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Bank of New York Mellon Goes to Trial Over Use of Sentinel Investor Funds

Bank of New York Mellon Corp. is defending itself at trial against allegations it knew cash management firm Sentinel Management Group Inc. was using investors’ assets as collateral for a $312 million credit line.

A lawyer for Sentinel liquidation trustee Frederick Grede told the court today the bank extended the firm credit knowing it lacked enough capital to cover the debt, helping its principals finance a heavily leveraged trading portfolio. Grede, claiming the bank enabled Sentinel to deceive its clients, seeks the recovery of about $600 million for its creditors.

“When Sentinel did crash,” trustee lawyer Chris Gair told U.S. District Judge James B. Zagel in Chicago in his opening statement, “it was Sentinel’s customers who took the hit.”

Sentinel, based in Northbrook, Illinois, filed for bankruptcy in 2007, four days after it froze client accounts citing credit market instability. Customer claims have totaled about $1.2 billion. U.S. Bankruptcy Judge John H. Squires in December 2008 approved a liquidation plan under which investors could be repaid 35 cents on the dollar.

Recovery on Lien

BNY Mellon is seeking enforce its collateralized claim for the $312 million in outstanding credit extended to the firm when it failed, plus accrued interest and attorney fees. Grede wants the Zagel to subordinate that lien to the claims of other Sentinel creditors.

“The bankers at the Bank of New York didn’t believe that Sentinel or its insiders were engaged in any misconduct,” the lender’s lawyer, Matthew Ingber, told Zagel during his more than two hours of opening remarks.

“They never suspected fraud,” Ingber said.

In papers filed before the trial, Gair said BNY Mellon promised and was required to “segregate customer assets, treat them as belonging solely to Sentinel’s customers, and not assert a lien over those assets.”

“BoNY did precisely the opposite,” he said.

By 2006, Sentinel was typically ending the day owing the bank more than $300 million, exceeding the indebtedness to BNY Mellon of securities firms including Goldman Sachs Group Inc., Bear Stearns Cos. -- now part of JPMorgan Chase & Co. -- and now-bankrupt Lehman Brothers Holdings Inc., and backing that obligation with client assets, Gair said.

The bank had had an “unblemished” 10-year relationship with Sentinel before it collapsed, Ingber countered. Its maintenance of the credit relationship was based on its experience with the firm and trust in its principals, he said.

‘Customer Assets’

The New York-based lender said in a court filing last month there is no evidence that the bank knew Sentinel was in violation of the federal commodity exchange act or that insiders were “misappropriating customer assets for their own benefit.”

“There was no misconduct -- much less the required egregious misconduct -- by the bank justifying the extraordinary remedy” of subordination, the bank said.

Sentinel founder Philip Bloom and his son, Chief Executive Officer Eric Bloom, and trusts they controlled agreed to pay $10.7 million to settle claims Grede filed against them, in 2008.

Grede, the trustee, was his own first witness, testifying today about his 25-year career at the Chicago Board of Trade, where he rose from an auditor to executive vice president of the exchange and then led the Hong Kong Futures Exchange as its chief executive officer.

Grede served initially as chapter 11 bankruptcy trustee for Sentinel, he told the court, and then as liquidation trustee after Squires approved the plan to dissolve the firm’s assets to repay creditors.

Zagel last year denied BNY Mellon’s request that he dismiss the lawsuit, calling the failure to segregate the customer funds “a very serious violation when committed on the scale alleged here.”

The case is Grede v. The Bank of New York, 08cv2582, in the Northern District of Illinois (Chicago).

To contact the reporter on this story: Andrew M. Harris in Chicago at Aharris16@bloomberg.net.

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