Distribution to Holders of Customer Accounts by Trustees in Commodity Broker Bankruptcy Estates
Regulation of the property of customers of commodities brokers is dictated by rules promulgated by the Commodity Futures Trading Commission. The CFTC’s authority stems from both the Commodity Exchange Act and Bankruptcy Code. The rules are meant to ensure customer protection in commodity broker liquidation. See In re Stotler & Co., 144 B.R. 385, 392 (N.D. Ill. 1992). The laws are designed to “ensure that the property entrusted by the customers to their brokers will not be subject to risks of the broker’s business and will be available to for disbursement to customers if the broker becomes bankrupt”. Id. at 387 (quoting S.Rep.No. 989, 95th Cong. 2d. Sess. (1997)). “[C]ommodity customers are granted the highest priority against the bankruptcy broker’s estate.” In re Bucyrus Grain Co., Inc., 127 B.R.45, 48 (D.Kan. 1988). Section 766 of the Bankruptcy Code provides that the trustee “shall distribute customer property ratably to customers on the basis and to the extent of such customers’ allowed net equity claims, and in priority to all other claims,” except for certain administrative expenses. See 11 U.S.C. § 766(h). The CFTC, acting pursuant 7 U.S.C. § 24, has enacted procedures for trustees implementing the CEA and Subchapter IV of Title 11 of the Bankruptcy Code. See 17 C.F.R. § 190.01-.10 & appendices. These regulations: (1) define what constitutes “customer property,” id. § 190.08; (2) establish a system of customer classes and account classes designed to ensure a fair and orderly process of pro rata distribution, id. §§ 190.01(a), (m), (bb), & (hh); and (3) provide a formula for calculating allowable “net equity” claims, id. § 190.07. Generally, all customer claims must be satisfied in full before property of the estate may be used to pay any general unsecured claims, see 11 U.S.C. § 766(h); 17 C.F.R. § 190.08(a), and no “insider” who also happens to be a brokerage customer may be paid until all public customers’ claims are fully satisfied, see 11 U.S.C. § 766(h); 17 C.F.R. § 190.08(b) & (c)(2).
The definition of customer property is governed by both the Bankruptcy Code and the CEA. The CEA allows the CFTA to augment the expansive definition of customer property established in 11 U.S.C. § 761(10). “Notwithstanding title 11 of the United States Code,” the CFTC may issue regulations to “provide . . . that certain cash, securities, other property, or commodity contracts are to be included in or excluded from customer property.” 7 U.S.C. § 24(a). The CFTC promulgated 17 C.F.R. § 190.08, which creates several categories of “Consumer Property” including: (a) segregated customer property, Section 190.08(a)(ii)(A); (b) property that should have been segregated, Section 190.08(a)(1)(i)(A); (c) property which had been unlawfully removed from segregation to the debtors general estate, Section 190.08(a)(1)(ii)(F); (d) property recovered by the trustee in an avoidance action if it would have been covered under Section 190.08(a)(1)(i)(A), because it was “received, acquired or held to margin, guarantee, secure, purchase or sell a commodity contract”; Section 190.08(a)(1)(ii)(D); (e) specially identifiable property as defined in Section 190.01(kk) which is non-fungible property posted as collateral; and (f) other estate property which may be needed to satisfy the claims of public customers if enumerated customer property is insufficient. Section 190.08(a)(1)(ii)(J).
Section 766 of the Code requires that commodity customer property be distributed ratably. 11 U.S.C. § 766(h). The trustee must allocate the “property of the debtor’s estate . . . among account classes and between customer classes.” 17 C.F.R. § 190.08. Each of the allocated amounts is treated as “a separate estate of the customer class and the account class to which it is allocated.” Id. Section 190.01(m) establishes two “customer classes”: public customers and non-public customers. Generally, a “non-public customer” is a customer who is also an insider, affiliate, or other controlling person or entity of the debtor. Id. § 190.01(bb). All other customers are public customers. Id. § 190.01(hh). All allowable net equity claims by public customers must be satisfied in full before any distribution may be made to any insider customer. See 11 U.S.C. § 766(h) (“Notwithstanding any other provision of this subsection, a customer net equity claim based on a proprietary account, as defined by Commission rule, regulation or order, may not be paid either in whole or in part, directly or indirectly, out of customer property unless all other customer net equity claims have been paid in full.”); 17 C.F.R. § 190.08(b); Id. § 190.08(c)(2).
Section 190.01(a) specifies six types of customer accounts that must be recognized by the trustee as separate “account classes” in liquidation: futures accounts, foreign futures accounts, leverage accounts, commodity option accounts, delivery accounts, and over-the-counter (OTC) derivative accounts. 17 C.F.R. § 190.01(a). The reason for creating classes of accounts is facilitation of pro rata distribution within the different types of investment accounts. Bankruptcy, 46 Fed. Reg. at 57536. Trustees are required to attribute all customer property to the appropriate account class. Section 190.08(c)(1) provides that “property held by or for the account of a customer, which is segregated on behalf of a specific account class, or readily traceable on the filing date to customers of such account class, must be allocated to the customer estate of the account class for which it is segregated or to which it is readily traceable.” See Bankruptcy, 46 Fed. Reg. at 57552. Once the traceable customer property has been properly allocated to its class, any customer property that is not segregated or traceable to a particular class must be allocated in a manner designed to to equalize the recovery in each class. 17 C.F.R. § 190.08(c)(2).
The Bankruptcy Code requires that pro rata distributions be made “on the basis and to the extent of such customers’ allowed net equity claims.” 11 U.S.C. § 766(h). Section 20(a)(5) of the CEA authorizes the CFTC to provide by rule or regulation “how the net equity of a customer is to be determined.” 7 U.S.C. § 24(a)(5); see also 11 U.S.C. § 761(17) (subjecting the statutory definition of “net equity” to “such rules and regulations as the [CFTC] promulgates under the [CEA]”). Section 190.07(b) defines “net equity” as “the total claim of a customer against the estate of the debtor based on the commodity contracts held by the debtor” net of certain amounts and then describes a six step process for calculation of net equity. 17 C.F.R. § 190.07(b). The valuation process considers; the net proceeds from sales of securities liquidated by the Trustee, Id. § 190.07(e); settlement prices of unliquidated securities, Id. § 190.07(e)(5); and the date on which the accounts or proceeds are returned to the customer, Bankruptcy, 46 Fed. Reg. at 57546. Tort claims and other obligations of a debtor to customers not related to their contract obligations are not included in the analysis (see 6-761 Collier on Bankruptcy ¶ 761.18 (2011)), but, if the non-commodity contract obligations of a customer exceeds the non-commodity obligation of a debtor to that customer, the difference may be deducted from his net equity balance.
Customers may receive distributions from multiple classes depending on the composition of their portfolios. Any negative net equity amounts in one class are used to offset any positive equity balance the same customer may have in a different class. 17 C.F.R. § 190.07(b)(3)(iii). Section 190.07(c) governs the determination of the pro rata amount that each claimant may be paid, based on the funds available in the estate (the “funded balance”). This is the amount that the customer will be paid for each account class up to the amount of the customer’s allowable net equity claim. Id. § 190.07(c).
Samuel D. Hodson
Partner, Taft Stettinius & Hollister LLP