Opinion
Adv. Case No. 01-4257 RJK, Debtor. Adv. Case, No. 01-4275 RJK Civ. No. 02-4775 RHK
April 7, 2003
Terrence M. Fruth and Thomas E. Jamison, Fruth, Jamison Elsass, Minneapolis, Minnesota, and Richard A. Kirby and Charles S. Sax, Shapiro, Sher, Guinot Sandler, Washington DC, for Appellants.
Robert L. Schnell, Jr., James L. Volling, Stephen M. Mertz, Ted R. Cheesebrough, Jason K. Walbourn, and Jessica R.F. Grassley, Faegre Benson, L.L.P., Minneapolis, Minnesota, for Appellee James P. Stephenson, as Trustee for the Estate of MJK Clearing, Inc.
Stephen P. Harbeck and Kenneth J. Caputo, Securities Investor Protection Corporation, Washington, D.C., for Appellee Securities Investor Protection Corporation.
MEMORANDUM OPINION AND ORDER
Introduction
In September 2001, the Securities Investor Protection Corporation ("the SIPC") determined that Debtor MJK Clearing, Inc. ("MJK"), a securities broker-dealer registered with the Securities and Exchange Commission ("SEC"), had failed to meet its obligations to customers and was insolvent and/or not in compliance with SEC rules regarding financial responsibility. On September 27, 2001, this Court granted the SIPC's application to have Appellee James P. Stephenson appointed as Trustee for the liquidation of MJK's business. This Court then transferred the liquidation proceeding to the United States Bankruptcy Court for the District of Minnesota, where the matter is captioned Securities Investor Protection Corp. v. MJK Clearing, Inc., Adv. Proc. 01-4257 (RJK) (hereinafter, "the liquidation proceeding").
The SIPC is a nonprofit corporation whose members are securities broker-dealers. Congress created the SIPC in 1970, see 15 U.S.C. § 78aaa et seq., but it is neither a government agency nor a regulatory authority.
Appellant Ferris, Baker Watts, Inc. ("FBW"), another securities broker-dealer registered with the SEC, thereafter commenced an adversary proceeding in the bankruptcy court against Trustee Stephenson to recover approximately $19.76 million in cash that it alleges was deposited with MJK as collateral for certain stock loan transactions between FBW and MJK. Specifically, FBW moved the bankruptcy court for an order declaring that $19.76 million in funds held by the Trustee is derived from those stock loan transactions and, therefore, either (a) is not "property of the bankruptcy estate" within the meaning of 11 U.S.C. § 541, or (b) is subject to a constructive trust because MJK wrongfully used the collateral. FBW sought an order that either would require the Trustee to return the $19.76 million to FBW or, alternatively, would impose a constructive trust on the identifiable proceeds of MJK's allegedly wrongful use of that collateral and would direct the Trustee to pay such proceeds to FBW.
The Honorable Robert J. Kressel, United States Bankruptcy Judge.
Stephenson answered FBW's adversary complaint and asserted a counterclaim for a declaration that (1) all funds in the Debtor's deposit accounts as of the date of bankruptcy were property of the Debtor's estate, free and clear of any interest that FBW might otherwise claim in them, and (2) FBW holds only a general unsecured claim against the Debtor's estate. FBW and Stephenson thereafter brought cross-motions for summary judgment.
On November 22, 2002, the bankruptcy court filed a Memorandum Opinion Granting Summary Judgment. The bankruptcy court granted FBW's motion only to the extent of determining the amount of FBW's claim against the Debtor in the underlying liquidation proceeding. The bankruptcy court otherwise denied FBW's motion and granted the Trustee's motion, holding that FBW was not entitled to either a constructive trust or an order directing the Trustee to pay funds to FBW.
FBW has appealed to this Court. This Court has jurisdiction to hear appeals from final judgments, orders, and decrees entered by the United States Bankruptcy Court. See 28 U.S.C. § 158(a)(1). For the reasons set forth below, this Court will affirm the judgment of the bankruptcy court.
The Court concludes that oral argument, requested by the Trustee, would not materially assist it in resolving the issues raised on appeal.
Factual Background
I. The Parties' Contractual Agreement
In January 1999, FBW and MJK entered into a contract called a "Master Stock Loan Agreement" ("MSLA") which set forth the terms and conditions of transactions between them involving the borrowing and lending of securities. (Am. Compl. ¶ 6; Answer ¶ 7.) Theodore Urban, FBW's Executive Vice President and General Counsel, executed the MSLA on behalf of the company. (Sept. 9, 2002 Decl. of Theodore W. Urban ¶ 2 (Appellant's App. at 494).) Prior to entering into the MSLA with FBW, MJK provided FBW with certain requested financial information, including information substantiating MJK's net capital. (Id. ¶¶ 3, 4 (Appellant's App. at 494-95).) MJK subsequently provided FBW with updates of its financial information periodically. (Id. ¶ 4 (Appellant's App. at 495).)
In general, the MSLA provided that
[s]ubject to the terms and conditions of this Agreement, Borrower or Lender may, from time to time, orally seek to initiate a transaction in which Lender will lend securities to Borrower. Borrower and Lender shall agree orally on the terms of each Loan, including the issuer of the securities, the amount of securities to be lent, the basis of compensation, and the amount of Collateral to be transferred by Borrower, which terms may be amended during the Loan.
(MSLA ¶ 1.1 (Appellant's App. at 149).) With respect to the collateral referenced in paragraph 1.1, the MSLA further stated that
The Collateral transferred by Borrower to Lender, as adjusted pursuant to Section 8, shall be security for Borrower's obligations in respect of such Loan and for any other obligations of Borrower to Lender. Borrower hereby pledges with, assigns to, and grants Lender a continuing first security interest in, and a lien upon, the Collateral, which shall attach upon the transfer of the Loaned Securities by Lender to Borrower and which shall cease upon the transfer of the Loaned Securities by Borrower to Lender. In addition to the rights and remedies given to Lender hereunder, Lender shall have all the rights and remedies of a secured party under the New York Uniform Commercial Code. It is understood that Lender may use or invest the Collateral, if such consists of cash, at its own risk, but that (unless Lender is a Broker-Dealer) Lender shall, during the term of any Loan hereunder, segregate Collateral from all securities or other assets in its possession. Lender may pledge, repledge, hypothecate, rehypothecate, lend, relend, sell or otherwise transfer the Collateral, or re-register Collateral evidenced by physical certificates in any name other than Borrower's, only (a) if Lender is [a] Broker-Dealer or (b) in the event of a Default by Borrower. Segregation of Collateral may be accomplished by appropriate identification on the books and records of Lender if it is a "financial intermediary" or a "clearing corporation" within the meaning of the New York Uniform Commercial Code.
(MSLA ¶ 3.2 (Appellant's App. at 150) (emphasis added).) Both MJK and FBW represented and warranted "that the execution, delivery and performance by it of this Agreement and each Loan hereunder will at all times comply with all applicable laws and regulations including those of applicable regulatory and self-regulatory organizations." (MSLA ¶ 9.2 (Appellant's App. at 154-55).)
The MSLA provided that the amount of collateral needed to secure a stock loan was a percentage of the market value of the loaned securities (never less than 100%), called the "margin percentage." (MSLA ¶ 3.1 (Appellant's App. at 150).) Ideally, the amount of collateral securing the stock loan would always equal the margin percentage. Because the price of stocks fluctuate in the market, however, the parties daily engaged in a process called "marking to market" that served to equalize the value of the securities and the amount of cash collateral. (MSLA ¶ 8.1 (Appellant's App. at 153-54).) If the value of the loaned securities exceeded the value of the collateral held by the lender, such that the loan was under-secured, the borrower had to transfer additional collateral to the lender no later than the close of the next business day. (Id.) Conversely, if the market value of the loaned securities fell, such that the value of the collateral exceeded the agreed-upon "margin percentage," the borrower could demand that the lender return that portion of the collateral exceeding the "margin percentage." (Id. ¶ 8.3 (Appellant's App. at 154).)
II. The Depository Trust Company's Role in the Stock Loan Transactions
Stock loan transactions, such as the GenesisIntermedia, Inc. ("GENI") stock loan at issue in this action, are processed electronically. A stock loan transaction between MJK and FBW typically involved the following steps:
¨ The parties agreed to the terms to the transaction by telephone.
¨ The lender of the securities notified "Loanet," a front-end software system, of the terms of the transaction.
¨ Loanet transmitted the transaction details to the Depository Trust Company ("DTC") pursuant to the lender's instructions.
¨ DTC provided a confirmation of the transaction to the borrower of the securities and to Loanet. Loanet also provided a copy of the confirmation to the borrower.
¨ DTC, as the custodian of the securities underlying securities transactions such as stock loan transactions, would facilitate the settlement of the stock loan transactions between the parties.
¨ DTC summarized the specific transaction and all of the other stock loan transactions between the parties during the day. The dollar values of the transactions were netted to arrive at an end-of-day settlement amount for each broker-dealer.
(Expert Report of Victor Capadona at 4, 6 (Trustee's App. at 90, 92); see also Dep. of Kenneth Mountcastle, III at 28-32 (id. at 77-78).)
DTC settles thousands of transactions every business day for its member participants. (Id. at 6 (Trustee's App. at 92).) MJK, for example, processed stock loan transactions involving many broker-dealers (not just FBW) through DTC. At the end of each business day, a broker-dealer could be either a net payer to DTC or a net receiver from DTC; thus, the broker-dealer's banks would either pay to or receive from DTC a net settlement amount each business day. (Id. at 4.) If MJK was a net payer for the day, it would transfer funds from its Harris Bank cash account to the DTC Clearing account. (Id. at 5 (Trustee's App. at 91).) At the close of business on September 21, 2001, for example, MJK was a net payer to DTC, paying approximately $7 million from its account at Harris Bank to DTC. (Id.)
III. The Loan Transactions Involving GENI Stocks
On September 21, 2001, Tom Brooks of MJK contacted James Lonergan at FBW and asked if FBW would do a "run-through" to Deutsche Bank Canada (specifically to an individual named Wayne Breedon) of two million shares of common stock in GENI, by way of A.G. Edwards. (Dep. of James E. Lonergan at 34-35 (Appellant's App. at 374); Dep. of Thomas Brooks at 107-08 (id. at 369).) Lonergan spoke to a representative of A.G. Edwards who was aware of the GENI stock destined for Deutsche Bank Canada. (Lonergan Dep. at 35.) FBW felt that, with a large firm such as Deutsche Bank as the end-taker, there would not be much risk associated with the run-through and agreed to the loan. (Lonergan Dep. at 38, 40-41 (Appellant's App. at 375-76).)
Thus, MJK loaned to FBW two million shares of common stock in GENI on September 21. (Am. Compl. ¶ 10; Answer ¶ 9.) GENI stock had closed the previous trading day at slightly less than $11 per share. (Id.) Accordingly, FBW transferred $22 million to MJK's account at the DTC. (Id.) FBW then delivered the GENI stock to A.G. Edwards on a stock loan, and A.G. Edwards in turn delivered the stock to Deutsche Bank Canada. (Lonergan Dep. at 36 (Appellant's App. at 374).)
At the close of trading on September 21, the price of GENI shares had dropped; therefore, the parties agreed to adjust the amount of money held as "collateral" based on a price for the stock of $10 per share. (Am. Compl. ¶ 11; Answer ¶ 10.) FBW demanded that MJK transfer $2 million to it and, on the next business day — Monday, September 24, 2001 — MJK did so. (Id.) By the close of trading on September 24, the price of GENI shares had dropped again; therefore, the parties agreed to adjust the amount of money held as "collateral" based on a price for the stock of $9 per share. (Am. Compl. ¶ 12; Answer ¶ 11.) FBW demanded that MJK transfer another $2 million to it and, on the next business day, MJK did so. (Id.)
On the afternoon of September 25, the price of GENI stock declined to less than $6 per share. (Am. Compl. ¶ 13; Answer ¶ 12.) The parties agreed to adjust their transaction based on a market price of $6 per share for GENI stock. (Id.) FBW demanded that MJK transfer an additional $6 million to it. (Id.) While MJK agreed to do so, it in fact failed to transfer the funds to FBW on the next business day. (Id.) MJK's failure to transfer funds to FBW constituted an event of default under the MSLA. (Id.) At the close of trading on September 25, 2001, the National Association of Securities Dealers ("NASD") suspended trading in GENI stock. (Am. Compl. ¶ 16; Answer ¶ 14.)
IV. The Demise of MJK
On September 25, 2001, MJK notified regulatory authorities that it lacked sufficient capital under applicable federal and self-regulatory rules to continue operations. (Am. Compl. ¶ 16; Answer ¶ 14.) As a result, MJK's access to the DTC clearance and settlement network was suspended, effectively preventing parties from transacting further business with MJK. (Id.) MJK's notice to regulatory authorities concerning its lack of sufficient capital constituted an event of default under the MSLA. (Am. Compl. ¶ 17; Answer ¶ 14.)
V. The Bankruptcy Court Proceedings
A. Procedural History
On September 27, 2001, this Court granted the SIPC's application to have Appellee James P. Stephenson appointed as Trustee for the liquidation of MJK's business. This Court thereupon transferred the liquidation proceeding to the United States Bankruptcy Court for the District of Minnesota. On September 28, 2001, A.G. Edwards returned the GENI stock to FBW. In turn, FBW tendered the stock to Trustee Stephenson, who refused to accept it or to pay FBW the $18 million it demanded. (Am. Compl. ¶ 18; Answer ¶ 15.)
In the underlying liquidation proceedings, FBW filed motions for declaratory and injunctive relief seeking, among other things, to prevent the Trustee from spending, transferring or otherwise dissipating the $18 million that it alleged belongs to it. The Bankruptcy Court denied the motions on the ground that such relief, while available in an adversary proceeding, is not available in contested matters.
FBW thereupon initiated an adversary proceeding against the Trustee, again seeking a preliminary injunction and an order directing the Trustee to transfer to FBW the $18 million associated with the GENI stock loan transaction or imposing a constructive trust on those funds. The Trustee answered, denying any obligation to transfer the $18 million to FBW and seeking by a counterclaim a declaration that FBW holds only a general unsecured claim against MJK's bankruptcy estate. The parties thereafter brought cross-motions for summary judgment.
B. The Bankruptcy Court's Decision on Summary Judgment
The bankruptcy court concluded that FBW was not entitled to a declaration that money held by the Trustee and "derived from the stock lending transactions with FBW" is not property of the estate within the meaning of 11 U.S.C. § 541 because FBW could not identify any funds in the Debtor's estate that currently belong to it. (Appellant's Addendum at 12.) The bankruptcy court determined that, once MJK had exercised its rights of alienability as provided in section 3.2 of the MSLA and used the cash FBW had posted, that cash no longer belonged to FBW; MJK's actions with respect to the $18 million in cash collateral were consistent with the requirements of New York's Uniform Commercial Code. (Id. at 13-14.) Nor could the bankruptcy court find that FBW had shown a property interest in cash in any account of the Debtor under a theory that the security interest FBW had given in the original $18 million had attached to identifiable proceeds of that collateral. (Id. at 15-16.) The bankruptcy court additionally concluded that, even if FBW had an interest in cash in the possession of the Trustee, the Trustee could avoid such interests pursuant to 11 U.S.C. § 544(a). (Id. at 16-18.)
Accordingly, FBW was not entitled to an order freezing cash in the possession of the Trustee or an order directing the Trustee not to use, sell or lease any property of the estate or cash collateral in his possession without express consent of FBW. (See Appellant's Addendum at 12.)
Turning to FBW's claims for an order directing the immediate return of cash based upon MJK's breach of the MSLA, the bankruptcy court concluded that FBW was not entitled to specific performance, an equitable remedy that compels the performance of a contract. (Id. at 18.) The bankruptcy court concluded that it would be inappropriate to grant specific performance where there is a valid contract and an adequate remedy at law. (Id. at 19.) The bankruptcy court determined that awarding FBW the equitable relief it sought would effectively (and inappropriately) give FBW — an unsecured creditor — a preference over other unsecured creditors of the Debtor's estate. (Id. at 20.)
Finally, the bankruptcy court dismissed FBW's claim for the equitable remedy of the establishment of a constructive trust, noting at the outset that, "if the property was actually FBW's property, creation of a constructive trust would be unnecessary. To the extent the trustee is not holding FBW's property, imposition of a constructive trust is inappropriate." (Id. at 21.) The bankruptcy court determined that FBW had failed to "provide facts sufficiently supported in the record to prove that MJK intended to mislead FBW by either misstating facts or deliberately failing to disclose facts regarding its financial position." (Id. at 23.) The bankruptcy court specifically criticized FBW for presenting many "facts" in support of its fraud claim that were "not facts at all but . . . conclusory statements, which essentially amount to nothing more than allegations, made by various persons, such as expert Norman Frager in his report." (Id. at 23 n. 17.) The bankruptcy court further rejected FBW's arguments that MJK had converted its property, citing paragraph 3.2 of the MSLA, which expressly granted MJK, as a broker-dealer, the right to "pledge, repledge, hypothecate, rehypothecate, lend, relend, sell or otherwise transfer the collateral." (Id. at 25-26.) Finally, the bankruptcy court concluded that the imposition of a post-petition constructive trust would be inappropriate because its effect would be to give the plaintiff a preference over other creditors. (Id. at 26-27.)
The bankruptcy court completed its order by determining that, in any event, FBW could not prevail because most, if not all, of the cash in the Trustee's possession constituted "customer property" of the Debtor pursuant to the Securities Investor Protection Act ("SIPA").
Issues Presented on Appeal
FBW limits its appeal to its claim for recovery of the $18 million transferred to MJK as collateral for the GENI stock transaction on September 21, 2001, and raises four principal contentions:
FBW also sought the return of collateral involved in other stock loan transactions with MJK in the amount of $1,763,631. (See Am. Compl. ¶¶ 36-43.) FBW does not, however, seek review of the bankruptcy court's grant of summary judgment to the Trustee on that sum. (Appellant's Br. at 3 n. 1.)
(a) the bankruptcy court erred in failing to impose a constructive trust on sums held by the Trustee. FBW argues that the bankruptcy court incorrectly concluded that no genuine issue of material fact existed as to whether MJK engaged in fraudulent conduct in inducing the GENI stock loan transaction;
(b) the bankruptcy court erred in dismissing FBW's breach of contract claim, having wrongly concluded that (i) FBW did not retain a property interest in the funds given to MJK as collateral, and (ii) MJK had an unqualified right under the Master Stock Loan Agreement to use FBW's cash collateral;
(c) the bankruptcy court erred in concluding that a trustee's strong-arm powers under 11 U.S.C. § 544(a) allowed Stephenson to avoid any interest that FBW might claim in the $18 million in question; and
(d) the bankruptcy court erred in determining that the customer property provisions of the SIPA applied to the funds paid by FBW to MJK as collateral.
Analysis
I. Standard of ReviewThis Court reviews de novo the bankruptcy court's decision to grant summary judgment to Trustee Stephenson. Tudor Oaks Ltd. P'ship v. Cochrane (In re Cochrane), 124 F.3d 978, 981 (8th Cir. 1997). Summary judgment is proper if, assuming all reasonable inferences favorable to the non-moving party, there is no genuine issue as to any material fact and the moving party is entitled to judgment as a matter of law. Fed.R.Civ.P. 56(c); Celotex Corp. v. Catrett, 477 U.S. 317, 322-23 (1986); Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 249-50 (1986). The moving party bears the burden of showing that the material facts in the case are undisputed. See Celotex, 477 U.S. at 322; Mems v. City of St. Paul, Dep't of Fire Safety Servs., 224 F.3d 735, 738 (8th Cir. 2000). The court must view the evidence, and the inferences which may be reasonably drawn from it, in the light most favorable to the nonmoving party. See Graves v. Arkansas Dep't of Fin. Admin., 229 F.3d 721, 723 (8th Cir. 2000); Calvit v. Minneapolis Pub. Schs., 122 F.3d 1112, 1116 (8th Cir. 1997).
The nonmoving party may not rest on mere allegations or denials, but rather must demonstrate the existence of specific facts that create a genuine issue for trial. See Anderson, 477 U.S. at 256; Krenik v. County of Le Sueur, 47 F.3d 953, 957 (8th Cir. 1995). Furthermore, it is not enough for the nonmovant to point to some alleged factual dispute between the parties. Any fact alleged to be in dispute must be "outcome determinative under prevailing law," that is, it must be material to an essential element of the specific theory of recovery at issue. See Dancy v. Hyster Co., 127 F.3d 649, 652 (8th Cir. 1997); Get Away Club, Inc. v. Coleman, 969 F.2d 664, 666 (8th Cir. 1992).
II. Breach of the Master Stock Loan Agreement
The second claim for relief in FBW's Amended Complaint pertains to the $18 million that collateralized the GENI stock loan transaction. In this cause of action, FBW contends that, upon MJK's report to regulatory authorities on September 25 that it lacked sufficient capital to continue operations, the GENI stock loan was terminated and all rights that MJK held in the collateral were also terminated. (Am. Compl. ¶ 27.) Accordingly, FBW alleges that MJK became obligated to return the $18 million in outstanding collateral to FBW. (Id.) FBW further alleges that the Trustee was obligated to return the $18 million to FBW when, following his appointment, FBW tendered the GENI stock to him. (Id. ¶ 29.) FBW claims that it is entitled to the immediate return of all money held by the Trustee as successor to the Debtor on account of the GENI stock loan transaction (id. ¶ 30), and "[a]n order of specific performance of the MSL Agreement requiring the Trustee to return the $18 million in collateral arising from the GENI stock loan transaction . . . held by the Trustee as successor to the Debtor." (Id. at 11 ¶ C (emphasis added).)
The first claim in the Amended Complaint alleges that MJK breached the MSLA by failing — on September 25 — to return to FBW $6 million in collateral related to the GENI stock loan after the value of the stock had dropped three dollars a share. (Am. Compl. ¶¶ 24, 25.) FBW claims that it is therefore entitled to the immediate return of the $6 million. (Id. ¶ 26.) FBW has not addressed this specific claim on appeal.
The third claim in the Amended Complaint alleges that MJK's failure to return the collateral deposited with it for the GENI stock loan transaction (and the Trustee's failure to do so as the successor of MJK)
was a breach of contract that has caused FBW injury, including but not limited to, damages equal to the difference between $18 million and the value of GENI stock, damages due to loss of use of the collateral, interest at the rates specified in the MSL Agreement and other expenses associated with the loss of use of the collateral.
(Am. Compl. ¶ 32.)
FBW contends that dismissal of this "breach of contract" claim was improper because the bankruptcy court erred in rejecting FBW's argument that the $18 million was never "property of the bankruptcy estate" within the meaning of 11 U.S.C. § 541. FBW complains that the bankruptcy court wrongly decided that section 3.2 of the MSLA and New York's Uniform Commercial Code permitted MJK to use the cash collateral as it did and wrongly held that FBW must be able to trace the $18 million into a specific account of the Debtor in order to obtain an order directing the Trustee to pay over those funds immediately.
A. Section 3.2 and the New York Uniform Commercial Code
FBW contends that $18 million in outstanding collateral belongs to it because "MJK received only a security interest in the collateral, to be utilized only in the event of a loan default by FBW, and even that security interest terminated upon FBW's tender of the GENI stock to the Trustee." (Appellant's Br. at 20 (emphasis added).) In support of that argument, FBW relies on section 12 of the MSLA, entitled "Lender's Remedies." FBW's argument implies that MJK should have segregated FBW's cash and touched it only if FBW defaulted on the GENI stock loan. That contention is not consistent, however, with either section 12 of the MSLA or the following language in section 3.2:
In addition to the rights and remedies given to Lender hereunder, Lender shall have all the rights and remedies of a secured party under the New York Uniform Commercial Code. It is understood that Lender may use or invest the Collateral, if such consists of cash, at its own risk, but that (unless Lender is a Broker-Dealer) Lender shall, during the term of any Loan hereunder, segregate Collateral from all securities or other assets in its possession. Lender may pledge, repledge, hypothecate, rehypothecate, lend, relend, sell or otherwise transfer the Collateral, or re-register Collateral evidenced by physical certificates in any name other than Borrower's, only (a) if Lender is [a] Broker-Dealer or (b) in the event of a Default by Borrower.
(MSLA ¶ 3.2 (Appellant's App. at 150) (emphasis added).)
To overcome the above-quoted language from section 3.2, FBW turns to New York's Uniform Commercial Code ("NYUCC" or "the Code"), which imposes on a secured party a non-disclaimable duty to "use reasonable care in the custody and preservation of collateral in the secured party's possession." NYUCC § 9-207(a); see id. § 1-102(3) (stating, in part, that "the obligations of good faith, diligence, reasonableness and care prescribed by this Act may not be disclaimed by agreement"); see also id. § 9-207 official cmt. 2 (stating, in part, that "[u]nder Section 1-102 the duty to exercise reasonable care may not be disclaimed by agreement"). FBW contends that the bankruptcy court erred in reading the MSLA as superseding the Code's duty of reasonable care. FBW's excursion into the NYUCC is incomplete, however, and does not fully resolve the situation presented by the GENI stock transaction.
While it is true that the parties may not disclaim obligations of reasonableness and care prescribed by the Code, section 1-102(3) also states that "the parties may by agreement determine the standards by which the performance of such obligations is to be measured if such standards are not manifestly unreasonable." NYUCC § 1-102(3) (emphasis added); id. § 9-207 official cmt. 2 (stating that under section 1-102 "the parties remain free to determine by agreement standards that are not manifestly unreasonable as to what constitutes reasonable care"); see also id. § 9-603(a) (stating that "[t]he parties may determine by agreement the standards measuring the fulfillment of . . . the duties of a secured party under a rule stated in Section 9-602 if the standards are not manifestly unreasonable."). Furthermore, section 9-207(b) expressly provides that a secured party in possession of collateral may commingle fungible collateral (such as cash), NYUCC § 9-207(b)(3), and "may use or operate the collateral . . . in the manner and to the extent agreed by the debtor." Id. § 9-207(b)(4)(C) (emphasis added).
A fundamental policy underlying the entire Code is "to permit the continued expansion of commercial practices through custom, usage and agreement of the parties," and the Code is to be liberally construed and applied to promote such a policy. NYUCC § 1-102(1) (2)(b). The parties agreed in section 3.2 of the MSLA that MJK could use or invest cash collateral "at its own risk" and that MJK did not — as a broker-dealer — have to segregate the cash collateral it received from other assets in its possession. It is undisputed that broker-dealers such as MJK and FBW customarily settle their stock loan transactions through the DTC. Furthermore, it is undisputed in the record before the Court that broker-dealers use cash that has been wired into the DTC as collateral in one stock loan transaction to satisfy "mark-to-market" obligations and collateral obligations for other stock loan transactions. FBW has not satisfactorily explained what section 3.2 of the MSLA means if not that MJK was entitled to do exactly what it did with the cash collateral received from FBW for the GENI loan. The bankruptcy court did not "erroneously fail to give effect to the language of section 12" of the MSLA and accurately determined MJK's rights and duties with respect to the $18 million that FBW paid to it as collateral on September 21.
In any event, section 12 of the MSLA only applies "[u]pon the occurrence of a Default under Section 11 entitling Lender to terminate all Loans hereunder." (MSLA ¶ 12 (Appellant's App. at 157).) FBW does not contend that an event of default had occurred that entitled the Lender (i.e., MJK) to terminate all stock loans under the MSLA.
Ultimately, any claim by FBW that the Trustee possessed $18 million dollars that "belonged" to FBW at the time the liquidation proceeding commenced can only succeed if FBW can trace the sum it gave to MJK for the GENI transaction to moneys held by the Trustee when the liquidation commenced. This brings the Court to the question of how to trace commingled funds under these circumstances.
B. The Proper Methodology for Tracing Funds
FBW argues on appeal that the Supreme Court's decision in Begier v. I.R.S., 496 U.S. 53 (1990), warrants the application of a "lowest intermediate balance" methodology to all of the assets of MJK, not just the account into which the $22 million cash collateral was deposited. (See Appellant's Reply Br. at 4-5.) Starting from this legal proposition — that all assets of the Debtor are fair game for a tracing analysis — FBW cites the report of its expert, Frances McCloskey, which indicates that at no time between September 21 and September 27, 2001, did MJK have less than $27 million in cash or cash equivalents available to it. FBW therefore claims to have successfully "traced" the cash "belonging" to it to MJK's assets at the time the liquidation proceedings began. The Court begins with the case law underlying FBW's approach.
In Begier, the bankruptcy trustee sought to recover from the Internal Revenue Service ("IRS") payments made by the debtor to the IRS of certain withholding and excise taxes before it filed for bankruptcy. 496 U.S. at 55. Noting that the policies underlying the trustee's avoidance powers are not implicated if a debtor has transferred property that would not have been available for distribution to his creditors, the Supreme Court evaluated whether the withholding and excise taxes paid to the IRS constituted "property of the estate" under § 541 of the Bankruptcy Code. Id. at 58-59. Observing that, "because the debtor does not own an equitable interest in property he holds in trust for another, that interest is not `property of the estate,'" id. at 59, the Supreme Court framed the issue in the case as whether the money the debtor transferred from its general operating accounts to the IRS was property that AIA had held in trust for the IRS. Id.
The Court evaluated the Internal Revenue Code's ("IRC") "trust-fund" tax provision, 26 U.S.C. § 7501, which states in relevant part as follows: "[w]henever any person is required to collect or withhold any internal revenue tax from any other person and to pay over such tax to the United States, the amount of tax so collected or withheld shall be held to be a special fund in trust for the United States." 26 U.S.C. § 7501(a).
The Court held that
[a] § 7501 trust is radically different from the common-law paradigm. . . . Unlike a common-law trust, in which the settlor sets aside particular property as the trust res, § 7501 creates a trust in an abstract `amount' — a dollar figure not tied to any particular assets — rather than in the actual dollars withheld.496 U.S. at 62 (emphasis in original). Accordingly, the Court concluded that "[c]ommon-law tracing rules, designed for a system in which particular property is identified as the trust res, are thus unhelpful in this special context." Id. at 62-63 (emphasis added).
FBW grossly overstates the scope of Begier when it asserts that Begier establishes a sweeping "entity-wide" tracing analysis as a matter of federal law. FBW cites no case law or statutory authority establishing that, by virtue of the GENI stock loan transaction at issue in this case, a trust was created in an abstract "amount." No language in either the MSLA or the NYUCC compares to that of § 7501(a) of the IRC. Begier represents a special case and is not controlling here.
There is no dispute that the $22 million cash collateral for the GENI stock loan transaction was wire-transferred to MJK's account at the DTC and, from there, was paid out such that, at the end of the business day on September 21, MJK had a negative balance with the DTC. FBW's collateral went into MJK's account at the DTC, where it was commingled with other cash. Using the "lowest intermediate balance" tracing rule, the bankruptcy court correctly concluded that, because the DTC account reached a negative balance before the liquidation proceeding commenced, FBW could not "trace" its funds to other moneys found in that account or in any other account belonging to MJK. The lowest intermediate balance was zero. FBW has failed to trace its initial payment of $18 million to MJK to any specific funds that came into the possession of the Trustee in the underlying liquidation proceeding.
C. Conclusion
FBW has failed to establish that a sum of $18 million in the debtor's estate is not "property of the estate" but rather "belongs" to FBW. To the extent MJK breached either the MSLA or the duties it owed FBW under the NYUCC with respect to the cash that collateralized the GENI stock loan, the appropriate remedy is a cause of action for money damages. See NYUCC § 9-625(b) (providing that a secured party is liable for damages in the amount of any loss caused by a failure to comply with the requirements of Article 9). The bankruptcy court correctly concluded that FBW has an unsecured claim against MJK in the amount of the lost collateral. FBW's claim for an order directing "specific performance" of the MSLA and the immediate turnover of $18 million was properly dismissed.
III. FBW's Claim for a Constructive Trust
In its fourth cause of action, FBW contends that
on information and belief, the Debtor wrongfully used the money it held as collateral with respect to the GENI stock loan transaction for purposes other than those permitted under the MSL Agreement. Such a use constituted a conversion by the Debtor of property of FBW and an unjust enrichment by the Debtor to the extent of the misuse.
(Am. Compl. ¶ 34.) FBW seeks the imposition of a constructive trust on "the proceeds of any property of the Debtor in the possession of the Trustee that was acquired with such converted money" and on "any property of the Debtor in the possession of the Trustee that was commingled with the money the Debtor held as collateral with respect to the GENI stock loan transaction." (Id. ¶ 35.)
FBW attacks the dismissal of its constructive trust claim in three main respects. It argues that the bankruptcy court erred in layering federal case law regarding constructive trusts in bankruptcy on top of Minnesota's law of constructive trusts. FBW also complains that there is, at a minimum, a genuine issue of material fact as to whether MJK fraudulently misrepresented to FBW that it was solvent and in compliance with statutorily mandated minimum net capital requirements at the time of the GENI stock loan transaction. Finally, FBW argues that the bankruptcy court "took a crabbed view of the legal criteria for tracing that is inconsistent with Minnesota law and recent federal cases." (Appellant's Br. at 13.)
A. The law of constructive trusts
On FBW's constructive trust claim, the bankruptcy court held that federal bankruptcy law ultimately determined whether a constructive trust was appropriate in a bankruptcy case, (Appellant's Addendum at 22), and that a post-petition constructive trust is inappropriate because its effect would be to give FBW a reference over other creditors. On appeal, FBW argues that the bankruptcy court misapprehended a key aspect of a constructive trust — namely, that such a trust arises when the wrongful conduct takes place, not when a court decrees that such a trust exists. FBW thus argues that it is seeking to enforce a trust that arose pre-petition and not seeking to create one post-petition.
Assuming arguendo that FBW is correct as to when a constructive trust arises, FBW still must establish that a constructive trust did, in fact, arise in this case. Under Minnesota law, "there is no unyielding formula for a court to apply in decreeing a constructive trust." Estate of Spiess v. Schumm, 448 N.W.2d 106, 108 (Minn.Ct.App. 1989). As the Minnesota Supreme Court has explained:
The nature of a constructive trust can best be comprehended by keeping clearly in mind that it is not, in its true sense, a trust at all, but purely a creation of equity designed to provide a remedy for the prevention of unjust enrichment where a person holding property is under a duty to convey it to another to whom it justly belongs.
Knox v. Knox, 25 N.W.2d 225, 228 (Minn. 1946); accord In re Estate of Eriksen, 337 N.W.2d 671, 674 (Minn. 1983). "More specifically, we have held that whenever the legal title to property is obtained through fraud, oppression, duress, undue influence, force, crime, or similar means . . . a constructive trust arises in favor of the person equitably entitled to the property." Wright v. Wright, 311 N.W.2d 484, 485 (Minn. 1981).
In this case, FBW alleged in its Amended Complaint that a constructive trust should be imposed based upon the "wrongful use" — or conversion — of the cash collateral for the GENI stock loan transaction. FBW subsequently argued on summary judgment that a constructive trust must be imposed because FBW was fraudulently induced to enter into the GENI loan transaction by misrepresentations as to MJK's financial condition on September 21. The Court considers each legal theory in turn.
B. Grounds for the imposition of a constructive trust
1. Conversion
"Under Minnesota law, conversion is defined as `an act of willful interference with the personal property of another which is without justification or which is inconsistent with the rights of the person entitled to the use, possession or ownership of the property.'" Christensen v. Milbank Ins. Co., 643 N.W.2d 639, 643 (Minn.Ct.App. 2002) (quoting Dain Bosworth Inc. v. Goetze, 374 N.W.2d 467, 471 (Minn.Ct.App. 1985)). This Court has rejected, above, FBW's argument that it only authorized MJK to use the cash paid as collateral for the GENI stock loan if FBW defaulted on that loan; that assertion is not supported by either the language of the MSLA or the NYUCC. The venerable rule of law stated by the bankruptcy court applies here: a disposition of property that is consented to by the owner is not a conversion of that property. See, e.g., Griffin v. Bristle, 40 N.W. 523, 523 (Minn. 1888). FBW agreed that MJK did not have to segregate the collateral, permitted MJK to use the cash, and further authorized MJK to "pledge, repledge, hypothecate, rehypothecate, lend, relend, sell or otherwise transfer the collateral." (MSLA ¶ 3.2.) Summary judgment on the claim that MJK "wrongfully used" the collateral is warranted.
2. Fraudulent inducement
Under Minnesota law, a party must prove the following five elements in order to prevail on a claim for fraudulent representation:
(1) there was a false representation by a party of a past or existing material fact susceptible of knowledge;
(2) made with knowledge of the falsity of the representation or made as of the party's own knowledge without knowing whether it was true or false;
(3) with the intention to induce another to act in reliance thereon;
(4) that the representation caused the other party to act in reliance thereon; and
(5) that the party suffer pecuniary damage as a result of the reliance.
Flynn v. American Home Products Corp., 627 N.W.2d 342, 349 (Minn.Ct.App. 2001) (citing Specialized Tours, Inc. v. Hagen, 392 N.W.2d 520, 532 (Minn. 1986)). FBW contends that it has, at a minimum, come forward with sufficient evidence to give rise to a genuine issue of material fact on its fraud claim; therefore, summary judgment against it was improper. The Court disagrees.
To correctly analyze the record presented by FBW on summary judgment, the Court must first revisit some fundamental principles of the law of summary judgment.
When a motion for summary judgment is made and supported as provided in this rule, an adverse party may not rest upon the mere allegations or denials of the adverse party's pleading, but the adverse party's response, by affidavits or as otherwise provided in this rule, must set forth specific facts showing that there is a genuine issue for trial.
Fed.R.Civ.P. 56(e). The facts and circumstances that the non-movant relies on to oppose summary judgment "must attain the dignity of substantial evidence and not be such as merely to create a suspicion." Metge v. Baehler, 762 F.2d 621, 625 (8th Cir. 1985) (emphasis added). Thus, "to survive a motion for summary judgment, the non-moving party must be able to show `sufficient probative evidence [that] would permit a finding in [his] favor on more than mere speculation, conjecture, or fantasy.'" Godfrey v. Pulitzer Pub'g Co., 276 F.3d 405, 412 (8th Cir. 2002) (quoting Moody v. St. Charles County, 23 F.3d 1410, 1412 (8th Cir. 1994)) (emphasis added). Put another way, a party opposing summary judgment "must show that admissible evidence will be available at trial to establish a genuine issue of material fact." Financial Timing Publ'ns, Inc. v. Compugraphic Corp., 893 F.2d 936, 942 (8th Cir. 1990); Walker v. Wayne County, Iowa, 850 F.2d 433, 434 (8th Cir. 1988) (holding that "[w]hen ruling on a summary judgment motion, the district court may consider only the portion of the submitted materials that is admissible or useable at trial").
With these principles firmly in mind, the Court finds merit in the bankruptcy court's criticism that FBW presented many "facts" in support of its fraud claim that were "not facts at all but . . . conclusory statements, which essentially amount to nothing more than allegations." (Appellant's Addendum at 23 n. 17.) On appeal, FBW has tried to establish the essential elements of a fraud claim by citing principally to two documents: (1) a June 21, 2002, unverified complaint that FBW filed in this Court to commence a lawsuit against various officers and directors of MJK, captioned Ferris, Baker Watts v. Eldon C. Miller, et al., Civ. No. 02-1322 (RHK/AJB); and (2) a July 3, 2002, unverified complaint that the Trustee filed in the United States Bankruptcy Court to commence a suit against various officers and directors of MJK, captioned James P. Stephenson, Trustee for MJK Clearing, Inc. v. Todd W. Miller, et al., Adv. Proc. No. 02-4131 (RJK). The key paragraphs FBW cites from those two pleadings were denied by the defendants in those cases. FBW and the Trustee later settled their cases without those issues of fact having been litigated and decided. Popp Telcom v. American Sharecom, Inc., 210 F.3d 928, 939 (8th Cir. 2000) (observing that, implicit in the doctrine of collateral estoppel, is "the universal recognition that . . . [it] does not apply in any case unless the disputed issue has actually been litigated and decided"). Therefore, collateral estoppel does not operate to make those facts "established."
FBW provides no authority for an implicit argument that allegations made by the Trustee in one lawsuit are deemed to be established against him in all other lawsuits in which he is a party. Because FBW never pleaded — in this lawsuit — the existence of a constructive trust based upon MJK's fraudulent inducement of the GENI stock loan transaction (and certainly never pleaded the facts underlying that alleged fraud with specificity as required by Rule 9 of the Federal Rules of Civil Procedure), it is unknown whether or to what extent the Trustee would have admitted facts relevant to that legal theory. This Court refuses to reward FBW for circumventing Rules 8, 9, and 12 of the Rules of Civil Procedure and will not invoke against the Trustee an equitable theory of estoppel so that FBW can rely on mere allegations made by the Trustee as opposed to presenting admissible evidence to substantiate its fraud claim.
FBW tries alchemically to transform the allegations in its district court pleading into probative evidence by arguing that it not only referenced the allegations of the Ferris, Baker Watts complaint in supplemental answers to interrogatories filed in this case but also "verified" those interrogatory responses, thereby "verifying" the complaint itself. (See e.g., Appellant's Reply Br. at 2.) An examination of the interrogatory responses and verification suggests that FBW's argument is without substance.
On the same day FBW filed its lawsuit against Eldon Miller and others at MJK, it also supplemented its answers to interrogatories with the following blanket statement:
While FBW continues to investigate the facts and circumstances relevant to these claims, FBW supplements its prior answers to state that further detail concerning its contentions about the conduct of MJK Clearing, Inc. and its management as relevant to this adversary proceeding are set forth in the attached complaint filed in the United States District Court for the District of Minnesota.
(Pl.'s Suppl. Resps. to Def.'s Second Set of Interrogs. at 1-2 (Appellant's App. at 144-45) (emphasis added).) Theodore Urban, FBW's Executive Vice President and General Counsel, thereafter stated as follows:
I hereby verify that I have reviewed the Plaintiff's Supplemental Responses to Defendant's Second Set of Interrogatories served on June 21, 2002 and the answers to the questions are, under penalty of perjury, true to the best of my knowledge and belief to the extent of my own personal knowledge, or to the extent not of my own personal knowledge, knowledge and belief formed after appropriate inquiry.
(Verification of Pl.'s Suppl. Responses to Def.'s Second Set of Interrogs. (Appellant's App. at 148) (emphasis added).)
Urban's verification thus establishes that he does not have personal knowledge of all of the details concerning "the conduct of MJK Clearing, Inc. and its management," as set out in the June 21 Ferris, Baker Watts complaint. This Court cannot tell, from the record before it, which allegations in the June 21 complaint Urban could verify from his own personal knowledge and which he could not. Federal Rule of Evidence 602 requires a witness to have personal knowledge of the matters about which he or she testifies. To the extent Urban lacks personal knowledge about the "conduct of MJK Clearing, Inc. and its management," his testimony on that subject is inadmissible at trial and cannot be relied on to oppose summary judgment. FBW has failed to establish that Urban has personal knowledge substantiating the factual allegations made in the June 21 Ferris, Baker Watts complaint. Thus, Urban's "verification" does not magically transmute the allegations in the June 21 complaint into admissible and probative evidence.
If one strips away the citations to the Trustee's July 3, 2002 complaint and the June 21, 2002 Ferris, Baker Watts complaint, what remains is that which reviewing courts must dislike — blanket citations to the entire record. In support of its key assertion that MJK engaged in "systematic violations of its minimum net capital requirements prior to the September 21st GENI transaction with FBW," for example, FBW has cited to pages 78 through 495 of the Appendix. (Appellant's Br. at 7 n. 2.) As a federal appellate court has correctly observed:
[I]t is foolhardy for counsel to rely on a court to find disputed issues of material fact not highlighted by counsel's paperwork. . . . [P]ractical constraints on the time of a judge make it impossible for the judge to examine a record of even moderate size with such finitude as to be both exhaustive and exhausting. Judges are not ferrets!
Nicholas Acoustics Specialty Co. v. H M Constr. Co., Inc., 695 F.2d 839, 846-47 (5th Cir. 1983); see also Northwestern Nat'l Ins. Co. v. Baltes, 15 F.3d 660, 662-63 (7th Cir. 1994) (Easterbrook, J.) (noting that judges "are not archaeologists. They need not excavate masses of papers in search of revealing tidbits — not only because the rules of procedure place the burden on the litigants, but also because their time is scarce.").
FBW has not come forward with sufficient probative evidence establishing genuine issues of material fact for trial on its allegations of fraudulent inducement. Dismissal of FBW's claim for the imposition of a constructive trust based on fraud is therefore also appropriate.
C. Tracing funds for purposes of a constructive trust
Even if genuine issues of material fact existed concerning whether MJK had engaged in conduct warranting the imposition of a constructive trust, FBW nevertheless cannot demonstrate that funds exist to which that trust should attach. "When the claimant seeks to impose the constructive trust upon property of a debtor in bankruptcy, and the trust fund has been mingled with the personal property of the debtor, the claimed beneficiary to the constructive trust must sufficiently trace the trust property." Chiu v. Wong, 16 F.3d 306, 310 (8th Cir. 1994).
As discussed above, Begier is a unique case arising from obligations imposed by the Internal Revenue Code to keep income tax withholdings, FICA, and excise taxes in trust. Its "entity-wide" tracing principles do not apply in a case such as this, involving a claim for a common-law constructive trust. Here, application of the "lowest intermediate balance" rule to MJK's account at the DTC, where FBW's cash indisputably went, compels the conclusion that, once that account reached a negative balance on September 21, there was no longer any property on which a constructive trust could be imposed. The bankruptcy court correctly determined that FBW's claim for a constructive trust fails for lack of an identifiable res.
Chiu does not advance FBW's argument, either. Chiu and the debtor's husband, Lai, had been business partners in a computer retail store. When the partnership broke up, Chiu did not receive his share of the partnership property. Instead, Lai held out the store as his own, thereby merging his and Chiu's interests in the partnership "into an indistinguishable mass." Chiu, 16 F.3d at 310. Lai and the debtor, Wong, thereafter created other computer businesses from property that included Chiu's interests in the partnership. Id. Ultimately, with funds derived primarily from these computer businesses, Lai bought a house, the property on which Chiu then sought to establish a constructive trust. Id.
Chiu is distinguishable from the instant case in two main respects. First, the property at issue in FBW's alleged constructive trust is cash, not an amorphous "partnership interest." Second, there is no evidence suggesting that the cash collateralizing the GENI stock loan was merged into "an indistinguishable mass." Rather, the cash in question went to a specific and identifiable place — MJK's account at the DTC.
IV. The Trustee's Strong-Arm Powers under Section 544(a)
FBW contends that the bankruptcy court erred in granting summary judgment on the Trustee's counterclaim that his avoiding powers under § 544(a) gave him a superior right to the "collateral." Expressly underlying part of FBW's argument on appeal, however, is the assumption that the court should recognize a constructive trust. Because the Court has concluded that a constructive trust is not warranted on the record presented by FBW, FBW's argument that § 541(d) of the Bankruptcy Code "trumps" § 544(a) is unpersuasive.
FBW alternatively argues that, assuming it is correct on its contract claim, MJK held a mere security interest in the collateral, and the Trustee can take no greater rights in the collateral than MJK had. As discussed above in Section II.A., FBW agreed that MJK had the right to use and otherwise to transfer the cash it received as collateral for the GENI stock loan. (See MSLA § 3.2.) Thus, FBW had given MJK more than a right merely to hold money as security for the stock loan; the rights of alienability that MJK enjoyed exceeded a "mere" security interest. The bankruptcy court's analysis of the Trustee's avoiding powers under § 544(a) is correct as a matter of law and summary judgment on that counterclaim will be affirmed.
V. Application of the Customer Property Provisions of SIPA
Finally, FBW appeals from the bankruptcy court's determination that, regardless of the outcome of the other issues on summary judgment, FBW cannot prevail because all of the cash in the debtor's possession on the filing date constituted "customer property" under the SIPA, which overrides all state law or bankruptcy law rights. Having rejected, as a matter of law, FBW's argument that the $18 million cash collateral for the GENI stock loan was not "property of the estate," the Court finds no merit to FBW's arguments attacking the "customer property" finding on appeal.
Conclusion
Based on the foregoing, and all of the files, records and proceedings herein, IT IS ORDERED that the Memorandum Order Granting Summary Judgment of the bankruptcy court is in all respects AFFIRMED. The appeal of Ferris, Baker Watts is hereby DISMISSED WITH PREJUDICE.
LET JUDGMENT BE ENTERED ACCORDINGLY.