Lending credence to the old adage “if it’s too good to be true, then it probably is,” the Seventh Circuit Court of Appeals recently held that a secured lender was on inquiry notice of possible fraud by its borrower in impermissibly pledging customers’ assets to secure loans. And the penalty was steep—the Court determined the pledge to be a fraudulent transfer to the lender and the lender’s failure to act upon inquiry notice destroyed the lender’s good faith defense. As a result, the lender’s $300 million secured claim was reduced to a near-worthless general unsecured claim. 

In In re Sentinel Management Group, Inc., the debtor, a cash management firm that traded for its customers and on its own account, ran into difficulties during the Great Recession of 2007. At the time of its bankruptcy, the debtor owed its lender $312 million secured by collateral that included customer accounts. The bankruptcy trustee sued to set aside the pledge of the customer accounts as an intentional fraudulent transfer. The lender responded that it had accepted the pledge in “good faith” without any knowledge of the alleged fraud and therefore the pledge could not be avoided.

The Seventh Circuit disagreed, holding that the lender could not have acted in good faith if it was on “inquiry notice” that the pledge was improper. Inquiry notice is “awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing.”

The Court focused on the lender’s internal files, which included the following note from a managing director: “How can they have so much collateral? With less than $20MM in capital I have to assume most of this collateral is for somebody else’s benefit. Do we really have rights on the whole $300MM?” The Court believed that the manger’s suspicion was enough to place the lender on notice of a possible fraud and require investigation. Yet the lender never did. This failure to investigate, which would have uncovered the fraud, emasculated the good faith defense, and the trustee was permitted to avoid the lender’s lien and render the claim unsecured.

The lender gained a bit of a reprieve (Pyrrhic as it may be); however, when the Seventh Circuit refused to equitably subordinate the lender’s unsecured claim to the claims of other unsecured creditors – a result that would have rendered the claim from near-worthless to valueless. The Court recognized that the type of conduct that justifies equitable subordination must be not only “inequitable” but must also be egregious, willful or tantamount to fraud. The record indicated that the lender may have been negligent regarding the uninvestigated suspicion of wrongdoing, but there was no evidence that the lender believed there was a high probability of fraud and deliberately avoided confirming it. Negligent conduct, according to the Seventh Circuit, does not give rise to equitable subordination.

To mix a metaphor: Where there is smoke . . . one cannot bury one’s head in the sand. Lenders should understand that if something does not look proper with respect to a borrower, lenders should investigate to be sure they are not complicit in a wrongdoing. Establishing protocols for running down issues raised by borrower reporting may satisfy the inquiry notice requirement and preserve the good faith defense to fraudulent transfer. Failure to do so could be very costly.