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Grede v. Bank of New York

January 27, 2009

FREDERICK J. GREDE, AS CHAPTER 11 TRUSTEE FOR SENTINEL MANAGEMENT GROUP, INC., PLAINTIFF,
v.
THE BANK OF NEW YORK AND THE BANK OF NEW YORK MELLON CORP., DEFENDANTS.



The opinion of the court was delivered by: Judge James B. Zagel

MEMORANDUM OPINION AND ORDER

I. BACKGROUND

Sentinel Management Group, Inc. was a registered futures commission merchant ("FCM") with the Commodities Future Trading Commission ("CFTC") and a registered investment advisor with the Securities and Exchange Commission ("SEC"). Sentinel did nothing other than manage investments. Its income was derived from its management fees based on the assets it held under management. It marketed itself with an attractive and very commonplace objective: "to achieve the highest yield consistent with the preservation of principal and daily liquidity." Its clients were supposed to be sophisticated investors and included hedge funds, futures commission merchants, financial institutions, pension plans and so forth. Sentinel had customer funds and a house account for its own securities and the benefit of insider investors. It was a privately held corporation, thinly capitalized, owned and operated by its founder, Philip Bloom, and his son, Eric Bloom, both of whom owned a significant percentage of its stock. Its chief trader, Charles Mosley, along with the Blooms, controlled Sentinel's day-to-day operations, including its website, accounting systems, investments, dealings with Bank of New York ("BNY" or "the Bank"), customer statements and various financial arrangements.

BNY extended a line of credit to provide liquidity, facilitate redemptions, and purchase securities. Sentinel dealt with BNY for many years. It began its relationship as a client of BNY's custodial services division and, some months later, began to use BNY's client services division, which offered same-day settlements and credit arrangements. When Sentinel began to use these services, its custodial accounts were closed and new accounts were opened under a new set of contracts (the "1997 Agreements"). These accounts were in place for a decade and included accounts in which Sentinel client assets were segregated and accounts in which non-segregated assets were held.

BNY was Sentinel's clearing bank and its secured lender during that time. BNY provided daily loans and credit, and Sentinel pledged collateral to secure the debt. To pledge collateral, Sentinel had to transfer securities to Sentinel's non-segregated accounts-its street or clearing accounts. To transfer, Sentinel had to issue a desegregation instruction to the Bank. Only Sentinel had the power to issue the instruction and, as is common, had to make warranties to BNY each time it did so.

Sentinel warranted that (a) it was authorized to issue the instruction and any claims to the securities transferred by customers or counterparties were extinguished; (b) it owned all the transferred securities free and clear; (c) if any securities were beneficially owned by others, Sentinel had the right to pledge them free of any claim by those owners; (d) BNY's interest in the pledged assets was superior in all respects to all other claims on them by any other party; and (e) it agreed to take all steps that BNY requires to assure itself of its priority rights including notifying or obtaining consent of any owner of the assets.

In January 2003, Sentinel made further agreements in order to take its money management business into global markets. These agreements for clearing services were, for all practical purposes, no different than the 1997 Agreements and, as before, BNY's clearing service division executed Sentinel's instructions concerning receipt, delivery and transfer of cash and securities. The Bank recorded these debits and credits in accounts and made loans to Sentinel after collateral was pledged.

In mid-2007, Sentinel went over the cliff. On August 13, it announced a halt of redemption of customer assets; four days later it filed here for Bankruptcy protection. The Bank filed a proof of claim for $312,247,000.

Less than two months after Sentinel filed for protection, Sentinel's trustee sued the principals of Sentinel. The trustee alleged, in an adversary action, that these individuals had perpetrated a fraud against Sentinel and its customers. Generally speaking, the alleged means of the fraud were diverting customer income and trading gains, and leveraging through bank loans; all of which was concealed and misrepresented. The trustee also alleges repeated and significant violation of clear custodial and segregation requirements with respect to customer accounts.

About five months after that complaint, Sentinel's trustee filed an adversary action against BNY claiming damages of over $550 million because the Bank "established a fundamentally flawed account structure for Sentinel's accounts in violation of its obligations under federal law and its duties to Sentinel." The trustee alleges that the Bank thereby enabled Sentinel's misuse of customer funds by allowing Sentinel to pledge customer assets to secure loans to Sentinel and to commingle customer assets with Sentinel assets.

The Bank moves for dismissal.

II. STANDARD OF REVIEW

A Rule 12(b)(6) motion tests the sufficiency of a complaint, not the merits of a case. Autry v. Northwest Premium Servs., Inc., 144 F.3d 1037, 1039 (7th Cir. 1998). Defendants' motion to dismiss should be granted only if Plaintiff cannot prove any set of facts in support of his claim that would entitle him to relief. Conley v. Gibson, 355 U.S. 41, 45-46 (1957). Furthermore, I must accept all well-pleaded factual allegations in the complaint as true, drawing all reasonable inferences from those facts in Plaintiff's favor. Cleveland v. Rotman, 297 F.3d 569, 571 (7th Cir. 2002). Stated another way, I should not grant Defendants' motion "unless no relief could be granted 'under any set of facts that could be proved consistent with the allegations.'" Nance v. Vieregge, 147 F.3d 589, 590 (7th Cir. 1998) (quoting Hishon v. King & Spalding, 467 U.S. 69, 73 (1984)). That said, Plaintiff's "obligation to provide the grounds of his entitlement for relief requires more than labels and conclusions, and a formulaic recitation of the elements of a cause of action will not do. Factual allegations must be enough to raise a right to relief above the speculative level." Bell Atlantic v. Twombly, 550 U.S. 544, 127 S.Ct. 1955, 1964-65, 167 L.Ed.2d 929 (2007).

III. DISCUSSION

A. The Federal Laws and Regulations

The Bank argues that the claim that federal law was violated is impermissible.

The federal laws cited are sections of the Commodity Exchange Act ("CEA") and its cognate rules and regulations adopted by the CFTC, along with the Investment Advisors Act of 1940 ("IAA") and its cognate, ...


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