In its fifth trip to the Seventh Circuit Court of Appeals, the Sentinel Management Group’s bankruptcy case recently explored complex issues bankruptcy practitioners often encounter in large chapter 11 cases with financial services debtors. In a far-ranging opinion, the Seventh Circuit held that the Bankruptcy Court’s oral “clarification” of an earlier order, which had already been reversed on appeal, could not serve to collaterally estop parties under the mandate rule and the law-of-the-case doctrine. The Seventh Circuit also reinforced that (i) assets subject to a statutory trust, in this case under the Commodities Exchange Act, are not property of the estate, (ii) tracing principles are applicable to determine whether certain assets are trust assets belonging to specific trust beneficiaries, and (iii) beneficiaries of a statutory trust can waive their rights to be treated as such through acquiescence to a reorganization plan.

Before filing for bankruptcy in 2007, Sentinel Management Group (“Sentinel”) managed investments for futures commission merchants (“FCMs”) who act as intermediaries between investors and futures markets. The investments were regulated under the Commodity Exchange Act, which provides in part that funds invested by and on behalf of FCMs are held in trust for the benefit of the investor. Just after filing for bankruptcy, Sentinel obtained bankruptcy court approval to pay out almost $300 million to certain FCMs (the “SEG1 FCMs”) from an account holding investments on their behalf. A small portion of the account was held back in reserve. Even though a chapter 11 trustee was appointed within the time to appeal the payment, no one, including the trustee, challenged the transfer at the time. Later on, Sentinel confirmed a reorganization plan in which the SEG1 FCMs maintained their entitlement to any funds to which they could trace to their investments. Another similar group of FCMs agreed to be treated as all other general unsecured creditors.

The trustee subsequently brought post-confirmation proceedings in district court to claw-back the original $300 million payment, arguing that the $300 million was property of the estate. The district court allowed the trustee to avoid the transfer in part because, after approving the payment, the bankruptcy court stated orally that its original approval of the payment was not intended to determine whether the money was property of the estate. The Seventh Circuit reversed, holding that, by approving the payment, the bankruptcy court was in effect ruling that the funds were not property of the bankruptcy estate, no one had timely challenged the approval, and all of the parties had carried on in reliance on the approval.

On remand, the trustee once again attempted to claw-back the $300 million payment, arguing that the SEG1 FCMs had only appealed the bankruptcy court’s order avoiding the payment, but they did not appeal the bankruptcy court’s oral statement that the payment approval did not determine to whom the funds belonged. Therefore, the trustee argued, the bankruptcy court’s “clarification” was entitled to preclusive effect against the SEG1 FCMs. The trustee also argued that the reserve account should be distributed to creditors as an asset of the estate under the plan. The district court rejected the trustee’s claw-back arguments, but agreed that the reserve account was an estate asset and should be distributed as such under the plan because Sentinel had pooled its investment funds—rendering tracing impossible—and competing statutory trust claims between the two groups of FCMs made it difficult to determine who had priority to the funds, even if tracing was possible.

The Seventh Circuit affirmed as to the claw-back issue, but reversed on the second. Regarding the claw-back, the Seventh Circuit held that the mandate rule and the law-of-the-case doctrine barred the trustee from trying to circumvent the court’s prior ruling and mandate on remand. The court explained that the mandate rule requires a lower court to adhere to the commands of a higher court on remand. The law-of-the-case doctrine is a corollary to the mandate rule and prohibits a lower court from reconsidering on remand an issue that was either expressly or implicitly decided by a higher court. The bankruptcy court’s oral “clarification” of its prior order approving the payment was not an appealable order and directly contradicted the Seventh Circuit’s earlier decision.

As to the second issue, the Seventh Circuit reinforced that assets held in trust under a statutory scheme, such as the Commodities Exchange Act, are not bankruptcy estate assets under Section 541(d) of the Bankruptcy Code. If the beneficiaries of such a trust are able to trace assets to particular funds, then those funds are not available for distribution to creditors. From a policy standpoint, the court explained that, because commodity investments lack protection under programs such as the Federal Deposit Insurance Corporation, the statutory trust protections are necessary to attract and maintain investors. With that background, the Seventh Circuit pointed out that the SEG1 FCMs’ forensic accounting expert had employed traditionally accepted principles to trace their investments to the reserve without significant challenge. The Seventh Circuit reversed the district court’s holding that tracing was not possible because Sentinel had pooled investment funds. The Court reasoned that, if mere pooling of funds was sufficient to prevent tracing, then tracing would not be useful in virtually any case as a practical matter. The Court then explained that, while two groups of FCMs could have claimed statutory trusts over the reserve, the SEG1 FCMs was the only group that had preserved its ability to assert a trust over the reserve in the plan, while the second group had waived its right to a trust because they agreed to be treated as general unsecured creditors under the plan. Accordingly, the Seventh Circuit remanded the case, directing the district court to order payment of the reserve funds to the SEG1 FCMs.

A creditor with an interest in specific funds can maximize its recovery by keeping those funds outside of the bankruptcy estate in the first place. The Sentinel decision underscores the need for such creditors and their counsel to be proactive when dealing with assets that are arguably not estate assets. Creditors who may be able to impose a trust on funds that would otherwise be assets of the bankruptcy estate must take all steps necessary in order to preserve their rights to make that assertion, including in the context of their treatment under a plan of reorganization. In order to do so, it is important to engage experienced counsel and appropriate expert witnesses early in order to build the strongest possible argument to trace and establish the res of a trust. Otherwise, creditors may risk losing their status as trust beneficiaries and be relegated to treatment as general unsecured creditors.