Tuesday, May 5, 2009

Bankruptcy Sleuths Find Cash in Trader Receipts for Lap Dancers

As Sentinel Management Group Inc. neared collapse in August 2007, piling up $950 million in losses, the Northbrook, Illinois-based investment firm wrote clients, saying it was yet another victim of the credit crunch -- an asset manager that grew too fast as it tried to ratchet up gains for customers.

The Securities and Exchange Commission didn’t buy the explanation of the 28-year-old company, which had about $1.4 billion under management, most of it for futures or commodities traders and hedge funds.

After a week-long examination, the SEC filed a civil suit against Sentinel in U.S. District Court in Chicago, accusing the company of, among other things, using client money to secure a $500 million credit line.

“The clients had no way of knowing that their assets had been used by Sentinel to obtain financing for its own purposes,” the SEC complaint says.

The task of unwinding Sentinel’s affairs and recovering money for an estimated 200 customers now falls to 56-year-old Frederick Grede, a former Chicago Board of Trade executive who is among the nation’s more than 1,400 federally appointed bankruptcy trustees.

These trustees -- along with overseers known as receivers -- find themselves in brisk demand these days as they sort through an avalanche of companies felled by the credit crisis and an assortment of alleged crooks and con artists who may have played a role in it.

Avalanche of Cases

On March 12, Bernard Madoff pleaded guilty to 11 counts of fraud as the operator of a $65 billion Ponzi scheme, the largest such fraud in history. With 64,318 companies filing for some form of bankruptcy last year -- a 50 percent increase from 2007 -- the job seldom has been more crucial.

“What receivers do is indispensable,” says Lewis Freeman, a Miami forensic accountant who has served as both a receiver and a trustee in overseeing the recovery and disposition of assets of companies that have collapsed as a result of frauds and the credit crunch.

“If you think of a case such as Madoff, the receiver all of a sudden is the CEO of a $50 billion fraud, responsible for preserving the assets, gathering information and figuring out where all the money went.”

Trustees and receivers bring broad powers to their jobs, sometimes sparking controversy. They can file civil suits on behalf of creditors, including investors, to recover money. Results of their civil investigations may lead to criminal charges by state or federal prosecutors.

Broad Powers

Federal bankruptcy law has evolved as a loosely regulated field, with no uniform application from jurisdiction to jurisdiction and no standard set of qualifications for those like Grede who get assigned to undertake the often complex work of mopping up defunct or troubled firms.

Grede is new to the trustee field. He won appointment by a federal bankruptcy judge in August 2007 after being nominated by a Sentinel creditors committee, whose members knew him from his 30-year career as a commodities executive. He started out in the Chicago Board of Trade’s surveillance department, conducting spot audits of traders.

A lawyer by education, he brings to his new job a digger’s mentality and a detective’s suspicious mind. His work on the Sentinel case is emblematic of what is core to a trustee’s job: to get to the bottom of a company’s collapse in order to recover assets for creditors.

As he delved into Sentinel’s demise, Grede says the case began to look like a parable of the current economic crisis. Grede laid out that case in a lawsuit filed in October 2007 in Chicago’s U.S. bankruptcy court against Sentinel’s chief trader, Charles Mosley, and its controlling shareholders, CEO Eric Bloom and his father, Philip Bloom, the company’s founder.

‘Phony’ Returns

In that suit, he alleges that the company defrauded and misled clients with “phony” returns while assuring those customers their cash was being parked in safe, liquid commercial paper or U.S. Treasuries. Grede says Sentinel was actually making huge bets on unorthodox 30-year instruments that turned out to be another example of financial engineering gone awry -- and hiding those bets with misleading accounting.

Grede says he began to understand Sentinel’s fondness for those instruments as he probed the machinations of Mosley, who had an alleged fondness for boozy lap dances, limousine rides and, according to additional lawsuits filed by Grede against outside brokers, bribes.

“I call it leverage gone wild,” Grede says. Neither Mosley, nor his lawyers, returned phone calls or e-mails seeking comment. The Blooms, in a settlement of Grede’s suit, agreed to return $10.7 million to Sentinel’s estate in exchange for a release of all claims.

FBI Interest

Grede’s suit continues against Mosley. The SEC lawsuit continues against Eric Bloom and Mosley. Grede says the Federal Bureau of Investigation and the U.S. Attorney are “looking at a variety of aspects of the case.” Neither agency would comment. None of the three men has been accused of any criminal wrongdoing.

Grede learned early on that his job wasn’t a popularity contest. “The bankruptcy code is clear that in respect to unsecured creditors, the objective is to equalize the pain,” he says.

While the sum at stake in the Sentinel case is small by comparison with, say, Madoff’s case, the pain is plentiful and palpable, with one client, Discus Master Ltd., a Paris-based hedge fund, suffering losses of an estimated $407 million.

Tremors through CBOT

On Aug. 13, 2007, Sentinel sent out a letter announcing it was freezing withdrawals, sending tremors through the trading pits of the Chicago Board of Trade in downtown Chicago, where many Sentinel customers worked.

“It was a shock,” recalls Henry Shatkin, a commodities trader and a former partner in the trading firm Shatkin Arbor Inc., whose other namesake, Patrick Arbor, is a one-time CBOT chairman. Shatkin, 81, now a district director at Macquarie Group Ltd., a Sydney investment bank that bought out Shatkin Arbor last year, estimates he has lost at least $400,000 in the collapse.

The U.S. Constitution gives federal courts jurisdiction over bankruptcy law while allowing judges wide leeway on how the law is administered. As a result, the qualifications and conduct of trustees, the manner in which they’re chosen and the fees they can charge vary widely from jurisdiction to jurisdiction.

Federal bankruptcy judges usually pick trustees from a list of 1,400 accredited overseers managed by the Department of Justice’s U.S. Trustee Program.

Hazy Qualifications

Applicants need not be lawyers or certified public accountants, according to the Trustee Program Web site; people with undergraduate business degrees or whose degree includes at least 20 semester hours of business-related courses are eligible, as are law school seniors and final-year students in Master of Business Administration programs. Judges aren’t obligated to choose trustees from the Trustee Program list.

As Grede’s appointment shows, bankruptcy judges sometimes go outside to select trustees, often at the request of creditors. Outside the federal trustee system is another network of receivers or administrators, numbering several hundred or more, who are appointed through a largely unregulated system .

Trustees and receivers, though they operate in different networks, can both handle high-profile cases. Madoff trustee Irving Picard is a lawyer with Baker & Hostetler LLP of Cleveland.

Gritty Duty

Robb Evans, who is sorting out a $554 million SEC case of alleged fraud against New York state hedge fund managers Paul Greenwood and Stephen Walsh, is a former Los Angeles banker who became a full-time receiver and trustee specializing in frauds. (Walsh has asked the court to dismiss the SEC’s case; Greenwood says the SEC charges are barred by statutes of limitations.)

Some receivers toil at the gritty level of their craft and come to their jobs through unorthodox routes. Richard Olsen ditched a job on Madison Avenue, where he once worked on the Black Flag roach killer account, and moved to Sedona, Arizona, in 1973 to manage a bar and run a real estate business on the side.

His real estate connections led him to a receiver’s job in 1989. Olsen once helped Arizona auction off a state-seized chain of 14 motels that had operated as brothels and drug dens.

While the vast majority of receivers perform their jobs ably, lawyers sometimes bemoan the lack of rules governing the field. “The problem is, there are no standards,” says Jay Adkisson, a Newport Beach, California, attorney specializing in financial fraud and offshore tax schemes.

“You could hang a sign saying you’re a receiver, and if someone is dumb enough to give you some matter to work on, you’re a receiver. There is not really any oversight.”

Fee Fights

Both receivers and trustees can run into flak over their fees. Last year, creditors in a case involving WexTrust Capital LLC complained to the presiding judge that Timothy Coleman, the federally appointed receiver, had run up excessive charges: $2.4 million for the first 20 days of work.

The SEC in August 2008 had accused the Chicago-based private equity firm of operating a $255 million Ponzi scheme that defrauded 1,196 investors, allegations the company has denied in court filings.

The judge, according to court records, awarded $1.7 million in fees, withholding judgment on the remainder until Coleman distributes recovered money to victims. A spokesman for Coleman’s law firm said it was “gratified” that the judge found the firm “has provided ‘extensive and outstanding legal services.’”

A Call to Action

Grede’s route to Sentinel included a long diversion abroad. He had worked his way into the No. 2 spot at the CBOT when, in 2000, he moved to Hong Kong to run the Hong Kong Futures Exchange. In 2004, he moved on to Bangkok to set up the Thailand Futures Exchange. He had wound down his job there and returned to Chicago in mid-2007 when the call came from Sentinel’s creditor committee.

Armed with an appointment from U.S. Bankruptcy Court Judge John H. Squires in Chicago, Grede and his team of lawyers from Chicago’s Jenner & Block LLP began going through papers, phone records and e-mails, trying to retrace the steps that had caused Sentinel’s implosion.

What principally caught his eye was that a firm touting conservative investments had been loading up on complex financial creations called PreTSLs (pronounced like pretzels), which stands for Preferred Term Securities Ltd. PreTSLs resemble collateralized-debt obligations in that they’re both pools of investments.

While CDOs are often made up of collections of mortgages, PreTSLs consist of bundles of preferred shares issued by banks to raise regulatory capital.

Misleading Ratings

Grede filed a lawsuit in November 2008 against Memphis- based FTN Financial Securities Corp. and another in January ’09 against New York-based Keefe, Bruyette & Woods Inc., now known as KBW Inc. The suits also named certain employees of each company who Grede said were responsible for selling PreTSLs to Sentinel.

Grede alleges the brokers maintained that the PreTSLs carried investment-grade ratings from rating firms when in fact most had never been rated.

The brokers said the PreTSLs were liquid because they had created a secondary market for them, yet the market was limited, according to the lawsuits, which seek a return of money and damages on behalf of Sentinel’s creditors.

The FTN suit further alleges that the brokers didn’t disclose that some of the preferred stock bundled into the PreTSLs had been issued by banks that had significant exposure to subprime loans, thus heightening the risk of default.

Mysterious Purchases

“Why was Sentinel buying these securities?” Grede recalls thinking as he dug deeper into the company’s undoing. “It didn’t make sense for the kind of business they were doing.” He also wondered why Sentinel had leveraged itself to the eyeballs; it had almost $3 billion in debt on a capital base of just $3 million.

Grede says the hunt bore quick fruit when he and his legal crew started rummaging through the effects and phone and e-mail trails of Mosley, Sentinel’s head trader and a five-year veteran of the firm.

The discovery of Chicago Bears season tickets tucked into Mosley’s trading desk drawer seemed of no consequence at first -- until Grede and his sleuths say they began to understand Mosley’s passion for attending sporting events.

Fancy Travel

Grede alleges, in the FTN and Keefe Bruyette suits, that in the four years before Sentinel’s demise, Mosley had developed a huge appetite for PreTSLs -- based on a quid-pro-quo relationship with brokers who lavished him with gifts and goodies, including tickets to baseball games and limousine rides to football games.

On June 9, 2004, for instance, Grede’s suit says, Dolores Rodriguez, a broker at Keefe Bruyette, offered Mosley and other Sentinel employees tickets to watch a Chicago Cubs game at a rooftop party adjacent to Wrigley Field. Rodriguez sold Sentinel PreTSLs with a face value of $5 million on the same day of the baseball game, followed the next day by the sale of $10 million more of the notes.

On Sept. 11, 2006, another Keefe Bruyette broker paid for Mosley to travel by limousine between Chicago and Green Bay, Wisconsin, a round trip of 350 miles (560 kilometers), to attend a Green Bay Packers-versus-Chicago Bears football game, Grede’s lawsuit says. Three days later, according to the lawsuit, Keefe Bruyette sold Sentinel PreTSLs with a face value of $19 million, earning $337,500 in commissions on the sale.

Grede also alleges Keefe Bruyette or its brokers gave Mosley luxury skybox seats and round-trip air tickets to the 2006 Orange Bowl college football game in Miami, according to the lawsuits.

Sponsored Lap Dances

While in Miami, brokers supplied Mosley with a limousine and took him to a strip club where a broker paid for several lap dances, the suit contends.

Keefe Bruyette and Rodriguez, who is no longer with the company, have filed motions to dismiss the lawsuit, as has one other Keefe Bruyette broker. A firm spokesman says the company doesn’t comment on pending litigation. Calls to Rodriguez’s lawyer seeking comment weren’t returned.

Grede’s November suit naming FTN Financial Securities accuses two of its employees, Stephen M. Folan and Jacques de Saint Phalle, of selling Mosley PreTSLs by “corrupt and deceptive methods.” The suit asks the court to return funds and award damages to Sentinel’s creditors, including customers.

‘Deceptive Schemes’

“First, defendants compromised, co-opted, duped and bribed Mosley,” states Grede’s lawsuit, which accumulated its evidence from thousands of hours of recorded phone calls from Sentinel’s office, as well as e-mails.

“Second, having compromised Mosley’s independent judgment, one or more of the defendants furthered their deceptive scheme by providing Sentinel with false and misleading information about the liquidity of the securities, particularly FTN’s ability and willingness to make a market in these securities, the ratings of the securities and whether the securities were exposed to risk arising from nonprime lending.”

FTN is a unit of First Horizon National Corp. The company filed a motion to dismiss.

A spokesman for FTN said in an e-mail that the firm has “meritorious defenses, and we will defend this matter aggressively.” Attorneys for Folan and de Saint Phalle didn’t respond to calls seeking comment.

Grede, in his October 2007 lawsuit naming Mosley and the Blooms, says Sentinel was magnifying its bets, partly by using clients’ money as collateral to obtain loans, like a $500 million line of credit from Bank of New York cited by the SEC in its 2007 action against Sentinel, so that it could purchase more PreTSLs.

‘Flawed Account Structure’

Grede also alleges in a lawsuit against Bank of New York filed in March 2008 that the bank took an active role in Sentinel’s deception of its clients by “establishing a flawed account structure for Sentinel” that allowed the company to commingle customer assets and facilitate “misuse of customer assets.”

In his suit, Grede is seeking $312 million for Sentinel customers. The bank, now Bank of New York Mellon Corp., filed a motion to dismiss that was granted in part. The bank also filed a suit, which was dismissed, seeking a declaration that Sentinel either owned the securities it had pledged for its loan or “had the right to transfer and pledge such assets as collateral to BNY.” The bank declined to comment.

Sentinel’s victims, meanwhile, are stung and, much like the victims of the Madoff scheme, can’t fathom how Sentinel escaped the eyes of regulators for so long.

Hiding Risks

Grede says his investigation revealed that Sentinel had repeatedly misled the SEC and clients by using auditors to file “false financial statements” that, among other things, hid its PreTSL holdings and the risk they posed.

“It’s disbelief that someone could get away with this kind of shell accounting,” says Russell Wasendorf Sr., CEO of PFGBest, a Chicago futures broker. Wasendorf says he lost a “tiny” amount of money in the collapse yet has many friends and colleagues who were among the victims.

Shatkin, the Chicago commodities broker who lost $400,000 in the collapse, says he further regrets steering his daughter to invest $600,000 in Sentinel. “Did anybody see the thing with Bernie Madoff coming?” Shatkin says.

He adds, “There were a lot of sophisticated people that parked money with Sentinel.” He also knew Philip Bloom; they both belonged to the Green Acres Country Club in suburban Chicago. “I’m pissed,” he says. “I trusted him.”

No Comment

Eric Bloom lives in a modest two-story home at the end of a quiet cul-de-sac in Northbrook, Illinois, not far from Sentinel’s former headquarters near the Green Acres Country Club. On a brisk day in late March, he answers his doorbell wearing green medical scrubs and slippers -- unshaven, slightly built and sporting a Jackson Hole, Wyoming, baseball cap.

While declining to comment on specific allegations, Bloom says the collapse of his firm has given him more time to tend to his new baby than he was able to spend with two now-older children from a prior marriage.

A lawyer for his father, Philip Bloom, didn’t return phone calls or e-mails seeking comment.

Farther north, in a subdivision in Vernon Hills, Illinois, no one answers the door at the two-story house identified in court filings as Mosley’s home. He didn’t respond to a note left at his door. Calls to his lawyer weren’t returned.

Sale Challenged

Shortly before Sentinel filed for bankruptcy, the firm sold a portfolio of securities valued at $384 million for a discounted price of $318 million to Kenneth Griffin’s Citadel Investment Group LLC hedge fund firm, according to Grede’s investigation. Last December, Grede filed suit in Chicago bankruptcy court seeking to force Citadel and Goldman Sachs Group Inc. to return the portfolio to Sentinel’s estate.

Grede alleges that “Citadel was able to exploit the insiders’ desperate attempt to cover up their underlying fraud by acquiring the securities for far less than their reasonably equivalent value” had Sentinel sought other buyers.

The money was to be used by Sentinel to pay certain clients and creditors and “create a false appearance” that Sentinel’s affairs were in order. Goldman agreed to help Citadel sell the securities and split the profits, Grede contends.

The companies have filed a joint motion to dismiss the claim, arguing they acquired the disputed assets at the urging of regulators and that they belonged to Sentinel customers, not the bankruptcy estate. A Citadel spokesman declined to comment; Goldman said it doesn’t comment on litigation in progress.

More than 20 months into the assignment, Grede says he has so far returned just 26 cents on the dollar, or about $350 million, to Sentinel customers. The money has come mostly from liquidating securities Sentinel held on its books. The reason for the slow return?

Most of the PreTSLs and other structured-finance securities on Sentinel’s books are all but worthless, according to Grede. “It’s wallpaper,” he says.