The opinion of the court was delivered by: Judge James B. Zagel
MEMORANDUM OPINION AND ORDER
Sentinel Management Group, Inc. ("Sentinel") filed under Chapter 11 of the Bankruptcy Code in August 2007. In September 2008, Plaintiff Liquidation Trustee filed adversary proceedings in the Bankruptcy Court for the Northern District of Illinois for avoidance and recovery of pre and post-petition transfers made by Sentinel to or for the benefit of certain customers. On October 29, 2008, I withdrew the reference to the Bankruptcy Court, finding that the adversary proceedings raised "significant open and unresolved issues" of non-bankruptcy law regarding the applicability of common law trust principles to statutory trusts, and the duty of futures commission merchants ("FCMs") to cover customer segregation shortfalls under the Commodity Exchange Act ("CEA") and its regulatory provisions. Grede v. Fortis Clearing Americas LLC , No. 09-C138, 2009 WL 3518159, at *3-4 (N.D. Ill. Oct. 28, 2009).
The instant adversary proceeding was chosen as a "test case" (as least in part) to resolve common legal issues among the Trustee's actions. Here, the Trustee seeks to avoid or reduce the transfer of approximately $15.6 million to Defendant FCStone. He alleges five counts: 1) avoidance and recovery of post-petition transfers (11 U.S.C. §§ 549(a) and 550); 2) avoidance and recovery of preferential transfers (11 U.S.C. §§ 547(b) and 550); 3) declaratory judgment that cash and securities held by Sentinel in allegedly segregated bank accounts is property of the Debtor's estate; 4) unjust enrichment; and 5) disallowance or reduction of claims (11 U.S.C. § 502(d)).
A bench trial was held on October 1 through 17, 2012. *fn1
Pursuant to Fed. R. Civ. P. 52(a), my findings of fact and
conclusions of law are laid out below.
II. FINDINGS OF FACT *fn2 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. 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 FCStone is an Iowa limited liability company with its principal place of business in Chicago, Illinois. FCStone is a futures commission merchant ("FCM"). As an FCM, FCStone maintains accounts and clears trades for customers in the futures markets; FCStone acts as a financial intermediary between its customers and the futures markets.
3. Sentinel was an Illinois corporation headquartered in Northbrook, Illinois. Sentinel managed investments for various clients, including FCMs, hedge funds, financial institutions, pension funds, and individuals.
4. Sentinel offered its customers several different portfolios as investment options. Sentinel represented to its customers that all of its portfolios met the dual objectives of low risk and high liquidity. Sentinel's marketing materials described the allowable investments in the three primary portfolios as follows:
Treasury Only Portfolio -- Direct obligations of the U.S. Treasury.
1.25 Portfolio -- Obligations of the U.S. Treasury, short term commercial paper rated A1/P1, medium and long term debt rated AA or higher, bank time deposits and repurchase agreements collateralized by the above.
Prime Portfolio -- Short term commercial paper rated A1/P1, investment grade corporate bonds, bank time deposits, repurchase agreements collateralized by the above and other highly rated marketable securities.
5. Sentinel classified its customers into three distinct segments or "SEGs" based on their regulatory status and the source and nature of their investments. The SEGs were comprised as follows:
SEG 1: Comprised of FCMs' customer funds required to be invested in compliance with CFTC Rule 1.25 and held in compliance with CEA and CFTC segregation requirements;
SEG 2: Comprised of FCMs' foreign futures and foreign options customer funds required to be invested in compliance with CFTC Rule 1.25 and held in separate accounts in compliance with CFTC Rule 30.7;
SEG 3: Comprised of hedge funds, other public and private trading funds, individual investors and FCMs investing proprietary or "House" funds.
6. Within each SEG, Sentinel further divided its customers into 11 groups, each of which consisted of customers with the same risk and return goals. Each customer participating within a specific group held an indirect beneficial ownership interest based on its pro rata share of the value of the securities held in that group's portfolio. The breakdown of the 11 customer groups by SEG, and their investment guidelines, were as follows:
SEG 1: FCM customers trading on U.S. exchanges
Group 1: Rule 1.25 -- Overnight reverse-repo government
securities only Group 7: Rule 1.25 -- Government
securities, corporate bonds, cash Group 8: Rule
1.25 -- Direct obligations of the U.S Treasury only Group 9:
Rule 1.25 -- Government securities (no agency), corporate
bonds, cash SEG 2: FCM customers trading foreign futures and
Group 5: Rule 30.7 -- Cash only
Group 6: Rule 30.7 -- Government securities and cash
SEG 3: Hedge funds, trusts, individual investors, FCM
proprietary or "House" funds
Group 2: Prime -- Government, corporate, sovereign debt rated as "investment grade" by an NRSRO.
Group 3: TOP -- Direct obligations of the U.S. Treasury only Group 4: Prime Group 10: Rule 1.25 -- Government securities, corporate bonds, cash Group 11: Prime -- Government, corporate, sovereign debt rated as "investment grade" by an NRSRO. *fn3
7. Defendant FCStone was a Sentinel customer. Defendant's funds were invested in the SEG 1, Group 7 customer portfolio.
8. Sentinel also managed a "House" or "Street" portfolio comprised of securities that were managed on a proprietary basis on behalf of Sentinel and certain employees, insiders and investors.
9. Prior to 2004, Sentinel entered into Investment Advisory Agreements, and post 2004 entered into Investment Management Agreements (collectively, "Customer Agreements"), with each of its investing customers. The Customer Agreements governed the terms of Sentinel's relationship with its customers. The Customer Agreements appointed Sentinel as a discretionary investment adviser with respect to assets deposited by customers. The Customer Agreements specified that the client's assets in a particular program would be invested along with the assets of other Sentinel clients in the same program and that the client would own an indirect interest in the segregated portfolio of the relevant program.
10. Sentinel's customers did not own any particular securities and were entitled only to redemptions of cash. All of Sentinel's transactions with customers were cash transactions. The Regulatory Framework that Governed Sentinel's Business
11. Sentinel was registered with the Securities and Exchange Commission ("SEC") as an investment adviser and with the Commodity Futures Trading Commission ("CFTC") as a futures commission merchant. FCM registration was necessary for Sentinel to provide its investment advisory services to FCMs investing funds of their commodity customers. Sentinel did not itself execute or clear futures transactions, as registered FCMS typically do.
12. The Commodity Exchange Act (CEA) and CFTC Rules promulgated thereunder required Sentinel to segregate commodity customers' funds from those of other customer groups and from Sentinel's own assets. The CEA and its related CFTC rule applied to Sentinel's SEG 1 FCM customers with respect to the funds of the FCMs' commodity customers.
13. 17 C.F.R. 275.206 (the "SEC Custody Rule"), a regulatory provision promulgated under the Investment Advisers Act (IAA,) required Sentinel to segregate its customers' assets from those of other customer groups and from Sentinel's own assets. The SEC Custody Rule applied to all of Sentinel's customers.
Sentinel's Account Structure at the Bank of New York and JP Morgan
14. Sentinel maintained several accounts at the Bank of New York ("BONY") to process daily transactions related to securities trading and customer cash deposit and withdrawal activity. BONY also functioned as the custodian of securities held on behalf of Sentinel's customers.
15. Sentinel maintained several accounts at JP Morgan, which functioned as the custodian for customer cash.
16. Specifically, Sentinel maintained three segregated cash accounts at BONY that were held for Sentinel's customers in SEGs 1, 2 and 3. The three BONY cash accounts were the transactional accounts through which all of Sentinel's customer deposits and withdrawals were received and paid. Customer deposits and withdrawals were wired in and out of these accounts on a daily basis.
17. Sentinel also maintained a House cash account at BONY.
18. Sentinel established three segregated securities accounts at BONY to hold government and governmental securities for customers in SEGS 1, 2 and 3.
19. Sentinel established three segregated securities accounts at BONY to hold Depository Trust Company registered corporate securities ("DTC securities") for customers in SEGs 1, 2 and 3.
20. The BONY account structure also included the SEN and SLM accounts. The SEN account was a lienable account that served as the central settlement account at BONY for Sentinel's investment and trading activity. All purchases and sales of government securities were processed through the SEN, whether for SEGs 1, 2, 3 or the House account. In addition to securities settlements, Sentinel used the SEN account for cash management. Cash from all SEGS as well as the House was commingled in the SEN account. The SEN account was active only during the business day and did not hold securities or cash overnight.
21. BONY provided an overnight loan to Sentinel. The loan's original purpose was to provide Sentinel with liquidity for customer redemptions and failed trades. Later, Sentinel used the BONY loan to fund its own proprietary repurchase agreements as part of a leveraged trading strategy.
22. The SLM account was Sentinel's lienable overnight loan account at BONY. At the close of each trading day, Sentinel would reset its overnight loan in the BONY system. BONY required an offsetting amount of securities to be held as collateral for Sentinel's loan each night. After the amount of the overnight loan was determined, Sentinel would transfer securities via the SEN account to the SLM account at an amount equal to or greater than the amount of the overnight loan. The following morning, the securities in the SLM account were returned to the SEN account.
23. The BONY account structure also included a lienable, non-segregated clearing account used to settle all DTC securities transactions (the "DTC Securities/Clearing Account" or "FC1"), including those made for the House. The FC1 account was not used for cash transactions. Cash transactions relating to DTC corporate transactions were processed in the SEN account.
24. Sentinel established a single clearing account at BONY for securities registered with Euroclear. Sentinel also established segregated Euroclear accounts at BONY, but never activated them.
25. Sentinel established three non-interest bearing cash accounts at JP Morgan as well as three interest bearing cash accounts that were linked to the corresponding non-interest bearing cash accounts. Two of the non-interest bearing accounts and their interest bearing counterparts were available to be used for both SEG 1 and SEG 3 customer funds. The other non-interest bearing account and its interest bearing counterpart was used to hold SEG 2 funds.
26. The JPMorgan cash accounts were non-transactional. Their sole purpose was to hold cash in segregation. Sentinel allocated interest earned on deposits at JP Morgan to customer accounts on a daily basis. SEG 1 and SEG 3 cash was pooled in at least one of the JP Morgan cash accounts. No cash belonging to Sentinel was held in the JP Morgan cash accounts. Sentinel's Investment Model
27. In order to invest with Sentinel, customers would wire cash to the applicable segregated cash account at BONY and, in exchange, receive a pro rata beneficial interest in securities held by Sentinel at BONY.
28. Sentinel managed customer group investments in securities on a daily basis by allocating suitable securities held by Sentinel to each group according to the group's investment guidelines and applicable regulatory restrictions.
29. The purpose of the allocation process was to invest customer funds deposited with Sentinel in a pool of securities. Sentinel allocated securities it held to each customer group with the total market value (less a small deduction called a "haircut") of the securities in the pool equaling the total value of the customers' accounts in that pool.
30. The daily allocation process was based upon: 1) changes in individual customer account balances due to deposit and withdrawal activity and the resulting changes in each group's total balance; 2) changes in market value of securities due to changing market conditions; and 3) changes in securities holdings of Sentinel due to securities trading and settlement activity.
31. Generally, the same or similar securities were allocated to each pool daily. However, Sentinel was free to move securities between customer groups without customer permission so long as those securities met the investment standards of the customer group portfolios. Sentinel was also free to liquidate securities held for customers at any time without customer permission.
32. During the relevant time period, Sentinel held billions of dollars in securities that it did not allocate to customers.
33. Sentinel did not generally buy and sell securities in response to daily customer deposits and redemptions. Rather, it operated under a pooled investment model in which one customer's withdrawal or another's deposit would affect the total balance of the customer group and shift each customer's pro rata interest in the group portfolio.
34. Sentinel also allocated interest income to each customer on a daily basis. The interest income was an approximation based on the interest earned by the entire pool of securities that Sentinel managed, not a calculation based on customers' indirect ownership interest in their group portfolio. This included interest earned on billions of dollars of securities that did not appear on any customer statements and the interest earned on securities listed on the account statements of other customer groups.
35. Sentinel issued daily statements ("Customer Statements") to its customers that summarized the daily account activity and detailed the net equity and net interest earned by the customer. The Customer Statements included a description of the securities reported to be held within the customer's group portfolio on the date of the statement, the number of units held for the customer, the cost per unit and the current market value of the securities.
36. The securities reflected on a given Customer Statement generally were not purchased with the cash the customer deposited, but instead came from Sentinel's large pool of pre-existing unallocated securities that was financed by the BONY loan and cash received from repo *fn4 counterparties.
37. Customer redemptions were generally funded by other customer deposits or with proceeds of the BONY loan.
38. Sentinel represented to its customers and to regulators that all of its customer funds were properly held in segregation.
39. In fact, Sentinel treated its own and its customers' assets as a single, undifferentiated pool of cash and securities.
40. All sources of cash, including cash deposited by customers, proceed from the BONY loan, cash received from repo counterparties, proceeds of securities transactions, and interest income received on securities were commingled in the unsegregated SEN Account on a daily basis.
Sentinel's Accounting Systems
41. Sentinel used two main accounting systems to track its customers' indirect beneficial ownership interests in its pool of cash and securities: FoxPro and Excel spreadsheets.
42. The FoxPro system was the primary ledger system used by Sentinel in recording and tracking daily accounting and transaction activity. FoxPro was comprised of two primary ledgers: 1) the Customer Ledger, which tracked customer transactions and balances, and formed the book-entry accounting system for Sentinel's customer accounts; and 2) the Securities Inventory, which recorded all securities held or controlled by Sentinel (whether for customers or market value the House).
43. The FoxPro system generated daily reports that provided detailed information on customer activity and accounts, including account deposits and withdrawals, beneficial interests in securities, interest received, and management fees and other expenses. Sentinel's daily ...