In re MJK Clearing, Inc., 286 B.R. 109 (Bkcy D. Idaho 2003)

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THE PARTIES

The plaintiff, Ferris, Baker Watts is a Delaware corporation with its principal place of business in Washington, D.C., and is registered with the United States Securities and Exchange Commission as a securities broker-dealer. The debtor, formerly known as Miller Johnson & Kuehn, is a corporation organized under the laws of Minnesota with its principal place of business in Golden Valley, Minnesota. The debtor, until it suspended business activities on September 25, 2001, was engaged in the business of securities brokerage and trading.

FBW and MJK entered into a Master Securities Loan Agreement in January of 1999. [FN1] The agreement was amended on January 26, 1999. Pursuant to the MSLA, if one party borrowed securities from the other, the borrower would deposit with the lender cash or other collateral in an amount equal to at least one hundred percent of the market value of the loaned securities. The lender would pay the borrower a cash collateral fee for any cash given as collateral for loaned securities at a rate agreed between the parties, and would hold that collateral as security for the borrower's obligations with respect to the loan. Moreover, the MSLA provided that if the value of the securities increased in the market, the borrower would provide additional cash collateral to the lender. Conversely, if the value of the securities decreased, the stock lender would return the amount of the decrease. This process is known as "marking to market," which serves to equalize the value of the securities and the cash collateral. Finally, section 3.2 of the MSLA provided:

FN1. MJK involved itself in numerous stock lending and borrowing transactions with companies other than FBW, such as Native Nations. In each of these lending and borrowing transactions the debtor acted as a lender or a borrower of securities pursuant to a Master Securities Loan Agreement similar to the agreement between MJK and FBW.

In addition to the rights and remedies given to Lender hereunder, Lender shall have all the rights and remedies of a secured party under the New York Uniform Commercial Code. It is understood that Lender may use or invest the Collateral, if such consists of cash, at its own risk, but that (unless Lender is a Broker-Dealer) Lender shall, during the term of any Loan hereunder, segregate Collateral from all securities or other assets in its possession. Lender may pledge, repledge, hypothecate, rehypothecate, lend, relend, sell or otherwise transfer the Collateral, or re-register Collateral evidenced by physical certificates in any name other than Borrower's only (a) if Lender is a Broker-Dealer or (b) in the event of a Default by Borrower.

The debtor's securities lending business involved transactions for one of three purposes: (1) loaning stock held by the debtor to raise capital; (2) borrowing stock to make deliveries; or (3) serving as a conduit/intermediary between parties. In this last type of transaction, the debtor would borrow securities from one party and loan those same securities to another party. In return, the debtor would receive cash collateral from the party to whom it loaned the securities, and the debtor would then post cash collateral with the party from which it borrowed securities as collateral for its own obligations.

All cash collateral received by MJK from any party to which it loaned securities was automatically reflected as a debit on MJK's account at the Depository Trust Company. Similarly, for every transaction in which MJK borrowed securities, MJK's DTC account reflected a credit representing the transfer of cash collateral out of the account. On any given day MJK's DTC account reflected numerous debits and credits that were the result of the plethora of securities transactions in which it participated. Each of these debits and credits were aggregated at the end of the day, providing a net amount for MJK's DTC account. As a consequence, any cash collateral posted by FBW or any other borrower of MJK was commingled with other cash collateral received by MJK from various securities transactions that day.

MJK'S DEMISE

Prior to September 2001, MJK entered into stock loan agreements with other broker dealers, one of which was Native Nations Securities, Inc. Pursuant to a MSLA with NNS, during 2000 and 2001 MJK entered into a series of stock loan transactions with respect to three securities: (1) various issues of bonds by Imperial Credit Industries, Inc.; (2) shares of common stock of GenesisIntermedia, Inc.; and (3) shares of common stock of Holiday RV Superstores, Inc. On or around July 17, 2001, MJK borrowed from NNS $64,000,000 face amount of bonds issued by ICII that MJK listed at a carrying value of $63,210,000. FBW claims that with respect to such bonds, there were no records of them trading on the market in the ensuing three months and there was no record that they had any market value. With respect to the GENI stock, as of July 2001, MJK had on account 6,611,700 shares valued by MJK at $18 per share for a total value of $119,010,600. FBW claims that the 6,611,700 shares of GENI stock represented nearly one-third of the outstanding stock of GENI and could not reasonably be liquidated at the value carried by MJK. Concerning the Holiday RV stock, MJK on or around July 17, 2001, MJK borrowed from NNS 4,000,000 shares that MJK valued at $4 per share for a total of $16,000,000. FBW claims that the 4,000,000 shares of RVEE represented more than 50% of the outstanding stock of RVEE and could not reasonably be liquidated at the value carried by MJK. FBW also claims that as of July 17, 2001, MJK held a stock-borrow receivable from NNS in the amount of $198,221,600 on ICII, GENI, and RVEE, but these stocks were worth no more than $17,600,000, thus causing MJK to be unsecured in an amount not less than $180,621,600.

MJK reported in its quarterly Focus Report to the SEC for the quarter ending June 30, 2001, that the company had net capital of $21,906,498, a net capital requirement of $6,311,774, and therefore excess net capital of $15,574,724. FBW alleges, however, that as of July 17, 2001, taking into account the net capital requirement of $6,311,774 and the amount of its unsecured receivable from NNS, which FBW alleges is not less than $180,621,600, MJK was in violation of its net capital requirement. [Footnote omitted.]

As of August 31, 2001, MJK reported to the SEC that it had a net capital of $22,528, 817, a net capital requirement of $7,645,029, and resulting in excess net capital of $14,883,788. FBW alleges, however, that MJK was in violation of its regulatory net capital requirements and insolvent from at least July 17, 2001, through the present and at no time did MJK inform the SEC of its net capital violations or insolvency. FBW also alleges that MJK's net capital deficiencies was caused by their failure to obtain the return of cash collateral from NNS when the market value of ICII bonds declined.

Prior to September 11, 2001, GENI shares traded consistently in the range of $17 per share. Its price for the purpose of establishing the amount of collateral held by NNS was generally fixed at $18 per share throughout the several months preceding September 11, 2001. Likewise, the mark set for shares of GENI that MJK loaned to other broker-dealers was $18 per share, and throughout July and August of 2001, and continuing through September 11, 2001, MJK's stock loan positions in GENI, as reflected in MJK's books, were matched on most days, meaning that the value of the securities corresponded to the value of the collateral.

On September 11, 2001, securities trading in the United States was halted. Trading was resumed on September 17, 2001. By the close of trading on September 17, 2001, the price of GENI stock had declined to $16.20 per share. On September 18, 2001, MJK paid GENI marks received from other broker-dealers in the amount of $7,211,400. FBW states that on that same date, MJK should have marked the price of GENI stock in the same amount to NNS and should have demanded that NNS return $7,211,400 in cash collateral. FBW alleges that MJK's failure to make such a demand created a collateral imbalance on the books of MJK in the amount of $7,211,400. FBW alleges that these factors required MJK to take a special charge to its net capital as of September 18, 2001, but that MJK failed to take a special charge. Had MJK taken this special charge, FBW alleges, MJK would have disclosed that it lacked the minimum stated capital necessary to operate.

The price of GENI stock continued to decline to a closing price of $13.38 per share on September 19, 2001. On that date, MJK satisfied marks at $3 per share on the 7,211,400 shares of GENI stock that it had lent to other broker-dealers, resulting in MJK's return of collateral to those broker-dealers in the amount of $21,634,200. FBW alleges that MJK did not demand that NNS return a like amount of cash collateral to MJK, and that this created a further collateral imbalance on the books of MJK in the amount of an additional $21,634,200. FBW alleges that this situation required MJK to take a further charge to its net capital as of September 20, 2001, and had MJK done this, MJK would have disclosed that its deficiency in minimum capital necessary to operate was increased by $21,634,200.

On September 20, 2001, the price of GENI stock continued to decline for a fourth consecutive day to close at $10.96 per share. MJK thereupon received and met additional marks at $3 per share on the outstanding 7,211,400 shares of GENI stock, requiring MJK to return collateral in the amount of $21,634,200. FBW claims that MJK should have demanded that NNS return a like amount of cash collateral to MJK but MJK failed to do so. FBW also claims that this collateral imbalance required MJK to take a further charge to its net capital as of September 21, 2001, in the amount of $21,634,200, but MJK failed to act. Had such a charge been taken, argues FBW, MJK would have disclosed that its deficiency in minimum capital necessary to operate as a broker-dealer was increased by another $21,634,200.

On September 21, 2001, MJK contacted FBW and proposed a stock loan transactions whereby FBW would borrow two million shares of common stock of GENI stock and deposit cash collateral based on the closing price for the stock of $10.90 a share on September 20, 2001, rounded to $11 per share. FBW agreed to borrow the stock. Pursuant to the terms agreed by the parties and in accordance with the MSLA, the DTC transferred two million shares of GENI stock from MJK's account at DTC to FBW's account at the DTC. [Footnote omitted.] In turn, the DTC transferred cash in the amount of $22,000,000 from FBW's account at the DTC to MJK's account at the DTC.

During the day of September 21, 2001, MJK settled numerous securities transactions through the DTC. Such transactions required MJK to pay funds to other parties in excess of the aggregate dollar value paid to MJK. This resulted in MJK, at the close of business on September 21, 2001, owing the DTC $7,055,946.85, an amount that MJK paid from its bank account held at the Harris Bank. Accordingly, the $22,000,000 transferred from FBW's DTC account into MJK's DTC account was used that same day by MJK to satisfy its other ordinary business obligations. [FN4]

FN4. Such a use was authorized by section 3.2 of the MSLA and is consistent with the practices of other broker-dealers in the industry.

At the close of trading on September 21, 2001, the price of GENI had declined to $10 per share, down $1 from the price at the close of business on September 20, 2001. Pursuant to the terms of the MSLA, the stock was "marked to market" and MJK transferred to FBW $2,000,000 on September 24, 2001. On that same date, the price of GENI stock declined further to $9 per share. Again, the stock was "marked to market" and MJK transferred $2,000,000 to FBW the following morning. On September 25, 2001 [FN5], the price of GENI declined even further to $6 per share. FBW "marked to market" each stock borrow position that was open with MJK based on the price of the security that day, and demanded that MJK transfer to FBW an additional $6,000,000 to reflect the revised values of $6 per share for the GENI stock. MJK agreed, but failed to transfer the funds to FBW. That failure was an event of default under the MSLA. That same day, trading of GENI was halted, [FN6] and MJK notified federal regulators that it lacked sufficient net capital under applicable federal and self-regulatory rules to continue operations.

FN5. Prior to September 25, 2001, MJK and FBW, pursuant to the MSLA, entered into various other securities transactions involving stock other than GENI. When FBW acted as a borrower of securities, it transferred cash to MJK pursuant to the MSLA. When FBW acted as a lender of securities, MJK transferred cash to FBW pursuant to the MSLA. Each business day, in accord with the terms of the MSLA, the parties "marked to market" the stock borrowed or loaned and transferred cash from one party to the other, through the DTC.

FN6. The trustee considers the value of GENI stock to be $0, even though it is now trading in "pink sheets" for pennies a share.

On September 27, 2001, at the request of the Securities Investors Protection Corporation, [Footnote omitted.] the district court entered a Protective Decree against MJK under 15 U.S.C. § 78eee(b), appointed James P. Stephenson as trustee pursuant to 15 U.S.C. §§ 78aaa-111, and removed the case to the bankruptcy court. [FN8] Following these events, FBW received return of the GENI stock it transferred to A.G. Edwards, tendered that stock to the trustee, and requested the return of the money it posted with MJK. The trustee has not transferred any money to FBW. With respect to securities lending or borrowing positions other than those involving GENI stock, FBW and the trustee entered into novation agreements. [FN9] With respect to other non-GENI stock transactions in which FBW borrowed stock from MJK and MJK defaulted, FBW exercised its rights as borrower under section 13 of the MSLA [FN10], sold the stock in its possession and applied the proceeds of the sales to the obligation of MJK. With respect to non-GENI stock loan transactions in which FBW loaned securities to MJK and received cash from MJK, upon default by MJK, FBW exercised its rights as lender under the MSLA and set off the amount of cash it received from MJK against amounts MJK owed to FBW. The net effect of those transactions involving non-GENI stock is that MJK owes FBW $1,763,631. This, coupled with the $18,000,000 from the GENI transaction, brings the total amount of FBW's claim against MJK to $19,763,631.

FN8. FBW states that these events constituted public acts of insolvency that triggered the automatic default without notice provisions of the MSLA, and as such, MJK had a duty to return all stock loan collateral held by it upon tender by FBW of the GENI and other stock. Of course, once a trustee was appointed, MJK lost the ability to transfer any money to FBW.

FN9. A novation is an agreement where one party, in this case MJK, removes itself from the middle of a conduit transaction. A conduit transaction is a securities lending transaction in which party B borrows securities from party A, and then re-lends those securities to party C. A novation agreement removes party B from the transaction, so that the transaction becomes a stock loan directly from party A to party C.

FN10. Section 13 of the MSLA states: Upon the occurrence of a Default under Section 11 entitling Borrower to terminate all Loans hereunder, Borrower shall have the right (without further notice to Lender), in addition to any other remedies provided herein or under applicable law, (a) to purchase a like amount of Collateral ("Replacement Collateral") in the principal market for such Collateral in a commercially reasonable manner, (b) to sell a like amount of the Loaned Securities in the principal market for such securities in a commercially reasonable manner and (c) to apply and set off the Loaned Securities and any proceeds thereof against (i) the payment of the purchase price for such Replacement Collateral (ii) Lender's obligations to return any cash or other Collateral and (iii) any amounts due to Borrower under Sections 4, 7, 17. In such event, Borrower may treat the Loaned Securities as its own and Lender's obligation to return a like amount of the Collateral shall terminate...Borrower may similarly apply the Loaned Securities and any proceeds thereof to any other obligation of Lender under this Agreement, including Lender's obligations with respect to distributions paid to Lender (and not forwarded to Borrower) in respect of Collateral. In the event that (i) the sales price received from such Loaned Securities is less than (ii) the purchase price of Replacement Collateral (plus the amount of any cash or other Collateral not replaced by Borrower and all other amounts, if any, due to Borrower hereunder), Lender shall be liable to Borrower for the amount of any such deficiency, together with interest...

FBW'S CLAIMS

FBW has asserted four causes of action against the trustee relating to securities lending transactions entered into with the debtor. These claims include declaratory judgment/injunctive relief, specific performance, and constructive trust. The trustee moves for summary judgment on all of FBW's claims.

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Burden of the Moving Party

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I conclude that the trustee is entitled to judgment as a matter of law on all of FBW's claims.

DISCUSSION

DECLARATORY JUDGMENT/INJUNCTIVE RELIEF

In its prayer for relief, FBW requests a declaration that the money held by the trustee derived from the stock lending transactions with FBW is not property of the estate within the meaning of 11 U.S.C. § 541. FBW further requests an order freezing not less than $19,763,631 of cash in possession of the trustee and an order directing the trustee not to use, sell or lease property of the estate or cash collateral in his possession without express consent of FBW or further order of the court. FBW is not entitled to this relief because it cannot identify any funds in the debtor's estate that currently belong to FBW. In coming to this conclusion, I look to the nature of the transfers of cash collateral from the debtor's DTC account, the rights and remedies of the parties as established in their Master Securities Loan Agreement, as well as the statutory laws stated in the Bankruptcy Code and the Uniform Commercial Code as adopted by the state of New York.

FBW cannot trace or identify the cash it posted with MJK. It is true that the books and records of the debtor identify the particular amounts of cash collateral posted by FBW to MJK. The trustee does not dispute that FBW posted cash collateral with MJK in exchange for loaned securities, and the debtor's DTC reports reflect such transactions. FBW cannot, however, trace and identify the particular assets in the possession of the trustee that FBW claims is its own, because once the debtor exercised its rights of alienability under section 3.2 of the MSLA and used the cash posted by FBW, the specific cash FBW once held no longer belonged to it. Moreover, under the MSLA, MJK was not required to segregate any cash for the benefit of FBW. Consequently, FBW cannot claim an interest in any specifically identifiable cash, and FBW is left with a claim against the debtor for damages, exactly as provided in section 13 of the MSLA.

FBW contends that the MSLA granted a security interest in favor of MJK as the lender FBW argues that under the Uniform Commercial Code as adopted by the state of New York, MJK as the secured party had a duty of reasonable care with regard to the cash collateral tendered to MJK by FBW, and an obligation to identify that cash collateral.

A secured party in possession of collateral is required to use reasonable care in the custody and preservation of that collateral. N.Y. U.C.C. § 9- 207(a) (2002). Official Comment 2 to Article 9 § 9-207 of the Uniform Commercial Code further states that "under Section 1-102, the duty to exercise reasonable care may not be disclaimed by agreement, although under that section the parties remain free to determine by agreement standards that are not manifestly unreasonable as to what constitutes reasonable care." U.C.C. § 9-207, Comment 2 (2002); see also Maple Securities U.S.A., Inc. v. Stephenson (In re MJK Clearing, Inc.), 2002 WL 31015219, at *4 (Bankr.D.Minn. Sept. 11, 2002). Under section 3.2 of the MSLA FBW and MJK did determine what constituted reasonable care with regard to preservation and custody of the cash collateral. As section 3.2 of the MSLA states, "Lender may pledge, repledge, hypothecate, rehypothecate, lend, relend, sell or otherwise transfer the Collateral, or re-register Collateral evidenced by physical certificates in any name other than Borrower's only (a) if Lender is a Broker-Dealer or (b) in the event of a Default by Borrower." Because MJK was a broker-dealer, section 3.2 of the MSLA did not require MJK to segregate the collateral. FBW also gave MJK specific rights of alienability with regard to the collateral, and in fact MJK exercised those rights by disposing of the collateral the same day FBW transferred it. Furthermore, under § 9-207(b)(3)(2002), the cash collateral FBW posted with MJK was fungible collateral that could be commingled. MJK, pursuant to statute and parties' agreement, commingled the cash it received from all those who borrowed securities from MJK and spent it.

MJK as the secured party could use the collateral to the extent agreed to by the debtor. N.Y. U.C.C. § 9-207(b)(4)(C) (2002). FBW, pursuant to the New York Uniform Commercial Code and section 3.2 of the MSLA, gave MJK the right to pledge, repledge, hypothecate, rehypothecate, lend, relend, sell or otherwise transfer the Collateral. Essentially, FBW gave MJK permission to treat the cash it received as its own, and upon default, MJK was to return a like amount of cash to FBW that equaled the amount of cash collateral FBW posted with MJK. This obligation on the part of MJK essentially amounts to nothing more than a monetary debt, and FBW is entitled to an unsecured claim against MJK's estate for that debt. In re MJK Clearing, Inc., 2002 WL 31015219, at *5.

Moreover, Official Comment 3 to Article 9 § 9-625 states that the basic remedy for the secured party's failure to comply with Article 9 is a damage recovery in the amount of loss caused by the non-compliance. U.C.C. § 9-625, Comment 3 (2002); see also In re MJK Clearing, Inc., 2002 WL 31015219, at *5. Thus, FBW is entitled to a claim against MJK's estate in an amount equal to the amount of cash delivered to MJK pursuant to the MSLA, less the value of any securities delivered by MJK to FBW, plus interest through September 27, 2001. The trustee acknowledges that FBW has a claim against MJK, but argues that this claim merely falls into the category of a general unsecured claim, and on that point the trustee is correct. [Footnote omitted.] In re MJK Clearing, Inc., 2002 WL 31015219, at *5.

FBW also argues that a security interest attaches to any identifiable proceeds of collateral, and when those proceeds are commingled with other identifiable proceeds, normal methods of tracing apply. See N.Y. U.C.C. § 9-315(a)(2), (b)(2). The perfected security interest continues in proceeds to the extent the original security interest was perfected in the collateral. Id. at § 9-315(c). I find that FBW, however, cannot show a property interest of cash in any account of the debtor.

Courts have traced commingled funds in a bank account by using the "lowest intermediate balance" rule of tracing. Under the lowest intermediate balance rule, it is assumed the traced proceeds are the last funds withdrawn from a contested account. [Citation omitted.] Once the traced proceeds are withdrawn, however, they are treated as lost, even though subsequent deposits are made into the account. Id.; see also 5 Collier on Bankruptcy ¶ 541.11, at 541-70 (15th ed.2001).

First of all, FBW has not made an initial showing that the proceeds from the cash it transferred to MJK, pursuant to the non-GENI stock loan transactions, reached a particular bank account of MJK or any account currently in the possession of the trustee. When the res is money, it must be clearly traced and identified in specific property. [Citation omitted.] FBW has not done so.

Moreover, on September 21, 2001, the day of the GENI transaction, FBW transferred $22,000,000 to the debtor's DTC account, yet at the end of the day MJK's DTC account had a negative balance and even after the GENI transaction, MJK was still required to pay more than $7,000,000 to the DTC from its Harris Bank account. Thus, the cash FBW transferred to MJK's DTC account was untraceable once that account dipped to a negative balance. Where all of the moneys are withdrawn, the equity of the cestui is lost, although moneys from other sources are subsequently deposited in the same account. [Citation omitted.]

FBW argues that I should look at the overall cash position of MJK or the debtor's overall assets in order to trace the proceeds, if any, from the cash it posted with MJK. FBW also states that at no time between September 21, 2001 and September 27, 2001, did MJK have less than $27,000,000 of cash and cash equivalents available to it. First, the point of tracing is to follow the particular entrusted assets, not simply to identify some assets. [Citation omitted.] Second, the fact remains that FBW has not traced any proceeds of the money it posted with MJK to any account of the debtor or to any account now in the possession of the trustee.

Applicability of 11 U.S.C. § 544(a)

Even if FBW had an interest in either the cash in possession of the trustee, the trustee could avoid such interests. [Footnote omitted.] [Citation omitted.] The trustee as hypothetical lien creditor can avoid, under 11 U.S.C. § 544(a)(1), any interest of FBW in the funds transferred by FBW to MJK pursuant to the MSLA. FBW argues that 11 U.S.C. § 544 [Footnote omitted.] is inapplicable because MJK held a mere security interest in the money FBW posted with MJK pursuant to the stock loan transactions. Moreover, FBW argues that under 11 U.S.C. § 541(d), the cash it posted with MJK is excluded from MJK's estate because MJK holds only bare legal title with no equitable interest.

First, the property of the bankruptcy estate is broadly defined in § 541(a)(1) of the Bankruptcy Code. [Citation omitted.] The commencement of a case under the Bankruptcy Code creates an estate which is comprised of virtually all the legal and equitable interests of the debtor in property wherever located, and that any exception or exclusion from the estate must be narrowly construed. [Citation omitted.] The scope of the estate is broad and all encompassing. Patterson v. Shumate, 504 U.S. 753, 757, 112 S.Ct. 2242, 2246, 119 L.Ed.2d 519 (1992); see also U.S. ex rel Gebert v. Transport Admin. Serv., 260 F.3d 909, 913 (8th Cir.2001) (stating that estate property is broadly defined and encompasses conditional, future, speculative and equitable interests of the debtor). The right of complete alienability, given to the debtor by FBW, is sufficient to make the cash it posted with MJK property of the estate. In re MJK Clearing, Inc., 286 B.R. 862, 875. Thus, the amounts in the debtor's bank account at the commencement of its liquidation proceeding is property of the estate under 11 U.S.C. § 541(a)(1).

The extent of the trustee's rights as a judicial lienholder or judgment creditor is measured by the state law governing the property in question. [Citations omitted.] Regarding the funds in the possession or control of the trustee, even if FBW could demonstrate that it had an interest in these funds, the trustee can avoid such interest under 11 U.S.C. § 544(a). In Minnesota, the debtor's principal place of business, the holder of a judicial lien against the debtor or a judgment creditor of the debtor would have the right to garnish any funds on deposit in any of the debtor's deposit accounts to satisfy such lien or judgment. Minn.Stat. § 571.71-571.932 (2002). Such garnishment would attach to all funds in the debtor's deposit accounts, and prime any interest that FBW would have had in such funds. Minn.Stat. § 571.81 (2002).

SPECIFIC PERFORMANCE

Count one, two and five of FBW's complaint seek the immediate return of cash based on MJK's breach of the MSLA. Though FBW does not state that it requests specific performance, FBW is essentially asserting a claim against the trustee for specific performance requiring the trustee to return $19,763,631 that was transferred by FBW to MJK pursuant to the securities lending transactions at issue. [Footnote omitted.] I find that FBW is not entitled to specific performance.

[Court’s reasoning is omitted.]

CONSTRUCTIVE TRUST

Counts four and six of FBW's complaint asserts a claim for a constructive trust. [Footnote omitted.] FBW argues that MJK converted the cash collateral it posted with MJK and was unjustly enriched by the proceeds of that collateral. FBW argues that MJK committed fraud on FBW in soliciting the cash collateral for GENI stock and other stock loans. FBW states that no later than August 31, 2001 and perhaps as early as March 2001, that MJK was operating in violation of net capital requirements. FBW argues that MJK (1) misrepresented its financial condition to FBW; (2) misrepresented to the Securities and Exchange Commission its financial status; (3) knew it would be unable to return FBW's collateral because MJK was insolvent; (4) was in violation of its regulatory net capital requirements; and (5) would have been shut down by the Securities and Exchange Commission before inducing trades from FBW had MJK not misrepresented its financial situation to the Securities and Exchange Commission. FBW further argues that MJK was required to disclose such facts to securities regulators and to FBW prior to entering into any stock loan transactions but failed to do so, and that the fraud perpetrated against FBW by MJK supports FBW's claim for a constructive trust on the identifiable collateral proceeds for the GENI stock as well as the other stock loans. At the outset I note that if the property was actually FBW's property, creation of a constructive trust would be unnecessary. To the extent the trustee is not holding FBW's property, imposition of a constructive trust is inappropriate. In re MJK Clearing, Inc., 286 B.R. 862, 880.

 "The imposition of a constructive trust is an equitable remedy which the court has discretion to grant or deny." In re Dynamic Technologies Corp., 106 B.R. 994, 1007 (Bankr.D.Minn.1989) (citing Thompson v. Nesheim, 280 Minn. 407, 414, 159 N.W.2d 910, 916 (1968)). The imposition of a constructive trust in bankruptcy may be appropriate if it would be sufficient under applicable state law. [Citations omitted.] However, it is the federal bankruptcy law that ultimately determines whether a constructive trust is appropriate in a bankruptcy case. [Citation omitted.] The unique considerations involved in a bankruptcy case must drive the result on the constructive trust issue. Id. There is no unyielding formula for a court to apply in decreeing a constructive trust. [Citation omitted.] Under Minnesota law, a court may impose a constructive trust only when there is clear and convincing evidence that a constructive trust is necessary to prevent unjust enrichment. [Citation omitted.] A constructive trust will arise "whenever the legal title to property is obtained through fraud, oppression, duress, undue influence, force, crime, or similar means, or by taking improper advantage of confidential or fiduciary relationship." Bly v. Gensmer, 386 N.W.2d 767, 769 (Minn.App.1986) (quoting Wright v. Wright, 311 N.W.2d 484, 485 (Minn.1981)). A constructive trust may be imposed only where there is some specific property identified as belonging, in equity and conscience, to the plaintiff. [Citation omitted.] Imposition of a constructive trust requires that the subject of the trust can be traced and identified with a sufficient degree of specificity. [Citation omitted.]

Fraud

First, FBW has failed to prove all of the elements of fraud. In Minnesota, to establish fraudulent misrepresentation there must be (1) a representation; (2) the representation must be false; (3) the representation must have to do with a present or past fact; (4) that fact must be material; (5) it must be susceptible of knowledge; (6) the representer must know it to be false or in the alternative, must assert it as of his own knowledge without knowing whether it is true or false; (7) the representer must intend to have the other person induced to act, or justified in acting upon it; (8) that person must be so induced to act or so justified in acting; (9) that person's action must be in reliance upon the representation; (10) that person must suffer damage; (11) that damage must be attributable to the misrepresentation, that is, the statement must be a proximate cause of the injury. [Citations omitted.] A misrepresentation may be made either (1) by an affirmative statement that is itself false or (2) by concealing or not disclosing certain facts that render the facts that are disclosed misleading. Id.

In this case, FBW has not provided facts sufficiently supported in the record to prove that MJK intended to mislead FBW by either misstating facts or deliberately failing to disclose facts regarding its financial position. [FN17] Moreover, FBW has failed to prove that management of the debtor intended FBW to rely on alleged misrepresentations or that FBW in fact relied on such misrepresentations when it agreed to enter into the stock loan transactions with MJK.

FN17. Many of the "facts" that FBW notes in its briefs to support its argument for fraud on the part of MJK are not facts at all but are conclusory statements, which essentially amount to nothing more than allegations, made by various persons such as expert Norman Frager in his report.

Unjust Enrichment

Secondly, there is no clear and convincing evidence that a constructive trust is necessary to prevent unjust enrichment in this case. Unjust enrichment has been invoked in support of claims based upon the failure of consideration, fraud, mistake, and in other situations where it would be morally wrong for one party to enrich himself at the expense of another. [Citation omitted.] Unjust enrichment claims do not lie simply because one party benefits from the efforts of others, instead "it must be shown that a party was unjustly enriched in the sense that the term unjustly could mean illegally or unlawfully." Schumacher v. Schumacher, 627 N.W.2d 725, 729 (Minn.Ct.App.2001) (quoting First Nat'l Bank of St. Paul v. Ramier, 311 N.W.2d 502, 504 (Minn.1981)). Unjust enrichment is an equitable claim that arises when a party gains a benefit illegally or unlawfully, and there is no valid contract completely governing the rights of the parties. [Citation omitted.] It must be kept in mind that the principle of unjust enrichment should not be invoked merely because a party has made a bad bargain. [Citation omitted.] Courts are not warranted in interfering with the contractual rights of parties as evidenced by their writings which purport to express their full agreement. Id.

Here there is a valid contract completely governing the rights of the parties, and I will not interfere with the contractual rights and remedies that were bargained for by FBW and MJK. The MSLA clearly identifies the rights and remedies of both parties. Also, there was no actionable fraud, and FBW has not proven that the debtor or the trustee committed any illegal or unlawful acts. Finally, in this case there is no merit to the argument that without a constructive trust MJK would be allowed to retain the fruits of their fraud, and it is incorrect both factually and legally. The debts of MJK far exceed its assets. MJK will not retain any funds in the estate. Rather, any funds of MJK still held by the trustee will be distributed to its creditors.

Conversion

Third, MJK did not convert FBW's property. Conversion exists when a defendant has wrongfully exercised dominion over a plaintiff's personalty that is without justification or that is inconsistent with the rights of the person entitled to use, possession, or ownership of the property. [Citation omitted.] A disposition of property consented to by the owner is not a conversion of that property. [Citations omitted.]

In this case, a conversion of FBW's property did not occur. FBW expressly granted MJK permission to pledge, repledge, hypothecate, rehypothecate, lend, relend, sell or otherwise transfer the collateral. MJK in fact exercised these rights. A conversion cannot occur when the owner gives consent to the disposition of that property. [Citation omitted.].

Moreover, the cash collateral in dispute was not obtained through fraud, oppression, duress, undue influence, force, crime, or by taking improper advantage of a confidential or fiduciary relationship. The MSLA specifically granted the debtor the right to pledge, repledge, hypothecate, rehypothecate, lend, relend, sell or otherwise transfer or re-register the collateral. Consequently, the debtor was well within its rights to transfer the cash collateral. Also the debtor, pursuant to terms of the MSLA, was not required to segregate the collateral. Furthermore, FBW has failed to establish a cause of action for fraud and conversion and has not proven that the debtor or the trustee acted in any criminal or illegal manner.

Tracing

Fifth, FBW has not been able to trace and identify with specificity the cash collateral that it posted with the debtor. As stated earlier, FBW has not traced the proceeds of any cash it posted with MJK to any account of the debtor or to any account now in the possession of the trustee.

Post-Petition Constructive Trust on Property of the Estate

Finally, FBW's claim for a constructive trust fails because imposition of a post-petition constructive trust is inappropriate when its effect is to give the plaintiff a preference over other creditors. [FN18] [Citations omitted.]FBW asserts the remedy of a constructive trust as a general unsecured creditor. Constructive trusts cannot be used to alter the priority scheme explicitly prescribed by Congress.  [Citation omitted.] If a creditor claims a constructive trust on property of the estate, there is a conflict with the Code's priority rules because one creditor would be preferred over the other creditors in contravention of the Bankruptcy Code's detailed distribution scheme. Id. FBW is not entitled to a constructive trust because doing so would allow FBW to rise in priority over other general unsecured creditors and such a result is not in agreement with the Bankruptcy Code. Unless a court has already impressed a constructive trust upon certain assets the claimant cannot properly represent to the Bankruptcy Court that he was, at the time of commencement of the case, a beneficiary of a constructive trust held by the debtor. Id. No constructive trust was imposed on the behalf of FBW at the commencement of the debtor's bankruptcy case.

FN18. Courts are split as to whether constructive trusts can be imposed in bankruptcy cases. In re Morken, 199 B.R. 940, 964 (Bankr.D.Minn.1996); Shubert v. Jeter (In re Jeter), 171 B.R. 1015, 1020 (Bankr.W.D.Mo.1994), aff'd, 73 F.3d 205 (8th Cir.1996). The Eighth Circuit has not placed a total ban on constructive trusts, but allows them in very limited circumstances. Kunkel v. Ries (In re Morken), 199 B.R. at 964. The circumstances under which the Eighth Circuit has allowed imposition of a post-petition constructive trust involved creditors who asserted ownership interests in exempt property, not property of the estate. Id. In Chiu v. Wong, the debtors misappropriated funds and invested the money in exempt homestead property in order to shield the funds from creditors. Chiu v. Wong, 16 F.3d 306 (8th Cir.1994). There the Eighth Circuit imposed a post-petition constructive trust on the exempt homestead property because the trust was imposed on the debtor's property, and did not diminish the estate to the detriment of other creditors. The Eighth Circuit may also allow imposition of a post-petition constructive trust to prevent a fraudulent debtor from being unjustly enriched. See Shubert v. Jeter (In re Jeter), 171 B.R. at 1020. In Jeter the bankruptcy court found that the creditor's claim for a constructive trust was a disguised attempt to recover pre-petition fraudulent transfers. The Eighth Circuit affirmed the bankruptcy and district courts, holding that because the debtor was not unjustly enriched by his fraud, the creditor was not entitled to any special rights. The court compared the circumstances in Jeter to those in Chiu v. Wong and reasoned that unlike the remaining creditors in Chiu v. Wong, the other creditors in Jeter would have been prejudiced by the imposition of a trust favoring one particular creditor. Shubert v. Jeter, 73 F.3d at 207 n. 2. Thus in the Eighth Circuit there are at least two requirements before a constructive trust can be imposed: the debtor's misconduct allows principles of equity to override legal considerations, and the contest is between a creditor and the debtor, not among creditors. [Citations omitted.]

Although a post-petition constructive trust may be imposed to prevent a fraudulent debtor from being unjustly enriched, FBW has not proven that the circumstances of this case support the imposition of a post-petition constructive trust. The circumstances of this case simply do not rise to a level so egregious as to warrant the disruption of priority schemes. Not only would it be inequitable to allow FBW to advance itself ahead of the general creditor body, there are other broker-dealers with claims that exceed the amount the trustee has on hand. [FN19]

FN19. Among those who have claims similar to FBW are: E* Trade-$64,736,900, Nomura-$19,700,000, Baird-$7,965,000, Dax-$9,200,700, Maple Securities-$1,414,780. Added to FBW's claim of $19,763,631, there are broker-dealers with claims of over $103,000,000. When the trustee took over he had total property of about $43,000,000, all of which has been distributed to customers and creditors, supplemented by advances of $194,000,000 from SIPC.

SIPA CUSTOMER PROPERTY

[Long discussion of the Securities Investor Protection Act (SIPA) to the effect that where SIPA is inconsistent with the BRA the specific provisions of SIPA control is omitted.]

ORDER

THEREFORE, IT IS ORDERED that:

1. The plaintiff's motion for partial summary judgment is granted in part.

2. The plaintiff has a claim in this case in the amount of $19,763,631.

3. Except as provided in paragraph two, the plaintiff's motion for partial summary judgment is denied.

4. The defendant's motion for summary judgment is granted.

5. Except as provided above, the plaintiff shall recover nothing from the defendant on its complaint.

LET JUDGMENT BE ENTERED ACCORDINGLY.