A recent ruling of the Seventh Circuit Court of Appeals resulted in an otherwise secured lender’s claim being rendered unsecured because the lender ignored warning signs casting doubt on the debtor’s right to pledge the collateral. In Grede v. Bank of New York Mellon Corp. (In re Sentinel Management Group, Inc.), 2016 U.S. App. LEXIS 284, the debtor was a cash management company. It invested its customers money and held the purchased securities for its customers’ accounts. The debtor also traded on its own account, and borrowed money to do so. It did not, however, have sufficient assets to collateralize a loan of the magnitude it needed. To get around the problem, the debtor pledged its customers’ securities to collateralize the loan. This was not only a violation of the agreements with its customers, but also a violation of Federal law.

When the debtor later commenced a bankruptcy case, it owed the lender $312 million. The trustee of the debtor’s estate sought to avoid the pledge of the securities as a fraudulent transfer. If successful, the trustee would be able to avoid the pledge of collateral and the lender would be left with merely a general unsecured claim. To avoid that result, the lender tried to take advantage of a “good faith” exception to fraudulent transfer liability. In short, a good faith recipient of a fraudulent transfer may be immune from avoidance to the extent that it provides value to the debtor. In this case, the lender argued that it provided value to the debtor in the form of loan advances.

The 7th Circuit, however, stated that the lender would not have been acting in good faith if it had “inquiry notice” that something was fishy (the Court’s term). The Court noted that the term “inquiry notice” means an “awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so uncover wrongdoing.” Sentinel at *3. The Court found more than sufficient evidence that the lender was aware of suspicious facts and should have investigated further. Primarily, internal lender emails revealed that a senior employee of the lender was puzzled about how the debtor could pledge so much collateral when it had only $2 million to $3 million in capital. The employee wondered whether the debtor had rights to the pledged collateral or whether it was instead held for the benefit of its customers. While the debtor assured the lender that it was permitted to use its customers’ segregated funds as collateral, the Court believed that the assurance was insufficient in the face of such red flags. According to the Court, “the [lender’s] failure to follow this obvious lead was a failure to act on inquiry notice.” Id. at *6.

The implications of the Sentinel decision are significant. To begin with, the inquiry notice standard is very low threshold. As the Court noted, “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.” Id. at *5. Accordingly, a lender has an affirmative obligation to investigate suspicious activity. Moreover, the consequences of failing to exercise appropriate diligence may be catastrophic. Like the lender in Sentinel, a lender may lose its security interest and be left with merely an unsecured claim. If so, ultimate recover may be pennies on the dollar at best. To avoid this result, a lender should implement structured procedures to demonstrate adequate investigation of suspicious activity.