From the October 01, 2007 issue of Futures Magazine • Subscribe!

Sentinel Management Group fails

In an industry that is often regarded as high risk, involving complex investment strategies and flamboyant traders, the custodial cash management business is usually viewed as the mousy librarian at the party. This is not a sexy investment strategy but the green lamp shade business of attempting to earn a couple of extra basis points above the risk-free rate on money held to back those more interesting investments.

This is not where you would expect the next financial blow-up to occur, but starting with Sentinel Management Group’s cryptic letter to investors on Aug. 13, basically telling them that they can’t have their own money, a picture began to develop with allegations of fraud, mismanagement and ultimately greed, as Sentinel fell into bankruptcy and a mad scramble ensued as investors vied for their assets.

The future commission merchant (FCM)/cash manager that claimed on its Web site that it “never lost a dime of client funds, or delayed even one day in returning the full amount of a client’s cash,” has been charged by the Securities and Exchange Commission (SEC) with fraud, mismanagement and misappropriation after the regulator found large discrepancies and shortfalls in the pools of money it managed.

What we are left with are numerous questions, the most intriguing being where is the money and why was Sentinel allowed to sell its Seg 1 portfolio, purportedly full of high-grade liquid investments, to hedge fund Citadel Investment Group.

Dan Driscoll, chief operating officer at the National Futures Association (NFA), says the NFA showed up at Sentinel’s offices at dawn the day following Sentinel’s announcement that is was seeking to halt redemptions.

The message from both regulators, the NFA and the Commodity Futures Trading Commission (CFTC) to Sentinel President and CEO Eric Bloom was to come up with a plan to make liquid the securities in the Seg 1 pool, which contained assets of FCMs with domestic customer deposits, and distribute them to FCM customers. Driscoll says Sentinel came up with two options: sell the entire Seg 1 portfolio to one bidder or liquidate all of the securities in the open market.

Another option, one not offered by Sentinel but suggested by several FCMs, was to simply move the entire portfolio to another FCM that was not under stress or the threat of an impending bankruptcy.

“All you have to do is move those securities, move those repos, move that cash,” says Neal Kottke, founder and chairman of Kottke Associates LLC, a customer of Sentinel. “This is so simple, a clearing FCM goes into the clearing houses, takes out funds and moves them to another house. You don’t have to liquidate everything, you just move it. You move it out of the bankruptcy. That is why the authority exists to move those positions out of an FCM.”

That is a solution that was also offered by Penson GHCO, which is suing both Sentinel and Citadel over the sale. In its suit, Penson claims Sentinel improperly invested Penson’s assets in violation of the terms of its agreement, violated fiduciary obligations by prohibiting redemptions and devised a “secretive and clandestine scheme to sell the portfolios assets at a substantial discount.”

It also highlights its attempt and those of others, to move assets from Sentinel rather than allow Sentinel to sell them — which the suit claims Sentinel had no authority to do.

Jeff Barclay, partner at Schuyler, Roche & Zwirner, filed a suit against Sentinel on behalf of Farr Financial Inc., a non-clearing FCM that had funds with Sentinel, and whose firm also represents several Sentinel customers with Seg 3 accounts, also questions Sentinel’s authority to sell the securities to Citadel.

“They were not their assets to sell,” says Barclay, who also would have preferred a transfer. “Horizon Cash Management had offered to do it that entire week; the NFA was there.”

Both Barclay and Kottke expressed dismay that a general accounting of the monies at Sentinel was not done, and still had not been produced as of Sept. 10.

“They didn’t have an accounting of where those securities were,” Barclay says, “and I saw that as reckless and told them so. How can you allow a sale of these securities when you don’t know what is there?” Barclay adds.

On Aug. 16 Sentinel delivered a letter to its clients announcing that it had arranged to sell its Seg 1 portfolio to Citadel, the sale would close the following day. As a result of the sale, customers in the Seg 1 pool received approximately 70¢ on the dollar, but not a full accounting, when funds were released the following week.

Driscoll acknowledges that several FCMs wanted to take back their securities but he was unaware of an offer to take the entire pool, other than Horizon’s, until it was too late. He says transferring the securities was not as easy at it sounds because several FCMs owned units of these securities and they weren’t in individual managed accounts. “Horizon did [make an offer] and we passed on the information to Sentinel. [But] because it wasn’t an FCM, it would have made it more difficult,” Driscoll says.

He adds that by the time Penson made the offer, a deal had been struck and the “window of opportunity had been closed.” But Kottke notes that the NFA and CFTC should have proactively been looking for a firm to transfer the securities to, not waiting on offers. “This is not that complicated, you’ve got to get the assets out of harm’s way. It can be done and it has to be done. The CFTC and NFA should know this; both entities have seen it done. The answer is you don’t try and make them liquid, you just transfer the securities.”

Driscoll acknowledged that some FCMs questioned the authority of Sentinel to sell the securities in the Seg 1 account to Citadel but stated, “Sentinel was designated as an investment advisor for these FCMs and as such had authority to buy and sell securities on their behalf.”

Another problem, according to Driscoll, is there remained a shortfall in the Seg 1 account of between $50 million and $70 million. While customers eventually received 70¢ on the dollar (5¢ being held at the Bank of New York) there were funds unaccounted for. “Basically Citadel paid 90¢ on the dollar for the assets they got,” Driscoll says.

Another controversy involved a report that some FCMs received all of their money in the Seg 1 account after Sentinel announced the freeze but before the sale to Citadel. Driscoll explains that four FCMs had repurchase agreements of overnight Treasuries that were liquidated that week and they got their money on Aug. 15. “It was never part of the Citadel deal.”

But a portion of the portfolio sold to Citadel had been in cash equivalents more liquid than overnight Treasuries, according to a Sentinel customer.

While unanswered questions regarding the sale of securities to Citadel remain, that does not answer the larger question of what caused the problem in the first place. As the SEC points out in its complaint, Sentinel’s explanation of its redemption suspension was false and misleading.”

The SEC charged Sentinel with fraud and misappropriation and misuse of client assets. Among the charges are that Sentinel transferred $460 million in securities from client accounts to its proprietary house account, used securities in client accounts as collateral to obtain a line of credit and additional leverage and did not disclose the commingling of customer securities; all violations of the Investment Advisor’s Act.

The Seg 3 account, containing assets of hedge funds, trust accounts, endowments and individuals, had or should have had $670 million worth of securities in it on Aug. 13 based on customer account records according to the SEC. But the Bank of New York custodial statement for the Seg 3 account as of Aug. 13 showed only $94 million.

In its complaint the SEC noted that Sentinel acknowledged moving securities among the Seg and house accounts. It also says a Sentinel representative told the SEC that since 2004, Sentinel used $1.5 billion in securities owned by clients to obtain financing and additional leverage.

As it stands, the Seg 3 customers stand to lose much more than those in the Seg 1 pool. Both pools consisted of 125 accounts(though not all of Seg 3 accounts are 125), which refers to the CFTC rule covering the allowable investments in which FCMs and derivatives clearing organizations are permitted to invest customer assets that are required to be segregated under the Commodity Exchange Act.

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