In its recent decision in In re Peregrine Financial Group, the Seventh Circuit became the first circuit to accept a definition of “customer property” which excludes retail foreign exchange contracts, or “forex contracts”, and spot metal contracts.[1]  The Court’s ruling highlights the risk parties that transact in foreign exchange transactions and OTC metal transactions may face in the event that a future commodities merchant is forced into liquidation.


Peregrine was a registered “Future Commission Merchant” (“FCM”) and a registered “Forex Dealer Member” of the National Futures Association. Peregrine, in addition to futures, dealt in retail foreign currency transactions and spot metal transactions. In 2012, it was discovered that over a twenty-year period Peregrine’s CEO, Russel L. Wasendorf, had embezzled nearly $200 million from Peregrine’s segregated customer future accounts.  In July 2012, as a result of this defalcation, Peregrine filed for bankruptcy and a trustee was appointed to administer the Peregrine estate.  Subchapter IV of Chapter 7 of the Bankruptcy Code, 11 U.S.C. §§ 761–767, governs the bankruptcy of a futures commissions merchant such as Peregrine, and provides for the distribution of “customer property” in priority to all other claims.  “Customer property” is defined as including funds received in connection with a commodity contract, 17 C.F.R. § 190.08(a)(1)(i)(A), which in turn is defined in § 761(4) of the Bankruptcy Code.

The Peregrine Trustee excluded certain former account holders of Peregrine from receiving priority distributions of customer property based on his determination that the forex and spot metal transactions they had conducted through Peregrine did not constitute “commodity contracts” as defined by the Bankruptcy Code.  In response to the Trustee’s determination, certain former account holders (the “Plaintiffs”) commenced an adversary and assert that their forex and spot metal contracts should be treated as commodity contracts, which would entitle them to priority distributions.[2]

Decision: Forex and Spot Metal Contracts are not “similar to” Commodities Contracts

The Seventh Circuit’s ruling turned on the definition of “commodity contract” contained in section 761 of the Bankruptcy Code. The Plaintiffs alleged that their forex and spot metal contracts should be treated as commodity contracts under the “similar to” clause in Chapter 7 of the Bankruptcy Code.[3]  The question of whether the forex and spot metal contracts are considered commodity contracts was vital to the Plaintiffs’ potential for recovery as Chapter 7 gives priority distribution to “customer property” which is defined as “property received, acquired, or held to margin, guarantee, secure, purchase, or sell a commodity contract.”[4]

As defined in section 761 of the Bankruptcy Code, a “commodity contract” includes futures contracts,[5] or a contract “similar to” a futures contract.[6]  In Peregrine, the Plaintiffs pointed to both the language of the statute and congressional intent that they suggested supported the finding that their retail forex contracts and spot metal contracts were “similar to” futures contracts and therefore fell within the definition of commodity contract contained in the Bankruptcy Code.  Based largely on its previous ruling in In re Zelener, 373 F.3d 861 (7th Cir. 2004), the Seventh Circuit disagreed.

In Zelener, the Seventh Circuit considered whether “[forex transactions] are contracts of sale of a commodity for future delivery regulated by the Commodity Futures Trading Commission.”[7]  The Seventh Circuit held that retail forex transactions were distinguishable from futures contracts because the “customer buys foreign currency immediately rather than as of a defined future date, and because the deals lack standard terms.  [The defendant] buys and sells as a principal; transactions differ in size, price, and settlement date.  The contracts are not fungible and thus could not be traded on an exchange.”[8]  The Court expanded on this reasoning to find that the retail forex transactions and spot metal transactions were also not “similar to” futures contracts because “Zelener illustrated these two types of transactions were not alike in substance or essentials.”[9]  As the Court explained, “[f]utures contracts are fungible instruments that allow parties to trade in the contract with a clearinghouse accepting the risk of any counterparty default.  Retail forex, in contrast, involves private transactions that bear no fungible features.”[10]  The Court also rejected the Plaintiff’s argument that the legislative history of section 761 indicates that Congress intended for retail forex transactions to be treated as commodities contractions, noting “Congress has had opportunities to include OTC metal and retail forex transactions in the definition of ‘commodity contract’ but has declined to do so.  For example, in 2010, as part of Dodd-Frank, Congress amended section 761(4) to include ‘cleared swap’ transactions, 11 U.S.C. § 761(4)(F)(ii), yet declined to include retail forex or OTC metals.”[11]  The Court noted that this reasoning was further strengthened by the overall goals of the commodity broker provisions of chapter 7, which are to promote market stability during events of insolvency; a concern that is not implicated with retail forex or OTC metals because they are uncleared transactions where the customer assumes the risk of default.

The decision provides an important warning to lesson to forex and spot metal traders. Namely, that forex and spot metal transactions are not protected under Chapter 7 of the Bankruptcy Code, and will not receive priority distribution in a liquidation.

* Olivia Bensinger assisted with the preparation of this post.


[1] In re Peregrine Fin. Grp, Inc., 866 F.3d 775 (7th Cir. 2017), adopting the opinion of Secure Leverage Grp., Inc. v. Bodenstein, 558 B.R. 226, 241 (N.D. Ill. 2016).

[2] 11 U.S.C. § 761(4)(F)(i) (2012).

[3] Id.

[4] Id. at § 761(10)(A)(i).

[5] Id. at § 761(4)(A).

[6] Id. at § 761(4)(F)(i).

[7] In re Zelener, 373 F.3d 861, 862 (7th Cir. 2004).

[8] Id. at 864.

[9] Secure Leverage Grp., 558 B.R. at 241.

[10] Id.

[11] Id. at 242.

Bank of New York Mellon lost priority status for its claim of $312 million in the liquidation of Sentinel Management Group when the 7th Circuit held that it should have suspected Sentinel was misusing customer assets and conducted an investigation into the source of the collateral Sentinel had posted.  The 7th Circuit clarified the doctrine of “inquiry notice” in a bankruptcy proceeding in its decision, and the holding requires firms to be reasonably diligent in investigating any suspicions they have relating to their customers or risk the loss of their security interest in pledged collateral.

Sentinel, a trading firm, had (in violation of federal law) pledged its customers’ securities to Bank of New York Mellon and Bank of New York (“BNYM”) as collateral for $312 million of loans to support Sentinel’s proprietary trading.  Following the bankruptcy, BNYM asserted a senior secured claim against Sentinel based on these pre-petition loans. The bankruptcy trustee, Fredrick J. Grede asserted that the transfer of customer securities to the firm’s clearing account constituted a fraudulent transfer, and that BNYM had not accepted the securities “in good faith” because it was on ‘inquiry notice’ – it was aware of suspicious facts that should have prompted an investigation that would have uncovered Sentinel’s use of its customer’s assets.  The District Court originally ruled that no fraudulent transfer had occurred, and the 7th Circuit reversed that decision on appeal and ruled that Sentinel had made fraudulent transfers, and remanded for determination of if BNYM had been on inquiry notice. After the District Court held that BNYM had not been on inquiry notice, Sentinel’s trustee appealed again to the 7th Circuit.

At stake in a finding that BNYM had not received the securities “in good faith” was the priority of BNYM’s $312 million claim.  If BNYM had received the securities in good faith it was entitled to senior secured status and a full recovery, while if it had not received the securities in good faith it was entitled only to an unsecured claim.

The 7th Circuit held that a company or person is on inquiry notice if they have “knowledge that would lead a reasonable, law-abiding person to inquire further” or would make a reasonable person “suspicious enough to conduct a diligent search for possible dirt.”  It is not necessary that such search actually be done, and that the company did not know of fraud or other wrongdoing is not sufficient to avoid being on inquiry notice.

The 7th Circuit identified a specific email from a BNYM employee, asking how Sentinel was able to provide $300 million in collateral with less than $20 million in capital (and, as the 7th Circuit noted, the actual figure was closer to $2-3 million) as sufficient information for a reasonable person to have begun an investigation.  Furthermore, had BNYM conducted an investigation into how Sentinel was able to provide its collateral, it would have discovered Sentinel was pledging its customers assets based on documents already in the bank’s possession.  BNYM had never conducted such an investigation and had relied on Sentinel’s assurances, but the 7th Circuit held that given the apparent disconnect between Sentinel’s capital and Sentinel’s ability to supply collateral, a reasonable person would have investigated and discovered Sentinel was misrepresenting its rights in the collateral.

The Sentinel decision is a significant victory for the Sentinel trustee and offers significant support to future trustees of failed financial firms seeking to recover misused customer funds, and ultimately the customers whose funds or securities were misused.  To avoid similar results, companies must be diligent in investigating any suspicions with regard to collateral they have received.  Relying on assurances from the firm that all regulations have been followed will not be sufficient to protect a company if a court determines that more investigation was needed.

Earlier this month the Supreme Court held oral argument on an appeal arising out of the Seventh Circuit Court of Appeals that revisits the thorny and frequently litigated issue of bankruptcy court jurisdiction post-Stern v. Marshall.

In Wellness Int’l Network v. Sharif, the Seventh Circuit Court of Appeals held that (i) a bankruptcy court lacks constitutional authority to issue a final judgment on the resolution of a claim involving state common law issues, and (ii) that a party’s consent to bankruptcy court jurisdiction cannot cure a constitutional deficiency.  727 F.3d 751 (7th Cir. 2013).

The debtor, Richard Sharif, filed for Chapter 7 relief and the petitioner, Wellness International Network Ltd., filed an adversary proceeding in the bankruptcy court to collect on a pre-petition judgment against Sharif, alleging that certain funds not reported on Sharif’s bankruptcy petition should be part of the bankruptcy estate under an alter ego theory of liability.  Following Sharif’s failure to comply with discovery orders in the adversary proceeding, the Bankruptcy Court entered a default judgment in favor of Wellness.  On appeal, Sharif argued that the Bankruptcy Court lacked constitutional jurisdiction to enter final judgment on Wellness’ claim.  The Seventh Circuit held that because Wellness’ claim, based on alter-ego liability, was rooted in state common law, it was not sufficiently related to the claims-allowance process to permit bankruptcy court jurisdiction.  The Seventh Circuit also rejected Wellness’ argument that Sharif had waived his Stern objection by consenting to bankruptcy court jurisdiction and failing to raise the issue in the Bankruptcy Court.

The Supreme Court granted certiorari to consider the following issues:

  1. Does the presence of a subsidiary state property law issue in an action brought against a debtor to determine whether property in the debtor’s possession is property of the bankruptcy estate mean that such action does not “stem[] from the bankruptcy itself” and therefore, that a bankruptcy court does not have the constitutional authority to enter a final order deciding that action; and
  2. Does Article III permits the exercise of the judicial power of the United States by the bankruptcy courts on the basis of litigant consent, and if so, whether implied consent based on a litigant’s conduct is sufficient to satisfy Article III.

At oral argument, Justice Breyer echoed the arguments put forth by counsel for Wellness and supported by the Solicitor General as amicus curiae, that removing questions of what property constitutes the bankruptcy estate — “the most fundamental thing imaginable” — from the jurisdiction of the bankruptcy court would disrupt “the constitutional grant to Congress to make uniform laws of bankruptcy.”  However, Justice Roberts expressed concern that allowing bankruptcy judges to decide certain state law issues “takes out of the Federal courts our constitutional birthright to decide cases and controversies under Article III.”

The Justices also spent some time considering the effect of any decision on lower courts, in light of the confusion that stemmed from Stern and its progeny.  Justice Scalia turned to the parties to ask which of the two questions presented to the Court “is the prettier question . . . or the one that you think has more real world effect?”  Justice Kennedy followed up, “are the bankruptcy courts more confused by Question 1 or Question 2?”  Justice Breyer suggested that there was no precedent of the Court that prohibited it from deciding both questions.

It is particularly difficult to speculate on the outcome of this oral argument because the Justices that joined the majority decision in Stern v. Marshall (Justices Roberts, Scalia, Kennedy, Thomas and Alito) did not indicate a strong preference for either side at oral argument.  We will report back when a decision is entered, which should occur before the end of the Supreme Court’s term in June 2015.

Participants in the securities and futures markets rely on the Bankruptcy Code’s safe harbor provisions to protect their transactions and assets when a counter-party enters bankruptcy.  Reliance on the safe harbor provisions, whose objective is to increase the overall stability of the financial markets, was tested by a recent decision of the District Court for the Northern District of Illinois in Grede v. FCStone LLC[1] when the court refused to apply the safe harbor protections of section 546(e) to defeat a preference action by a liquidating trustee against a futures commission merchant that had received a pre-petition transfer from the debtor. Securities and futures market participants surely breathed a sigh of relief on March 19, 2014 when the Court of Appeals for the Seventh Circuit reversed the District Court’s decision[2] and held that the “deliberately broad” text of section 546(e) protected the pre-petition transfers to the futures commission merchant despite the “powerful and equitable” arguments at the heart of the District Court’s decision.  The Seventh Circuit’s decision is consistent with decisions in the Second, Sixth and Tenth Circuits and reemphasized the broad protections that the safe harbor provisions provide to financial market participants in events of counter-party bankruptcy.[3]

Grede focused on a transfer by Sentinel Management Group (“Sentinel”) to FCStone LLC, a former customer of Sentinel, just prior to its collapse in 2007.  The day before it filed for bankruptcy, Sentinel sold a portfolio of customer securities to an equity fund for more than $300 million and deposited the cash proceeds into an omnibus segregated customer cash account.  Mere hours before filing its petition, Sentinel started paying out full and partial redemptions to certain customers, FCStone being one of them.  After the bankruptcy court appointed a trustee for the estate, the trustee commenced adversary proceedings to avoid the transfer to FCStone (as well as transfers to other former customers) as preferential. The District Court withdrew the reference to the bankruptcy court, finding that the proceedings raised significant unresolved non-bankruptcy issues.  It then held that the trustee could avoid the transfer as preferential because it constituted a mere “distributions of proceeds” and because applying the safe harbor could create systematic risk to the financial markets.

On appeal, the Seventh Circuit reversed, holding that safe harbor contained in section 546(e) prevented the avoidance of the transfer as preferential. Specifically, the court found that the transfer was a “settlement payment…in connection with a securities contract,” and that the securities sale to the equity fund, a swap of shares for cash, fell squarely within section 546(e)’s definition of a “settlement payment.”  The Court also noted that even though the customers did not have rights to the specific securities in their investment portfolios, their investment agreements obligated Sentinel to purchase and sell securities for their benefit.  As such, each agreement constituted a “contract for the purchase or sale of a security” thereby satisfying the requirements of section 546(e).  The Seventh Circuit recognized the public policy reasons for the District Court’s ruling, but held that, absent a finding of actual fraud in the pre-petition transfer, the District Court’s decision was in direct conflict with the explicit, broad language of the safe harbor provision.

The Seventh Circuit’s ruling paid particular attention to Congress’s intention in enacting the safe harbor provision to prevent a large bankruptcy from having a domino effect of successive bankruptcies among affected securities or futures businesses.  The court recognized that in the securities and futures industry, where large amounts of money are transacted rapidly to settle trades, the finality of a transaction is of critical importance.  The safe harbor provision reflects Congress’s decision to prioritize finality over equity, allowing some otherwise avoidable pre-petition transfers to stand rather than allowing uncertainty and lack of liquidity to persist for 90 days after every settlement payment.[4]

Although the District Court and the Seventh Circuit both took notice of Sentinel’s wrongful conduct of commingling its customers’ supposedly segregated assets with its own, ultimately, these facts did not serve to defeat Congress’s clear intent in passing the safe harbors.  The Seventh Circuit’s ruling provides assurances to market participants that the protections of the Bankruptcy Code’s safe harbor provisions will be applied regardless of the facts of a particular bankruptcy.

[1]       485B.R. 854 (N.D. Ill. 2013)

[2]       Grede v. FCStone, LLC, Nos. 13-1232, 13-1278 (7th Cir. Mar. 19, 2014)

[3]       See, Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V., 651 F.3d 329, 334 (2d Cir. 2011); QSI Holdings Inc. v. Alford (In re QSI Holdings Inc.), 571 F.3d 545, 547 (6th Cir. 2009); Kaiser Steel Corp. v. Pearl Brewing Co. (In re Kaiser Steel Corp.), 952 F.3d 1230, 1235 (10th Cir. 1991).

[4]       To reach this conclusion, the Seventh Circuit analyzed the two sets of transfers separately.  The court held that the post-petition transfer could not be avoided under section 549 of the Bankruptcy Code because the bankruptcy court had specifically authorized the disbursement of funds and because the parties relied on that authorization.  The safe harbor provision did not govern the post-petition transfer’s analysis.