Legal Alert: Court Rejects Safe Harbor Defenses for Futures Customers

On January 4, 2013, the U.S. District Court for the Northern District of Illinois issued an opinion that strikes a significant blow against the rights of futures customers that might otherwise enjoy the Bankruptcy Code’s safe harbor protections. The opinion, arising out of the Chapter 11 bankruptcy case of Sentinel Management Group, Inc. (Sentinel), fashions a new exception to the safe harbor protections in the event of distributions or redemptions to customers of a failed futures commission merchant (FCM). The defendant on the losing end of the opinion, FCStone, LLC, has indicated that it will appeal the ruling, which sets the stage for a compelling battle in front of the U.S. Court of Appeals for the Seventh Circuit in the coming months.

Sentinel’s Business Model, its Relationship with FCStone and its Eventual Downfall

Sentinel managed investments for clients, such as FCMs, hedge funds, financial institutions and pension funds. It was registered with the Securities and Exchange Commission as an investment adviser, and with the Commodity Futures Trading Commission (CFTC) as an FCM. Sentinel’s registration as an FCM was due to a legal technicality; it did not perform the typical FCM roles of execution and clearing.

Sentinel provided its clients with a choice of various investment portfolios, based on the type of investment held in each. In addition to each client’s election, Sentinel broke down its investor accounts into further classifications in accordance with the relevant CFTC regulations that applied to each customer. In Sentinel’s nomenclature, “SEG 1” referred to FCMs’ accounts used for domestic futures trading; “SEG 2” to FCMs’ accounts used for foreign futures trading; and “SEG 3” for other financial institutions and individuals. Finally, there were sub-classifications into 11 groups within each of the three “SEGs,” based on customers’ risk and return goals.

Please see full alert below for more information.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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