The Bottom Line

The Seventh Circuit recently held, in Grede v. FCStone, LLC, Nos. 16-1896 & 16-1916, 2017 WL 3470145 (7th Cir. Aug. 14, 2017), that (i) a transfer previously authorized by a bankruptcy court order cannot be avoided due to the court’s later clarifying language, particularly where a higher court previously ruled that such avoidance was improper and (ii) where statutory trust beneficiaries can trace their initial investment in funds held by the debtor, such funds are trust funds, not property of the estate, and cannot be distributed to general unsecured creditors. This decision is the second time these issues have been before the Seventh Circuit in this case.

What Happened?

Background

The bankruptcy case of the debtor, Sentinel Management Group, Inc. (“Sentinel”), began in 2007. Sentinel managed investments for futures commission merchants (“FCMs”) who are regulated under the Commodity Exchange Act, and other investors regulated by the Investment Advisers Act of 1940. Both regulatory regimes require investment managers such as Sentinel to hold its customers’ funds in segregated accounts and create statutory trusts for the customers to protect their property from creditors. See, e.g., 7 U.S.C. § 6d(a). Sentinel organized its customers into different tranches known as segments or “SEGs.” SEG 1 contained FCM customer assets while SEG 3 contained assets belonging to other investors.

Sentinel did not comply with these segregation rules and regularly combined and commingled customer funds. The day before its chapter 11 filing, Sentinel sold a large portfolio of SEG 1 securities to an outside firm and deposited the proceeds of this sale into a SEG 1 cash account. A few days after its bankruptcy filing, Sentinel filed an emergency motion for an order approving payment of these sale proceeds to SEG 1 customers. The bankruptcy court issued an order authorizing these payments to FCStone and other SEG 1 customers, less a 5% holdback, which was placed into a reserve. The SEG 1 customers received approximately $297 million from this “postpetition transfer.” The bankruptcy court appointed a chapter 11 trustee shortly thereafter.

A year later, the trustee sought to vacate the court’s authorization of the postpetition transfer, arguing that he should be permitted to bring avoidance actions against the SEG 1 customers who received payment. The bankruptcy judge declined to vacate or modify its prior order, but stated on the record that he was “clarifying” the order in two respects. First, he stated that he did not decide whether any of the proceeds subject to that order were property of the estate or trust funds. Second, he stated that he did not intend the prior order to foreclose the trustee or any party from bringing avoidance actions.

FCStone I

In late 2008, the bankruptcy court approved Sentinel’s chapter 11 plan of liquidation, which contained language stating that all customer claimants shall be treated as unsecured creditors, with an exception for SEG 1 customers who voted against the plan or lodged objections thereto. FCStone and other SEG 1 customers opposed drafts of the plan that would have treated them as unsecured creditors. The plan also stated that such SEG 1 customers will only share pro rata with holders of general unsecured claims if the court ultimately determines that the reserve funds are property of the estate.

Around the same time, the trustee commenced certain adversary proceedings against FCStone and other SEG 1 customers to (i) recover the postpetition transfer and (ii) request a declaration that the funds held in the holdback reserve were property of the estate. The district court ruled in favor of the trustee on both issues. On the first issue, the district court determined that in light of the bankruptcy court’s “clarification,” the postpetition transfer was not authorized by the bankruptcy court. On the reserve issue, the district court reasoned that the reserve funds were property of the estate because (i) both SEG 1 and SEG 3 customers were protected by statutory trusts and thus were similarly situated and (ii) FCStone and other SEG 1 customers could not trace the reserve proceeds back to their original investments.

These issues then reached the Seventh Circuit for the first time, where the Court reversed the holding of the district court. The Court held that the bankruptcy court’s order authorized the postpetition transfer, despite the later “clarification,” which the court found was an abuse of discretion. However, the Court did not specifically address the status of the reserve funds and remanded for further proceedings.

On remand, the trustee argued that FCStone should be collaterally estopped from asserting that the postpetition transfer was authorized due to the bankruptcy court’s later “clarification,” which was entitled to preclusive effect. The district court disagreed, holding that the Seventh Circuit’s earlier ruling that the “clarification” was an abuse of discretion stripped that ruling of any force and effect. On the second issue, the district court held that actual tracing of the reserve funds to the SEG 1 customers was difficult if not impossible due to Sentinel’s commingling and, therefore, the reserve funds should be treated as property of the estate.

Current Appeal

On the issue of whether the postpetition transfer was authorized, the Seventh Circuit held that due to the mandate rule and the law of the case doctrine, the trustee should have been precluded from arguing his collateral estoppel theory in the district court. The mandate rule requires a lower court to adhere to the commands of a higher court on remand, while the law of the case doctrine, a corollary to the mandate rule, prohibits a lower court from reconsidering on remand an issue expressly or impliedly decided by a higher court. Due to the previous ruling by the Seventh Circuit that the “clarification” was ineffective, the district court was correct in declining to reach the merits on this issue on remand.

The Seventh Circuit also stated that even if the trustee could have pursued his collateral estoppel theory on the merits, such argument would fail due to finality concerns. The Court held that collateral estoppel does not attach to tentative orders, such as the “clarification.” Therefore, if any order was entitled to preclusive effect, it was the bankruptcy court’s order authorizing the postpetition transfer, not the judge’s later comments about his subjective intentions.

The Court then turned to the issue of whether the reserve funds were property of the estate or trust funds, ultimately holding that the funds were trust property belonging to FCStone and other SEG 1 customers. The district court’s original ruling stated that because the SEG 1 and SEG 3 customers were similarly situated, the reserve funds could not be treated as trust property for the SEG 1 customers. The Circuit Court noted, however, that while both the SEG 1 and SEG 3 customers were entitled to the protections of a statutory trust, the language in the debtor’s chapter 11 plan prevented them from receiving similar treatment. Under the plan, the SEG 3 customers agreed to be treated as unsecured creditors without any exception for statutory trust claims, while the SEG 1 customers preserved their rights under their statutory trust. Therefore, the SEG 3 customers lost their status as trust beneficiaries for the purposes of distribution from the reserve funds.

On the issue of tracing, the district court originally held that the reserve funds were not trust funds because the SEG 1 customers could not trace their original investments due to Sentinel’s commingling of funds. However, the Circuit Court noted that trust property does not lose its trust character because a debtor misappropriated or commingled it with the debtor’s own property. The Court also held that because FCStone presented credible evidence during trial, including testimony of a forensic accounting expert, that it could, in fact, trace the funds in the reserve back to its original investment, it was entitled to judgment in its favor that the reserve funds are trust funds held for the benefit of SEG 1 customers alone.

Why This Case is Interesting

With this decision, the Seventh Circuit has articulated three key points to take away. First, the Court underscored the important of adhering to prior higher court decisions. Given that the Court previously ruled that the “clarification” was ineffective to modify the prior bankruptcy court order, such ruling became the “law of the case,” which must be followed by all lower courts hearing the same issues on remand. Second, this case highlights the important of carefully crafting language in a chapter 11 plan, which becomes in effect a contract between the parties thereto. Had the SEG 3 customers fought for language in the plan which would have excepted them from treatment as general unsecured creditors, they could have potentially received recovery from the reserve funds as well. Finally, the Court focused on the importance of credible evidence and testimony, particularly when tracing trust funds. Once funds are determined to be trust funds, they cannot lose this characteristic due to the bad behavior of a debtor. If a trust beneficiary can present credible evidence that the funds are entitled to trust protection, this can greatly benefit the beneficiary’s distributions in a chapter 11 case.