Victory For Customer Protection in Sentinel Case

Long before there was an MF Global debacle or Peregrine Financial Group (PFG) fraud (or at least before it was revealed) there was Sentinel Management Group. Sentinel was unique in that it was a futures commission merchant (FCM) in name only. Its core business was custodial cash management and in August of 2007 it declared bankruptcy after first freezing customer redemptions before it was revealed/alleged that they misappropriated customer funds and could not meet their obligation.

Sentinel was (and is) a messy case as it highlighted the conflicts of a bifurcated regulatory environment. The Securities and Exchange Commission charged Sentinel with fraud and wanted to freeze customer assets, assets customers placed with Sentinel specifically so they could access them at a moment’s notice. The Commodity Futures Trading Commission (CFTC) pointed this out to the bankruptcy judge and luckily, for FCM clients, prevailed.

Custodial cash management firms don’t execute trades but rather make short-term investments for its mainly FCM and hedge fund clients to earn a few basis points above the risk free rate. Ironically, in this case, it was seen as a safe haven to place assets in to avoid losing money if your FCM goes under. Hedge fund and commodity pool customers typically sweep their accounts on a regular basis and place excess cash not needed for margin with a cash manager just in case their FCM goes into bankruptcy. But Sentinel was expanding its investment portfolio into instruments outside of the ultra-safe bonds cash managers typically invest in and worst yet was putting client assets in firm accounts and using those assets as collateral for positions with Bank of New York Mellon  (BONY). BONY was the custodial bank for Sentinel and a large custodial bank involved in futures.

Why the walk down memory lane? Well, earlier this week the trustee for Sentinel won an appeal to the Seventh circuit court in a lawsuit he filed against BONY.

Fred Grede, the Sentinel trustee, sued BONY claiming there was a reasonable expectation that it knew or should have known the nature of the funds Sentinel put up for collateral. After all, Sentinel was in one business and BONY knew what that business was and as a custodial bank to the futures industry it certainly had a responsibility to understand the rules of segregation.  Amazingly Grede lost and lost the initial appeal as well but back in December the Seventh circuit vacated its own ruling in the appeal and earlier this week reversed it.

If you recall, one of the major controversies in the MF Global case was a letter JPMorgan sent directly to Jon Corzine asking MF Global to ensure a recent transfer to its London affiliate to cover an overdraft  did not come from segregated customer accounts. BONY didn’t even ask for a get out of jail letter ala JPMorgan, they just took the money.

We often hear about the need for personal responsibility but that doesn’t ever seem to extend to the banking world. This case also has significance to the PFG case as the CFTC is suing US Bank (CFTC US Bank Complaint), which was the custodial bank to PFG during their 20-year long fraud. The complaint goes beyond charging US Bank with a lack of supervision, it claims that it improperly used customer funds.

A press release put out by the trustee’s Law firm, Gair Law Group, stated, “The ruling is a major victory for the trustee and the former Sentinel customers, who stand to recover a far larger share of the funds they lost when Sentinel collapsed.”

Grede noted in an e-mail, that the decision was a “big victory for the protection of customer funds.”


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