Member Article

On January 4, 2013, the United States District Court for the Northern District of Illinois, Eastern Division (the “District Court”) issued a Memorandum Opinion and Order¹ that seems demonstrably at odds with the majority of cases analyzing the § 546(e) safe harbor provision.²

General Background Facts

Sentinel Management Group, Inc. (“Sentinel” or “Debtor”) was an SEC-registered investment advisor and a CFTC-regulated futures commission merchant (“FCM”) that managed investments for its various customers and divided its customers into different investment groups.

Sentinel entered into customer agreements with each of its customers (each, a “Customer Agreement”) which specified that the customer’s cash investment would be invested in a specific investment group, along with the cash investments from other Sentinel customers in the same investment group. Each customer within the investment group would own an indirect interest in the segregated investment portfolio of their particular investment group, but the customers did not own any of the particular securities included in the investment group’s portfolio. Rather, the customers were entitled to receive redemptions of cash proceeds from the investment group.

Preference Action Against FCStone

In August 2007, Sentinel filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code. Grede, the trustee for the liquidation trust created by the Debtor’s plan of reorganization, filed an adversary proceeding seeking to avoid and recover pre- and post-petition transfers made by Sentinel to FCStone, LLC (“FCStone”), one of Sentinel’s many customers. Count II of the adversary proceeding sought to avoid one such transfer in the amount of just more than $1 million as an avoidable preference pursuant to § 547(b).

On the day before Sentinel filed bankruptcy, Sentinel sold to Citadel, a third party, a portfolio of 98 securities that had been allocated to certain Sentinel investment groups. The net sale proceeds realized from the sale of the securities exceeded $300 million, and such proceeds were deposited by Sentinel into a segregated cash account to be further allocated to the investment groups. On the next day, Sentinel distributed approximately $22.5 million of the Citadel sale proceeds to an account specifically for the benefit of two investment groups. Of the $22.5 million, just more than $1 million was then distributed as a cash redemption to FCStone, one of the investment group customers. Later that same day, Sentinel filed its voluntary petition for relief initiating its bankruptcy case.

In its Memorandum Opinion and Order, the District Court summarized the above transactions relevant toCount II through the following figure:

Analysis of Application of § 546(e)

The dispute over Count II was whether the $1 million transfer from Sentinel to FCStone was shielded from avoidance by the § 546(e) safe harbor provision, which protects from avoidance settlement payments and transfers in connection with securities contracts. FCStone asserted that the customer redemption transfer was both a settlement payment made to a commodity broker as well as a transfer made in connection with a securities contract, to wit, the Customer Agreement that governed the relationship between Sentinel and FCStone. The Trustee, on the other hand, argued that the $1 million customer redemption transfer was not made “in connection with a securities contract” pursuant to § 546(e) because the Customer Agreement was not a “contract for the purchase, sale, or loan of a security,” pursuant to § 741(7). In addition, the Trustee argued that the $1 million transfer was not a “settlement payment” because it was not “made to complete [a] securities transaction.” Rather, the Trustee asserted that the relevant “securities transaction” took place between Sentinel and Citadel rather than the cash redemption transaction that took place between Sentinel to FCStone.

The District Court affirmatively declined to address the specific arguments raised by the parties. Rather, the District Court stated that “regardless of whether the distribution of the Citadel proceeds fits under a literal interpretation of § 546(e), I find it inconceivable that Congress intended the safe harbor provisions to apply to the circumstances of this case.” The District Court based its conclusion that “applying the safe harbor here would produce a result ‘demonstrably at odds with the intentions of its drafters’” on its findings that (1) applying the safe harbor to shield the transfers to FCStone would create the very type of systemic market risks that Congress sought to prevent, and (2) failing to apply the safe harbor to this case would not result in the unwinding of completed transactions that Congress sought to protect.

In support of its finding that application of the safe harbor in this case would actually create the systemic risk that it was designed to prevent, the District Court first noted that Congress enacted § 546(e) as a means of “minimizing the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.” The District Court then observed that if a debtor “distributes proceeds in an uneven and arbitrary manner (i.e., favoring certain customers over others with an equally forceful legal claim to the funds), extending § 546(e) safe harbors to uphold the distribution would destabilize the financial system by making it utterly unpredictable how losses will be apportioned in the event that an FCM or investment advisor goes bankrupt” and “[t]hat a few of these customers could be forced to bear all losses, rather than their pro rata share, in the event of an FCM or investment advisor’s bankruptcy raises the likelihood of institutional collapse and associated systemic fallout.”

In support of its finding that the transaction at issue in this case was not the type of transaction that Congress sought to protect in enacting § 546(e), the District Court noted that “[t]he relevant security transaction in this case was between Sentinel and Citadel; no securities were ever exchanged between Sentinel and FCStone.” The District Court went on to note that the § 546(e) safe harbor provision was “very clearly designed to protect Citadel from having to return the securities it received from Sentinel, as those securities may be necessary to meet its current trading obligations.” The District Court declined, however, to find that the § 546(e) safe harbor provision was broad enough cover the subsequent cash redemption payment made to FCStone. Rather, the District Court stated that “[t]he legislative record is devoid of indication that Congress intended § 546(e) to govern how the debtor distributes proceeds from a completed securities transaction if that debtor happens to be trading on behalf of third parties.” Finally, the District Court maintained that the “customer deposits and redemptions at Sentinel were not directly tied to the purchase or sale of securities – customer deposits were not necessary to settle security purchases, nor were customer redemptions necessary to settle security sales – and therefore did not affect the settlement chain § 546(e) was designed to protect.”

Based on these findings, the District Court concluded that applying § 546(e) in this case would be demonstrably at odds with the intentions of its drafters and therefore held that the § 546(e) safe harbor did not apply in this case; accordingly, judgment was entered against FCStone on Count II.

In a footnote, the District Court conceded that Congress intended for § 546(e) to reach a broad scope of financial instruments. However, the District Court declined to extend § 546(e) “beyond the securities transaction to subsequent, indirectly related cash transactions to customers.” The District Court also acknowledged that the Southern District of New York has ruled differently on this issue. See Picard v. Katz, 462 B.R. 447 (S.D.N.Y. 2011); Picard v. Greiff et al., No. 11 Civ. 3775, 2012 WL 1505349 (S.D.N.Y. April 30, 2012). The holding in Grede is also difficult to reconcile with such cases as the Second Circuit opinion inEnron³ and the decisions in Quebecor⁴ and Verizon,⁵ which take a broader view of what constitutes a transfer “in connection with” a securities contract and is a rare example of a holding determining that a bankruptcy statute is unenforceable as demonstrably at odds with the intent of the drafters. See Lamie v. U.S. Tr., 540 U.S. 526, 534 (2004) (noting that where statutory language is plain, “the sole function of the courts—at least where the disposition required by the text is not absurd—is to enforce it according to its terms”); see also U.S. v. Ron Pair Enters., Inc., 489 U.S. 235, 242 (1989) (“The plain meaning of legislation should be conclusive, except in the ‘rare cases [in which] the literal application of a statute will produce a result demonstrably at odds with the intentions of its drafters.’”).

Please note that the District Court’s ruling currently stands in contrast to much of the existing case law regarding § 546(e) and that FCStone is currently appealing the decision to the Seventh Circuit Court of Appeals.

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