from Sentinel's own or "house" funds. Both regimes also created statutory trusts in the customers' favor to protect their property from Sentinel and its other creditors.

         Sentinel, unfortunately, did not honor the statutory trusts and comply with the segregation rules under the Commodity Exchange Act and the Investment Advisers Act. Instead, as the district court found, Sentinel routinely used hundreds of millions of dollars in securities it had allocated to customers as collateral to support Sentinel's own borrowing to pursue its leveraged trading strategy for its own benefit. It moved those securities out of segregation and into a lienable account at the Bank of New York, its main lender, putting customer property at risk for Sentinel's benefit. As Sentinel's leveraged trading increased, its outstanding debt ballooned, and it drew more and more on its customers' assets to support its borrowing habit.

         During the summer of 2007, Sentinel's investment scheme collapsed. As credit markets tightened and liquidity dried up on Wall Street (this was the beginning of what would become the financial crisis of the late 2000s), the market value of many Sentinel assets dropped. Sentinel's trading partners began making demands that forced it to borrow more heavily and in turn to provide more collateral-which it did by using customers' property as collateral. In late June and July 2007, Sentinel moved $250 million worth of securities allocated to SEG 1 to the lienable Bank of New York account. Then, in late July Sentinel swapped these securities with securities allocated to SEG 3 customers, resulting in a "massive shift of loss exposure" from SEG 1 to SEG 3. See Grede, 485 B.R. at 866.

         That final manipulation proved fateful for SEG 3 customers in the looming bankruptcy. Sentinel's wheeling and dealing had bought it some time, but in the end the firm could not keep up with redemption requests and demands from the Bank of New York. On Monday, August 13, 2007, Sentinel advised its customers that it was halting all redemptions (i.e., payments to them from their accounts). On Thursday, August 16, Sentinel sold a large portfolio of securities then allocated to SEG 1 to a firm called Citadel, depositing the proceeds in a SEG 1 cash account at the Bank of New York. The next day, Sentinel filed for Chapter 11 bankruptcy protection.

         B. Chapter 11 Proceedings

         1. Early Litigation

         On Monday, August 20, 2007, the first business day after it filed for bankruptcy, Sentinel (still under the control of its insiders) filed an emergency motion in the bankruptcy court seeking an order approving payment of the Citadel sale proceeds to SEG 1 customers. After emergency hearings, the bankruptcy court issued an order authorizing the Bank of New York to disburse the funds, less an approximately five percent holdback. The bank did so, and the SEG 1 customers received $297 million in what the parties describe as the "post-petition transfer/' with FCStone receiving a little shy of $15 million.

         Frederick Grede was appointed as Chapter 11 trustee. The bankruptcy court approved his appointment on August 29, 2007, within the fourteen-day window for appealing the order authorizing the post-petition transfer. See Fed.R.Bankr.P. 8002. The trustee did not appeal. A year later, however, he filed a "Motion to Clarify or in the Alternative to Vacate or Modify the Court's August 20, 2007 Order." In essence, the trustee argued that he should be permitted to bring avoidance actions against FCStone and the other SEG 1 customers who received, in the trustee's view, a disproportionate payout through the post-petition transfer.

         A group of SEG 1 customers including FCStone opposed the trustee's motion. At the conclusion of a hearing on the motion, the bankruptcy judge declined to vacate or modify the prior order. The judge said, however, that he was clarifying the order in that he "did not decide on August 20 and ... am not deciding today whether or not any of the proceeds that were the subject of that order are property of the estate ... or whether ... they were trust funds." The judge said that in his August 20 order, he "did not intend to foreclose the trustee or any party from any avoidance action whatsoever."

         2. FCStone I

         The bankruptcy court entered an order confirming the Fourth Amended Chapter 11 Plan of Liquidation in late 2008. (We discuss several provisions of the confirmed Chapter 11 plan in Part II-B.) Around that same time, the trustee commenced adversary actions against FCStone and other SEG 1 customers who had received distributions from the Citadel security sale back in August 2007. The trustee sought to avoid the post-petition transfers and to recover the Citadel sale proceeds (Count I), and he requested a declaration that funds held in reserve are property of the bankruptcy estate (Count III).[1] The district court withdrew the reference to the bankruptcy court, see 28 U.S.C. § 157(d), and presided over the case against FCStone as a test case.

         Following a bench trial, the district court ruled in favor of the trustee on Counts I and III. Grede, 485 B.R. at 889-90. The court concluded that the Citadel sale proceeds should be treated as property of the bankruptcy estate. Id. at 880. The court reasoned that (1) both SEG 1 and SEG 3 customers were protected by statutory trusts; (2) because the two classes of customers were similarly situated and because there were insufficient funds to satisfy all their claims, tracing fictions or conventions were inappropriate; and (3) FCStone and other SEG 1 customers could not trace the Citadel sale proceeds back to their original investments given Sentinel's coming-ling and misappropriation of customer assets that should have been segregated in trust for the customers. Id. at 873, 878, 880. The district court added that, for purposes of 11 U.S.C. § 549, and in light of the bankruptcy court's 2008 "clarification, " the 2007 post-petition transfer had not been "authorized" by the bankruptcy court. Id. at 881.

         We reversed in FCStone I, 746 F.3d at 260. We explained that the bankruptcy court's after-the-fact "clarification" of its subjective intentions concerning the post-petition authorization order ran contrary to the plain language of the order and amounted to an abuse of discretion. Id. at 255. "Whether the property belonged to the estate or not/' we reasoned, "in the absence of reversal, the authorization order ended any discussion about its original ownership, and the disputed property cannot later be clawed back by the trustee." Id.

         Because the parties had focused on the post-petition transfer, we did not specifically address the status of the funds held in reserve.[2] For that matter, we declined to decide "whether the funds at issue were, in fact, property of the estate, " id. at 258, though we agreed with the district court that there was no generally applicable legal basis for placing one statutory trust ahead of another. We tentatively approved the district court's requirement that would-be trust claimants (such as FCStone) must actually trace their investment property to the disputed funds. Id. at 259. We remanded for further proceedings.

         3. The Decisions on Remand

         On remand, the trustee moved for judgment on Counts I and III, while FCStone sought judgment on Count I and summary judgment on Count III. With respect to Count I, the trustee argued that FCStone should be collaterally estopped from asserting that the post-petition transfer was authorized. In the trustee's view, the bankruptcy judge's October 2008 "clarification" was entitled to preclusive effect. The district judge disagreed, writing that our decision in FCStone I-holding that the "clarification" was an abuse of discretion-stripped that ruling of "any force and effect." Grede v. FC Stone, LLC, 556 B.R. 357, 362 (N.D. Ill. 2016). The court entered judgment for FCStone on Count I. The trustee appeals that decision.

         The district judge then considered the status of the disputed reserves. The judge reiterated his view that equity prevented him from "favoring one statutory trust claim over another" and that actual tracing is difficult if not impossible given Sentinel's egregious pattern of commingling. Id. at 365. The judge concluded that the reserve funds should be treated as property of the estate, subject to pro rata distribution according to the confirmed Chapter 11 plan. Id. at 366. The court entered judgment for the trustee on Count III. FCStone cross-appeals that decision.

         II. Analysis

         A. The Trustee's Appeal - Collateral Estoppel

         On the issue of collateral estoppel (also known as issue preclusion) presented by the trustee's appeal, no facts are disputed, so we review de novo the district court's decision on this question of law. Adams v. Adams, 738 F.3d 861, 864 (7th Cir. 2013); Bernstein v. Bankert, 733 F.3d 190, 225 (7th Cir. 2013).

         1. Mandate Rule and Law of the Case

         The trustee's collateral estoppel argument is straightforward, if improbable. In the trustee's view, FCStone's failure to appeal the bankruptcy court's oral "clarification" of its prior written order means that FCStone should be bound by that "clarification" rather than being able to rely on the underlying order.

         As a preliminary matter, we conclude that the collateral estoppel argument was not even available to the trustee on remand following our decision in FCStone I. We did not specifically address collateral estoppel in our prior opinion because the trustee did not raise the issue, even though he had presented it earlier to the district court as an alternative argument in support of his § 549 avoidance action. But our broader discussion of the post-petition transfer left nothing to the imagination on this point. We said that the transfer was authorized and that it therefore "cannot be avoided under the express terms of 11 U.S.C. § 549." FCStone I, 746 F.3d at 247. We repeated that the transfer was "clearly authorized" and that, regardless whether the transferred property was part of the bankruptcy estate, "in the absence of reversal, the authorization order ended any discussion about its original ownership, and the disputed property cannot later be clawed back by the trustee." Id. at 255.

         Given our unambiguous resolution of the dispute over the post-petition transfer, two closely related doctrines-the mandate rule and the law-of-the-case doctrine-should have precluded the trustee from resurrecting his collateral estoppel theory in the district court and getting a second bite at the § 549 apple. Compare EEOC v. Sears, Roebuck & Co.,417 F.3d 789, 796 (7th Cir. 2005) ("In general, any issue conclusively decided by this Court on appeal may not be reconsidered by the district court on remand."), and United States v. Polland, 56 F.3d 776, 777 (7th Cir. 1995) ("The mandate rule requires a lower court to adhere to the commands of a higher court on remand."), with United States v. Adams,746 F.3d 734, 744 (7th Cir. 2014) ("The law of the case doctrine is a corollary to the mandate rule and ...

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