In the latest ruling in the long-running dispute in Sentinel Management’s bankruptcy case, the Seventh Circuit recently held that a bank employee’s suspicions about the source of the bank’s collateral should have put the bank on inquiry notice, thus precluding the bank from asserting a “good faith” defense to a fraudulent transfer claim that a liquidating trustee brought against the bank.  However, the bank’s failure to follow up on its suspicions of wrongdoing did not meet the high standard for equitable subordination.  Today’s post will review the appellate court’s decision on the fraudulent transfer claim, while a follow up post will discuss the court’s ruling on equitable subordination.

Background

Sentinel Management Group, Inc. was an investment manager with several accounts at Bank of New York Mellon (“BNY”).  Among its accounts at BNY were segregated accounts (not subject to the bank’s lien) that held customer funds.  Sentinel represented to clients that at all times it would hold their funds in segregated accounts, as was required under the Commodity Exchange Act.  However, beginning around 2007, Sentinel began using assets in the customer accounts to secure its overnight loans at BNY by transferring assets out of the customer accounts and into other accounts subject to the bank’s lien.  At a certain point, a managing director at BNY became suspicious and wrote an email questioning whether the assets pledged as collateral for the overnight loans “[were] for someone else’s benefit” and whether the bank had rights on all the collateral, but the bank did not conduct a further inquiry.

When Sentinel filed for bankruptcy in August 2007, it owed BNY $312,247,000.  BNY filed a claim as the only secured creditor in the case.  The liquidating trustee for Sentinel’s estate brought a variety of claims against BNY, including fraudulent transfer claims and equitable subordination.

The trustee alleged that Sentinel acted with actual intent to hinder, delay or defraud its customers when it used customer assets from segregated accounts to finance the overnight loans with BNY that covered Sentinel’s own in-house trading activity.  The trustee further alleged that (i) BNY was aware of suspicious facts that should have led the bank to investigate what Sentinel was doing, (ii) an investigation would have revealed that BNY could not accept the customer assets Sentinel pledged as security for BNY’s loans to Sentinel, and, therefore, (iii) BNY acted inequitably and unlawfully, and its liens on the collateral should be avoided.

BNY asserted a good faith transferee defense under section 548(c) of the Bankruptcy Code, arguing that it was not on inquiry notice of Sentinel’s fraudulent behavior.  BNY also argued that equitable subordination was inappropriate under the facts.

In 2010, the district court conducted a bench trial and ruled against the trustee. On appeal from that ruling, the Seventh Circuit initially affirmed, but after rehearing en banc, the original panel vacated its decision.  Later, in August 2013, the Seventh Circuit reversed and remanded for further findings.  On remand, the district court again ruled against the trustee and issued a supplemental opinion to clarify its earlier findings.  The trustee appealed again.

On January 8, 2016, in a decision authored by Judge Richard Posner, the Seventh Circuit again reversed the district court, holding that BNY did not accept the liens on Sentinel’s assets in good faith and therefore cannot retain those liens, because BNY had information that should have placed it on inquiry notice that Sentinel was improperly using customer assets to secure the bank’s loans to Sentinel.

Analysis

Section 548(c) of the Bankruptcy Code provides transferees subject to fraudulent transfer actions with an affirmative defense if they received the transfer for value and in good faith.  The Seventh Circuit held that a transferee does not act in good faith if it has “inquiry notice” of the transfer’s fraudulent purpose.  As Judge Posner writes in this case, courts will look for “an awareness of suspicious facts” (often described as “red flags”) “that would have led a reasonable firm, acting diligently, to investigate further and by doing so uncover [the fraud].”  A number of federal courts, including the Seventh Circuit, have ruled that the good faith defense should be judged by an objective test (although, recently, the Fourth Circuit Court of Appeal seems to have injected the subjective knowledge of the transferee into the inquiry).

In Sentinel’s case, the appellate panel disagreed with how the district court applied the standard under section 548(c):

The opinion suggests that [BNY], as long as it did not believe that Sentinel had pledged customers’ assets to secure its loans without the customers’ permission, was entitled to accept that security for its loans without any investigation.  That’s incorrect because inquiry notice is not knowledge of fraud or other wrongdoing but merely knowledge that would lead a reasonable, law-abiding person to inquire further—would make him in other words suspicious enough to conduct a diligent search for possible dirt.

The district court held that the bank had no reason to verify the source of the funds because it relied on Sentinel’s representations and warranties that it was allowed to use the segregated funds as collateral.  But the Seventh Circuit disagreed, finding that the bank executive’s suspicion was enough to place him on notice of fraud and should have prompted an investigation, even if he did not “know” that Sentinel was improperly pledging customer assets:

Notice that because of the recipient’s obtuseness fails to trigger suspicion is nevertheless sufficient to create inquiry notice because all that is required to trigger it is information that would cause a reasonableperson to be suspicious enough to investigate.

In reviewing the district court’s findings, the appellate panel found that there were sufficient red flags in the bank’s records regarding the amount of collateral securing BNY’s loan as compared to Sentinel’s capital levels to conclude that BNY should have been on inquiry notice (e.g., “The bank had lent approximately $300 million to a company that had capital equal to roughly 1/150th of that amount.”).  Accordingly, BNY could not assert a good faith transferee defense under section 548(c) of the Bankruptcy Code and was left with an unsecured claim against the bankruptcy estate.

Observations

The Seventh Circuit reached a different conclusion of law from the district court, but did so using the lower court’s findings of fact, and, in particular, findings based on discovery from the bank’s own records.  The key evidence was the internal correspondence that revealed a bank executive was suspicious of Sentinel’s use of the collateral to secure the overnight loans.  According to the Seventh Circuit, the district court erroneously stopped short of concluding that BNY was on inquiry notice because it found that BNY did not actually know or believe that Sentinel was engaging in fraud, even though there was reason to disbelieve Sentinel’s assurances, and a reasonable person conducting a diligent inquiry would have uncovered the misrepresentations (and ultimately, the fraud).  The ruling serves as a cautionary tale for financial institutions to conduct a reasonably diligent inquiry into suspicions about a client’s use of collateral, and not to rely solely on the client’s assurances.