When the sponsor fails: does the asset survive

Graduate · enrolled learners

This lesson opens with Sentinel Management Group, 2007.

What happened

Sentinel Management Group was a registered investment adviser that managed short-term cash portfolios for futures brokers, hedge funds, pension funds and others, and the futures brokers' customer assets it held were required by law to be kept segregated, separate from its own, so that if Sentinel failed the clients' assets were safe. Sentinel did not keep them apart. It moved client securities out of segregation into accounts it pledged to Bank of New York as collateral for a loan that financed leveraged trading for its own house portfolio, as much as 444 million dollars of commodity customers' securities by the CFTC's account, so the assets its clients believed were segregated were in fact encumbered by Sentinel's lender. In August 2007 Sentinel halted client redemptions and filed for bankruptcy owing the bank 312 million dollars, and the bank moved to liquidate the collateral, which the trustee said would deny customers more than 500 million dollars in redemptions. The bank claimed the pledged assets as a senior secured creditor, and after a seventeen-day trial the district court agreed. The clients got their priority back only on appeal: in 2013 the Seventh Circuit held the transfers out of segregation were fraudulent, and in January 2016, more than eight years after the collapse, it held the bank had been on inquiry notice, so it lost its security interest and remained only an unsecured creditor. A lender that had taken the pledge in good faith would have kept it. Segregation had existed on paper and in the clients' understanding, and it did not protect them when Sentinel failed, because the assets had been pledged away; what protected them in the end was years of litigation over what the bank should have suspected.

The decision point

Whether an asset survives its sponsor's failure depends on one thing: whether it was genuinely segregated and placed beyond the reach of the sponsor's creditors, or whether, despite the label of segregation, it had been pledged, commingled, or otherwise encumbered so that the sponsor's creditors could reach it. Sentinel is the case that shows the label is not the protection: client assets described and believed to be segregated had been pledged to Sentinel's lender, so when Sentinel failed the lender claimed priority, a trial court upheld its lien, and the clients recovered their priority only after more than eight years of litigation, because the bank was found to have been on notice. For a tokenized real-world asset, this is the final test of the SPV structure the course has built: the token is worth the underlying only if the underlying genuinely survives the sponsor's failure, and it survives only if it is really held apart and beyond the sponsor's creditors, not merely called segregated. So the decision when structuring or holding a tokenized asset is to verify that the underlying is actually beyond the sponsor's creditors, not pledged, not commingled, not encumbered, and to confirm who would have priority to it if the sponsor failed, because segregation that exists only on paper collapses in the sponsor's bankruptcy, and a token backed by an underlying the sponsor has pledged away is a token whose asset does not survive the sponsor, as Sentinel's clients discovered.

Recorded loss

$500,000,000

Orientation and Year One are open: anyone can read them without an account. From Year Two onward the lessons are for enrolled learners, because progress through the later years only means anything if it is tracked against a record.

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