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Grede v. Bank of New York Mellon

November 3, 2010

FREDERICK J. GREDE, NOT INDIVIDUALLY BUT AS LIQUIDATION TRUSTEE FOR THE SENTINEL LIQUIDATION TRUST, PLAINTIFF,
v.
THE BANK OF NEW YORK MELLON 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

Plaintiff Liquidation Trustee alleges the following counts against Defendants: (1) avoidance and recovery of fraudulent transfers pursuant to §§ 548(a)(1)(A) and 550(a) of the Bankruptcy Code; (2) avoidance and recovery of fraudulent transfers pursuant to 740 ILL. COMP STAT. 160/5(a)(1) and 160/8(a), and §§ 544(b)(1) and 550(a) of the Bankruptcy Code; (3) avoidance and recovery of preferential transfers pursuant to §§ 547(b) and 550(a) of the Bankruptcy Code; and (4) equitable subordination of claims and transfer of subordinated lien pursuant to § 510(c) of the Bankruptcy Code. Defendants filed a counterclaim seeking declaratory judgment that Defendants have a valid, first-priority, perfected security interest in the lien that is the subject of the litigation. Defendants also allege breach of contract and request indemnification for attorneys' fees and expenses, and, if liable to Trustee, a setoff of any damages due to the Bank as a result of Sentinel's alleged breach of contract and indemnification of fees and expenses.

A bench trial was set in this matter for April 19, 2010. A few weeks prior to the trial date, Defendants moved for summary judgment. I granted Plaintiff's request to take the motion with the case. The following opinion and ruling addresses both the motion for summary judgment and the bench trial.

II. STATEMENT OF UNDISPUTED FACTS*fn1

Parties

1. The Sentinel Liquidation Trust (the "Trust") is a liquidating trust created under the Fourth Amended Chapter 11 Plan of Liquidation (the "Plan") for Sentinel Management Group, Inc. ("Sentinel"). The effective date of the Plan was December 17, 2008. Plaintiff Frederick J. Grede was formerly the chapter 11 trustee for Sentinel. On December 17, 2008, pursuant to the terms of the Plan, Grede was appointed Liquidation Trustee of the Trust (the "Trustee").

2. Defendant The Bank of New York (n/k/a The Bank of New York Mellon) is a state-chartered bank with its principal place of business located in New York, New York. It is a subsidiary of Defendant The Bank of New York Mellon Corp. (defendants are collectively referred to herein as, "BNYM" or the "Bank").

3. Defendant The Bank of New York Mellon Corp. is a corporation organized under the laws of Delaware, with its principal place of business located in New York, New York. It is the successor-in-interest to The Bank of New York, Inc. and was formed in July 2007 through a merger between The Bank of New York, Inc. and Mellon Financial Corporation.

Sentinel's Business

4. Sentinel was registered with the Securities and Exchange Commission ("SEC") as an Investment Adviser. (TTX 93A; Tr. 196:5-12.)

5. Sentinel was registered with the Commodity Futures Trading Commission ("CFTC") as a futures commission merchant ("FCM"). (TTX 93A; BTX 1.)

6. On May 7, 1981, Sentinel received a "no-action" letter from the Division of Trading and Markets ("Division") of the CFTC that exempted Sentinel from the net-capital requirements applicable to registered FCMs. (TTX 1; Bjarnason Dep. Tr. 29:21-32:16.)

7. The Division's no-action letter required that Sentinel meet certain conditions in order to remain exempt from the CFTC's net-capital requirements. (TTX 1.)

8. Sentinel never solicited or accepted "orders for the purchase or sale of any commodity for future delivery, or involving contracts for the sale of any commodity for future delivery, on or subject to the rules of any contract market." (TTX 1; TTX 93A; Tr. 2313:16-18.)

9. Sentinel's Designated Self-Regulatory Organization was the National Futures Association ("NFA"). (Tr. 772:17-19.)

10. Sentinel invested FCM's customer money. (TTX 93A; TTX 925; Tr. 234:22- 235:23.)

11. Sentinel represented to the public and regulators that its Seg I portfolio consisted of funds and property of customers of other FCMs. (TTX 11; TTX 93A; Tr. 234:22-235:23.)

12. Sentinel had several customer groups with different investment strategies within the Seg I portfolio. (Tr. 311:1-15.)

13. Sentinel also invested proprietary or "house" funds of FCMs and hedge funds. (TTX 93A; Tr. 239:16-22.)

14. Sentinel represented to the public and regulators that its Seg III portfolio consisted of funds and property of FCM proprietary or "house" funds, as well as funds and property of hedge funds, trusts, and individuals. (TTX 93A; Tr. 239:16-22.)

15. Sentinel had several customer groups with different investment strategies within the Seg III portfolio. (TTX 925; Tr. 311:1-15.)

16. Sentinel had two principal investment portfolios: a "125 Portfolio" and a "Prime Portfolio." (TTX 925; BTX 314.) Sentinel represented that the 1.25 Portfolio's and Prime Portfolio's stated investment objectives were preservation of capital and liquidity and to achieve competitive yields. (TTX 925.)

17. Sentinel represented to its customers that the minimum credit rating for securities purchased for the 125 Portfolio would be A1/P1 for short term investments and AA for longterm investments. (TTX 925; BTX 109; BTX 314; Tr. 236:7-16.)

18. Sentinel represented to its customers that the minimum credit rating for securities purchased for the Prime Portfolio would be investment grade, typically defined as BBB or better. (TTX 925; BTX 109; BTX 314; Tr. 238:23-239:11; Tr. 2820:4-8.)

19. By the end of 2005, Sentinel had begun to represent that it purchased securities for its own house account. (TTX 930; TTX 983.)

Oversight of Sentinel

A. CFTC

20. Sentinel filed a Form 1-FR on a monthly basis with the CFTC. (Tr. 255:8-14.)

21. Sentinel filed its audited financial statements on an annual basis with the CFTC. (TTX 85; TTX 118; TTX 120; TTX 165; TTX 225; Tr. 256:21-257:5.)

22. On October 7, 2003, the Division provided Sentinel with a list of questions about its business that it wanted Sentinel to answer. (BTX 71.)

23. On October 24, 2003, Sentinel responded to the Division's questions. (BTX 74.)

24. On November 21, 2003, Sentinel responded to additional follow-up questions that had been posed by the Division. (BTX 75.)

25. On January 21, 2004, the Division issued a letter confirming its view that funds deposited at Sentinel in Seg I would continue to count towards Sentinel's customers' segregation requirements under the Commodity Exchange Act and CFTC Rules and that Sentinel's client FCMs' house funds held in Seg III would qualify, for the purpose of computing their minimum adjusted net capital pursuant to CFTC requirements, as current assets. (TTX 93A; TTX 188; Tr. 217:7-227:9.)

26. The Division received a copy of the 1997 Securities Clearing Agreement between BNYM and Sentinel. (BTX 11.)

27. The Division received a copy of TTX 11. (TTX 93A; BTX 74.)

B. NFA

28. The NFA conducted examinations of Sentinel including in 2003, 2004, and 2006. (BTX 60; BTX 63; BTX 105; BTX 106; BTX 107; BTX 108; BTX 111; BTX 179; BTX 193; BTX 226; BTX 531.) The last NFA examination of Sentinel was in 2006. (BTX 179; BTX 193; BTX 226.)

29. In connection with the NFA's examination of Sentinel's books and records as of July 31, 2003, BNYM responded to the NFA's account balance confirmation requests. (BTX 60.)

30. In connection with the NFA's examination of Sentinel's books and records as of September 30, 2004, BNYM responded to the NFA's account balance confirmation requests. (BTX 105; BTX 106; BTX 107.)

31. In connection with the NFA's examination of Sentinel's books and records as of March 31, 2006, BNYM responded to the NFA's requests for confirmation of certain account balances. (BTX 193.)

32. In August 2003, NFA employees drafted a memorandum intended to provide an overview of Sentinel and its operations. (BTX 531.)

33. The NFA received a copy of the 1997 Securities Clearing Agreement between BNYM and Sentinel. (BTX 111.)

C. McGladrey

34. Sentinel's independent outsider auditor, McGladrey & Pullen LLP and its predecessor Altschuler, Melvoin and Glasser LLP (collectively, "McGladrey"), issued an annual unqualified audit opinion attesting that Sentinel's statement of financial condition presents fairly, in all material respects, the financial position of Sentinel as of the respective year-end date for 2003-2006. (TTX 85; TTX 118; TTX 120; TTX 165; TTX 225.)

35. In connection with McGladrey's audit of Sentinel's financial statements as of December 31, 2005, BNYM responded to McGladrey's account balance confirmation requests. (BTX 162; BTX 163.)

36. In connection with McGladrey's audit of Sentinel's financial statements as of December 31, 2006, BNYM responded to McGladrey's account balance confirmation requests. (BTX 213; BTX 214; BTX 215; BTX 219.)

D. SEC

37. Sentinel filed a Form ADV with the SEC on an annual basis. (BTX 121; BTX 249; BTX 757.)

38. Sentinel's independent auditor, McGladrey, filed with the SEC, on an annual basis, an Independent Accountant's Report stating that it had examined on a test basis Sentinel's books and records and that in its opinion Sentinel had complied with certain provisions of rules 204-2(b) and 206(4)-2 of the Investment Advisers Act of 1940, as of and during the respective period. (BTX 204.)

Sentinel's Relationship With BNYM

39. On December 13, 1996, Debra Coscia (of BNYM) sent a letter to Barbara Sapienza (of Sentinel) regarding Sentinel's transition from First Chicago National Bank to BNYM and certain draft "CFTC compliance letters" that Sentinel had provided to BNYM. (BTX 390.)

40. Ms. Coscia told Sentinel that the draft "CFTC compliance letters" were sent to BNYM's legal department for review. (BTX 390.)

41. On March 13, 1997, Sentinel and BNYM executed the Global Custody Agreement, pursuant to which Sentinel became a customer of BNYM's Institutional Custody Division ("Custody Division"). (BTX 5; Tr. 373:19-374:10.)

42. On March 31, 1997, Joseph Ciacciarelli, who ran BNYM's relationship with Sentinel, signed TTX 11, 12 and 13, dated March 14, 1997. (TTX 11; TTX 12; TTX 13.)

43. On May 20, 1997, Joseph Ciacciarelli sent an email to Jeffrey Tessler, Mike Burns, Charles McGraw, Martin Geffon, and A. Lucia Ferrara, copying John Bhonslay. (TTX 18; Tr. 602:6-607:7.)

44. In the May 20, 1997 email, Mr. Ciacciarelli recommended that Sentinel be transitioned to Broker Dealer Services ("BDS"). (TTX 18.)

45. Mr. Bhonslay responded to Mr. Ciacciarelli's May 20, 1997 email and explained that he agreed. (Id.)

46. In September and August 1997, Eric Bloom (a Sentinel Insider) and Glenn Colletti corresponded regarding the Securities Clearing Agreement and Sentinel's transition from the Custody Division to BDS. (BTX 9; BTX 435; Tr. 608:8-12; Tr. 611:19-612:2.)

47. On October 21, 1997, Sentinel signed the Securities Clearing Agreement and related Security Agreement. (TTX 21; BTX 14; Tr. 387:6-10.)

48. On January 9, 2003, Sentinel signed the Global Clearing and Custody Agreement in connection with its opening of certain Euroclear accounts. (TTX 43.)

49. As of August 13, 2007, Sentinel maintained, among others, the following accounts at BNYM:

a. Four demand deposit accounts for handling cash called "Sentinel Mgmt Group as agt Cust Seg FDS #1/E. Bloom," "Sentinel Mgmt Group as agt Cust Seg Funds 11 30.7," "Sent Mgmt Group as agt Cust Seg FDS 3/E Bloom," and the "Street Account." (TTX 611; BTX 60; Tr. 208:18-209:24.)

b. One lienable, clearing account to settle transactions involving government securities, which was maintained on BNYM's GSCX system (the "GSCX Clearing Account") and was referred to as the "Sen Clearance Coll A/C FBO BNY" account ("SEN account"). (TTX 311; TTX 611; BTX 60; Tr. 210:23-211:6; Tr. 212:1-11.)

c. One lienable account to hold government securities used as collateral for Sentinel's overnight loan, which was maintained on BNYM's GSCX system and was referred to as the SLM account. (TTX 611; BTX 60.)

d. Three segregated, non-clearing accounts to hold government securities, which were maintained on BNYM's GSCX system (respectively, the "GSCX Seg 1 Account," "GSCX Seg 2 Account," and "GSCX Seg 3 Account"). (TTX 611; BTX 60; Tr. 212:12-213:2.)

e. One lienable, clearing account to settle transactions involving securities registered with the Depository Trust Company ("DTC Securities"), which was maintained on BNYM's CLASS system (the "DTC Clearing Account") and was referred to as the FC1 account. (TTX 611; BTX 60; Tr. 213:3-10.)

f. Three segregated, non-clearing accounts to hold DTC Securities, which were maintained on BNYM's CLASS system (respectively, the "DTC Seg 1 Account," "DTC Seg 2 Account," and "DTC Seg 3 Account"). (TTX 611; BTX 60; Tr. 213:3-10.)

g. One lienable, clearing account (Account No. 521010) to settle transactions involving Euroclear registered securities, which was maintained on BNYM's Inform system. (TTX 611; Tr. 214:3-8.)

h. One segregated, non-clearing account (Account No. 521011) to hold Euroclear registered securities, which was maintained on BNYM's Inform system. (TTX 611; BTX 72.) This account was never used. (Tr. 1746:14-21; Tr. 1754:6-11.)

i. Another segregated, non-clearing account (Account No. 521012) to hold Euroclear registered securities, which was maintained on BNYM's Inform system. (TTX 611.) This account was never used. (Tr. 1746:14-21; Tr. 1754:6-11.)

j. Four non-segregated accounts to maintain funds denominated in foreign currencies. (TTX 611.)

k. One segregated cash account (Account No. 8033807113) to hold funds denominated in Euro currency. (TTX 611; BTX 60; BTX 106.)

l. One non-segregated account (Account No. 329079) to settle transactions involving physical securities and to hold physical securities. (TTX 611; Tr. 213:11-214:2.)

50. Beginning in at least 2003, BNYM received copies of Sentinel's annual audited statements of financial condition that were prepared by its independent outside auditor, McGladrey. (TTX 85; TTX 118; TTX 120; TTX 165; TTX 225; TTX 441; TTX 930.)

51. Joseph Ciacciarelli, Terence Law (a BNYM client executive), and Stephen Brennan (a BNYM managing director) reviewed Sentinel's audited financial statements. (Tr. 447:9-22; Tr. 458:8-14; Tr. 1070:14-1071:6; Tr. 1304:7- 1305:7.)

52. On July 23, 2004, Mark Rogers (a BNYM managing director) sent an email to Joseph Ciacciarelli regarding Sentinel. (TTX 113.)

53. On January 6, 2005, Joseph Ciacciarelli and Mark Rogers exchanged emails regarding Sentinel. (TTX 123.)

54. On February 4, 2005, Mark Rogers sent an email to Joseph Ciacciarelli and Stephen Brennan regarding Sentinel. (TTX 127; Tr. 2651:25-2652:15.)

55. On February 16, 2005, Stephen Brennan sent an email to Joseph Ciacciarelli regarding Sentinel. (TTX 128.)

56. Beginning in November 2005, BNYM received copies of Sentinel's monthly Form 1-FR that Sentinel filed with the CFTC. (TTX 140; TTX 155; TTX 164; TTX 175; TTX 182; TTX 189; TTX 197; TTX 199; TTX 202; TTX 203; TTX 211; TTX 214; TTX 218; TTX 220; TTX 224; TTX 235; TTX 247; TTX 392.)

57. Joseph Ciacciarelli, Terence Law, and Stephen Brennan reviewed Sentinel's Form 1-FRs. (Tr. 449:9-450:12; Tr. 1236:2-11; Tr. 1243:25-1244:2; Tr. 1287:18-1288:14; Tr. 1290:13-22.)

58. From October 2004 through June 2007, Sentinel's 1-FRs and BNYM's credit reviews of Sentinel reflected that Sentinel had approximately $3 million in net capital or less. (TTX 115, 140; TTX 155; TTX 164; TTX 171; TTX 172; TTX 175; TTX 182; TTX 185; TTX 189; TTX 197; TTX 199; TTX 202; TTX 203; TTX 211; TTX 214; TTX 218; TTX 220; TTX 224; TTX 235; TTX 247; TTX 392.)

59. On November 22, 2005, Terence Law circulated a call report regarding his November 9, 2005 visit to Sentinel. (TTX 150.)

60. On November 23, 2005, Mark Rogers sent Stephen Brennan an email regarding Sentinel. (TTX 732.)

61. On January 24, 2006, Terence Law circulated a call report pertaining to his visit to Sentinel in November, along with Theresa Arana's phone number. (TTX 170.)

62. TTX 171 and 172 are versions of BNYM credit review write-ups of Sentinel dated January 25, 2006. (TTX 171; TTX 172.)

63. On January 26, 2006, Theresa Arana sent an email to Bernard Lambert attaching a copy of Sentinel's revised audited statement of financial condition and Sentinel's most recent monthly 1-FR. (BTX 156.)

64. TTX 179 is a BNYM credit review write-up of Sentinel dated February 6, 2006. (TTX 179.) 65. On February 22, 2006, Joseph Ciacciarelli, Brian Ruane (a BNYM executive vice president), and Mike Burns exchanged emails regarding Sentinel. (TTX 181.)

66. On March 15, 2006, Mark Rogers sent an email to Stephen Brennan and Joseph Ciacciarelli requesting a meeting to discuss Sentinel. (TTX 183.)

67. On March 28, 2006, Bernard Lambert circulated the February 6, 2006 credit review write-up to Stephen Brennan, Joseph Ciacciarelli, Terence Law and Mark Rogers in advance of a meeting regarding Sentinel. (TTX 185.)

68. On March 30, 2006, Mark Rogers met with Stephen Brennan, Joseph Ciacciarelli, Terence Law and Bernard Lambert to discuss Sentinel. (Tr. 2655:1-19.)

69. On March 31, 2006, Mark Rogers sent an email to Joseph Ciacciarelli, Terence Law, Stephen Brennan and Bernard Lambert raising certain questions regarding Sentinel and forwarded a copy of the January 21, 2004 letter from the Division. (TTX 188; Tr. 2664:8- 2666:5.)

70. On April 6, 2006, Terence Law scheduled a conference call with Eric Bloom. (BTX 323.)

71. On April 10, 2006, BNYM had a conference call with Sentinel. (BTX 324; BTX 325; Tr. 634:9-16.)

72. There is no evidence that BNYM received or reviewed Sentinel's Active and Matured Securities Report. (Tr. 280:17-23.)

73. There is no evidence that BNYM received or reviewed Sentinel's Daily Yield Calculation Report. (Tr. 284:8-13.)

74. There is no evidence that BNYM received or reviewed Sentinel's daily statement of segregation. (Tr. 286:25-287:13.)

75. Prior to May 1, 2004, Sentinel's guidance line was $30 million. (TTX 88; TTX 1000; Tr. 254:15-20.)

76. On or about May 2004, BNYM increased Sentinel's guidance line from $30 million to $55 million. (TTX 88; TTX 1000.)

77. On or about December 2004, BNYM increased Sentinel's guidance line from $55 million to $95 million. (TTX 88; TTX 1000.)

78. On or about June 2005, BNYM increased Sentinel's guidance line from $95 million to $175 million. (TTX 88; TTX 1000.)

79. On or about September 2006, BNYM increased Sentinel's guidance line from $175 million to $300 million. (TTX 88; TTX 1000.)

80. The average daily loan balance from November 4, 2005 through August 13, 2007 was $292,632,224. (TTX 1000.) The lowest daily loan balance during that period was $225,983,000. (Id.)

81. The average daily loan balance from June 1, 2007 through August 13, 2007 was $369,084,986. (TTX 1000.) The lowest daily loan balance was $312,945,000. (Id.) The highest daily loan balance was $573.8 million. (Id.)

82. When Sentinel requested a loan in excess of its guidance line, someone from Credit Risk and someone from SIBD would have to approve the loan. (Tr. 836:17-838:16.)

83. Prior to February 2005, BNYM charged Sentinel its cost of borrowing (typically fed funds rate), plus a spread of 50 basis points. (TTX 125; Tr. 858:6-8.)

84. After February 2005, BNYM charged Sentinel its cost of borrowing, plus a spread of 75 basis points. (TTX 125; Tr. 858:6-8.)

Sentinel's Relationship With Its Customers

85. Sentinel's customers wired money from their accounts at other institutions into the accounts at BNYM called "Sentinel Mgmt Group as agt Cust Seg FDS #1/E. Bloom," "Sentinel Mgmt Group as agt Cust Seg Funds 11 30.7," and "Sent Mgmt Group as agt Cust Seg FDS 3/E Bloom". (TTX 93A; TTX 611; Tr. 219:12-18; Tr. 723:24-724:11; Tr. 776:4-777:8; Tr. 795:25-797:1; Tr. 1468:3-25.)

86. Cash from multiple sources was commingled in the SEN account. (Tr. 1798:9- 1799:12.)

87. Sentinel treated its and its customers' assets as a single, undifferentiated pool of cash and securities. (Tr. 1795:25-1796:12.)

88. In response to inquiries from current and prospective customers, Sentinel provided copies of its audited statements of financial condition. (BTX 183; BTX 218; BTX 231; Tr. 763:4-18; Tr. 1517:5-12; Tr. 2317:22-2318:8; Tr. 2318:20-25.)

89. Capital Fund Management did not raise any concerns regarding the contents of Sentinel's 2005 audited financial statements. (Tr. 1517:5-1518:17.)

90. It was Sentinel's practice to provide a copy of its current Form ADV to its prospective customers. (BTX 216; BTX 388; BTX 411; Tr. 811:16-812:4; Tr. 2328:10-14.)

91. It was Sentinel's practice to provide its customers with the most current Form ADV on an annual basis. (BTX 109; Tr. 1501:25-1502:1; Tr. 2328:15-18.)

92. On June 22, 2007, Sentinel sent certain of its customers its Form ADV dated March 16, 2007. (BTX 249; BTX 757; BTX 791; Tr. 759:5-760:12.)

93. Capital Fund Management, Kottke and TransAct Futures did not inquire into Sentinel's disclosures in its Form ADV. (Tr. 761:2-763:3; Tr. 1509:12-1510:2; Tr. 1516:9-20.)

94. Sentinel sent daily statements to its customers in substantially the format reflected in TTX 958, TTX 961, and TTX 963.

95. Capital Fund Management had more than $400 million invested with Sentinel at the time of Sentinel's bankruptcy. (Tr. 1499:15-18.)

96. Kottke's balance with Sentinel on August 13, 2007 was approximately $53 million. (Tr. 741:18-21.)

97. TransAct filed a proof of claim in connection with the Sentinel bankruptcy for approximately $13.7 million, reflecting its balance in TransAct's customer segregated funds account (Tr. 804:19-805:4.)

Sentinel's Relationship with its Repo Counterparties

98. Starting in 2001, Sentinel entered into numerous repurchase agreements with repo lender FIMAT USA ("FIMAT"). (BTX 20; A. Byrne Tr. 37:19-38:8.)

99. In spring of 2007, FIMAT became more conservative regarding the type of collateral that it would accept as security for its repurchase transactions and closed out certain repurchase transactions with Sentinel. (A. Byrne Tr. 131:19-135:19; A. Byrne Tr. 161:5- 162:12.)

100. Starting in October 2004, Sentinel entered into numerous repurchase agreements with repo lender Cantor Fitzgerald & Co. ("Cantor"). (BTX 110.)

101. In spring 2007, Cantor became more conservative regarding the collateral pool that it accepted from its counterparties, including Sentinel and closed out certain repurchase transactions with Sentinel. (J. Miller Tr. 89:13-90:8; J. Miller Tr. 90:18-92:8; J. Miller ...


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