Source: http://il.findacase.com/research/wfrmDocViewer.aspx/xq/fac.20180320_0000570.NIL.htm/qx
Timestamp: 2019-04-21 17:22:15+00:00

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The short-term cash management firm Sentinel Management Group, Inc. collapsed and filed for bankruptcy in August 2007 at the outset of the financial crisis. Required by federal law to segregate its clients' funds and invest in only the highest grade government securities, Sentinel instead pledged the securities in its clients' accounts as collateral for loans from the Bank of New York-which Sentinel then used to buy even more securities on its own “House” account for the benefit of corporate insiders. As credit markets tightened in the summer of 2007, Sentinel found itself unable to both repay the Bank's loan and return its clients' money on demand. All told, Sentinel cost its investors more than $600 million. See United States v. Bloom, 846 F.3d 243, 245-46 (7th Cir. 2017) (affirming Sentinel CEO Eric Bloom's convictions on nineteen counts of wire fraud and investment advisor fraud). Dozens of lawsuits were filed in the wake of Sentinel's failure. Many are ongoing to this day.
For the reasons stated below, the Defendant's motion for summary judgment  is granted.
Sentinel Management Group, Inc. was an Illinois corporation that provided cash-management services for institutional investors, hedge funds, and individuals. (UBS Securities LLC's Local Rule 56.1 Statement of Uncontested Material Facts  (“UBS SoF”), ¶ 3.) Its primary business consisted of making safe, short-term investments of the excess cash held by other investment firms called futures commission merchants (“FCMs”)-brokers that execute trades in the futures and options markets and that are regulated by the Commodity Futures Trading Commission (“CFTC”). (Id.) Although Sentinel did not itself execute futures or options trades, it too was registered as an FCM with the CFTC as a prerequisite for managing the funds of typical FCMs. (Id.); see also Bloom, 846 F.3d at 246 (describing Sentinel's business model as “unique” and operating “like a mutual fund, pa[ying] a return based on profits and losses.”) Importantly, this meant that Sentinel was governed by the same securities law and regulations as its clients. (UBS's SoF ¶ 4.) These regulations required Sentinel to maintain its clients' funds in segregated accounts, and limited Sentinel's use of those funds to “investments [in] certain high-quality government and corporate securities” such as U.S. Treasury bills. (Id. at ¶¶ 9-10) (citing 7 U.S.C. § 6d(b) and 17 C.F.R. § 1.25).
Sentinel offered a variety of investment programs to account for different investment objectives and to comply with various regulations, but ultimately pooled all of its clients' assets into one of three distinct groups. (UBS's SoF ¶ 10) Sentinel called these groups SEG 1, SEG 2, and SEG 3. (Id.) When advertising its investment options to potential customers, Sentinel referred to the SEG 1 group as the “125 Portfolio” (named after CFTC Rule 1.25) and the SEG 3 group as the “Prime Portfolio.” Bloom, 846 F.3d at 247. SEG 1 was more conservative and intended for FCMs investing their own customers' funds, while SEG 3 offered a higher rate of return at slightly greater risk and was open to Sentinel's non-FCM clients: hedge funds, individuals, and FCMs investing their proprietary, non-customer funds. Id. Clients who invested money into one or more SEGs were promised “an undivided, pro-rata beneficial interest in the pool of securities” purchased using the funds within each SEG. (UBS's SoF ¶ 12.) This meant that Sentinel's investors did not own specific securities outright, but saw their funds “exchanged for securities and interest-bearing cash through a process that Sentinel called ‘allocation'” and instead held indirect shares of their respective SEG based on their level of investment. Grede v. FCStone, LLC, 867 F.3d 767, 771 (7th Cir. 2017) (“FCStone II”).
In addition to making trades for its clients, Sentinel also traded on its own “House” account for the benefit of corporate insiders, which included the chairman, Philip Bloom; the CEO, Eric Bloom (Philip's son); and the vice president of trading, Charles Mosley. (Trustee's Statement of Additional Material Facts in Opposition to UBS's SoF  (“Trustee's SoAF”), ¶ 4.) Sentinel's House account was not constrained by the laws and regulations that governed the grade and risk of investments within the customer SEGs. Bloom, 846 F.3d at 247. Federal law, federal regulations, and Sentinel's client agreements did, however, require all client funds to be segregated from each other as well from Sentinel's House funds. (UBS's SoF ¶ 9) (citing 7 U.S.C. §§ 6d(a) and 6d(b); 17 C.F.R. §§ 1.3(gg), 1.20, 1.25, and 1.26(a)).
As has been well documented in more than a dozen published and unpublished opinions dating back to 2009, Sentinel failed to abide by these rules. In 1997, Sentinel opened up a line of credit-called the “overnight loan”-with the Bank of New York for the purpose of providing liquidity for customer redemptions and failed trades. In re Sentinel Management Group, Inc., 728 F.3d 660, 663-64 (7th Cir. 2013) (“BONY I”); (Trustee's SoAF ¶ 11). Although Sentinel at certain points held well over $1 billion in customer assets, it kept very little cash on hand-never more than $3 million. BONY I, 728 F.3d at 663; (Trustee's SoAF ¶ 12). This overnight loan from the Bank of New York allowed Sentinel to pay its redeeming clients in cash immediately, rather than after waiting for specific securities to sell. BONY I, 728 F.3d at 664; (see also Expert Report of Frances M. McCloskey (“McCloskey Rep.”), ¶¶ 64-67, Ex. 2 to UBS Securities, LLC's Response to Trustee's SoAF [121-2] (“UBS's Resp. to Trustee's SoAF”).) As acknowledged by the Seventh Circuit, the original overnight loan arrangement “did not violate segregation requirements[:] When a customer cashed out, the amount needed in segregation dropped by the amount lent by the Bank via the line of credit.” BONY I, 728 F.3d at 664.
Sentinel's primary clearing accounts at the Bank of New York were called the “SEN account” and the “SLM account.” (Id. at ¶ 9.) These two accounts operated together to clear transactions and to secure the overnight loan from the Bank. (McCloskey Rep. ¶¶ 64-67.) The SEN account was the clearing account and only held securities or cash during the day. Every evening, Sentinel would zero out the SEN account and transfer securities to the night-time SLM account to secure the overnight loan. At some point, however, Sentinel began securing the overnight loan using the assets in all of the non-segregated accounts, not just the overnight SLM account. BONY I, 728 F.3d at 663.
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.
FCStone II, 867 F.3d at 772; see also Bloom, 846 F.3d at 249-50. The Seventh Circuit called this practice “a flagrant violation of both SEC and CFTC requirements” which left both SEG 1 and SEG 3 “chronically underfunded.” FCStone I, 746 F.3d at 248. Sentinel's customers remained unaware of these machinations, as “securities that were serving as collateral for the BONY loan continued to appear on customer statements as if they were being held in segregated accounts for their benefit even though Sentinel was routinely removing them from those accounts.” Id.
“By the summer of 2007, Sentinel no longer slouched toward bankruptcy; it careened.” Bloom, 846 F.3d at 249. The crisis in the subprime mortgage industry spread to the economy as whole, and Sentinel's repo counterparties reacted by pushing their now-worthless securities back onto Sentinel. In June and July 2007, two of Sentinel's largest repo counterparties returned more than $400 million worth of securities to Sentinel, which forced Sentinel to borrow more heavily from the Bank of New York to compensate-always using its customers' property as collateral. Id.; FCStone II, 867 F.3d at 772. As the summer went on, Sentinel found itself unable to keep up with its customers' redemption requests and BONY's demand for collateral to secure the loan. Id.. On August 17, 2007, Sentinel filed for Chapter 11 bankruptcy protection. Sentinel had by then lost more than $600 million of its clients' money, and owed BONY in particular $313 million it had secured with client property. Bloom, 846 F.3d at 245-49.
Sentinel [ ] would calculate the interest earned by all securities, including those belonging to other Segments and the house pool. Sentinel would then guesstimate the yield its customers expected to receive on their group's securities portfolio, add a little extra so that the rate of return seemed highly competitive, and report the customer's pro rata share of that amount, minus fees, on the customer's statement.
During the SEC's civil enforcement case against Sentinel and its officers, VP Charles Mosley conceded the same point. SEC v. Sentinel Management Group, Inc., No. 07-CV-4684, 2012 WL 1079961, at *16 (N.D. Ill. Mar. 30, 2012) (Kocoras, J.). “Mosley admitted that Sentinel would pool the interest generated by the various portfolios, including the House Portfolio, and distribute that interest across the investors' portfolios[, and] further admitted that the interest distributed to investors bore no relation to the interest that the investors' securities had actually accrued.” Id. Judge Kocoras granted the SEC's motion for summary judgment based on this admission, finding that Mosley violated sections 17(a)(1)-(3) of the Securities Act, 15 U.S.C. § 77a et seq., because he “actively and knowingly participated in Sentinel's scheme to defraud its investors, obtained money by means of Sentinel's misrepresentations, and engaged in a course of fraudulent business.” Id.
Sentinel used the yields from the house account and the Prime Portfolio [i.e., SEG 3] to inflate artificially the returns from the 125 Portfolio [i.e., SEG 1]. Sentinel's high-risk trading in the house account generated higher returns than the more conservative 125 Portfolio. The Prime Portfolio, which was slightly riskier than the 125 Portfolio, likewise generated higher returns. Sentinel redistributed some of these returns from the house account and the Prime Portfolio to the 125 Portfolio, effectively using the riskier accounts to subsidize the more conservative account. With these inflated rates of return in the 125 Portfolio, Sentinel could attract new clients by outperforming its competition. Indeed, it advertised these rates in its marketing material and on its website.
Sentinel employees testified that they doctored the yield rates on a daily basis from 2004 until the company's bankruptcy in 2007. Instead of paying customers the interest they actually earned, Sentinel employees divvied up interest payments according to the instruction of Bloom or Charles Mosley. Bloom in fact created a spreadsheet to help employees calculate how to redistribute funds, which was called the “Daily Yield/Rate Calculation.” The spreadsheet listed both the actual interest earned by customers' securities and the rate set by Sentinel.
The rate setting often favored the customers in “Seg 1” (125 Portfolio). For example, on December 7, 2006, the interest actually earned by Seg 1 was $96, 942.63. After the rate manipulation by Sentinel, that portfolio was allocated $103, 832.46. On that same day, Seg 3 (Prime Portfolio) actually earned $148, 005.09 in interest and the house account earned $17, 949.85. After Sentinel's rate adjustment, Seg 3 customers were paid just $112, 657.32 and the house account received $49.11.
. . . [O]n July 30, 2007, Bloom spoke with an employee who was setting the rates and agreed to inflate the 125 Portfolio to keep it competitive. At the end of that day, Seg 1 actually earned $63, 477.53, but was paid $100, 420.34 using the interest earned by customers in Seg 3 and by the house account. Another employee testified that he raised the matter with Bloom before May 15, 2007, and Bloom acknowledged that Seg 3 and the house account supplemented Seg 1.
Question: Was there anything improper with Sentinel accruing interest and allocating it to customers on a daily basis? . . .
FELTMAN: Not from the standpoint of the process. The actual procedure that Sentinel used or the procedure that Sentinel used incorporated examining the entire portfolio of securities it held including interest on repos and taking into account the daily interest charges on the loan and putting that into the overall calculus on a gross and net basis, but at the end of the day Sentinel made, in my view, a significant attempt to match the interest accrued and allocated to customer accounts to the actual earnings that the securities would have reflected for those customers.
Unlike many of Sentinel's clients, UBS managed to withdraw its entire position in SEG 1 well ahead of Sentinel's collapse. The Trustee filed numerous avoidance actions against other SEG 1 investors who received funds on the days immediately surrounding Sentinel's bankruptcy, see e.g. FCStone I, 746 F.3d at 252-54 (holding that various pre- and post-petition transfers were not avoidable); however, those transfers bear little resemblance to the one at issue here.
My understanding is [Sentinel's] rates of return are fairly high relative to what anybody out there is getting at the moment[, ] . . . historically. I'd like to understand how you're [ ] achieving that. . . . The perception would be you're taking more risk as a result, and I'd like to understand what those risks are and where you're picking up your yields . . . in the underlying portfolio.
What are the risks, what - where are you at within 125 [the 125 Portfolio, a.k.a. SEG 1], where are you getting the pickup and . . . how. So are you going out double A, you know, going all . . . the way out on the credit spectrum in terms of 125 and all the way out in terms of duration. . . . You know, what is it. And - and I believe we'd like to understand that.
Just got off the phone with Greg Hardiman @ UBS. They are pulling the $$$ because they are not comfortable with how we obtain the yields we post without incurring some “unknown” level of risk. Greg agreed to give us a chance to explain how we achieve this but is expecting a Q & A session in Stamford with you, me & Charles. I suspect the bulk of the questions will be directed to Charles. . . .
Conversation was slightly more positive than I expected. Bottom line is that they can't stay invested in a vehicle that they don't fully understand & are [sic] comfortable with.

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